Price Elasticity: From Tires to Toothpicks
INTRODUCTION
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.
TASK
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 differ in price elasticity.
PROCESS
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:
1.
2.
3.
4.
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.
CONCLUSION
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?
ASSESSMENT ACTIVITY
Now read the article called “Price Elasticity of Demand.” Look at elasticity of the various goods
in the chart. 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 questions on the “Elasticity of Demand
Worksheet.” For extra credit you may complete the extension activity.
EXTENSION ACTIVITY
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.
1. Calculate the price elasticity of demand using the formula given.
2. Is this good elastic or inelastic?
3. Does your answer support what you've learned about elasticity? Explain.