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. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center