Elasticity of Demand Flashcards
What is choice overload?
When overloaded with choices, consumers get confused, and do not always make rational decisions
▪ Example includes massive cereal aisles in Walmart
Explain the different types of framing
Loss Aversion
o A loss hurts more than a gain, even of the same size
▪ If we have a good, our willingness to accept money to give it up is greater than what we are willing to pay in the first place
▪ Possession/ownership of a good means that it takes on an additional value to the consumer
▪ For this reason, money back guarantees do not always get utilised
- Anchoring
o A consumer’s decision can be influenced based on the specific pieces of information which they are provided with
o Incorporates the concept of a ‘reference point’
▪ A price increase that is still below the willingness to pay can feel like a loss, and illogically cause consumers to stop purchasing the product
What is demand elasticity?
Elasticity is a measure of how much buyers and sellers respond to changes in market conditions
Price elasticity is how responsive quantity demanded is to changes in the price level
What are the two formulas for calculating demand elasticity?
What will the value of price elasticity be?
Price elasticity of demand will always be negative
o This is because the demand curve is downward sloping
If the price elasticity of demand is –0.2, this indicates that:
o The quantity demanded will change by 0.2% for every 1% price change
What is inelastic demand?
Quantity demanded is not very responsive to changes in price
%Change In Quantity Demanded < %Change in Price
When a good is inelastic, it’s value will be less than 1
What is elastic demand?
Quantity demanded is relatively responsive to changes in price
%Change In Quantity Demanded > %Change in Price
When a good is elastic, it’s value will be greater than 1
What is unit elasticity?
A price change leads to a proportional change in the quantity demanded
%Change In Quantity Demanded = %Change in Price
When a good is unit elastic, it’s value will be 1
What are perfectly elastic and inelastic goods?
A good is perfectly elastic when its elasticity of demand is equal to infinity
o This means that any price change will eliminate all demand for the product
A good is perfectly inelastic when its elasticity of demand is equal to zero
o This means that no price change can shift the quantity demanded
- In reality these extremes do not occur, but they are good reference points
What are the determinants of elasticity?
Availability of Substitutes
o When a good can be easily replaced, an increase in price is likely to lead to a proportionally larger decrease in quantity demanded (eg butter)
o If a good doesn’t have a close substitute, a price increase will still see a fall in quantity demanded, but at a smaller rate (eg eggs)
Necessary vs Luxury Goods
o A necessary good (eg insulin) is unavoidable for purchasing – therefore an increase in price will lead to a much smaller decrease in demand
▪ This can also incorporate addictive goods (eg cigarettes)
o However, luxury goods will be far more elastic, as it is easier to let go of them
Definition of the Market
o If there is a market with multiple goods (eg brands of shampoo), then a price change will see a much greater change in quantity demanded, as consumers have choice
o If the price of all products in a market change, demand will be more inelastic
▪ These ideas are linked to the availability of substitutes
The Time Horizon
o The longer the time horizon, the more opportunity a consumer has to find substitute goods
▪ In the short-term, consumers will continue to buy the product because of routine/lack of knowledge of the market (inelastic)
▪ In the long-term, consumers will change habits (elastic)
Size of Share in Budget
o If a product only makes up a small proportion of a consumer’s budget, they are less likely to be influenced by price changes (inelastic)
o The reverse is true for budgets that take up a higher proportion of the budget, as a price change is more likely to be felt (elastic)
How does total expenditure relate to demand elasticity?
Total expenditure refers to how much consumers pay/producers receive from the sales they make
When there is a price increase, the decreased spending on fewer quantity is offset by the increased spending on the quantity we do buy
o The change in total expenditure depends on the relative size of the quantity effect vs the price effect
▪ Price Effect: if you increase (decrease) the price, the higher (lower) price will increase (decrease) total revenue
▪ Quantity Effect: the increase (decrease) in price causes a decrease (increase) in quantity demanded, which will decrease (increase) TR
What will happen to total expenditure when demand is inelastic?
If demand is inelastic, the percentage change in price will be greater than the percentage change in quantity
o This means that the price effect will be larger than the quantity effect, meaning:
▪ an increase in price will lead to an increase in total expenditure
▪ a decrease in price will lead to a decrease in total expenditure
What will happen to total expenditure if demand is elastic?
If demand is elastic, the percentage change in quantity demanded will be greater than the percentage change in quantity
o This means that the quantity effect will be larger than the price effect, meaning:
▪ an increase in price will lead to a decrease in total expenditure
▪ a decrease in price will lead to an increase in total expenditure
How does elasticity change along a linear demand curve?
The price elasticity of demand is not constant along a linear demand curve
o Above the midpoint, elasticity will be larger than one (elastic)
o Below the midpoint, elasticity will be smaller than one (inelastic)
- This occurs because at $1, a price increase of $1 is proportionally larger than a price increase of $1 when we are already spending $5
o The reverse is true with regards to quantity
What is cross-price elasticity of demand?
Measures how much the quantity demanded of a good responds to a change in the price of a related good
▪ It is calculated as the percentage change in the quantity demanded divided by the percentage change in the price of the related good
o The reference point of cross price elasticity is zero
▪ When the value is more than zero, the goods are substitutes
▪ When the value is less than zero, the goods are complements
What is income elasticity of demand?
Measures how much the quantity demanded of a good responds to a change in the
consumer’s income
▪ It is calculated as the percentage change in the quantity demanded divided by the percentage change in income
o The reference point of income elasticity is zero
▪ When the value is more than zero and less than one, the good is a normal good
▪ When the value is less than zero, the good is an inferior good
▪ When the value is more than 1, the good is a luxury good
