Lecture Notes: Price Elasticity of Demand

Introduction to Price Elasticity of Demand

• Definition: Measures the responsiveness of buyers to price changes.
• Formula: Percentage change in quantity demanded divided by percentage change in price.

Determinants of Price Elasticity of Demand

1. Substitutes

• Key Idea: Availability of substitutes greatly affects responsiveness.
• Example: If the price of Cheerios increases significantly, consumers may switch to other cereals like Raisin Bran or Rice Krispies.
• Conclusion: More substitutes available lead to higher elasticity.

2. Share of Budget

• Concept: The proportion of a consumer's budget spent on a good affects elasticity.
• Example: Rent (large budget share) vs. salt (small budget share).
• Conclusion: Consumers are more sensitive to price changes in goods that take up a larger portion of their budget.

3. Necessities vs. Luxuries

• Necessities: Goods required for survival (e.g., insulin for diabetics) tend to have inelastic demand.
• Luxuries: Non-essential goods (e.g., Caribbean cruise) have more elastic demand.
• Conclusion: Necessities have fewer substitutes and less elasticity, while luxuries have more substitutes and higher elasticity.

4. Market Definition: Broad vs. Narrow

• Broad Market: Fewer substitutes, lower elasticity (e.g., clothing).
• Narrow Market: More substitutes, higher elasticity (e.g., blue jeans).
• Example: Specific car model vs. all cars.

5. Time Period: Short vs. Long Run

• Short Run: Less time to find substitutes, lower elasticity.
• Long Run: More time to adapt, higher elasticity.
• Example: Immediate response to gasoline price increase vs. long-term adjustments like carpooling.

Mathematical Definition and Calculation

• Price Elasticity of Demand Formula:
  • Percentage change in quantity demanded / Percentage change in price.
• Example Calculation:
  • A 5% price increase in Cheerios leads to a 10% decrease in quantity demanded.
  • Elasticity = -10% / 5% = -2 (typically expressed as an absolute value).
  • Interpretation: Elasticity of 2 means the quantity demanded is twice as responsive as the price change.

Calculating Elasticity: The Midpoint Method

• Purpose: Calculates elasticity over a price range.
• Formula:
  • ( \frac{\text{Change in Quantity} / \text{Average Quantity}}{\text{Change in Price} / \text{Average Price}} )
• Benefit: More accurate measure of elasticity between two points on the demand curve.

Conclusion

• Understanding these determinants and calculations helps explain consumer responsiveness to price changes and is crucial for economic analysis.