Essay About Price Elasticity Of Demand And Price Changes

Elasticity of Demand and Supply
Elasticity of Demand and Supply
PRINCIPLES OF MICROECONOMICS—Notes
ECO101—
Elasticity of Demand and Supply
Overview
In this chapter, we will examine the
price elasticity of demand
—a crucial concept in economics as it has direct
connection with business revenues—(and to a lesser extent
cross elasticity,
income elasticity, and elasticity of
supply
), and illustrate how to use this concept to specific situations, such as the pricing of airline tickets for first
class or economy, bad harvests (for instance coffee or orange frost) and its impact on prices, or the imposition
of excise taxes on cigarettes or alcohol. We will also make the distinction between long-run and short-run price
elasticity.
Price Elasticity of Demand
All sellers (small or large, educated or street-wise) know very well the law of demand—that there is an inverse
relationship between price and quantity demanded. They know that if they lower their prices—
ceteris paribus
or other things being the same—most probably their sales will increase, and vice-versa. The critical question is:
Is it enough for a businessperson to know simply in which direction quantity would change as a result of a
change in price?
The answer is that it is not enough! They also need to know by
how much
. They need to know, in other words,
responsiveness
(or sensitivity) of sales (quantity demanded) to price changes. The reason is that for the
businessperson, what is important is the impact of prices changes on total revenue.
In order to measure this responsiveness of quantity to price changes—and ultimately the impact on total
revenue—economists have devised the concept of
elasticity.
It is defined as:
Price elasticity = (% change in quantity) / (% change in price) = % Q / % P
(where stands for “change in”)
To find the percentage change in quantity (or price) we divide the change in quantity (or price) by the level of
quantity (or price): i.e, Q / Q (for quantity) and P / P (for price). We can therefore rewrite the expression for
price elasticity as:
= ( Q / Q)
( P / P) or E
= ( Q / P) X (P / Q)
Calculating Elasticity
Looking at the graph below lets see how we calculate elasticity. Lets take for instance the case of moving from
point A to point B. The percentage (or proportionate) change in quantity (from 2 unit to 4 units) is 100%. Thus
the value of the numerator in the elasticity expression is 100. The percentage change in price (from £5 to £4) is
-20%, thus the value of the denominator is 20.
Therefore, the price elasticity is:
100 / -20 = -5
Note that since price and quantity move in opposite direction for the majority of goods (normal goods), the
value of price elasticity of demand usually has a negative value—since either the denominator or the numerator
would have a negative value.
A result of greater than 1 denotes a
price