we have already noted the law of demand which tells us that as the price Rises people will buy less of that thing but there's another dimension to that response that is important to think about how strongly do people respond to price changes if the price of diamonds spikes people would probably respond to it by buying a lot fewer diamonds opting for Alternatives instead or foregoing the luxury altogether but when the price of gasoline spikes up people usually respond with a lot of anger because they don't have many Alternatives nor the option to forego it all together higher prices for gasoline mean people will buy less but not a lot less this feature of demand is what we call price elasticity which is a measure of how responsive consumers are to price changes we can express this idea pretty simply with an equation elasticity represented by the Greek letter Epsilon is the percent change in the quantity demanded divided by the percent change in the price the triangle symbol in there is the Greek letter Delta which is often used to mean change let's see a calculation of elasticity so we can better understand it let's say we start at a price of forty dollars and a quantity demanded of 60 units but then the price Rises to sixty dollars and so people choose to buy less of this thing now buying only 40 units of the good let's start by thinking about what the percent change in the quantity demanded will be the quantity demanded went from 60 down to 40. what is the percent change well the formula for a percent change is always the same it is your new value minus the old value divided by the old value in this case it is the new quantity demanded minus the old quantity demanded divided by the old quantity demanded I've denoted the new and old quantities by labeling them one and two one is the old quantity or the first quantity and two is the new quantity we can just plug in our values and solve the new quantity demanded is 40. while the old one is 60. 40 minus 60 is 20 which when we divide by 60 we get Negative 0.333 in percentage form that is negative 33.33 percent so the quantity demanded dropped by 33.33 percent cool foreign now let's do the same for the percent change in the price the new price is sixty dollars while the old price is forty dollars so we will have 60 minus 40 which is 20 and then when we divide by 40 that'll give us 0.5 or 50 percent the price Rose by 50 percent when we put those into our elasticity formula we take negative 33.33 percent and divide by fifty percent the percent change in the quantity demanded divided by the percent change in the price this gives us negative 0.67 so what does that mean it means that when the price increases by one percent the quantity demanded decreases by 0.67 percent we know that a price increase results in a quantity decrease both because of the law of demand but also because the elasticity is negative in fact the price elasticity of demand will always be negative due to the law of demand so what would you say are consumers here very responsive to a price change I would say no the price went up by a whopping 50 percent but consumers only reduced their consumption by 33 percent a big response would be if they raised the price by 50 and then the consumer bought say 75 percent less think about it the numerator of this equation tells us how customers responded to what happened in the denominator the price increase when the numerator of this equation is bigger than the denominator it means consumers kind of overreacted to the price increase whereas when the numerator is less than the denominator as it is with our example here consumers are under reacting this is how we think about elasticity when the numerator is bigger than the denominator then in absolute value the elasticity will be greater than one remember the elasticity of demand is always negative which is why we need to take the absolute value When comparing it to positive one an elastic demand curve runs flat like this yellow demand here it means that consumers are really sensitive to price changes if you raise the price just a little they will buy a lot less likewise if you lower the price a little they will buy a lot more when the absolute value of elasticity is below 1 meaning the numerator is smaller than the denominator then we call it inelastic demand like this steep red demand here when demand is like this you can raise the price a lot and people will reduce their purchases only a little then there's this special case where elasticity is equal to one meaning the numerator and denominator are the same magnitude we call this unit elastic and while it seems unlikely that the percentage change in the quantity demanded would be exactly the same as the percentage change in the price we will see later on in the course that this is actually The Sweet Spot most businesses want to find with their pricing so what would determine whether or not demand for a product is elastic or inelastic the demand for something will be more elastic meaning consumers are more price sensitive when they have lots of substitutes this is why demand for gasoline is so inelastic we often don't have a lot of substitutes to fueling up our car to get around I would expect demand for gasoline to be more elastic in places like New York or London or Paris where they have extensive public transportation because consumers there have a viable alternative to driving around but in a place like Phoenix where our alternatives to personal vehicles are limited demand is less elastic or more inelastic of course one thing that helps us find Alternatives is time we won't be able to reduce our demand for gasoline right away but if prices remain high people will begin to find other Solutions like carpooling or buying electric vehicles demand is more inelastic in the short run but more elastic in the long run demand is also more elastic for specific items or Brands if Nike raises their price for sneakers a lot people will just turn to Adidas or other competitors so Nike consumers are more price sensitive even if the overall market for sneakers is less elastic or we could use our gasoline example again the demand for gasoline at the Circle K on Union Hills and 32nd Street is very elastic If they raise their price even a little relative to nearby gas stations they will lose almost all of their customers and that is true even if our overall demand for gas is very inelastic the more specific we get with regard to location or brand the more sensitive consumers are to price changes and the more elastic demand is another determinant of the elasticity is the status of the good in our preferences our overall demand for water is pretty inelastic we need it no matter what the price is but our demand for diamonds is very elastic high prices send lots of customers away this goes along with the role of substitutes high prices encourage us to find Alternatives but if something is more of a luxury than a necessity we don't even need to find an alternative we can just say no lastly is the role of our budget constraint when the price of bananas doubles I might still buy just as many because it's such a small expense I hardly notice the difference in the grocery bill but when groceries overall get more expensive I might start looking for ways to pinch pennies the larger the share of our budget something takes up the more price sensitive we have to be because we just can't afford big increases when rents go up by 20 we might be forced to move somewhere less expensive and so the demand for big budget items tends to be more elastic let's look at a company that is obsessed with the price elasticity of demand to get a better idea of what this all means and why it matters back in 2013 Netflix embarked on a deliberate strategy to reduce the elasticity of demand for their service at the time they were streaming mostly unoriginal content movies and TV shows made by other Studios but that year they launched a bunch of original content not available anywhere else Netflix's Chief content officer said the goal is to become HBO faster than HBO can become us considering everything that has happened in the streaming world since 2013 that was a pretty prophetic statement at the time HBO was about twice as expensive as Netflix but today Netflix is quite a bit more expensive than HBO the reason is a change in the elasticity of demand early on Netflix customers were very price sensitive it was a luxury good with a lot of Alternatives like cable television HBO and even physical movie rentals but when Netflix started producing quality content you couldn't see anywhere else their customers became more reluctant to cancel after a price hike Netflix deliberately tried to produce shows like stranger things which would become part of the pop culture and producing dream projects from famous filmmakers and then aggressively campaigning for awards like the Oscars to raise the profile of what they were selling they wanted their customers to think I can't live without my Netflix that is the price elasticity of demand in action when you have a very flat elastic demand customers are very sensitive to the price even a small increase in the price results in a huge loss in sales but if you can make demand less elastic or more inelastic then the same increase in the price now has a very small effect on sales for Netflix this meant they could raise their price a lot and only lose a small number of customers it's no good to lose customers but if you keep those losses small well you're making a lot more from the ones who stay you end up making a lot more money in 2013 Netflix was making about four billion dollars a year in Revenue almost a decade later in 2022 they were making over 30 billion dollars understanding demand and the elasticity of demand isn't just good for your economics class it's good for business