question archive There are some important points regarding elasticity of demand that, if you can master, will see you through an introductory microeconomics course and, more importantly, help you apply the concept in the business world
There are some important points regarding elasticity of demand that, if you can master, will see you through an introductory microeconomics course and, more importantly, help you apply the concept in the business world
Subject:BusinessPrice: Bought3
There are some important points regarding elasticity of demand that, if you can master, will see
you through an introductory microeconomics course and, more importantly, help you apply the
concept in the business world. The text does a very good job of explaining elasticity, but there is
also a great deal of detail that is provided which may obscure the most significant points.
Therefore, this paper will focus on the most critical points regarding elasticity of demand that
you need to know.
THE LAW OF DEMAND
First of all, we know that price and quantity demanded are inversely related because of the Law of
Demand. Therefore, an increase in price will always result in a decrease in quantity demanded and,
conversely, a decrease in price will always result in an increase in quantity demanded. We take that
as a given.
The implications of the Law of Demand for revenue are as follows:
When price increases, we will gain revenue from the price increase, but we will lose
revenue from a decrease in quantity demanded.
When price decreases, we will lose revenue from the decrease in price, but we will gain
revenue from an increase in quantity demanded.
The net effect on revenue, i.e., whether total revenue will increase or decrease, will depend upon
the elasticity of demand, all other things being equal. Elasticity of demand will tell us the
magnitude of the response of quantity demanded to a price change and answer the question of which
is greater…the change in quantity demanded or the change in price. With that information, we can
determine the impact on revenue of all price changes.
ELASTIC DEMAND
Elasticity greater than 1 (in absolute value because we always ignore the sign) indicates that
when there is a change in price, the change in quantity demanded will be greater than the change
in price, i.e., %ΔQD > %ΔP.
Revenue implications of elastic demand:
When price increases, the loss in revenue from the decrease in quantity demanded will be
greater than the gain in revenue from the increase in price and, therefore, total revenue
will decrease.
When price decreases, the gain in revenue from the increase in quantity demanded will
exceed the loss in revenue from the price decrease and, therefore, total revenue will
increase.
Summary: A price increase will cause total revenue to fall and a price decrease will cause
revenue to rise when demand is elastic. Just remember that when demand is elastic, revenue and
price will move in the opposite direction. ↑P → ↓R and ↓P → ↑R
INELASTIC DEMAND
Elasticity between 0 and 1 (absolute value) indicates that when there is a change in price, the
change in quantity demanded will be less than the change in price, i.e., %ΔQD < %ΔP.
Revenue implications of inelastic demand:
When price increases, the gain in revenue from the price increase will exceed the loss in
revenue from the decrease in quantity demanded, and, therefore, revenue will increase.
When price decreases, the loss in revenue from the price increase will exceed the gain in
revenue from an increase in quantity demanded and, therefore, revenue will decrease.
Summary: A price increase will cause total revenue to increase. However, a price decrease will
result in a decrease in revenue. Therefore, when demand is inelastic, revenue and price will move in
the same direction. ↑P →↑R and ↓P → ↓R
UNIT ELASTICITY
Elasticity of 1 (absolute value) indicates that when there is a change in price, the change in
quantity demanded will be the same, i.e., %ΔQD = %ΔP.
Revenue implications of unit elasticity of demand:
When price increases, the loss in revenue from the decrease in quantity demanded will be
equal to the gain in revenue from the increase in price and, therefore, total revenue will
not change.
When price decreases, the gain in revenue from the increase in quantity demanded will be
equal to the loss in revenue from the price decrease and, therefore, total revenue will not
change.
Summary: With unit elasticity, price changes will result in no change in revenue.
PERFECTLY INELASTIC DEMAND
Elasticity of zero indicates perfectly inelastic demand. When there is a change in price, there
will be no change in quantity demanded. The result is a vertical demand curve.
PERFECTLY ELASTIC DEMAND
Perfectly elastic demand occurs when the coefficient of price elasticity of demand is infinite.
The result is a horizontal demand curve. Responses to changes in price are infinite. When price
increases, demand will be zero. When price decreases, demand will be infinite and all available
quantities will be sold.
