Price Elasticity of Demand Flashcards
What is Demand?
Demand is a schedule of the amounts of a good or service that consumers are willing and able to purchase at various prices during a period of time
Quantity demanded is the amount that will be purchased at a specified price during a period of time
What is the law of demand?
The law of demand states that if all other factors are held constant (ceteris paribus), the price of a product and the quantity demanded are inversely (negatively) related (i.e. the higher the price, the lower the demand)
As the price of a good falls, consumers have more buying power (also called higher real income). They can buy more of the good with the same amount of money. This is termed the income effect
As the price of one good falls, it becomes cheaper relative to other goods. Consumers will thus have a tendency to spend money on the cheaper good in preference to the more expensive one. This is termed the substitution effect
What is Price elasticity of demand?
The price elasticity of demand (Ed) measures the sensitivity of the quantity demanded of a product to a change in its price
Ed = % change in quantity demanded / % change in price
Elasticity describes the reaction to a change in price from one level to another. Thus, the most accurate way of calculating elasticity is the arc method, which measures elasticity across a range
=[ (Q1 - Q2) / (Q1 + Q2)]
/
[(P1 - P2) / (P1 + P2)]
Note that because elasticity is always measured with a positive number, absolute value is used in the formula
When the demand elasticity coefficient is Greater than 1, what does this mean?
When the demand elasticity coefficient is greater than 1, demand is in a relatively elastic range. A small change in price results in a large change in quantity demanded
When the demand elasticity coefficient = 1, what does this mean?
When the demand elasticity coefficient = 1, demand has unitary elasticity (usually a very limited range)
A single-unit change in price brings about a single-unit change in quantity demanded
When the demand elasticity coefficient is LESS than 1, what does this mean?
When the demand elasticity coefficient is less than 1, demand is in a relatively inelastic range
A large change in price results in a small change in quantity demanded
When demand elasticity coefficient is Infinite, what does this mean?
When the demand elasticity coefficient is infinite, demand is perfectly elastic (depicted as a horizontal line)
In pure competition, the number of firms is so great that one firm cannot influence the market price. The demand curve faced by a single seller in such a market is perfectly elastic (although the demand curve for the market as a whole has the normal downward slope)
Example: Consumers will buy a farmer’s total output of soybeans at the market price but will buy none at a slightly higher price. Also, the farmer cannot sell below the market price without incurring losses
When the demand elasticity coefficient = 0, what does this mean?
When the demand elasticity coefficient = 0, demand is perfectly inelastic (depicted as a vertical line)
Some consumers’ need for a certain product is so high that they will pay whatever price the market sets. The number of these consumers is limited and the amount they desire is relatively fixed
Example: Addiction to illegal drugs tends to result in demand that is unresponsive to price changes. In this example, existing buyers (addicts) will not be driven out of the market by a rise in price and no new buyers will be induced to enter the market by a reduction in price
What effect will a price increase have on total revenue?
Price elasticity of demand is useful for a firm wondering how a change in the price of a product will affect total revenue from that product
Effect on Total Revenue:
Elastic range - DECREASE
Unitary Elasticity - No change
Inelastic range - INCREASE
What effect will a price decrease have on total revenue?
Price elasticity of demand is useful for a firm wondering how a change in the price of a product will affect total revenue from that product
Effect on Total Revenue:
Elastic range - INCREASE
Unitary Elasticity - No change
Inelastic range - DECREASE
