In this lecture we will be discussing a concept
called price elasticity and we’ll take a
look at how it can help us understand future
concepts in this course.
The syllabus includes various elasticities
of demand, and the price elasticity of supply.
Let’s start by examining the concept of
price elasticity of demand.
Price elasticity of demand is essentially
a unit-free way to measure the responsiveness
of the quantity demanded of any good to a
change in its price, assuming that everything
else remains constant.
I’ll explain why the unit free part of the
definition is so important a little later
on.
We calculate price elasticity of demand by
dividing the percent change in quantity of
a good by the percent change in price of that
good.
I would like to note that in introductory
microeconomics, we need to observe a change
in the price and/or quantity demanded to be
able to calculate the price elasticity of
demand.
To calculate the percent change in quantity
demanded, we’re going to subtract the old
quantity from the new quantity, or Q2 minus
Q1.
We’re going to divide that by the average
of the two quantities.
This may be a bit confusing, and to be honest,
I don’t find it super intuitive either,
but this is the way it’s taught so, do what
you will with that.
We’ll perform a similar calculation for
the change in price.
P2 minus P1 over the average price.
We then divide the answer we got in the first
part by the answer we got in the second part,
and we get an answer for the price elasticity
of demand.
I would like to note, however, that for all
of the situations you will encounter in your
introductory microeconomics course, the price
elasticity of demand will be negative.
Normally we just drop the negative sign and
take the absolute value of the price elasticity
of demand to perform any analysis.
At this point you might be asking yourself
a couple of questions.
Hopefully this slide can clear some of them
up.
So we just learned that in order to calculate
price elasticity of demand, we use average
prices and average quantities.
We do this because it gives us the price elasticity
of demand at the midpoint between the two
prices and quantities.
It’s just for accuracy purposes.
We use percentage changes to calculate the
price elasticity of demand because we want
to get rid of all of the units, and the easiest
way to do that is to divide a percentage by
another percentage.
We want to get rid of units in elasticity
because this way we can compare elasticities
between different goods.
Imagine trying to compare a change in the
quantity of coconuts to a change in the quantity
of iPhones.
It really doesn’t give you a whole lot of
information.
By getting rid of units, we’re able to extract
a bit more data out of our numbers.
The value we get for the elasticity of demand
is almost always negative.
It makes sense, because we know that price
and quantity are inversely related.
Basically, if we decrease price, we expect
an increase in quantity, and vice versa.
Therefore, one of the percentages in our calculation
will always be negative, thus rendering the
elasticity value negative.
If we end up with an absolute value of elasticity
of demand that is less than 1, we say that
demand is inelastic.
If we think back to the way we calculated
it, it means that a change in price brings
about a proportionately smaller change in
quantity demanded.
Think about goods such as insulin, which are
necessary for certain people to survive.
A change in price would not bring about that
much of a change in the quantity demanded
because it is a necessity.
A good’s elasticity of demand can also change
based on the way we categorize it.
If we try to look at the elasticity of demand
of food, then it would be extremely inelastic.
However, if we go into a subcategory of food
and look at a specific type of food, such
as apples, then we would see an increase in
the elasticity of demand.
This is because apples have more substitutes
than the broad category of food.
There is a special case where the elasticity
of demand might equal zero.
In other words, the quantity demanded of a
good doesn’t respond to changes in price
at all.
Consider a good such as oil.
If the price drastically changes on one day,
then in the short-run the quantity demanded
of oil wouldn’t change.
We don’t have any alternative means of transportation
or production of goods and services readily
available.
Therefore, in the short-run, the elasticity
of demand of oil might even be perfectly inelastic.
Unit elastic demand just means that a change
in price induces a proportionate change in
quantity demanded.
If the percent change in price equals the
percent change in quantity demanded, then
the elasticity of demand would equal 1.
If the price elasticity of demand is greater
than 1, the good is said to be elastic.
In other words, the good’s quantity demanded
is very responsive to a change in prices.
This is often something we see with goods
that are not necessities.
Going back to the subject of categorization,
if we talk about very specific goods, then
the elasticity of demand tends to be a lot
more elastic.
For example, if we talk about red apples from
a particular brand, the elasticity of demand
would be much more elastic than if we were
to talk about fruits in general.
Just like with the case of perfectly inelastic
demand, there is an extreme on the other end
of the spectrum as well.
If the elasticity of demand turns out to be
infinite, then we say that the good is perfectly
elastic.
Essentially, a small change in price brings
about an infinite change in the quantity demanded
of the good.
I briefly touched on a few factors that can
affect the elasticity of demand, but I will
go over them formally one more time.
If a good has a lot of close substitutes,
then its elasticity of demand will be much
higher.
It will be an elastic good.
On the other hand, if it does not have many
close substitutes, it will be an inelastic
good.
Another factor is the proportion of income
spent on the good.
If a high proportion of income is spent on
that good, then it will be a fairly elastic
good.
If a low proportion of income is spent on
a good, then it will be a fairly inelastic
good.
Lastly, the time elapsed since the price change
is another important factor.
This has to do with the time that the market
has to find substitutes for the good.
Back to our oil example, if the price of oil
rises, then in the short-run we don’t really
have any feasible alternatives to turn to.
However, if the price of oil continues to
rise year over year, people might switch over
to electric cars.
Therefore, in the long-run, the quantity demanded
of oil would fall, but in the short-run it
would not.
An important distinction that needs to be
made is the fact that the price elasticity
of demand of a good is not the same thing
as the slope of its demand curve.
It really depends on which part of the good’s
demand curve we are examining, because elasticity
changes over different quantities and prices.
On a linear demand curve, the midpoint on
the demand curve will be where the elasticity
of demand is equal to 1, or the good is unit
elastic.
On the top half of the curve, the good is
considered to be elastic, and on the bottom
half of the curve the good is considered to
be inelastic.
The concept of elasticity can be helpful to
firms who might be considering pricing strategies.
If they know that the elasticity of demand
for their good is elastic, then they can infer
that a change in price would bring about a
greater change in the quantity demanded.
Thus, if they reduce price, their revenues
would increase.
However, if they increase the price, then
their revenues would decrease.
Similarly, if a firm knows that the elasticity
of demand for the good that it is selling
is inelastic, then it won’t earn any more
revenues by decreasing the price of the good,
since a decrease in price brings about a proportionally
less increase in quantity demanded.
Thus, it could increase the price of the good
in order to increase revenues.
Maximum revenues occur at the point where
the elasticity of demand of the good is equal
to 1, or where the good is unit elastic.
