Worked Problems Price Elasticity of Demand

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Problem 4.1 - Elasticity of demand

Problem: Answer:

Suppose a firm sells 20,000 units when the price is $16, The midpoint formula uses the average of the two
but sells 30,000 units when the price falls to $14. quantities as the reference point for computing the
percentage change. In this example, the percentage
Calculate the percentage change in the quantity sold change is (30,000 – 20,000)/25,000 = 0.40, or 40%.
over this price range using the midpoint formula. The percentage change is (16 – 14)/15 = 0.133, or
Calculate the percentage change in the price using the 13.3%.
midpoint formula. The price elasticity of demand is the ratio of the
Find the price elasticity of demand over this range of percentage change in quantity to the percentage
prices. State whether demand is elastic or inelastic over change in price. In this example, Ed = 40/13.3 = 3.
this range. Since Ed is bigger than one, demand is elastic.
Suppose the firm's elasticity of demand is constant over The elasticity of demand equals the percentage change
a large range of prices, equal to the value found in part in quantity divided by the percentage change in price.
c. If the price were to fall another 4%, what should the Rearranging this relationship, the percentage change in
firm predict will happen to its quantity sold? quantity is equal to the elasticity of demand times
percentage change in price. In this example, E
the price change is 4%, so quantity sold will increase by
12%. 12% = 3 x 4%.

Problem 4.2 - Total-revenue test

Problem: Answer:

Suppose a firm sells 70 units when the price is $6, but Revenue equals price times quantity sold. At P = $6,
sells 80 units when the price falls to $4. revenue equals $420. $420 = $6 x 70. At P = $4,
revenue = $4 x 80 = $320.
Calculate the firm's revenue at each of the prices. Revenue falls when the price falls, suggesting demand
Use the total-revenue test to determine whether is inelastic over this range.
demand is elastic or inelastic over this range. Ed = [(80 – 70)/75] / [(6 – 4)/5] = .133/.40 = .33, or
Verify your previous answer by calculating the elasticity 1/3. This is less than one, verifying that demand is
of demand using the midpoint formula. inelastic.

Price Elasticity of Demand

This is a measure of the responsiveness of demand to changes in price. Price elasticity of
demand may be calculated using the point method as follows:
For example, assume the price of particular new car model rose from $20,000 to $25,000,
resulting in demand falling from 10,000 to 5,000 new car sales.

The calculation would be as follows;

If elasticity is greater than 1 (as in the above example), there is an ELASTIC demand; if
elasticity equals 1 (or less) then demand is INELASTIC.

ELASTIC DEMAND means that when price increases lead to a MORE THAN proportional
decrease in the quantity demanded, and vice versa.

The degree of elasticity depends on the availability of substitutes. Elastic demand tends to
be for products often regarded as luxuries, including DVD equipment, cameras, and cars
etc.

INELASTIC DEMAND means that when price increases lead to a LESS THAN proportional
decrease in the quantity demanded and vice versa. Inelastic demand tends to be for
essential products, which cannot be done without, such as bread, milk, beer and cigarettes
etc.

Another example: (for other types of elasticity like the ‘income demand elasticity’)

Demand elasticity is an economic measure of the sensitivity of demand relative to a

change in another variable. The quantity demanded of a good or service depends on
multiple factors, such as price, income and preference. Whenever there is a change
in these variables, it causes a change in the quantity demanded of the good or
service.

For example, when there is a relationship between the change in the quantity
demanded and the price of a good or service, the elasticity is known as price
elasticity of demand. The two other main types of demand elasticity are income
elasticity of demand and cross elasticity of demand.

Consumers' incomes play a very important role in the demand for a good or service.
When there is a change in consumers' incomes, it causes a change in the quantity
demanded of a good or service if all other factors remain the same. The sensitivity of
a change in the quantity demanded of a good or service relative to a change in
consumers' incomes is known as income elasticity of demand. The formula used to
calculate the income elasticity of demand is the percent change in the quantity
demanded of a good or service divided by its percent change in consumers'
incomes.

If the income elasticity of demand is greater than 1, the good or service is considered
a luxury and income elastic. A good or service that has an income elasticity of
demand between zero and 1 is considered a normal good and income inelastic. If a
good or service has an income elasticity of demand below zero, it is considered
an inferior good and has negative income elasticity.

For example, suppose a good has an income elasticity of demand of -1.5. The good
is considered inferior and the quantity demanded for this good falls as consumers'
incomes rise.

Another example of demand elasticity is cross elasticity of demand. This measures

how sensitive the quantity demanded of a good or service is relative to a change in
the price of a similar good or service. The cross elasticity of demand is calculated by
dividing the percent change of the quantity demanded of one good divided by the
percent change in the price of a substitute good.

If the cross elasticity of demand of goods is greater than zero, the goods are said to
be substitutes. With goods that have a cross elasticity of demand equal to zero, the
two goods are independent of each other. If the cross elasticity of demand is less
than zero, the two goods are said to be complementary.

For example, toothpaste is an example of a substitute good. If the price of one brand
of toothpaste increases, the demand for another brand increases as well. An
example of complementary goods are hot dog buns and hot dogs. If the price of hot
dogs increases with everything else remaining unchanged, the quantity demanded
for hot dog buns decreases.

Read more: What are some examples of demand elasticity other than price elasticity of
demand? | Investopedia https://www.investopedia.com/ask/answers/040815/what-are-some-
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