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From Wikipedia, the free encyclopedia

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"Elasticity of demand" redirects here. For income elasticity, see income elasticity

of demand. For cross elasticity, see cross elasticity of demand. For wealth

elasticity, see wealth elasticity of demand.

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"Price elasticity" redirects here. It is not to be confused with Price elasticity

of supply.

Price elasticity of demand (PED or Ed) is a measure used in economics to show the

responsiveness, or elasticity, of the quantity demanded of a good or service to a

change in its price, ceteris paribus. More precisely, it gives the percentage

change in quantity demanded in response to a one percent change in price (ceteris

paribus).

Price elasticities are almost always negative, although analysts tend to ignore the

sign even though this can lead to ambiguity. Only goods which do not conform to the

law of demand, such as Veblen and Giffen goods, have a positive PED. In general,

the demand for a good is said to be inelastic (or relatively inelastic) when the

PED is less than one (in absolute value): that is, changes in price have a

relatively small effect on the quantity of the good demanded. The demand for a good

is said to be elastic (or relatively elastic) when its PED is greater than one (in

absolute value): that is, changes in price have a relatively large effect on the

quantity of a good demanded. Demand for a good is:

e_{{\langle p\rangle }}={\frac {{\mathrm {d}}Q/Q}{{\mathrm {d}}P/P}}

Revenue is maximized when price is set so that the PED is exactly one. The PED of a

good can also be used to predict the incidence (or "burden") of a tax on that good.

Various research methods are used to determine price elasticity, including test

markets, analysis of historical sales data and conjoint analysis.

Contents [hide]

1 Definition

2 Point-price elasticity of demand

3 Arc elasticity

4 History

5 Determinants

6 Relation to marginal revenue

7 Effect on total revenue

8 Effect on tax incidence

9 Optimal pricing

9.1 Constant elasticity and optimal pricing

9.2 Non-constant elasticity and optimal pricing

9.3 Limitations of revenue-maximizing and profit-maximizing pricing strategies

10 Selected price elasticities

11 See also

12 Notes

13 References

14 External links

Definition[edit]

The variation in demand in response to a variation in price is called the price

elasticity of demand. It may also be defined as the ratio of the percentage change

in demand to the percentage change in price of particular commodity.[1] The formula

for the coefficient of price elasticity of demand for a good is:[2][3][4]

e_{{\langle p\rangle }}={\frac {{\mathrm {d}}Q/Q}{{\mathrm {d}}P/P}}

The above formula usually yields a negative value, due to the inverse nature of the

relationship between price and quantity demanded, as described by the "law of

demand".[3] For example, if the price increases by 5% and quantity demanded

decreases by 5%, then the elasticity at the initial price and quantity = -5%/5% =

-1. The only classes of goods which have a PED of greater than 0 are Veblen and

Giffen goods.[5] Although the PED is negative for the vast majority of goods and

services, economists often refer to price elasticity of demand as a positive value

(i.e., in absolute value terms).[4]

demand for a good, i.e., the elasticity of demand with respect to the good's own

price, in order to distinguish it from the elasticity of demand for that good with

respect to the change in the price of some other good, i.e., a complementary or

substitute good.[1] The latter type of elasticity measure is called a cross-price

elasticity of demand.[6][7]

As the difference between the two prices or quantities increases, the accuracy of

the PED given by the formula above decreases for a combination of two reasons.

First, the PED for a good is not necessarily constant; as explained below, PED can

vary at different points along the demand curve, due to its percentage nature.[8]

[9] Elasticity is not the same thing as the slope of the demand curve, which is

dependent on the units used for both price and quantity.[10][11] Second, percentage

changes are not symmetric; instead, the percentage change between any two values

depends on which one is chosen as the starting value and which as the ending value.

For example, if quantity demanded increases from 10 units to 15 units, the

percentage change is 50%, i.e., (15 - 10) 10 (converted to a percentage). But if

quantity demanded decreases from 15 units to 10 units, the percentage change is

-33.3%, i.e., (10 - 15) 15.[12][13]

basic elasticity formula: point-price elasticity and arc elasticity.

The point elasticity of demand method is used to determine change in demand within

the same demand curve, basically a very small amount of change in demand is

measured through point elasticity. One way to avoid the accuracy problem described

above is to minimize the difference between the starting and ending prices and

quantities. This is the approach taken in the definition of point-price elasticity,

which uses differential calculus to calculate the elasticity for an infinitesimal

change in price and quantity at any given point on the demand curve:[14]

{d} P}}} E_{d}={\frac {P}{Q_{d}}}\times {\frac {{\mathrm {d}}Q_{d}}{{\mathrm

{d}}P}}

In other words, it is equal to the absolute value of the first derivative of

quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided

by its quantity (Qd).[15] However, the point-price elasticity can be computed only

if the formula for the demand function, {\displaystyle Q_{d}=f(P)} Q_{d}=f(P), is

known so its derivative with respect to price, {\displaystyle {dQ_{d}/dP}}

{dQ_{d}/dP}, can be determined.

defined as follows:[16] let {\displaystyle \displaystyle x(p,w)} \displaystyle

x(p,w) be the demand of goods {\displaystyle x_{1},x_{2},\dots ,x_{L}}

x_{1},x_{2},\dots ,x_{L} as a function of parameters price and wealth, and let

{\displaystyle \displaystyle x_{l}(p,w)} \displaystyle x_{l}(p,w) be the demand for

good {\displaystyle \displaystyle l} \displaystyle l. The elasticity of demand for

good {\displaystyle \displaystyle x_{l}(p,w)} \displaystyle x_{l}(p,w) with respect

to price {\displaystyle p_{k}} p_{k} is

{\frac {p_{k}}{x_{l}(p,w)}}={\frac {\partial \log x_{l}(p,w)}{\partial \log

p_{k}}}} E_{{x_{l},p_{k}}}={\frac {\partial x_{l}(p,w)}{\partial p_{k}}}\cdot

{\frac {p_{k}}{x_{l}(p,w)}}={\frac {\partial \log x_{l}(p,w)}{\partial \log

p_{k}}}

Arc elasticity[edit]

Main article: arc elasticity

A second solution to the asymmetry problem of having a PED dependent on which of

the two given points on a demand curve is chosen as the "original" point will and

which as the "new" one is to compute the percentage change in P and Q relative to

the average of the two prices and the average of the two quantities, rather than

just the change relative to one point or the other. Loosely speaking, this gives an

"average" elasticity for the section of the actual demand curvei.e., the arc of

the curvebetween the two points. As a result, this measure is known as the arc

elasticity, in this case with respect to the price of the good. The arc elasticity

is defined mathematically as:[13][17][18]

{2}}}\times {\frac {\Delta Q_{d}}{\Delta P}}={\frac {P_{1}+P_{2}}{Q_{d_{1}}

+Q_{d_{2}}}}\times {\frac {\Delta Q_{d}}{\Delta P}}} E_{d}={\frac {{\frac

{P_{1}+P_{2}}{2}}}{{\frac {Q_{{d_{1}}}+Q_{{d_{2}}}}{2}}}}\times {\frac {\Delta

Q_{d}}{\Delta P}}={\frac {P_{1}+P_{2}}{Q_{{d_{1}}}+Q_{{d_{2}}}}}\times {\frac

{\Delta Q_{d}}{\Delta P}}

This method for computing the price elasticity is also known as the "midpoints

formula", because the average price and average quantity are the coordinates of the

midpoint of the straight line between the two given points.[12][18] This formula is

an application of the midpoint method. However, because this formula implicitly

assumes the section of the demand curve between those points is linear, the greater

the curvature of the actual demand curve is over that range, the worse this

approximation of its elasticity will be.[17][19]

History[edit]

The illustration that accompanied Marshall's original definition of PED, the ratio

of PT to Pt

Together with the concept of an economic "elasticity" coefficient, Alfred Marshall

is credited with defining PED ("elasticity of demand") in his book Principles of

Economics, published in 1890.[20] He described it thus: "And we may say generally:

the elasticity (or responsiveness) of demand in a market is great or small

according as the amount demanded increases much or little for a given fall in

price, and diminishes much or little for a given rise in price".[21] He reasons

this since "the only universal law as to a person's desire for a commodity is that

it diminishes... but this diminution may be slow or rapid. If it is slow... a small

fall in price will cause a comparatively large increase in his purchases. But if it

is rapid, a small fall in price will cause only a very small increase in his

purchases. In the former case... the elasticity of his wants, we may say, is great.

In the latter case... the elasticity of his demand is small."[22] Mathematically,

the Marshallian PED was based on a point-price definition, using differential

calculus to calculate elasticities.[23]

Determinants[edit]

The overriding factor in determining PED is the willingness and ability of

consumers after a price change to postpone immediate consumption decisions

concerning the good and to search for substitutes ("wait and look").[24] A number

of factors can thus affect the elasticity of demand for a good:[25]

The more and closer the substitutes available, the higher the elasticity is likely

to be, as people can easily switch from one good to another if an even minor price

change is made;[25][26][27] There is a strong substitution effect.[28] If no close

substitutes are available, the substitution effect will be small and the demand

inelastic.[28]

Breadth of definition of a good

The broader the definition of a good (or service), the lower the elasticity. For

example, Company X's fish and chips would tend to have a relatively high elasticity

of demand if a significant number of substitutes are available, whereas food in

general would have an extremely low elasticity of demand because no substitutes

exist.[29]

Percentage of income

The higher the percentage of the consumer's income that the product's price

represents, the higher the elasticity tends to be, as people will pay more

attention when purchasing the good because of its cost;[25][26] The income effect

is substantial.[30] When the goods represent only a negligible portion of the

budget the income effect will be insignificant and demand inelastic,[30]

Necessity

The more necessary a good is, the lower the elasticity, as people will attempt to

buy it no matter the price, such as the case of insulin for those who need it.[10]

[26]

Duration

For most goods, the longer a price change holds, the higher the elasticity is

likely to be, as more and more consumers find they have the time and inclination to

search for substitutes.[25][27] When fuel prices increase suddenly, for instance,

consumers may still fill up their empty tanks in the short run, but when prices

remain high over several years, more consumers will reduce their demand for fuel by

switching to carpooling or public transportation, investing in vehicles with

greater fuel economy or taking other measures.[26] This does not hold for consumer

durables such as the cars themselves, however; eventually, it may become necessary

for consumers to replace their present cars, so one would expect demand to be less

elastic.[26]

Brand loyalty

An attachment to a certain brandeither out of tradition or because of proprietary

barrierscan override sensitivity to price changes, resulting in more inelastic

demand.[29][31]

Who pays

Where the purchaser does not directly pay for the good they consume, such as with

corporate expense accounts, demand is likely to be more inelastic.[31]

Relation to marginal revenue[edit]

The following equation holds:

{E_{d}}}\right)

where

R' is the marginal revenue

P is the price

Proof:

TR = Total Revenue

90

{\displaystyle R'={\dfrac {\partial TR}{\partial Q}}={\dfrac {\partial }{\partial

Q}}(P\,Q)=P+Q\,{\dfrac {\partial P}{\partial Q}}} R'={\dfrac {\partial TR}

{\partial Q}}={\dfrac {\partial }{\partial Q}}(P\,Q)=P+Q\,{\dfrac {\partial P}

{\partial Q}}

{Q}}\Rightarrow E_{d}\cdot {\dfrac {Q}{P}}={\dfrac {\partial Q}{\partial

P}}\Rightarrow {\dfrac {P}{E_{d}\cdot Q}}={\dfrac {\partial P}{\partial Q}}}

{\displaystyle E_{d}={\dfrac {\partial Q}{\partial P}}\cdot {\dfrac {P}

{Q}}\Rightarrow E_{d}\cdot {\dfrac {Q}{P}}={\dfrac {\partial Q}{\partial

P}}\Rightarrow {\dfrac {P}{E_{d}\cdot Q}}={\dfrac {\partial P}{\partial Q}}}

{E_{d}}}\right)} {\displaystyle R'=P+Q\cdot {\dfrac {P}{E_{d}\cdot Q}}=P\,\left(1+

{\dfrac {1}{E_{d}}}\right)}

On a graph with both a demand curve and a marginal revenue curve, demand will be

elastic at all quantities where marginal revenue is positive. Demand is unit

elastic at the quantity where marginal revenue is zero. Demand is inelastic at

every quantity where marginal revenue is negative.[32]

See also: Total revenue test

A set of graphs shows the relationship between demand and total revenue (TR) for a

linear demand curve. As price decreases in the elastic range, TR increases, but in

the inelastic range, TR decreases. TR is maximised at the quantity where PED = 1.

A firm considering a price change must know what effect the change in price will

have on total revenue. Revenue is simply the product of unit price times quantity:

Generally any change in price will have two effects:[33]

For inelastic goods, an increase in unit price will tend to increase revenue, while

a decrease in price will tend to decrease revenue. (The effect is reversed for

elastic goods.)

The quantity effect

An increase in unit price will tend to lead to fewer units sold, while a decrease

in unit price will tend to lead to more units sold.

For inelastic goods, because of the inverse nature of the relationship between

price and quantity demanded (i.e., the law of demand), the two effects affect total

revenue in opposite directions. But in determining whether to increase or decrease

prices, a firm needs to know what the net effect will be. Elasticity provides the

answer: The percentage change in total revenue is approximately equal to the

percentage change in quantity demanded plus the percentage change in price. (One

change will be positive, the other negative.)[34] The percentage change in quantity

is related to the percentage change in price by elasticity: hence the percentage

change in revenue can be calculated by knowing the elasticity and the percentage

change in price alone.

As a result, the relationship between PED and total revenue can be described for

any good:[35][36]

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0),

changes in the price do not affect the quantity demanded for the good; raising

prices will always cause total revenue to increase. Goods necessary to survival can

be classified here; a rational person will be willing to pay anything for a good if

the alternative is death. For example, a person in the desert weak and dying of

thirst would easily give all the money in his wallet, no matter how much, for a

bottle of water if he would otherwise die. His demand is not contingent on the

price.

When the price elasticity of demand for a good is relatively inelastic (-1 < Ed <

0), the percentage change in quantity demanded is smaller than that in price.

Hence, when the price is raised, the total revenue increases, and vice versa.

When the price elasticity of demand for a good is unit (or unitary) elastic (Ed =

-1), the percentage change in quantity demanded is equal to that in price, so a

change in price will not affect total revenue.

When the price elasticity of demand for a good is relatively elastic ( -? < Ed <

-1), the percentage change in quantity demanded is greater than that in price.

Hence, when the price is raised, the total revenue falls, and vice versa.

When the price elasticity of demand for a good is perfectly elastic (Ed is - ?),

any increase in the price, no matter how small, will cause the quantity demanded

for the good to drop to zero. Hence, when the price is raised, the total revenue

falls to zero. This situation is typical for goods that have their value defined by

law (such as fiat currency); if a 5 dollar bill were sold for anything more than 5

dollars, nobody would buy it, so demand is zero.

Hence, as the accompanying diagram shows, total revenue is maximized at the

combination of price and quantity demanded where the elasticity of demand is

unitary.[36]

constant over all price ranges. The linear demand curve in the accompanying diagram

illustrates that changes in price also change the elasticity: the price elasticity

is different at every point on the curve.

When demand is more inelastic than supply, consumers will bear a greater proportion

of the tax burden than producers will.

Main article: tax incidence

PEDs, in combination with price elasticity of supply (PES), can be used to assess

where the incidence (or "burden") of a per-unit tax is falling or to predict where

it will fall if the tax is imposed. For example, when demand is perfectly

inelastic, by definition consumers have no alternative to purchasing the good or

service if the price increases, so the quantity demanded would remain constant.

Hence, suppliers can increase the price by the full amount of the tax, and the

consumer would end up paying the entirety. In the opposite case, when demand is

perfectly elastic, by definition consumers have an infinite ability to switch to

alternatives if the price increases, so they would stop buying the good or service

in question completelyquantity demanded would fall to zero. As a result, firms

cannot pass on any part of the tax by raising prices, so they would be forced to

pay all of it themselves.[37]

inelastic, that is, somewhere between the extreme cases of perfect elasticity or

inelasticity. More generally, then, the higher the elasticity of demand compared to

PES, the heavier the burden on producers; conversely, the more inelastic the demand

compared to PES, the heavier the burden on consumers. The general principle is that

the party (i.e., consumers or producers) that has fewer opportunities to avoid the

tax by switching to alternatives will bear the greater proportion of the tax

burden.[37] In the end the whole tax burden is carried by individual households

since they are the ultimate owners of the means of production that the firm

utilises (see Circular flow of income).

PED and PES can also have an effect on the deadweight loss associated with a tax

regime. When PED, PES or both are inelastic, the deadweight loss is lower than a

comparable scenario with higher elasticity.

Optimal pricing[edit]

Among the most common applications of price elasticity is to determine prices that

maximize revenue or profit.

If one point elasticity is used to model demand changes over a finite range of

prices, elasticity is implicitly assumed constant with respect to price over the

finite price range. The equation defining price elasticity for one product can be

rewritten (omitting secondary variables) as a linear equation.

where

{\displaystyle K} K is a constant.

Similarly, the equations for cross elasticity for {\displaystyle n} n products can

be written as a set of {\displaystyle n} n simultaneous linear equations.

LP^{k}

where

,n,LQ_{l}=\ln(Q_{l}),LP^{l}=\ln(P^{l})} k=1,\dotsc

,n,LQ_{l}=\ln(Q_{l}),LP^{l}=\ln(P^{l}), and {\displaystyle K_{l}} K_{l} are

constants; and appearance of a letter index as both an upper index and a lower

index in the same term implies summation over that index.

This form of the equations shows that point elasticities assumed constant over a

price range cannot determine what prices generate maximum values of

{\displaystyle \ln(Q)} \ln(Q); similarly they cannot predict prices that generate

maximum {\displaystyle Q} Q or maximum revenue.

elasticities at several points, to determine the price at which point elasticity

equals -1 (or, for multiple products, the set of prices at which the point

elasticity matrix is the negative identity matrix).

If the definition of price elasticity is extended to yield a quadratic relationship

between demand units ( {\displaystyle Q} Q) and price, then it is possible to

compute prices that maximize {\displaystyle \ln(Q)} \ln(Q), {\displaystyle Q} Q,

and revenue. The fundamental equation for one product becomes

LP+E_{2}\times LP^{2}

and the corresponding equation for several products becomes

LQ_{l}=K_{l}+E1_{{l,k}}\times LP^{k}+E2_{{l,k}}\times (LP^{k})^{2}

Excel models are available that compute constant elasticity, and use non-constant

elasticity to estimate prices that optimize revenue or profit for one product[38]

or several products.[39]

In most situations, revenue-maximizing prices are not profit-maximizing prices. For

example, if variable costs per unit are nonzero (which they almost always are),

then a more complex computation of a similar kind yields prices that generate

optimal profits.

example, where scale economies are large (as they often are), capturing market

share may be the key to long-term dominance of a market, so maximizing revenue or

profit may not be the optimal strategy.

Various research methods are used to calculate price elasticities in real life,

including analysis of historic sales data, both public and private, and use of

present-day surveys of customers' preferences to build up test markets capable of

modelling such changes. Alternatively, conjoint analysis (a ranking of users'

preferences which can then be statistically analysed) may be used.[40] Approximate

estimates of price elasticity can be calculated from the income elasticity of

demand, under conditions of preference independence. This approach has been

emprirically validated using bundles of goods (e.g. food, healthcare, education,

recreation, etc.).[41]

Though PEDs for most demand schedules vary depending on price, they can be modeled

assuming constant elasticity.[42] Using this method, the PEDs for various

goodsintended to act as examples of the theory described aboveare as follows. For

suggestions on why these goods and services may have the PED shown, see the above

section on determinants of price elasticity.

Cigarettes (US)[43]

-0.3 to -0.6 (General)

-0.6 to -0.7 (Youth)

Alcoholic beverages (US)[44]

-0.3 or -0.7 to -0.9 as of 1972 (Beer)

-1.0 (Wine)

-1.5 (Spirits)

Airline travel (US)[45]

-0.3 (First Class)

-0.9 (Discount)

-1.5 (for Pleasure Travelers)

Livestock

-0.5 to -0.6 (Broiler Chickens)[46]

Oil (World)

-0.4

Car fuel[47]

-0.09 (Short run)

-0.31 (Long run)

Medicine (US)

-0.31 (Medical insurance)[48]

-0.03 to -0.06 (Pediatric Visits)[49]

Patents

-0.30 to -0.50[50]

Rice[51]

-0.47 (Austria)

-0.8 (Bangladesh)

-0.8 (China)

-0.25 (Japan)

-0.55 (US)

Cinema visits (US)

-0.87 (General)[48]

Live Performing Arts (Theater, etc.)

-0.4 to -0.9[52]

Transport

-0.20 (Bus travel US)[48]

-2.8 (Ford compact automobile)[53]

Cannabis (US)[54]

-0.655

Soft drinks

-0.8 to -1.0 (general)[55]

-3.8 (Coca-Cola)[56]

-4.4 (Mountain Dew)[56]

Steel

-0.2 to -0.3[57]

Telecommunications

-0.405 (Mobile)[58]

-0.434 (Broadband)[59]

Eggs

-0.1 (US: Household only)[60]

-0.35 (Canada)[61]

-0.55 (South Africa)[62]

Golf

-0.3 to -0.7[57]

See also[edit]

Arc elasticity

Cross elasticity of demand

Income elasticity of demand

Price elasticity of supply

Supply and demand

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^ Jump up to: a b Parkin; Powell; Matthews (2002). p.75.

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^ Jump up to: a b Ruffin; Gregory (1988). pp.518-519.

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Jump up ^ Taylor, John (2006). p.93.

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^ Jump up to: a b Frank (2008) 119.

^ Jump up to: a b Png, Ivan (1999). p.62-3.

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^ Jump up to: a b Arnold, Roger (2008). p. 385.

^ Jump up to: a b Wall, Stuart; Griffiths, Alan (2008). pp.57-58.

Jump up ^ "Pricing Tests and Price Elasticity for one product".

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Jump up ^ de Rassenfosse and van Pottelsberghe (2007, p.598; 2012, p.72)

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External links[edit]

A Lesson on Elasticity in Four Parts, Youtube, Jodi Beggs

Price Elasticity Models and Optimization

Price elasticity of demand : Practical Applications

Approx. PED of Various Products (U.S.)

Approx. PED of Various Home-Consumed Foods (U.K.)

Categories: Elasticity (economics)DemandPricing

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