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Understanding Price Elasticity of Demand: A Guide for Business Owners

As a business owner looking to increase revenue, understanding price elasticity of demand is crucial. This concept measures how sensitive the quantity demanded of a good or service is to price changes. Goods can be elastic (strongly responsive to price changes) or inelastic (weakly responsive). Factors influencing elasticity include the availability of substitutes, the necessity of the product, and consumer preferences. This guide highlights the ranking of various goods by elasticity, perfect elasticity and inelasticity, and how price changes impact total revenue.

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Understanding Price Elasticity of Demand: A Guide for Business Owners

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  1. 3/7/13 • Warm-up: Imagine you are a business owner who would like to generate more revenue. Should you raise or lower prices? Explain.

  2. It Depends!

  3. Learning Goal • SWBAT: define price elasticity of demand, identify the determinants of elasticity, and illustrate elasticity in the market graph.

  4. Consider… • How would you respond if the price of cell phone service doubled? • How would you respond if the price of jeans doubled?

  5. Price Elasticity of Demand

  6. Price Elasticity of Demand • A measure of how sensitive or responsive the quantity demanded of a good of service is to a change in price

  7. Price Elasticity of Demand • If there is a big change in quantity demanded for a good or service when the price changes, it is said to have an elastic demand • If there is a very small change in quantity demanded for a good or service when the price changes, it is said to have an inelastic demand

  8. Your task • Rank the goods/services in terms of price elasticity of demand • The first item should be the one for which consumers would be most sensitive/responsive to a change in price • The last item should be the one for which consumers would be least sensitive/responsive to a change in price

  9. Most Elastic to Most Inelastic • Fresh Tomatoes (4.6) • Foreign Travel (4.0) • Restaurant Meals (2.3) • Tires (0.95) • DVDs (0.9) • Physician Services (0.6) • Tobacco (0.45) • Coffee (0.25) • Gasoline (0.2) • Salt (0.1)

  10. Calculating Price Elasticity of Demand % change in quantity demanded % change in price *all negative signs are dropped – absolute values only

  11. For example… • Imagine the quantity of Good A demanded fell by 80% as a result of a 20% increase in price • Good A’s price elasticity of demand would be 4 • (80% ÷ 20%)

  12. Perfect Inelasticity • When quantity demanded does not respond at all to changes in price • Price elasticity of demand = 0 • Air, water, electricity, insulin, drugs (for an addict)

  13. Perfect Elasticity • When quantity demanded will drop to zero as a result of a price increase • price elasticity of demand = ∞ • Goods in a perfectly competitive market

  14. Unit Elastic • When the quantity demanded changes by the same percentage as a change in price • Price elasticity of demand = 1 • Downward sloping demand curve • Most goods/services have a price elasticity of demand between .5 and 1.5

  15. Relative Elasticity

  16. Most Sensitive to Least Sensitive • Fresh Tomatoes (4.6) • Foreign Travel (4.0) • Restaurant Meals (2.3) • Tires (0.95) • DVDs (0.9) • Physician Services (0.6) • Tobacco (0.45) • Coffee (0.25) • Gasoline (0.2) • Salt (0.1)

  17. 3/7/13 • Warm-up: Imagine you are a business owner who would like to generate more revenue. Should you raise or lower prices? Explain.

  18. Total Revenue Test • If D for a good is unit elastic an  in price does not change total revenue • If D for a good is inelastic  in price leads to an  total revenue • If D for a good is elastic  in price leads to a  total revenue

  19. Why might the Demand for some goods be more elastic than others? What factors matter?

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