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CBSE Notes 2011-2012

Price Elasticity of Demand

Price elasticity of demand
When the price of a good falls, the quantity consumers demand of the good typically rises--if it costs less, consumers buy more. Price elasticity of demand measures the responsiveness of a change in quantity demanded for a good or service to a change in price.
Interpretation of Elasticity
Value Meaning
n = 0 Perfectly inelastic.
0 < n < 1 Relatively inelastic.
n = 1 Unit elastic.
1 < n < ? Relatively elastic.
n = ? Perfectly elastic.
Price elasticity of demand is rarely constant throughout the ranges of quantity demanded and price. A good or service can have relatively inelastic demand up to a certain price, above which demand becomes elastic. Even if automobiles, for example, were extremely inexpensive, parking or other related ownership issues would presumably keep most people from owning more than some "maximum" number of automobiles. For these and other reasons, elasticity of demand remains valid only over a specific (and small) range of price. Demand for cars (as well as other goods and services) is not elastic or inelastic for all prices. Elasticity of demand can change dramatically across a range of prices.
Inelastic demand is commonly associated with "necessities," although there are many more reasons a good or service may have inelastic demand other than the fact that consumers may "need" it. Demand for salt, for instance, at its modern levels of supply is highly inelastic not because it is a necessity but because it is such a small part of the household budget. (Technology has increased the supply of salt modernly and reduced its historically high price.) Demand for water, another necessity, is highly inelastic for similar supply side reasons. Demand for other goods, like chocolate, which is not a necessity, can be highly elastic.
Substitution serves as a much more reliable predictor of elasticity of demand than "necessity." For example, few substitutes for oil and gasoline exist, and as such, demand for these goods is relatively inelastic. However, products with a high elasticity usually have many substitutes. For example, potato chips are only one type of snack food out of many others, such as corn chips or crackers, and predictably, consumers have more room to turn to those substitutes if potato chips were to become more expensive.
It may be possible that quantity demanded for a good rises as its price rises, even under conventional economic assumptions of consumer rationality. Two such classes of goods are known as Giffen goods or Veblen goods. Another case is the price inflation during an economic bubble. Consumer perception plays an important role in explaining the demand for products in these categories. A starving musician who offers lessons at a bargain basement rate of $5.00 per hour will continue to starve, but if the musician were to raise the price to $35.00 per hour, consumers may perceive the musician's lessons ability to charge higher prices as an indication of higher quality, thus increasing the quantity of lessons demanded.

Mathematical definition
The formula used to calculate the coefficient of price elasticity of demand is

Or, using the differential calculus:

or alternatively:

P = price
Q = quantity
Qd = original quantity
Pd = original price
?Qd = Qdnew - Qdold
?Pd = Pdnew - Pdold
One caveat in using this (valid) formula: Will you use the original or the new quantity demanded in the denominator? Will you use the original or new price in the denominator? Be consistent at least and use one set or the other. A more elegant and reliable calculation uses a midpoint analysis--instead of the original or the new, try using the point half way between the two for your calculations.

Elasticity and revenue

A set of graphs shows the relationship between demand and total revenue. As elasticity decreases in the elastic range, revenue increases, but in the inelastic range, revenue decreases.
When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa.
When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa.
When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage change in quantity is equal to that in price. Hence, when the price is raised, the total revenue remains unchanged. The demand curve is a rectangular hyperbola.
When the price elasticity of demand for a good is perfectly elastic (Ed is undefined), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line. A ten-dollar banknote is an example of a perfectly elastic good; nobody would pay $10.01, yet everyone will pay $9.99 for it.
When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line; this violates the law of demand. An example of a perfectly inelastic good is a human heart for someone who needs a transplant; neither increases nor decreases in price effect the quantity demanded (no matter what the price, a person will pay for one heart but only one; nobody would buy more than the exact amount of hearts demanded, no matter how low the price is).

Point-price elasticity
· Point Elasticity = (% change in Quantity)/(% change in Price)
· Point Elasticity = (?Q/Q)/(?P/P)
· Point Elasticity = (P ?Q)/(Q ?P)
· Point Elasticity = (P/Q)(?Q/?P) Note: In the limit (or "at the margin"), "(?Q/?P)" is the derivative of the demand function with respect to P. "Q" means 'Quantity' and "P" means 'Price'.
· Example
demand curve: Q = 1,000 - .6P
a.) Given this demand curve determine the point price elasticity of demand at P = 80 and P = 40 as follows.
i.) obtain the derivative of the demand function when it's expressed Q as a function of P.

ii.) next apply the above equation to the sought ordered pairs: (40, 976), (80, 952)

e = -.6(40/976) = -.02
e = -.6(80/952) = -.05

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Price Elasticity of demand

thanx so much a nice article and more imfrormative too.it explained in simple language helped a MBA student thanx. buddy