ECONOMICS TOPIC 3 LESSON 3

ECONOMICS TOPIC 3 LESSON 3

Elasticity of Demand

ESSENTIAL QUESTION

How do we affect the economy?

Elasticity Defined

economists have developed a way to calculate just how strongly people react to a change in price. Several factors—including the original price and how much you want or need a particular good— will determine your demand for that product.

The Concept of Elasticity

Economists describe the way that consumers respond to price changes as elasticity of demand. Elasticity of demand measures how drastically buyers will cut back or increase their demand for a good when the price rises or falls, respectively. 

The Concept of Elasticity

If you buy the same amount or just a little less of a good after a large price increase, your demand is inelastic, or relatively unresponsive to price changes. If you buy much less of a good after a small price increase, your demand is elastic.

Open Ended

Gasoline is a good many people continue to buy even when the price rises. Analyze Political Cartoons What does this cartoon suggest about the challenge consumers face when gas prices rise?

How Elasticity Is Calculated

In order to calculate elasticity of demand, take the percentage change in the quantity of the good demanded, and divide this number by the percentage change in the price of the good. The result is the elasticity of demand for the good.

Open Ended

Economists use the steps shown here to calculate elasticity of demand. Generate Explanations Why do you think observers may want to be able to measure elasticity precisely?

Price Range

The elasticity of demand for a good varies at every price level. Demand for a good can be highly elastic at one price and inelastic at a different price. 

Open Ended

The formula for measuring elasticity is the same for price increases and decreases. Make Generalizations How do demand curves for elastic demand differ from curves for inelastic demand?

Elasticity Values

the terms inelastic and elastic  describe consumers’ responses to price changes—including increases and decreases. These terms have precise mathematical definitions. If the elasticity of demand for a good at a certain price is less than 1, we describe demand as inelastic. If the elasticity is greater than 1, demand is elastic. If elasticity is exactly equal to 1, we describe demand as unitary elastic.

Multiple Choice

This chart analyzes the elasticity of Ashley’s demand for pizza. Apply Concepts How would you describe Ashley’s response to a small price increase?

• elastic

• inelastic

• unitary elastic

Multiple Choice

Distinguish Describe your demand for a product if you buy the same amount of it or just a small amount less after a large price increase.

• elastic

• unitary elastic

• inelastic

• hyperelastic

Factors Affecting Elasticity

Several different factors, including several non-price determinants, can affect a person’s elasticity of demand for a specific good.

Availability of Substitutes

If there are few substitutes for a good, then even when its price rises greatly, you might still buy it. You believe you have no good alternatives.

Open Ended

Elasticity of demand varies from situation to situation. Analyze Charts Why do you think demand is inelastic for the two items on the left side of the continuum?

Relative Importance

A second factor in determining a good’s elasticity of demand is how much of your budget you spend on the good. If you already spend a large share of your income on a good, a price increase will force you to make some tough choices. 

Necessities Versus Luxuries

The third factor in determining a good’s elasticity varies a great deal from person to person, but it is nonetheless important. Whether a person considers a good to be a necessity or a luxury has a great impact on a person’s elasticity of demand for that good. 

Change Over Time

When a price changes, consumers often need time to change their spending habits. Consumers do not always react quickly to a price increase, because it takes time to find substitutes. 

Multiple Choice

Identify Central Ideas Which of the following is an example of inelastic demand?

• Jason wants the most expensive cellphone. He decides to get a cheaper model.

• Priya wants to go to the season-opening game. Tickets to another game cost less, but she still buys tickets for the opener.

• Tianna wants to try out a new, expensive restaurant. She goes to another restaurant whose food is excellent and costs less.

• Shawn wants to buy a house in one neighborhood. But after searching, he decides to buy a house elsewhere instead.

How Elasticity Affects Revenue

Elasticity is important to the study of economics because elasticity helps us measure how consumers respond to price changes for different products. Elasticity is also an important tool for business planners, like the pizzeria owner described earlier in this topic. The elasticity of demand determines how a change in prices will affect a firm’s total revenue, or income.

Total Revenue

A company’s total revenue is defined as the amount of money the company receives by selling its goods. This is determined by two factors: the price of the goods and the quantity sold.

Total Revenue and Elastic Demand

The law of demand tells us that an increase in price will decrease the quantity demanded. When a good has an elastic demand, raising the price of each unit sold by 20 percent will decrease the quantity sold by a larger percentage, say 50 percent. The quantity sold will drop enough to actually reduce the firm’s total revenue.

Open Ended

Achieving higher revenue means finding the best combination of price and quantity demanded. Analyze Charts Why does revenue for this restaurant fall when price increases from $4 to $5?

Total Revenue and Inelastic Demand

Remember that if demand is inelastic, consumers’ demand is not very responsive to price changes. When demand is inelastic, price and total revenue move in the same direction: An increase in price raises total revenue, and a decrease in price reduces total revenue.

Open Ended

The relationship between price change and revenue differs depending on elasticity of demand. Analyze Charts In which two situations will revenue likely fall in response to a price change?

How Elasticity Affects Pricing Policies

Because of these relationships, a firm needs to know whether the demand for its product is elastic or inelastic at a given price. This knowledge helps the firm make pricing decisions that lead to the greatest revenue.

If a firm knows that the demand for its product is elastic at the current price, it knows that an increase in price might reduce total revenues.

Multiple Choice

Identify Central Issues How does elasticity affect potential revenue for a firm?

• If demand for a good is inelastic, lowering the price could raise revenue.

• If demand for a good is inelastic, raising the price could reduce revenue.

• If demand for a good is elastic, raising the price must increase revenue.

• If demand for a good is elastic, raising the price could reduce revenue.

Open Ended

How do we affect the economy?