ECO2011 Basic Microeconomics

Fall 2020
Emily Zheng
Measuring responsiveness to price changes

How can we come up with a sensible way to measure how much

quantity changes when price changes?

One idea is to look at the slope of the demand curve.

• But this won’t work, since the value of the slope depends on the
units used to measure on the axes.
Price elasticity of demand

A better way to measure responsiveness of quantity demanded to

think in terms of percentage changes.
• This avoids the problem with units of measurement.
Percentage change in quantity demanded
Price elasticity of demand 
Percentage change in price

Although the slope and price elasticity of demand are related, they
are not the same thing.

Since price and quantity change in opposite directions on the

demand curve, the price elasticity of demand is a negative number.
• However we often refer to “more negative” elasticities as being
“larger” or “higher”.
Price elasticity of demand terminology

A “large” value for the price elasticity of demand means that

quantity demanded changes a lot in response to a price change.

Formally, we say demand is price elastic if its price elasticity of

demand is larger (in absolute value) than 1.
• So a 10% increase in price would result in a greater than 10%
decrease in quantity demanded.

Demand is price inelastic if its price elasticity of demand is smaller

(in absolute value) than 1.
• That is, close to zero, indicating that quantity demanded
changes little in response to a price change.

Demand is unit price elastic if the price elasticity of demand is

exactly equal to (negative) 1.
 Elastic and inelastic demand

Along D1, cutting the price

from $4.00 to $3.70
increases the number of
gallons sold from 1,000 per
day to 1,200 per day, so
demand is elastic between
point A and point B.

Along D2, cutting the price

from $4.00 to $3.70
increases the number of
gallons sold from 1,000 per
day only to 1,050 per day,
so demand is inelastic
between point A and point
C.
Percentage change calculation and the midpoint formula

Percentage changes have the unfortunate characteristic that the

percentage change from A to B is not the negative of the
percentage change from B to A.

Example: On the previous slide, from point A to point B, quantity

increased from 1000 to 1200, an increase of 20%.
However from B to A, quantity decreases by 16.7%.

This would mean the elasticity from A to B was different from the
elasticity from B to A, an undesirable characteristic.

To avoid this, we calculate percentage changes using the midpoint

formula: ( A  B)
Percentage Change 
 A B 
 
 2 
The midpoint formula

The midpoint formula avoids the confusion of whether we are

going from A to B or from B to A: we use the average of A and B in
the denominator instead of choosing one of them.

Price elasticity of demand becomes:

(Q2  Q1 ) ( P2  P1 )
Price elasticity of demand  
 Q1  Q2   P1  P2 
   
 2   2 

The first term is the percentage change in quantity, using the

midpoint formula.
The second term is the percentage change in price, using the
midpoint formula.
Example: calculating price elasticity of demand

At your gas station, you cut

price from $3.50 per gallon to
$3.30 per gallon. Gasoline
sales went up from 2000 to
2500 gallons per day.

To calculate this price elasticity,

we first need the average
quantity and price:

2,000  2,500 $3.50  $3.30

Average quantity   2,250 Average price   $3.40
2 2
 Example: calculating price elasticity of demand

Now calculate the percentage

change in quantity and price:
Percentage change 2,500  2,000
 100
in quantity demanded 2,250
 22.2%

Percentage change $3.30  $3.50

 100
in price $3.40
 5.9%

Then price elasticity of demand

is the ratio of these two:
Price elasticity 22.2%

of demand  5.9%
 3.8
This is greater in absolute value than –1, so we say that demand in
this range is price elastic.
 Example: calculating price elasticity of demand

What if quantity had only

increased to 2100?

Percentage change in price

remains the same (-5.9%).

Percentage change in quantity

is now:
Percentage change 2,100  2,000
 100
in quantity demanded 2,050
 4.9%

So price elasticity of demand is now…

Price elasticity 4.9%

of demand  5.9%
 0.8
This is smaller (in absolute value) than -1, so demand is inelastic.
Observations about elasticity

While slope and elasticity are not the same, they are related:
• If two demand curves go through the same point, the one with
the higher slope also has the higher (more negative) elasticity.

A vertical demand curve means that quantity demanded does not

change as price changes.
• So elasticity is zero.
• A vertical demand curve is perfectly inelastic.

A horizontal demand curve means quantity demanded is infinitely

responsive to price changes.
• Elasticity is infinite.
• A horizontal demand curve is perfectly elastic.
Summary of the Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Summary of the Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Summary of the Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Summary of the Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

Summary of the Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
What determines the price elasticity of demand

Why do some goods have a high price elasticity of demand, while

others have a low price elasticity of demand?

There are several characteristics of the good, of the market, etc.

that determine this.

1. The availability of close substitutes

If a product has more substitutes available, it will have more elastic

demand.
Example: There are few substitutes for gasoline, so its price
elasticity of demand is low.
Example: There are many substitutes for Nikes (Reeboks, Adidas,
etc.), so their price elasticity of demand is high.
2. The passage of time

Over time, people can adjust their buying habits more easily.
Elasticity in general is higher in the long run than the short run.
Example: If the price of gasoline rises, it takes a while for people to
adjust their gasoline consumption. How might they do that?
• Buying a more fuel-efficient car
• Moving closer to work

3. Whether the good is a luxury or a necessity

People are more flexible with luxuries than necessities, so price
elasticity of demand is higher for luxuries.
Example: Many people consider milk and bread necessities; they
will buy them every week almost regardless of the price.
And if the price goes down, they won’t drastically increase their
consumption of bread or milk.
4. Definition of the market

The more narrowly-defined is the market, the more substitutes are

available, and hence the more elastic is demand.
Example: You might believe there is no good substitute for jeans,
so your demand for jeans is very inelastic.
But if you consider different brands of jeans, you might be more
sensitive to the price of a particular brand.

5. Share of the good in a consumer’s budget

If a good is a small portion of your budget, you will likely not be

very sensitive to its price.
Example: You might buy table salt once a year or less; changes in
its price will not affect very much how much you buy.
Example: Changes in the price of housing do affect where people
choose to live.