Definition:
Law of demand tells us that consumers will respond to a price drop by buying
more, but it does not tell us how much more. The degree of sensitivity of
consumers to a change in price is measured by the concept of price
elasticity of demand.
Price elasticity formula: Ed = percentage change in
Qd / percentage change in Price.
If the percentage change is not given in a problem, it can be computed
using the following formula:
Percentage change in Qd = (Q1-Q2) / [1/2 (Q1+Q2)]
where Q1 = initial Qd, and Q2 = new Qd.
Percentage change in P = (P1-P2) / [1/2 (P1 + P2)]
where P1 = initial Price, and P2 = New Price.
Putting the two above equations together:
Ed = {(Q1-Q2) / [1/2
(Q1+Q2)] } /
{(P1-P2) / [1/2 (P1 + P2)]}
Because of the inverse relationship between Qd and Price, the Ed
coefficient will always be a negative number. But, we focus on the magnitude
of the the change by neglecting the minus sign and use absolute value
Examples:
1. If the price of Product A increased by 10%, the quantity demanded
decreased by 20%. Then the coefficient for price elasticity of the demand
of Product A is:
Ed = percentage change in Qd / percentage change in
Price = (20%) / (10%) = 2
2. If the quantity demanded of Product B has decreased from 1000 units to
900 units as price increased from $2 to $4 per unit, the coefficient for Ed
is:
Ed = {(Q1-Q2) / [1/2
(Q1+Q2)] } /
{(P1-P2) / [1/2 (P1 + P2)]} =
{(1000 - 900) / 1/2(1000 + 900)}
/ {(2 - 4) / 1/2 (2+4)}
= - 0.16
Take the absolute value of - 0.16, Ed = 0.16
Characteristics:
Ed approaches infinity, demand is perfectly elastic. Consumers are very
sensitive to price change.
Ed > 1, demand is elastic. Consumers are relatively responsive to price
changes.
Ed = 1, demand is unit elastic. Consumers’ response and price change are
in same proportion.
Ed < 1, demand is inelastic. Consumers are relatively unresponsive to
price changes.
Ed approaches 0, demand is perfectly inelastic. Consumers are very
insensitive to price change.
Ed is usually greater in the higher price range than in lower price
range. Demand is more elastic in upper left portion of the demand curve than
in the lower right portion of the curve. However, it is impossible to judge
elasticity of a demand curve by its flatness or steepness. Along a linear
demand curve, its elasticity changes. This relationship is demonstrated in
the following example:
