The Price-Elasticity Coefficient and Formula:

• Price elasticity of demand = consumers' responsiveness/sensitivity to a product's price change
  • A product is elastic if a small change in its price elicits very large changes in the quantity demanded.
  • • Movement on the demand curve
      ex. products that are not required in people's daily lives are often elastic products. (not necessity but luxury)
  • A product is inelastic if a big price change elicits very little influence on the quantity demanded.
    • Minimal movement on the demand curve
    • ex. products that are required in people's daily lives are often inelastic products. (not luxury but necessity)
  It is important to keep in mind that elasticity involves percentage change in price and quantity demanded; not absolute change.

Midpoint Formula for calculating elasticity:

• We use the formula in computing the price-elasticity coefficient.
  • Ex: A change of $4-$5 along a demand curve is a 25% increase, but the opposite price change from $5-$4 along the same curve is a 20% decrease. Since elasticity should be the same whether price rises or falls, the midpoint formula is needed.
• This formula simply averages the two prices and the two quantities as the reference points for computing the percentages.
  • Ex: the reference point for the $5-$4 and $4-$5 price range is $4.50.
• Eliminates the "up vs. down" problem

• Drop the negative sign.

• Ed = Change in quantity ÷ Change in price

• (Sum of quantities/2) (Sum of prices/2)
  

Interpretations of Ed:

• Elastic: Ed> 1 ; When % change in price elicits a larger % change than from change in quantity demanded
• When price increase 20%, quantity demand decrease more than 20%
  
• Inelastic: Ed < 1 ; When % change in price elicits a smaller % change than % change from quantity demanded
• When price increase 20%, quantity demand decrease less than 20%
• Unit elasticity: Ed = 1 ; When % change in price will cause the exact same % change in quantity demanded; i.e. % change in quantity demanded = % change in price.
• Perfectly Inelastic: If a price change creates no change at all in quantity demanded.
  • Ed= 0, change in price is irrelevant to demand.
  • Graph: Demand line = parallel to the vertical axis.
  • Example: Insulin for diabetes; insulin is essential for diabetics to live, therefore, if the price increases by any amount they still have to buy it.
• Perfectly Elastic:
• Ed= Infinite; a small price reduction causes buyers to change purchases from zero to all they can get.
• Graph: Demand line = parallel to the horizontal axis.
• Example: Gift certificates; if gift certificates that are worth $100 are being sold for $90 people will buy as much as they can because they are getting a free $10.
  
• 

The Total-Revenue Test:

• Total Revenue = Total amount a seller receives for a product during a certain time period.
  • TR = Price x Quantity demanded and sold
    
  Total revenue and price elasticity of demand are related (see below) .

Price Elasticity and the Total-Revenue Curve:

• Elastic (Ed>1)	Price ↑; TR ↓ Price ↓; TR ↑ [Price and revenue move in opposite directions]	Percentage of quantity demanded is larger than percentage on change of price
  Inelastic (Ed<1)	Price ↑; TR ↑ Price ↓; TR ↓ [Price and revenue move in same direction]	Percentage of the average quantity demanded is smaller than percentage of the average price
  Unitary (Ed=1)	Price ↑; TR unchanged Price ↓; TR unchanged	Percentage of the average quantity demand = percentage of average price

  

• Price Elasticity along a Linear Demand Curve: elasticity varies in different price ranges of the same demand curve.

Determinants of Price Elasticity of Demand:
(remember SPLAT!)

1. Substitutability: Direct relationship between the number of substitute goods of a product and the elasticity of the product

# of substitutes up = elasticity up
# of substitutes down= elasticity down

(ex): If Reebok running shoes are the only choice of running shoes available, its number of substitutes is low and people would not be very sensitive towards its price changes because they need running shoes anyway. Hence, elasticity goes down.
If other companies such as Nike and Adidas start to manufacture running shoes as well, the number of substitutes would go up and if Reebok still increases its prices, people would buy the substitutes instead. Hence, elasticity goes up.

2. Proportion of Income: If other things are equal, there's a direct relationship between the price of good relative to income and the elasticity of demand of the good.
The higher the price of a good relative to consumer's incomes, the greater the price elasticity of demand.

(ex) Price of toothpaste up by 10% = few dollars extra. Consumers will still buy the toothpaste since its still relatively cheap.
Price of sports car up by 10% = few thousand dollars extra. Consumers will react sharply to the price increase because the original price of the good is already so high.

3. Luxuries vs. Necessities:
Necessities = inelastic, we NEED it no matter what price; ex: food
Luxuries = elastic, we can do without it; ex: Designer handbag

4. Addictiveness: If the product is very addictive (i.e. cigarettes) people will continue to buy the product regardless of price

5. Time: Basically,
Short time (Less durable) to consider whether to buy a product = inelastic. No time to adjust to price change
Long time ( durable) to consider whether to buy a product = elastic. Plenty of time creates consumer sensitivity


Applications of Price Elasticity of Demand:

• Large crop yields:

• Demands for a majority of farm products are mostly inelastic, with Ed around 0.20 or 0.25.
• An increase in output of farm products causes a decrease in their prices and the incomes of farmers.
  • Therefore, farmers find large crop yields undesirable

Excise Taxes:
• • The government focuses on products with high Ed
    • If products with high elasticity are greatly affected by taxes enforced by the government, total revenue of these products will decrease and affect the market greatly.
    • Higher taxes on elastic products are therefore undesirable.
• Decriminalization of Illegal Drugs:
  • Debates have been going on about whether or not drugs should be legalized, like alcohol and cigarettes. Many are now saying that the government is losing too much money on the war against drugs: the need for more prison cells, a larger police force and the increasing number of people dying. If drugs are legalized, the government could gain some money through taxes.
  • Some argue that drugs are more elastic than people think. Besides the portion of consumers that are inelastic, there are also some people who are "occasional users" and can abstain from or substitute drugs with other things such as alcohol.