Calculus Price Elasticity

Suppose following question is given: Demand is Q = 110 - 5P. What is price (point) elasticity at Rs 5? We saw that we can calculate any elasticity by the formula: Elasticity of Z with respect to Y = (dZ / dY)*(Y/Z) In the case of price elasticity of demand, we are interested in the elasticity of quantity demand with respect to price. Thus we can use the following equation: Price elasticity of demand: = (dQ / dP)*(P/Q) In order to use this equation, we must have quantity alone on the left-hand side, and the right-hand side be some function of price. That is the case in our demand equation of Q = 110 - 5P. Thus we differentiate with respect to P and get: dQ/dP = -5 So we substitute dQ/dP = -5 and Q = 110 - 5P into our price elasticity of demand equation: Price elasticity of demand: = (dQ / dP)*(P/Q) Price elasticity of demand: = (-5)*(P/(110-5P) Price elasticity of demand: = -5P/(110-5P) Since We're interested in finding what the price elasticity is at P = 5, so we substitute this into our price elasticity of demand equation: Price elasticity of demand: = -5P/(110-5P) Price elasticity of demand: = -25/85 Price elasticity of demand: = -5/17 Thus our price elasticity of demand is -5/17 Since it is less than 1 in absolute terms, we say that Demand is Price Inelastic

A Primer on the Price Elasticity of Demand

The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of response of quantity demanded due to a price change. The formula for the Price Elasticity of Demand (PEoD) is: PEoD = (% Change in Quantity Demanded)/(% Change in Price)

Calculating the Price Elasticity of Demand

You may be asked the question "Given the following data, calculate the price elasticity of demand when the price changes from $9.00 to $10.00" Using the chart on the bottom of the page, I'll walk you through answering this question. (Your course may use the more complicated Arc Price Elasticity of Demand formula. If so you'll need to see the article on Arc Elasticity) First we'll need to find the data we need. We know that the original price is $9 and the new price is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity demanded when the price is $9 is 150 and when the price is $10 is 110. Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=110, where "QDemand" is short for "Quantity Demanded". So we have: Price(OLD)=9 Price(NEW)=10 QDemand(OLD)=150 QDemand(NEW)=110 To calculate the price elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD) By filling in the values we wrote down, we get: [110 - 150] / 150 = (-40/150) = -0.2667 We note that % Change in Quantity Demanded = -0.2667 (We leave this in decimal terms. In percentage terms this would be -26.67%). Now we need to calculate the percentage change in price.

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage change in price is: [Price(NEW) - Price(OLD)] / Price(OLD) By filling in the values we wrote down, we get: [10 - 9] / 9 = (1/9) = 0.1111 We have both the percentage change in quantity demand and the percentage change in price, so we can calculate the price elasticity of demand.

Final Step of Calculating the Price Elasticity of Demand

We go back to our formula of: PEoD = (% Change in Quantity Demanded)/(% Change in Price) We can now fill in the two percentages in this equation using the figures we calculated earlier. PEoD = (-0.2667)/(0.1111) = -2.4005 When we analyze price elasticities we're concerned with their absolute value, so we ignore the negative value. We conclude that the price elasticity of demand when the price increases from $9 to $10 is 2.4005.

How Do We Interpret the Price Elasticity of Demand?

A good economist is not just interested in calculating numbers. The number is a means to an end; in the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity suggests that when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on demand. Often an assignment or a test will ask you a follow up question such as "Is the good price elastic or inelastic between $9 and $10". To answer that question, you use the following rule of thumb:

If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If PEoD = 1 then Demand is Unit Elastic If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

Recall that we always ignore the negative sign when analyzing price elasticity, so PEoD is always positive. In the case of our good, we calculated the price elasticity of demand to be 2.4005, so our good is price elastic and thus demand is very sensitive to price changes. Next: Price Elasticity of Supply Data Price Quantity Demanded Quantity Supplied $7 200 50 $8 180 90 $9 150 150 $10 110 210 250 $11 60

Price Elasticity of Demand

An important characteristic of demand is the relationship among market price, quantity demand and consumer expenditure. The nature of demand is

such that a reduction in market price will usually lead to an increase in quantity demanded. Given that consumer expenditure is the product of these two variables, the effect of a price reduction will have an uncertain impact on this expenditure. In some cases a reduction in price will be more than offset by a large increase in quantity demanded -- a situation where demand is price sensitive or price elastic. (Pmkt ) (Qdemanded ) = Expenditure In other cases, the reduction in price results in a proportionally smaller increase in quantity demanded-- a situation where demand is price insensitive or price inelastic. (Pmkt ) (Qdemanded ) = Expenditure This relationship between price and quantity (for a linear demand function) can demonstrated in the diagram below (use the scrollbar to see changes in market price):

When the price falls from $150 to $125 -- a 16.6% reduction, quantity demanded increases by 50% (50 units to 75 units). Thus %Qd > %Pmkt and Expenditure increases. However, when the price falls from $75 to $50 (a 33.3% reduction -- same $25 price change with a smaller base number), quantity demanded only increases by 20% and expenditure falls. On a linear demand function, all points on the upper half of the function represent price-quantity combinations where demand is price elastic. Points on the lower half represent combinations where demand is price inelastic. Also note that at a price of zero (the horizontal intercept), the price elasticity of demand is equal to zero. Numerically, the price elasticity of demand 'p' represents the following ratio:

p = (%Q)/ (%P) such that if (%Q) > %(P) then |p| > 1.0 and demand is price elastic if the opposite is true then |p| < 1.0 and demand is price inelastic This relationship between price changes and expenditure can be summarized in the following table: Elasticity
Price Reduction Price Increase

Demand is Price Demand is Price Elastic: |p| > 1.0 Inelastic: |p| < 1.0
Expenditure increases Expenditure decreases Expenditure decreases Expenditure increases

The formula for the Price Elasticity of Demand can be written as follows:

p = %Q / %P = (Q/Q)/(P/P) = (Q/Q)(P/P) = (Q/P)(P/Q) = (Q)(P)/(P)(Q)

Using this last expression we find that numerator: '(Q)(P)' is defined by the Teal-Green shaded area and the denominator: (P)(Q) is defined by the Blue shaded area. Thus the ratio of these two area provide a graphical look at the elasticity computation. Drag the Price button in both the elastic and inelastic ranges of the demand curve and compare the areas of these two shaded regions. Answers... A. Working with this particular demand equation, a $25.00 change in price will result in a 25 unit change in quantity demanded. Given a starting price of $150, and quantity of 50 units, quantity demanded changes by 50% (Q = 25,

base-Q = 50). The price has changed by only 16.6% (P = $25.00, base-P = $150). In this situation the quantity demanded is starting from a low base value and the base price is relatively high. Thus the %-change in quantity is likely to be greater than the %-change in price -- demand is Price Elastic (p = |50%/16.6%| > 1.0). B. In this case, we are starting with a higher base value for quantity demanded. The percentage change in quantity is 20% (Q = 25 units, baseQ = 125) and the percentage in Price is 33.3% (P = $25.00, base-P = 75.00 a much smaller base value). The %-change in quantity demanded is less than the %-change in price -- demand is Price Inelastic C. In the Price Inelastic range of demand, an increase in market price will result in an increase in revenue. D. When demand is Price Elastic market price and revenue move in opposite directions (i.e., P , Revenue and vice-versa). When demand is Price Inelastic market price and revenue move in the same direction (i.e., P , Revenue and vice-versa).