If you were planning to have a pizza for dinner and saw a sign in your favorite pizza restaurant that read, 'Due to increases in the cost of cheese - all items on the menu have been increased by $3.00 until further notice' would you still go in and order pizza for dinner? Suppose you notice the fuel indicator on your car pointing to 'Empty.' As you pull into the gas station, you see the price of gasoline has risen by $.50 a gallon. Do you still get gas? The answers to these questions may well depend on the price elasticity of demand.
In this lesson, you will learn about the law of demand, the definition of price elasticity of demand, how we measure price elasticity of demand and some actual price-elasticity measurements for various goods, and why different goods have different goods differ in price elasticity.
Have you ever heard of the law of demand? This economic principle says that we will buy less of a good if the price rises. You can probably think of many goods you buy that would meet the law of demand. But there are other goods that seem to defy the law of demand. That may be due to the price elasticity of the good.
What is the price elasticity of demand? It is a measure of the responsiveness of quantity demanded to a price change. In other words, if the price of a good changes, do we change the quantity we buy? In the example above, many of us would not get pizza but would go to another restaurant (or eat at home) if prices increased by $3.00. But we probably would still fill up our car with gasoline even if the price were increased by 50 cents per gallon. Why? Because restaurant meals and gasoline have very different price elasticity. Study the graphs to help understand elasticity.
Gasoline is considered inelastic (meaning price changes have little effect on the quantity we buy).
Restaurant meals, on the other hand, are very elastic (meaning price changes greatly affect our purchase of them).
There are several factors that affect the price elasticity of a good. These include the following:
- Availability of substitutes
- The degree of necessity
- The proportion of a purchaser's budget consumed by the item
- The time period involved.
If a good has a large number of substitutes, we can pick a substitute if the price rises on the good. For example, if beef has a price increase, we might substitute chicken, pork or fish. Another factor is the degree of want for the good or service. Perfume is not considered something that you need for survival but if you're a diabetic, insulin is. If the good consumes a relatively small proportion of your budget, price changes do not greatly affect the amount you buy. For example, if you buy a couple of packages of gum every month and that represents a very small percentage of your budget, a price increase of 20 percent (say from $1 to $1.20) probably would not affect your quantity purchased. The time period involved is also a factor in price elasticity. If you have a short period to make a decision, you may have to accept price changes. But in the long run, you can change your consumption of this good or brand in some cases. If the only pet store in town raises the price of the special bird seed you feed your pet parrot and you are all out of bird seed, in the short run, you will probably buy the bird seed. But in the long run, you could experiment with other seeds or food or perhaps order bird seed from the Internet at a better price (or sell the parrot and buy a dog!). In other words, you have time to vary the amount purchased or the price you pay. Now let's compare gasoline and restaurant meals. Complete the following interactive activity about price elasticity.
The price elasticity of demand is a useful indicator of how we would expect the quantity demanded for a good to change if the price of the good changes. Producers would want to know the price elasticity of demand before they changed the price of their good.
Suppose you are a producer of a good and are considering raising prices. Would you prefer that your product had an elastic demand or inelastic demand? Why?
Look at elasticity of the various goods on the Mackinac Center for Public Policy . If the elasticity is less than 1, the demand for the good is considered inelastic. If the elasticity is greater than 1, the demand for the good is elastic. Unitary elasticity is when the elasticity is approximately 1 (which means the percentage change in quantity demanded is about the same as the percentage change in price). Answer the following questions. When you are finished, print your answers and hand them in to your teacher.
1. Which products are the most inelastic?
2. What factors would most likely explain why salt is very inelastic?
3. Why would the demand for tooth picks be inelastic?
4. Although both short-run and long-run gasoline are both inelastic, why is short-run gasoline more inelastic than long-run gasoline?
5. What factors would likely explain why Chevrolet cars are very elastic?
6. Why would tires have unitary elasticity while gasoline is inelastic?
To calculate the price elasticity of demand, we use the formula:
Percentage change in quantity demanded divided by percentage change in price.
The percentage of change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
The percentage of change in price is: [Price(NEW) - Price(OLD)] / Price(OLD)
Based on the following information, calculate the price elasticity of demand for paper towels. At a price of $1, the quantity demanded is 10. At a price of $1.50, the quantity demanded is 3.
- Calculate the price elasticity of demand using the formula given.
- Is this good elastic or inelastic?
- Does your answer support what you've learned about elasticity? Explain.
For a graphical application of the price elasticity of demand, go to the following graph