Microeconomics Monday-Price Elasticity of Demand

Each Monday, I am doing a series on Microeconomics.  I think it’s a horribly misunderstood topic. People have been taught that economics is simply a trade off between guns or butter and it’s simply not true.

One of the most fascinating concepts in economics is elasticity.  Each economic curve, supply and demand, has their own elasticity. In many cases, it’s easier to control the elasticity of supply versus demand. This is why there is so much focus on supply chain economics.

Elasticity is general measure of one variable to another.  It is the percent change in one variable that corresponds to a 1% change in another variable. Here is the mathematical formula:

That looks messy, so here is a practical application.  Suppose we have a demand curve that is graphed by using the equation Q=8-2P; where Q= Quantity demanded, and P=Price.  What is the elasticity of demand when P=1?

∆Q/∆P= -2  If P=1, Q=6 then Elasticity =(1/6)(-2)= -1/3 or .33333

How do we interpret this?  A 1% drop in price will equal a 33% increase in demand.  Or, a 3% increase in price will cause demand to drop by 1%.  Very important point to notice, all demand curves have negative slope-except in very, very, rare cases.  Elasticity is critical information to know when you are running a business.

Is elasticity the same with every price?  No, it’s not.  On a simple linear demand curve, elasticity can change depending on the input of Price or Quantity.

Another important point, the slope of the demand curve.  Steeper slopes indicate less elasticity.  This means there are few substitutes for the product you are producing.  Gasoline has a steep slope.  Ironically, governments tend to load taxes onto products that have less elastic demand!  Now you know why.  A horizontal line that has no slope has an elasticity of infinity, or is infinitely elastic.  Vertical lines with no slope have an elasticity of 0.

What determines elasticity?

• the uniqueness of the product
• awareness of substitutes-even the retail configuration within a store; which is why retailers can charge slotting fees
• difficulty of comparisons-experience goods, high fixed cost to buy, price is difficult to compare across product options

Another piece of information that can change elasticity is your time horizon.  Is it the short run, or long run?  In the short run, you probably can’t change.  But, in the long run you may be able to change so you can switch to another product.

Many goods elasticity are determined by the complimentary goods that they are used with. For example, ink cartridges on ink jet printers.  The higher the cost of the investment in one good, the less elastic the demand.  Software can also be this way.  Figuring out a way to provide choices with inelastic goods is a great way to form a start up business.

Demand is more elastic when considering the end benefit.  When customers are more sensitive to the price of the finished good, the prices for the inputs to that good are more elastic. When the products price accounts for a larger share of the total cost benefit, demand is more elastic.  Think about turkey and cranberries as components of a Thanksgiving dinner.  When price is a large expenditure in a budget, demand can be more elastic.  When parties share costs, demand can be elastic.  Think in terms of insurance co-pays, expense account items, tax deductible items.  Demand is more elastic in the short run if the customer can hold inventory and wait for market prices to change.  Cooking oil is highly price elastic.  Decongestants are not.

Some goods are highly dependent on other goods for their elasticity.  Tennis rackets and tennis balls for example.  This is called the cross price elasticity.

If the cross price elasticity is positive, goods can be substituted. Mercedes and BMW for example, or groceries and restaurants. If the cross price elasticity is negative, the goods are compliments. Golf clubs and golf balls, shoes and laces, PC’s and software. Here is the cross price elasticity of demand for certain soft drinks.

Price elasticity of demand is a critical concept to understand as a part of any go to market strategy. It’s related to total revenue, marginal revenue, and the profit maximizing price charged for a good or service.

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