Microeconomics - Price Elasticity

Now that you have completed the basics, let us move onto the various learning outcomes on Microeconomics you should look to know for your upcoming exam.

Price Elasticity
In general, the elasticity of a particular variable is the percentage change in quantity demanded or supplied, divided by the percentage change in the variable of concern. This ratio is often called the elasticity coefficient.

Price elasticity is defined as the percentage change in quantity demanded divided by the percentage change in price.

The price elasticity of demand can be expressed as:

Formula 3.1

Example: Price Elasticity
Where Ep is the price elasticity coefficient, %ΔQ represents the percentage in quantity, and %ΔP represents the percentage in price. If the price of gasoline goes up by 50%, and the quantity demanded decreases by 20%, the price elasticity of gasoline would be:

Ep = %Δ Quantity = -20% = -0.4
%Δ Price +50%

Typically, the negative sign is ignored and we would say that the price elasticity of gasoline is 0.4.

To calculate elasticity we must first have data for quantities purchased at different prices. Suppose that the price of a good goes from P0 to P1, and that we have data for the change in quantity demanded, which goes from Q0 to Q1. The calculation is typically made by dividing the actual change by the average(or midpoint) of the beginning and ending values. Suppose that the quantity demanded of a good goes from 10 to 14. The percentage change in quantity demanded could be expressed as:

(Q0 - Q1) = 4 = 0.333
0.5(Q0 + Q1) 0.5(24)

That number would be multiplied by 100 to get the percentage change, which in this case would be 33.3%.

Similarly, the percentage change in price can be expressed as:

(P0 - P1) x 100
0.5(P0 + P1)

Look Out!
Sometimes the denominator used for these percentage change calculations is simply the original value (P0 and Q0). Because the CFA text uses the midpoint method, unless the exam has instructions to the contrary, it would be safer to use the midpoint method.

The full elasticity calculation can be simplified by canceling out the 0.5 (one-half) and 100. The more simplified expression can be stated as:

Example:
Suppose, to continue the example given above, that the change in quantity demanded for the good (10 to 14) was in response to a price decrease from $8 to $7. In that case, the elasticity would be expressed as:

(10 - 14) / (10 + 14) = -4 / 24 = -1/6 = -15 = -2.5
(8 - 7) / (8 + 7) 1 / 15 1/15 6

Alternatively, the elasticity could have been calculated as: -4 divided by half of 24, which is equal to -0.333, over 1 divided by half of 15, which equals 0.1333.

So the elasticity would be -0.333 over 0.133 = - 2.5, the same answer as above.

The following definitions apply to calculations of price elasticity:

1) If Ep > 1, Demand is elastic. The percentage change in price will produce a greater percentage in quantity demanded. If the price goes up, then total revenues will go down. If the price goes down, then total revenues willincrease.

2) If Ep < 1, Demand is inelastic. The percentage change in price will produce a lower percentage in quantity demanded. If the price goes up, then total revenues will go up. If the price goes down, then total revenues will decrease. Put simply, these changes will be less drastic than if demand is elastic.

3) If Ep = 1, Demand has unitary elasticity. A percentage in price will produce the exact same percentage change in quantity. Therefore, changes in price will no have effect on total revenues.
If demand is elastic for a product, then a small change in price will cause a large change in quantity demanded. If the demand for a product is inelastic, even a large change in price might cause little change in quantity demanded.

Elasticity of Demand


Related Articles
  1. Economics

    Economics Basics: Elasticity

    Investopedia Explains: What elasticity is, how to calculate elasticity, the difference between elastic and inelastic curves, and the various factors that impact elasticity.
  2. Fundamental Analysis

    How Demand Changes With a Variation in Price

    What is demand elasticity?
  3. Economics

    What's Demand Elasticity?

    Demand elasticity is the measure of how demand changes as other factors change. Demand elasticity is often referred to as price elasticity of demand because price is most often the factor used ...
  4. Economics

    Price Elasticity Of Demand

    Price elasticity of demand describes how changes in the cost of a product or service affect a company's revenue.
  5. Economics

    Calculating Income Elasticity of Demand

    Income elasticity of demand is a measure of how consumer demand changes when income changes.
  6. Economics

    What Does Inferior Good Mean?

    The term “inferior good” does not describe a lack of quality, but rather, is an economic term used when discussing elasticity of demand for a good.
  7. Fundamental Analysis

    Calculating The Gain Or Loss On An Investment

    Calculating the percentage of change in an investment is easy. Take the amount the investment gains and divide it by the amount invested.
  8. Economics

    What is Demand?

    Demand is the economic term for the cumulative wants and desires of consumers as they relate to a particular good or service. Generally speaking, if all other factors remain constant, as demand ...
  9. Economics

    What Is Supply?

    Supply is the amount of goods a producer is willing to produce at a given price, and is one of the most basic concepts in economics.
  10. Options & Futures

    A Guide To Investing In Consumer Staples

    These companies may not be flashy but they offer investors structure and diversification.
RELATED TERMS
  1. Cross Elasticity Of Demand

    An economic concept that measures the responsiveness in the quantity ...
  2. Income Elasticity Of Demand

    A measure of the relationship between a change in the quantity ...
  3. Arc Elasticity

    The elasticity of one variable with respect to another between ...
  4. Elastic

    An economic term referring to the change in behavior that buyers ...
  5. Total Revenue Test

    A test that approximates the price elasticity of demand by comparing ...
  6. Elasticity

    A measure of a variable's sensitivity to a change in another ...
RELATED FAQS
  1. What are some examples of demand elasticity other than price elasticity of demand?

    Learn about income elasticity of demand and cross elasticity of demand and how to interpret these two measures of demand ... Read Answer >>
  2. Under what circumstances might price elasticity significantly change?

    Discover under what circumstances price elasticity of demand might change and why it is such an important economic concept ... Read Answer >>
  3. Which factors are more important in determining the demand elasticity of a good or ...

    Learn about demand elasticity of goods and services and the main factors that influence the elasticity of demand. Read Answer >>
  4. How does price elasticity change in relation to supply and demand?

    Learn about how variations in price elasticity affect the supply and demand curves and what factors cause differences in ... Read Answer >>
  5. If a particular good's price elasticity is high, does this mean the supplier should ...

    Learn the basics of price elasticity of supply and demand and how each influences a company's production of goods and pricing ... Read Answer >>
  6. How do you quantify price elasticity?

    Learn how to calculate the coefficient for price elasticity, enabling you to approximate how sensitive supply and demand ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center