2.6. Elasticity of Demand

The demand for a good moves in the opposite direction of its price. But the impact of the price change is always not the same. Sometimes, the demand for a good changes considerably even for small price changes. On the other hand, there are some goods for which the demand is not affected much by price changes.

This chunk introduces the concept of price elasticity of demand, which measures how responsive the quantity demanded of a good is to a change in its price. It establishes that while demand typically decreases as price increases (and vice versa), the extent of this change can vary significantly. Some goods might see a large drop in demand with a slight price increase, while others may experience little to no change.

Consider snacks like chips versus a life-saving medication. If the price of chips goes up by 10%, many people might buy significantly fewer chips because they can easily go without or find cheaper alternatives. However, if the price of a life-saving medication increases, patients may be forced to make sacrifices but will likely still purchase it because it is essential for their health.

Price elasticity of demand is a measure of the responsiveness of the demand for a good to changes in its price. Price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price.

Price elasticity of demand quantifies how much the quantity demanded changes in response to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. This provides a numerical value that indicates whether demand is elastic, inelastic, or unitary elastic based on its sensitivity to price changes.

Imagine a local coffee shop. If the price of a cup of coffee rises by 20%, and as a result, customers reduce their consumption from 100 cups to 80 cups per day, we can calculate the price elasticity of demand. The resulting percentage changes might show that demand is elastic if the drop in quantity demanded is significant compared to the price increase.

When the percentage change in quantity demanded is less than the percentage change in market price, the demand for the good is said to be inelastic. When the percentage change in quantity demanded is more than the percentage change in market price, the demand is said to be elastic. When the percentage change in quantity demanded equals the percentage change in its market price, the demand for the good is said to be unitary-elastic.

Demand can be categorized into three types based on elasticity: inelastic (demand changes less than price), elastic (demand changes more than price), and unitary elastic (demand changes exactly as much as price). These concepts help understand consumer behavior and market dynamics as they indicate how sensitive consumers are to price changes.

Think of a luxury car versus basic groceries. An increase in the price of a luxury car might lead to a significant drop in sales (elastic demand), while people might still buy groceries regardless of a small price increase (inelastic demand) because they need them regardless of price. If the price of a subway ticket increases, and the quantity demanded remains constant, it reflects unitary elasticity.

The elasticity of demand is different at different points on a linear demand curve. At price equal to zero, the elasticity is zero, at quantity equal to zero, elasticity is infinite.

On a linear demand curve, the elasticity of demand changes depending on the price level. Near the top of the curve (high prices), demand tends to be inelastic, and near the bottom (low prices), it can be more elastic. This variation signifies that different price points yield different elasticity values, which is essential for businesses to determine optimal pricing strategies.

Consider the price of concert tickets. When tickets are priced high, a few die-hard fans might still buy them, showing inelastic behavior. However, if ticket prices drop significantly, a larger audience is willing to buy tickets, showing elastic behavior. Understanding this allows event organizers to maximize revenue.

The price elasticity of demand for a good depends on the nature of the good and the availability of close substitutes of the good. Demand for necessities tends to be inelastic whereas demand for luxuries is more elastic.

Several factors determine how elastic the demand for a product is: the necessity of the product, availability of substitutes, percentage of income spent on the good, and time period considered. Necessities tend to have inelastic demand, while luxuries, with many alternatives, tend to have elastic demand.

Take sugar as a necessity and gourmet chocolates as a luxury. If the price of sugar increases, people will still need to buy it, demonstrating inelastic demand. On the other hand, if gourmet chocolates become too expensive, consumers might skip them altogether or switch to different treats, highlighting more elastic demand behavior.

Expenditure on a good is equal to the demand for the good times its price. Whether expenditure on the good goes up or down as a result of an increase in its price depends on how responsive the demand for the good is to the price change.

The relationship between price changes and total expenditure depends on the elasticity of demand. If demand is elastic, an increase in price leads to a decrease in total revenue (expenditure). Conversely, if demand is inelastic, an increase in price can lead to increased revenue. This is crucial for businesses setting their pricing strategies.

Think about cinema tickets. If ticket prices rise but attendance drops significantly, the total revenue may fall if demand is elastic. However, if people largely continue attending films despite price hikes (inelastic demand), the cinema can benefit from higher prices without losing many customers.

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