Price Elasticity of Demand

Overheads
How much would your roommate pay
to watch a live fight?
How does Showtime decide how
much to charge for a live fight?
What about Hank and Sons Concrete?
How much should they charge per square foot?
Can ISU raise parking revenue by raising parking fees?
Or will the increase in price drive demand
down so far that revenue falls?
All of these pricing issues revolve around the issue
of how responsive the quantity demanded is to price.
Elasticity is a measure of how responsive
one variable is to changes in another variable?
The Law of Demand
The law of demand states that when
the price of a good rises,
and everything else remains the same,
the quantity of the good demanded will fall.
The real issue is how far it will fall.
Q
D
h(P, Z
D
)
The demand function is given by
Q
D
= quantity demanded
P = price of the good
Z
D
= other factors that affect demand
The inverse demand function is given by
P h
1
(Q
D
, Z
D
)
P g(Q
D
, Z
D
)
To obtain the inverse demand function we
just solve the demand function for P
as a function of Q
Examples
Q
D
= 20 - 2P
2P + Q
D
= 20
2P = 20 - Q
D

P = 10 - 1/2 Q
D

Slope = - 1/2
Examples
Q
D
= 60 - 3P
3P + Q
D
= 60
3P = 60 - Q
D

P = 20 - 1/3 Q
D

Slope = - 1/3
The slope of a demand curve is given by the
change in Q divided by the change in P
One measure of responsiveness is slope
Q
D
h(P, Z
D
)
slope
Q
D
P
For demand
The slope of an inverse demand curve is given by
the change in P divided by the change in Q
P g(Q
D
, Z
D
)
slope
P
Q
D
For inverse demand
Q
D
= 60 - 3P
Examples
Slope = - 1/3
Slope = - 3
P = 20 - 1/3 Q
D

Q
D
= 20 - 2P
Examples
Slope = - 1/2
Slope = - 2
P = 10 - 1/2 Q
D

We can also find slope from tabular data
Q P
0 10
2 9
4 8
6 7
8 6
10 5
Q P

slope
Q
D
P

2
1
2
Q P
0 10
1 9.5
2 9
3 8.5
4 8
5 7.5
6 7
7 6.5
8 6
9 5.5
10 5
11 4.5
12 4
13 3.5
14 3
15 2.5
16 2
17 1.5
18 1
19 0.5
20 0
Demand for Handballs
Q P
0 10
1 9.5
2 9
3 8.5
4 8
5 7.5
6 7
7 6.5
8 6
9 5.5
10 5
11 4.5
12 4
13 3.5
14 3
15 2.5
16 2
17 1.5
18 1
19 0.5
20 0

Demand for Handballs
0
1
2
3
4
5
6
7
8
9
10
11
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
P
r
i
c
e

P
Q P
0 10
1 9.5
2 9
3 8.5
4 8
5 7.5
6 7
7 6.5
8 6
9 5.5
10 5
11 4.5
12 4
13 3.5
14 3
15 2.5
16 2
17 1.5
18 1
19 0.5
20 0

Demand for Handballs
0
1
2
3
4
5
6
7
8
9
10
11
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
P
r
i
c
e

Q
P
Q = 2 - 4 = -2
P = 9 - 8 = 1
slope
P
Q
D

1
2
Problems with slope as a measure of responsiveness
Slope depends on the units of measurement
The same slope can be associated with
very different percentage changes
Examples
Q
D
= 200 - 2P
2P + Q
D
= 200
2P = 200 - Q
D

P = 100 - 1/2 Q
D

slope
P
Q
D

1
2
Q P
0 100
1 99.5
2 99
3 98.5
4 98
5 97.5
6 97
7 96.5
8 96
9 95.5
10 95
11 94.5
12 94
13 93.5
14 93
Consider data on racquets
Let P change from 95 to 96
P = 96 - 95 = 1
Q = 8 - 10 = -2

Q
P

A $1.00 price change when P = $95.00 is tiny
Graphically for racquets
Demand for Racquets
88
90
92
94
96
98
100
102
0 2 4 6 8 10 12 14 16 18
Quantity
P
r
i
c
e

Large % change in Q
Small % change in P
Slope = - 1/2
Graphically for hand balls
Large % change in Q Large % change in P
Slope = - 1/2
Demand for Handballs
0
1
2
3
4
5
6
7
8
9
10
11
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
P
r
i
c
e

P
P = 7 - 6 = 1
Q = 6 - 8 = -2
So slope is not such a good measure
of responsiveness
Instead of slope we use percentage changes
The ratio of the percentage change in one variable
to the percentage change in another variable
is called elasticity

D
%Q
D
%P
Q
D
Q
D
P
P
The Own Price Elasticity of Demand
is given by
There are a number of ways to compute
percentage changes
Initial point method for computing
The Own Price Elasticity of Demand

%Q
D
%P

Q
D
Q
D
P
P
Price Elasticity of Demand
(Initial Point Method)
P Q
6 8
5.5 9
5 10
4.5 11
4 12

(8 10)
8
(6 5)
6

( 8 10)
8
6
(6 5)
Q

P

2
8
6
1

12
8
1.5
Final point method for computing
The Own Price Elasticity of Demand
Price Elasticity of Demand
(Final Point Method)
P Q
6 8
5.5 9
5 10
4.5 11
4 12

( 8 10)
10
(6 5)
5

( 8 10)
10
5
(6 5)
Q

P

2
10
5
1

10
10
1.0

%Q
D
%P

Q
D
Q
D
P
P
The answer is very different
depending on the choice of the
base point
So we usually use
The midpoint method for computing
The Own Price Elasticity of Demand
Q
D
Q
1
Q
0
or Q
0
Q
1
Elasticity of Demand Using the Mid-Point

%Q
D
%P

Q
D
Q
D
P
P
Q
D

1
2
(Q
1
Q
0
)
For Q
D
we use the midpoint of the Qs
Similarly for prices
P P
1
P
0
or P
0
P
1
P
1
2
( P
1
P
0
)
For P we use the midpoint of the Ps

(Q
1
Q
0
)
1
2
( Q
1
Q
0
)
(P
1
P
0
)
1
2
( P
1
P
0
)

(Q
1
Q
0
)
(Q
1
Q
0
)
(P
1
P
0
)
( P
1
P
0
)

%Q
D
%P

Q
D
Q
D
P
P
Price Elasticity of Demand
(Mid-Point Method)
Q P
8 6
9 5.5
10 5
11 4.5
12 4

(Q
1
Q
0
)
(P
1
P
0
)
(P
1
P
0
)
(Q
1
Q
0
)

(Q
1
Q
0
)
(Q
1
Q
0
)
(P
1
P
0
)
(P
1
P
0
)

%Q
D
%P

Q
D
Q
D
P
P

(8 10)
(6 5)
(6 5)
(8 10)

(2)
(1)
(11)
(18)

22
18

11
9
Classification of the elasticity of demand
Inelastic demand
When the numerical value of the elasticity of demand
is between 0 and -1.0, we say that demand is inelastic.

%Q
D
%P
< 1
%Q
D
< %P
Classification of the elasticity of demand
Elastic demand
When the numerical value of the elasticity of demand
is less than -1.0, we say that demand is elastic.

%Q
D
%P
> 1
%Q
D
> %P
Classification of the elasticity of demand
Unitary elastic demand
When the numerical value of the elasticity of demand
is equal to -1.0, we say that demand is unitary elastic.

%Q
D
%P
1
%Q
D
%P
Classification of the elasticity of demand
Perfectly elastic -
D
= -

Perfectly inelastic -
D
= 0

horizontal
vertical
Elasticity of demand with linear demand
Consider a linear inverse demand function
P A BQ
D
P 12 0.5Q
D
The slope is (-B) for all values of P and Q
For example,
The slope is -0.5 = - 1/2
P Q
12 0
11.5 1
11 2
10.5 3
10 4
9.5 5
9 6
8.5 7
8 8
7.5 9
7 10
6.5 11
6 12
5.5 13
5 14
4.5 15
4 16
3.5 17
3 18
Demand for Diskettes
0
1
2
3
4
5
6
7
8
9
10
11
12
13
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
P
r
i
c
e

Q
D
P
2.0

P Q

P Q

Q
P
(P
1
P
0
)
(Q
1
Q
0
)

%Q
D
%P

Q
D
Q
D
P
P

(8 10)
(8 7)
(8 7)
(8 10)

(2)
(1)
(15)
(18)

30
18

5
3
The slope is constant but the
elasticity of demand will vary
P Q
12 0
11.5 1
11 2
10.5 3
10 4
9.5 5
9 6
8.5 7
8 8
7.5 9
7 10
6.5 11
6 12
5.5 13
5 14
4.5 15
4 16
3.5 17
3 18

P Q

%Q
D
%P

Q
D
Q
D
P
P

(14 16)
(5 4)
(5 4)
(14 16)

(2)
(1)
(9)
(30)

18
30

3
5
The slope is constant but the
elasticity of demand will vary
P Q
12 0
11.5 1
11 2
10.5 3
10 4
9.5 5
9 6
8.5 7
8 8
7.5 9
7 10
6.5 11
6 12
5.5 13
5 14
4.5 15
4 16
3.5 17
3 18

P Q

Q
P
(P
1
P
0
)
(Q
1
Q
0
)
The slope is constant but the
elasticity of demand will vary
A linear demand curve becomes more inelastic
as we lower price and increase quantity

%Q
D
%P

Q
P
(P
1
P
0
)
(Q
1
Q
0
)
P smaller
Q larger
The elasticity gets closer to zero
Q P Elasticity Expenditure
0 12 0
2 11 -23.0000 22
4 10 -7.0000 40
6 9 -3.8000 54
8 8 -2.4286 64
10 7 -1.6667 70
12 6 -1.1818 72
14 5 -0.8462 70
16 4 -0.6000 64
18 3 -0.4118 54
20 2 -0.2632 40
22 1 -0.1429 22
24 0 -0.0435 0
The slope is constant but the
elasticity of demand will vary
Q P Elasticity Expenditure
0 12 0
2 11 -23.0000 22
4 10 -7.0000 40
6 9 -3.8000 54
8 8 -2.4286 64
10 7 -1.6667 70
12 6 -1.1818 72
14 5 -0.8462 70
16 4 -0.6000 64
18 3 -0.4118 54
20 2 -0.2632 40
22 1 -0.1429 22
24 0 -0.0435 0
The slope is constant but the
elasticity of demand will vary
Note
We do not say that demand is elastic
or inelastic ..
We say that demand is elastic or
inelastic at a given point

%Q
D
%P

Q
D
Q
D
P
P

Q
P
(P
1
P
0
)
(Q
1
Q
0
)
Example
Constant with linear demand
The Own Price Elasticity of Demand
and Total Expenditure on an Item
How do changes in an items price affect
expenditure on the item?
If I lower the price of a product, will the increased
sales make up for the lower price per unit?
Expenditure for the consumer
is equal to revenue for the firm
Revenue = R = price x quantity = PQ
Expenditure = E = price x quantity = PQ
P = change in price
Modeling changes in price and quantity
Q = change in quantity
The Law of Demand says that
as P increases Q will decrease
P Q
P = initial price
P = change in price
So
P + P = final price
Q = initial quantity
Q = change in quantity
Q + Q = final quantity
Initial Revenue = PQ
So
P + P = final price
= P Q + P Q + P Q + P Q
Q + Q = final quantity
Final Revenue = (P + P) (Q + Q)
Now find the change in revenue
R = final revenue - initial revenue
= P Q + P Q + P Q + P Q - P Q
= P Q + P Q + P Q
%R = R / R = R / P Q
R
PQ

P Q P Q P Q
PQ
R
PQ

P Q
PQ

PQ
PQ

P Q
PQ
We can rewrite this expression as follows
%R
P
P

Q
Q

P Q
PQ
%R %P %Q
Classification of the elasticity of demand
Inelastic demand

%Q
D
%P
< 1
%Q
D
< %P
%R %P %Q
% Q and % P are of opposite sign so
%R has the same sign as %P
+
-
Classification of the elasticity of demand
Inelastic demand

%Q
D
%P
< 1
%Q
D
< %P
%R %P %Q
% Q and % P are of opposite sign so
%R has the same sign as %P
-
+
Lower price lower revenue
Higher price higher revenue
Classification of the elasticity of demand
Elastic demand

%Q
D
%P
> 1
%Q
D
> %P
%R %P %Q
% Q and % P are of opposite sign so
%R has the opposite sign as %P
Higher price lower revenue
Lower price higher revenue
+
-
Classification of the elasticity of demand
Unitary elastic demand

%Q
D
%P
1
%Q
D
%P
%R %P %Q
% Q and % P are of opposite sign so their
effects will cancel out and %R = 0.
+
-
Q P Elasticity Revenue
0 12 0
2 11 -23.0000 22
4 10 -7.0000 40
6 9 -3.8000 54
8 8 -2.4286 64
10 7 -1.6667 70
12 6 -1.1818 72
14 5 -0.8462 70
16 4 -0.6000 64
18 3 -0.4118 54
20 2 -0.2632 40
22 1 -0.1429 22
24 0 -0.0435 0
Tabular data
Elastic
Inelastic
Revenue falls
Price falls
Price falls
0 12 0
2 11 -23.0000 22
4 10 -7.0000 40
6 9 -3.8000 54
8 8 -2.4286 64
10 7 -1.6667 70
12 6 -1.1818 72
14 5 -0.8462 70
16 4 -0.6000 64
18 3 -0.4118 54
20 2 -0.2632 40
22 1 -0.1429 22
24 0 -0.0435 0
Graphical analysis
Q P Elasticity Revenue
Demand for Diskettes
0
1
2
3
4
5
6
7
8
9
10
11
12
13
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
P
r
i
c
e

Demand
A
B
C
P0, Q0
P1, Q1
Lose B, gain A, revenue rises
0 12 0
2 11 -23.0000 22
4 10 -7.0000 40
6 9 -3.8000 54
8 8 -2.4286 64
10 7 -1.6667 70
12 6 -1.1818 72
14 5 -0.8462 70
16 4 -0.6000 64
18 3 -0.4118 54
20 2 -0.2632 40
22 1 -0.1429 22
24 0 -0.0435 0
Graphical analysis
Q P Elasticity Revenue
Demand for Diskettes
0
1
2
3
4
5
6
7
8
9
10
11
12
13
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
P
r
i
c
e

Demand
P1, Q1
Lose A, gain B, revenue falls
P0, Q0
A
B
Factors affecting the elasticity of demand
Availability of substitutes
Importance of item in the buyers budget
Availability of substitutes
The easier it is to substitute for a good,
the more elastic the demand
With many substitutes, individuals will
move away from a good whose price increases
Examples of goods with easy substitution
Gasoline at different stores
Soft drinks
Detergent
Airline tickets
Local telephone service
Narrow definition of product
The more narrowly we define an item,
the more elastic the demand
With a narrow definition, there will lots of
substitutes
Examples of narrowly defined goods
Lemon-lime drinks
Corn at a specific farmers market
Vanilla ice cream
Food
Transportation
Necessities tend to have inelastic demand
Necessities tend to have few substitutes
Examples of necessities
Salt
Insulin
Food
Trips to Hawaii
Sailboats
Demand is more elastic in the long-run
There is more time to adjust in the long run
Examples of short and long run elasticity
Postal rates
Gasoline
Sweeteners
Factors affecting the elasticity of demand
Importance of item in the buyers budget
The more of their total budget consumers
spend on an item,
the more elastic the demand for the good
The elasticity is larger because the item has
a large budget impact
Big ticket items and elasticity
Housing
Big summer vacations
Table salt
College tuition
The End