Price Elasticity ofDemand and Supply

©2006 South-Western College Publishing

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What is elasticity?

A term economists use to describe responsiveness, or sensitivity, to a change in price

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What is priceelasticity of demand? The ratio of the percentage change in the quantity demanded of a product to a percentage change in its price

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% in Q demanded% in priceEd =

Price Elasticity of Demand

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How is the percent increase or decrease

of two numbers calculated?

Percent change is the difference between the two numbers divided by the original number

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New - Old --------------- x 100%

Old

Ranges of Elasticity

Inelastic Demand Quantity demanded does not respond

strongly to price changes.

Elastic Demand Quantity demanded responds strongly to

changes in price.

Elasticity and Total Revenue

Total revenue is the amount paid by buyers and received by sellers of a good.

Computed as the price of the good times the quantity sold.

TR = P x Q

Elasticity and Total Revenue: Inelastic Demand

$3

Quantity0

Price

80

Revenue = $240

Demand$1 Demand

Quantity0

Revenue = $100

100

Price

An increase in price from $1 to $3...

…leads to an increase in total revenue

from$100 to $240

Elasticity and Total Revenue: Elastic Demand

Demand

Quantity0

Price

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

Revenue = $200

An increase in price from $4 to $5...

…leads to a decrease in total revenue

from$200 to $100

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Price increase

Decrease in total revenue

Elastic Demand

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Price increase

Increase in total revenue

Inelastic Demand

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Price increase

No change in total revenue

Unitary Elastic Demand

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If demand is elastic - total revenue goes down

If demand is inelastic - total revenue goes up

If a college raises tuition, what happens

to revenue?

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Coke and Pepsi are close substitutes, and the demand for each is relatively elastic. What strategies do Coca-Cola (http://cocacola.com/) and Pepsi (http://pepsi.com/) use to make the demand for their products less elastic?

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What do substitutes have to do with a

price change?The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve

Taxes

Governments levy taxes to raise revenue for public

projects.

What was the impact of tax?

Taxes discourage market activity.

When a good is taxed, the quantity sold is smaller.

Buyers and sellers share the tax burden.

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The Tax Wedge

Quantity ofPizzas

0

Price

Price without

tax

Pizza demand

Pizza supply

Tax wedge

Price we pay

Amount producers

receive

So, how is the burden of the tax divided?

The burden of a tax falls more

heavily on the side of the market that

is less elastic.