Lecture Notes: Price Elasticity of Demand

Law of Demand

• Definition: As the price rises, people buy less.
• Response to Price Changes:
  • Luxury Goods: Significant reduction in quantity demanded when prices rise (e.g., diamonds).
  • Necessities: Smaller reduction in quantity demanded (e.g., gasoline).

Price Elasticity of Demand

• Definition: Measures consumer responsiveness to price changes.
• Formula: Elasticity ( \epsilon ) = ( \frac{% \text{ change in quantity demanded}}{% \text{ change in price}} )
  • ( \Delta ) (Delta) represents change.

Calculation Example

• Initial Price and Quantity: $40 and 60 units.
• New Price and Quantity: $60 and 40 units.
• Percent Change in Quantity:
  • Formula: ( \frac{\text{new quantity} - \text{old quantity}}{\text{old quantity}} )
  • Calculation: ( \frac{40 - 60}{60} = -0.333 ) or -33.33%
• Percent Change in Price:
  • Calculation: ( \frac{60 - 40}{40} = 0.5 ) or 50%
• Elasticity Calculation:
  • ( \frac{-33.33%}{50%} = -0.67 )
  • Interpretation: Price increase by 1% results in a 0.67% decrease in quantity demanded.

Understanding Elasticity

• Demand Sensitivity:
  • Elastic Demand: Numerator > Denominator, Elasticity > 1 (in absolute value).
  • Inelastic Demand: Numerator < Denominator, Elasticity < 1.
  • Unit Elastic: Elasticity = 1, equal change in price and quantity.

Determinants of Elasticity

• Availability of Substitutes:
  • More substitutes lead to more elastic demand.
  • Example: Gasoline demand more elastic in cities with public transport.
• Time Factor:
  • Demand more inelastic short-term, more elastic long-term.
• Specificity of Product:
  • Brand-specific demand is more elastic.
  • Example: Specific gasoline station's demand is very elastic.
• Necessity vs Luxury:
  • Luxuries (e.g., diamonds) have more elastic demand.
  • Necessities (e.g., water) have inelastic demand.
• Budget Constraint:
  • Larger budget share = more elastic demand.
  • Example: Overall grocery price changes vs. single item change.

Case Study: Netflix

• Strategy: Reduce elasticity of demand.
  • Original content creation (e.g., "Stranger Things").
  • Increase inelasticity by creating unique, desirable content.
• Outcome:
  • Increased prices without significant customer loss.
  • Revenue growth from $4 billion in 2013 to over $30 billion in 2022.

Conclusion

• Understanding price elasticity of demand is crucial for business strategies and economics.