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Price Elasticity of Demand in Microeconomics

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  • 0:01 Setting the Stage
  • 0:57 Definition and Formula
  • 2:35 Categories
  • 4:51 Calculation Examples
  • 6:59 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Discover the definition and formula for price elasticity of demand. See some real-world examples of how it is calculated, and find out what it means for demand of a good to be inelastic or elastic.

Setting the Stage

How many times a day or week do you make a decision to buy something based on price? Would your buying habits change if a new dress shirt cost $70 instead of $15? How about if a gallon of milk cost $7 instead of $4? Whether you make five decisions a day or fifty, there is no doubt that price elasticity of demand is playing a major role in your purchases! Let's discuss price elasticity of demand and how it plays a role in the everyday life of consumers or business owners, like you and I.

In talking about the price elasticity of demand, it's worth reviewing the law of demand, which states that more of a good will be demanded, the lower its price, all else constant. Less of a good will be demanded, the higher its price, all else constant. How much more or less is demanded? That is where elasticity comes in.

Definition and Formula

Price elasticity of demand is the measure of the percent change in the quantity of a good demanded divided by the percent change in the price of that good. It is the term economists use to describe how responsive consumers are to a change in price. I bet you can think of an item you wouldn't hesitate to pay more for if the price rose.

How about an item you might not buy any longer if the price increased? That logic and reasoning is exactly what makes up and determines the price elasticity of demand. It is a very important concept in economics and a foundation for many advanced lessons on how individuals and business owners make purchasing decisions. The mathematical equation looks like this:

Ed (Elasticity of Demand) = Percent change in quantity / Percent change in price

Let's look at a quick example. If the price of a good goes up by 20% and the quantity demanded falls by 40%, looking at the equation, you will find that the elasticity is 2, which, plugged into the equation, looks like this: 2 = 40% / 20%. It is important to note that you may often see a negative or minus sign in front of elasticity numbers. For the purposes of this lesson, disregard that and remember that elasticity is often spoken about in positive numbers. So a negative two is actually talked about and referred to as a positive two. So what does that two really mean? Let's explore that now.

Categories

When discussing elasticity of demand, it can often be categorized in three common ways. Based on the result we get from our formula, we can define elasticity as:

Elastic - If elasticity is greater than one, a rise in price lowers total revenue; a decrease in price increases total revenue. Price and total revenue move in opposite directions. These are goods that are often very responsive to changes in price, such as non-necessities or goods that we can easily live without. Candy, entertainment, and specific brands of soda are a few examples. For example, if a major league baseball ticket increased in price, many people would likely cut back on going to the game, all else constant. If it goes down, people will go more often and actually increase revenue for the baseball club.

Inelastic - If elasticity is less than one, a rise in price increases total revenue and a good is said to be inelastic. Price and total revenue move in the same direction. These are goods that many consider necessary to everyday living, such as water, gas, toilet paper, and so on. If the price of toilet paper increases, most people will not stop buying toilet paper.

To summarize, an inelastic good is a good where if the price goes up, people will only slightly reduce demand of a particular product; and if the price goes down, people will only slightly increase demand of a particular good. Many business owners wish to sell inelastic goods or services. They know that if they raise their price, they won't lose many customers and ultimately, they will make more money.

Unitary elastic - A good is unitary elastic when it is exactly one. Said another way, the percent change in quantity equals the percent change in price. A rise in the price results in absolutely no change to total revenue. This is more of an economic concept in theory. In the real world, demand for almost all goods will either be elastic or inelastic.

Calculation Examples

Let's see how this all relates in the real world. The first is a grocery store owner who is thinking of raising the price on a gallon of milk so he can increase his total revenue. If the grocery store owner knows from previous experience that raising the price 10% will decrease the quantity purchased by 5%, should he do it? Let's find out by calculating the elasticity and plugging the numbers into the equation: 5% / 10% = .5. This tells us that milk is inelastic because it is less than 1.

If the grocery store raises prices on milk, they will increase their total revenue. Another way to think about it is that a 10% rise in the price more than covers the 5% drop in the actual gallons of milk sold. On the other hand, if the grocery store lowers the price, the total revenue will fall. The increased demand or additional gallons of milk sold will not be enough to make up for the drop in prices across the board.

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