The Elasticity of Demand: Definition, Formula & Examples

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  • 0:02 Defining Elasticity of Demand
  • 1:06 Formulas
  • 3:44 Arc Elasticity of Demand
  • 6:06 Price-Point Elasticity
  • 9:13 Lesson Summary
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Lesson Transcript
Instructor: Kallie Wells
Do people buy more when prices drop? How much more do they buy? These questions can be answered by evaluating a good's elasticity of demand, which is defined and illustrated in this lesson with a few examples.

Defining Elasticity of Demand

The elasticity of demand (Ed), also referred to as the price elasticity of demand, measures how responsive demand is to changes in a price of a given good. More precisely, it is the percent change in quantity demanded relative to a one percent change in price, holding all else constant (ceteris paribus). Demand of goods can be classified as either perfectly elastic, elastic, unitary elastic, inelastic, or perfectly inelastic based on the elasticity of demand. This table shows the values of elasticity of demand that correspond to the different categories.

The Ed values differ based on the demand category
Graph and table for Ed values

The graph illustrates the demand curves and places along the demand curve that correspond to the table. The elasticity of demand changes as one moves along the demand curve. This is an important concept - the elasticity of demand for a good changes as you evaluate it at different price points. These charts are for illustration only. To determine if a demand is elastic at a given price, you have to evaluate it with the methods we're about to discuss.

Formulas for Elasticity of Demand

The formula for elasticity of demand can be formulated two different ways depending on what is available to you at the time. To calculate the elasticity of demand in either case, you will need a demand curve for a good. This can be in graphical or equation format. Essentially, when determining the elasticity of demand, you are trying to determine the slope of the demand curve at a given point on the curve. The first method is called arc elasticity of demand. This method is used when either:

  1. You don't have the exact equation for demand
  2. You aren't familiar with taking derivatives

The second method is called point-price elasticity of demand. This method is used when you:

  1. Have the mathematical equation for demand
  2. Are familiar with taking derivatives of equations

As we've already said, the elasticity of demand is evaluating the slope of the demanded curve at a given point. The arc elasticity of demand takes the difference between two points along the curve. Therefore, there can be slight inaccuracies when using this method since it uses an arc on the curve rather than a single point, which is how the point-price elasticity of demand calculates the elasticity of demand.

The arc elasticity of demand formula is:

  • E sub d = (P sub 1 + P sub 2)/(Q sub d1 + Q sub d2) * change in Q sub d/change in P, where:
    • P sub 1 is the original price point, P sub 2 is the new price point,
    • Q sub d1 is the quantity demanded at the original price point
    • Q sub d2 is the quantity demanded at the new price point
    • Change in Q sub d is the change in quantity demanded: Q sub d2 - Q sub d1
    • Change in P is the change in price: P sub 2 - P sub 1

The price-point elasticity of demand formula is:

  • Ed = P/Q sub d * dQ/Dp, where:
    • P is the price at which you are evaluating the elasticity of demand
    • Q sub d is the quantity demanded at the point you are evaluating elasticity of demand
    • dQ/dP is the first derivative of quantity demanded with respect to price

When calculating the elasticity of demand for all goods with a downward sloping demand curve, you should get a negative value. Remember this as a good reality check on your work. However, in some reports and texts, people will leave off the negative sign when reporting elasticity of demand because it is almost always negative.

Example of Arc Elasticity of Demand

Follow these steps to determine the elasticity of demand via arc elasticity:

  1. Determine an original and new price point - for this example: P sub 1 and P sub 2.
  2. Evaluate the quantity demanded using the demand curve at points: P sub 1 and P sub 2; Q sub d1 and Q sub d2, respectively.
  3. Use this formula above and plug in the values for P sub 1 and P sub 2; Q sub d1 and Q sub d2.
  4. Reality check and interpret your results - you should get a negative value assuming the good is a downward sloping line!

So, assume this is the demand curve for lattes and you have to determine the elasticity of demand if prices increased from $4 per latte to $5 per latte. Since you do not have the exact formula, you have to use the arc elasticity of demand method. Following the four steps we just covered, you would get:

  1. P sub 1 = $4; P sub 2 = $5
  2. At P sub 1, Q sub d1 = 20 lattes (this is the quantity demanded at $4); at P sub 2, Q sub d2 = 10 lattes (quantity demanded at $5)
  3. Using the formula provided: Ed = (P sub 1 + P sub 2)/(Q sub d1 + Q sub d2) * change in Q sub d/change in P; and the values in steps one and two, you would get Ed = ($4 + $5)/(10 + 20) * (10 - 20)/($5 - $4) = $9/30 * (-10)/$1 = 0.3 * -10 = -3
  4. It's a negative value. For every percent increase in price, quantity demanded will decrease by 3 lattes. Also, please note that the units (dollars and lattes) cancel out; therefore, the elasticity of demand is unit-less.

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