Understanding Price Elasticity of Demand

If the price elasticity of demand measures the responsiveness of buyers, what types of things might influence that responsiveness? Let's turn to the determinants of the price elasticity of demand to think about some reasons why. First, substitutes. Arguably, this is the most important factor that influences an individual's responsiveness. Remember, substitutes reflects the idea that you can use one good in substitution for another. So let's take an example. Let's suppose that you really enjoy eating breakfast cereal, and your very favorite cereal is Cheerios. So you go through, maybe let's say a box a week, and so every week you go to the grocery store and you buy one additional box of Cheerios that you eat for breakfast every week. But let's suppose that this week you go to the grocery store and you see that the price of Cheerios has gone from $2 a box to $5 a box. None of the other cereals are more expensive, but Cheerios is substantially so. So what do you do? How do you respond? The law of demand would tell us that you'd reduce the consumption of Cheerios. But if it's your favorite cereal, do you really want to do that? What are your individual preferences? Well, in this case, what we look at is how many substitutes do you have? How many other choices do you have that you perceive as a good option? In other words, you could buy Raisin Bran, you could buy Rice Krispies, you could buy so many other cereals. Dozens of other cereals are littering the aisles. So, do you stick with your Cheerios, or do you change? The benefit here is you've got lots of substitutes, and that makes you more responsive to prices, holding everything else equal. Share of the budget. This reflects what percent of the budget is expended on this item. Let's use some comparisons. Let's say that we look at the rent for your apartment. And the rent for your apartment, let's say, comprises 40% of your budget. So if there's an increase in your rent, that's a substantial hit to your budget. However, let's compare that to the cost of salt. Now what do I mean when I say salt? Let's imagine in our heads the small cylinder of salt that you buy from the grocery store. How often do you buy one of those? Maybe once a year? So how expensive? maybe 50 cents, 75 cents for one of those containers of salt. So not only do you not buy a lot, but it's also something that comprises an extremely small portion of your budget, especially compared to rent. So if the cost of salt doubled to where you had to spend $2 instead of $1 every six months, that wouldn't necessarily change a lot of your consumption. But if your rent doubled, let's say from $500 to $1,000, $1,000. it would take a substantial hit on your budget. And so that makes consumers more responsive to items that comprise larger amounts of the budget. What about necessities versus luxuries? A necessity is something that you have to have. A luxury is something that you want or you enjoy. A necessity might be, for example, insulin if you're diabetic, whereas a luxury might be something like a cruise, a cruise vacation to the Caribbean, for example. If you're a diabetic, you have to have insulin. Keep in mind there's also not very many substitutes for that product. And so you tend to be very price insensitive. In other words, you're not very responsive to those changes in price. However, if you're talking about a cruise, specifically a cruise to the Caribbean, and the price goes up, you might be sensitive or you might be responsive. In other words, you might choose to go somewhere else on vacation. You might choose to go on a different cruise or you might choose not to take a cruise at all. It's something that you want, not something that you need. And there's lots of other choices. And so you can afford to be more responsive. What about broad versus narrow definition of the market? When we talk about broad versus narrow definition, it's helpful to have another example. Let's suppose we wanted to compare the responsiveness in the market for blue jeans versus the market for clothing in general. So if blue jeans go up in price, what can you do? You can substitute towards another piece of clothing. But if the price of all clothing goes up, you can't substitute away. And so when we talk about a very narrow definition of the market, we're increasing the number of substitutes. When we talk about a broad definition, we're decreasing the number of substitutes. Another good example in this case is a car, right? All cars in general. versus one specific model year of one type of car. Finally, time. Short versus long run. When we say short versus long run, an easy way to think of this is a short period of time and a long period of time. We'll come back later and discuss how economists define short run and long run more in the context of the firm. But in this case, you can just simply think of it as a short time period and a long time period. When we refer to time, we can think of one product and how we respond at different points. So if we think about gasoline, if let's suppose that you're you're somewhere with your car and you realize that you're almost out of gas. And so you pull over to the gas station and you see that the price since the last time you filled up has tripled. But you know that you can't drive your car home without buying at least a gallon worth of gas. And so what do you do? Well, you go ahead and buy the gas because you don't have any other choice. A.K.A. you don't have any substitutes. But once you get your car back home, you can do what? You can substitute away from having to use your car as much. Maybe you carpool with friends, maybe you take the bus, maybe you ride your bike. As the time period goes on, you can be more adaptive and therefore more responsive to those changes in price. So these help us define exactly why individuals may be more or less responsive. Let's look at exactly what we mean when we talk about this responsiveness or sensitivity in terms of a mathematical definition. Remember, we said the price elasticity of demand is the change in quantity demanded based on a change in price. And we said we define that in percentage terms. So specifically, we divide the percentage change of quantity demanded by the percentage change in price. In terms of a formula. we can see that the price elasticity of demand is exactly that ratio. So let's take a quick example. Let's suppose that we were talking about a product, let's say that price of Cheerios, and the price of Cheerios went up by 5%. That's an increase in the price by 5%. That led to a decrease by 10% of your quantity demanded. So what does that mean in terms of your price elasticity of demand? If we substitute in the formula, a decrease in the quantity demanded would be a negative 10%. An increase in the price by 5% would be a positive 5%. Our percents cancel out and we're left with 10 divided by 5 or 2. Now, don't forget your negative sign. We've got minus 10 over positive 5. So we would also add a negative sign to that elasticity. However, typically the connotation, especially in an introductory economics course, is to drop that negative sign. In other words, we simply just take the absolute value and leave our elasticity at 2. So what does an elasticity of 2 mean? Well, it tells me that my change in quantity demanded in percent terms was twice as large as my change in price. That tells me that in this case a small increase in price led to a relatively larger decrease in demand. This consumer is price sensitive. Now in most cases we talk about percentage change and that's how we'll calculate our elasticity. But more often than not we're going to be given our changes in terms of the context of our demand equation, our demand curve. Therefore we have to look at specifically an example where we talk about how to calculate that percentage. So we're going to use what's called the midpoint method to calculate our elasticity. The midpoint method uses the same percentage change in quantity and price, except it gives you a specific formula about how it changes across a range of prices and quantities. So in the numerator, we look at the change in quantity over the averages of our quantities. In other words, the starting quantity. relative to the ending quantity. We do the same for price. So our specific formula becomes the following. Our price elasticity of demand, remember, is percentage change in quantity demanded over the percentage change in price, but we also look at it from the difference between our quantities divided by the average of our quantities, q2 plus q1 divided by 2, all over the percentage change in price or our difference in price divided by the averages of our price. What this allows us to do is get a price elasticity over the range. In other words, we're comparing two different points on our demand curve and asking how quickly do consumers or how responsive are consumers to these changes.

Arguably, this is the most important factor that influences an individual's responsiveness. Remember, substitutes reflects the idea that you can use one good in substitution for another. So let's take an example. Let's suppose that you really enjoy eating breakfast cereal, and your very favorite cereal is Cheerios. So you go through, maybe let's say a box a week, and so every week you go to the grocery store and you buy one additional box of Cheerios that you eat for breakfast every week.

But let's suppose that this week you go to the grocery store and you see that the price of Cheerios has gone from $2 a box to $5 a box. None of the other cereals are more expensive, but Cheerios is substantially so. So what do you do? How do you respond? The law of demand would tell us that you'd reduce the consumption of Cheerios.

But if it's your favorite cereal, do you really want to do that? What are your individual preferences? Well, in this case, what we look at is how many substitutes do you have? How many other choices do you have that you perceive as a good option? In other words, you could buy Raisin Bran, you could buy Rice Krispies, you could buy so many other cereals.

Dozens of other cereals are littering the aisles. So, do you stick with your Cheerios, or do you change? The benefit here is you've got lots of substitutes, and that makes you more responsive to prices, holding everything else equal. Share of the budget. This reflects what percent of the budget is expended on this item.

Let's use some comparisons. Let's say that we look at the rent for your apartment. And the rent for your apartment, let's say, comprises 40% of your budget.

So if there's an increase in your rent, that's a substantial hit to your budget. However, let's compare that to the cost of salt. Now what do I mean when I say salt? Let's imagine in our heads the small cylinder of salt that you buy from the grocery store.

How often do you buy one of those? Maybe once a year? So how expensive?

maybe 50 cents, 75 cents for one of those containers of salt. So not only do you not buy a lot, but it's also something that comprises an extremely small portion of your budget, especially compared to rent. So if the cost of salt doubled to where you had to spend $2 instead of $1 every six months, that wouldn't necessarily change a lot of your consumption. But if your rent doubled, let's say from $500 to $1,000, $1,000.

it would take a substantial hit on your budget. And so that makes consumers more responsive to items that comprise larger amounts of the budget. What about necessities versus luxuries? A necessity is something that you have to have.

A luxury is something that you want or you enjoy. A necessity might be, for example, insulin if you're diabetic, whereas a luxury might be something like a cruise, a cruise vacation to the Caribbean, for example. If you're a diabetic, you have to have insulin.

Keep in mind there's also not very many substitutes for that product. And so you tend to be very price insensitive. In other words, you're not very responsive to those changes in price.

However, if you're talking about a cruise, specifically a cruise to the Caribbean, and the price goes up, you might be sensitive or you might be responsive. In other words, you might choose to go somewhere else on vacation. You might choose to go on a different cruise or you might choose not to take a cruise at all.

It's something that you want, not something that you need. And there's lots of other choices. And so you can afford to be more responsive.

What about broad versus narrow definition of the market? When we talk about broad versus narrow definition, it's helpful to have another example. Let's suppose we wanted to compare the responsiveness in the market for blue jeans versus the market for clothing in general. So if blue jeans go up in price, what can you do?

You can substitute towards another piece of clothing. But if the price of all clothing goes up, you can't substitute away. And so when we talk about a very narrow definition of the market, we're increasing the number of substitutes. When we talk about a broad definition, we're decreasing the number of substitutes. Another good example in this case is a car, right?

All cars in general. versus one specific model year of one type of car. Finally, time.

Short versus long run. When we say short versus long run, an easy way to think of this is a short period of time and a long period of time. We'll come back later and discuss how economists define short run and long run more in the context of the firm. But in this case, you can just simply think of it as a short time period and a long time period. When we refer to time, we can think of one product and how we respond at different points.

So if we think about gasoline, if let's suppose that you're you're somewhere with your car and you realize that you're almost out of gas. And so you pull over to the gas station and you see that the price since the last time you filled up has tripled. But you know that you can't drive your car home without buying at least a gallon worth of gas.

And so what do you do? Well, you go ahead and buy the gas because you don't have any other choice. A.K.A. you don't have any substitutes. But once you get your car back home, you can do what? You can substitute away from having to use your car as much.

Maybe you carpool with friends, maybe you take the bus, maybe you ride your bike. As the time period goes on, you can be more adaptive and therefore more responsive to those changes in price. So these help us define exactly why individuals may be more or less responsive.

Let's look at exactly what we mean when we talk about this responsiveness or sensitivity in terms of a mathematical definition. Remember, we said the price elasticity of demand is the change in quantity demanded based on a change in price. And we said we define that in percentage terms.

So specifically, we divide the percentage change of quantity demanded by the percentage change in price. In terms of a formula. we can see that the price elasticity of demand is exactly that ratio.

So let's take a quick example. Let's suppose that we were talking about a product, let's say that price of Cheerios, and the price of Cheerios went up by 5%. That's an increase in the price by 5%.

That led to a decrease by 10% of your quantity demanded. So what does that mean in terms of your price elasticity of demand? If we substitute in the formula, a decrease in the quantity demanded would be a negative 10%. An increase in the price by 5% would be a positive 5%. Our percents cancel out and we're left with 10 divided by 5 or 2. Now, don't forget your negative sign.

We've got minus 10 over positive 5. So we would also add a negative sign to that elasticity. However, typically the connotation, especially in an introductory economics course, is to drop that negative sign. In other words, we simply just take the absolute value and leave our elasticity at 2. So what does an elasticity of 2 mean?

Well, it tells me that my change in quantity demanded in percent terms was twice as large as my change in price. That tells me that in this case a small increase in price led to a relatively larger decrease in demand. This consumer is price sensitive. Now in most cases we talk about percentage change and that's how we'll calculate our elasticity. But more often than not we're going to be given our changes in terms of the context of our demand equation, our demand curve.

Therefore we have to look at specifically an example where we talk about how to calculate that percentage. So we're going to use what's called the midpoint method to calculate our elasticity. The midpoint method uses the same percentage change in quantity and price, except it gives you a specific formula about how it changes across a range of prices and quantities. So in the numerator, we look at the change in quantity over the averages of our quantities.

In other words, the starting quantity. relative to the ending quantity. We do the same for price.

So our specific formula becomes the following. Our price elasticity of demand, remember, is percentage change in quantity demanded over the percentage change in price, but we also look at it from the difference between our quantities divided by the average of our quantities, q2 plus q1 divided by 2, all over the percentage change in price or our difference in price divided by the averages of our price. What this allows us to do is get a price elasticity over the range. In other words, we're comparing two different points on our demand curve and asking how quickly do consumers or how responsive are consumers to these changes.

Transcript for:Understanding Price Elasticity of Demand

Transcript for:
Understanding Price Elasticity of Demand