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| | ==Price Elasticity of Demand== | | ==Price Elasticity of Demand== |
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| − | The “price elasticity” of demand is the percentage change in quantity demanded divided by the percentage change in price. It is usually negative but the sign is dropped so that price elasticity is always a positive number.
| + | Here is a new concept for you: "price elasticity of demand." This concept is needed to solve the problem discussed in the prior section above: if the price of a good increases, will the revenue increase or decrease? The answer to that question is provided by the "price elasticity of demand" for the good. |
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| − | More simply, price elasticity is responsiveness to changes in price. Think of a rubber band. How easily can you stretch it any point? The issue is the same for the public’s response to a change in price. Will the public pay the higher price without complaint, or will they tend to refuse?
| + | Let's first try to define what "price elasticity of demand" is. Think of a rubber band. How "elastic" is the rubber band? If you pull on it, does it stretch easily or not? If you pull with a fixed force on a bunch of different rubber bands, the ones having greater elasticity will stretch more than the ones having less elasticity. |
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| − | Let’s take an example. Suppose the local NFL (football) team wants to make even more profit than it does already. The owner decides to increase the ticket prices by 20% for next season. Because watching football is an obsession for many fans, most are likely to pay the higher prices. Maybe only 5% will choose not to renew. The quantity demanded changed little despite a large increase in price. This means the elasticity of demand is low. To be precise, it is the percentage change in quantity demanded divided by the percentage change in price: -5%/20% = -1/4. The sign is dropped so the elasticity is expressed as “1/4”. This low elasticity encourages the supplier (the football team owner) to repeatedly increase the price. Low inelasticity is described as an “inelastic demand” by economists.
| + | Our "force" is a change in price, and our "rubber band" is the demand by the public for the good. The "price elasticity of demand" of the good is the change in demand for the good in response to a change in price. Does an increase in price for the good cause a large decrease in demand? If so, then it has high elasticity. But if an increase in price for the good does not cause much change in demand, then it has low elasticity. |
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| − | How much more revenue does the team make by increasing the price? Revenue is price times quantity. If its original price was P and its original quantity Q, then initial revenue is PxQ, or PQ. After the price increase, the revenue is (1.20 x P) x (.95 x Q) = 1.14PQ. Revenue has thus increase 14% simply by increasing the price. Nice business, if you don’t mind the silliness of watching it!
| + | Specifically, the price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. It is usually negative but the sign is dropped so that price elasticity is always a positive number. |
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| − | Let’s take another example. Suppose that airlines increase the price on their flights from New York to Florida from an average of $300 per seat to $500 per seat. That is a 67% increase. What would that do to the tourist traffic to Florida from New York? It only takes a day and a half to drive to Florida, which incurs gas charges of less than $100 and a hotel charge of perhaps $80. Tourists would likely drive rather than pay the higher fares. The demand for these higher-priced tickets could fall by 75%, assuming that business travel is only a small percentage of that traffic. | + | Let’s take an example. Suppose the local NFL (football) team wants to make even more profit than it does already. The owner decides to increase the ticket prices by 20% for next season. Because watching football is an obsession for many fans, most are likely to pay the higher prices anyway. Maybe only 5% will choose not to renew. The quantity demanded changed little despite a large increase in price. This means the elasticity of demand is low. To be precise, it is the percentage change in quantity demanded divided by the percentage change in price: -5%/20% = -1/4. The sign is dropped so the elasticity is expressed as “1/4”. This low elasticity encourages the supplier (the football team owner) to repeatedly increase the price. Low elasticity is described as an “inelastic demand” by economists. |
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| − | What is the price elasticity of this demand? The percent change in quantity demanded is -75% (3/4) and the percent change in price is 67% (2/3), so the elasticity is -3/4 divided by 2/3 = -9/8. The sign is dropped so the elasticity is expressed as 9/8. It is greater than 1, and thus is described as having an “elastic demand” rather than an “inelastic demand,” which is less than 1. (If it equaled 1, then it would be called “unit elasticity of demand.”) | + | How much more revenue does the team make by increasing the price? Revenue is price times quantity. If its original price was P and its original quantity Q, then initial revenue is PxQ, or PQ. After the price increase, the revenue is (1.20 x P) x (.95 x Q) = 1.14PQ. Revenue has thus increase 14% simply by increasing the price. That explains why ticket prices for professional sports keep increasing, and why the luxury boxes are so expensive. The price elasticity of demand for professional sports (particularly football and baseball) is low. The fans still want to watch, no matter how expensive it gets. Of course, a higher price does cause a decrease in demand, just not much of a decrease. |
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| | + | Let’s take another example. Suppose that airlines increase the price on their flights from New York to Florida from an average of $300 per seat to $500 per seat. That is a 67% increase. What would that do to the tourist traffic to Florida from New York? It only takes a day and a half to drive to Florida, which incurs gas charges of less than $100 and a hotel charge of perhaps $80. Many tourists would likely drive rather than pay the higher fares. The demand for these higher-priced tickets could fall by 75%, assuming that many of the ticket-buyers are tourists rather than people traveling for their job. |
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| | + | What is the price elasticity of this demand? The percent change in quantity demanded is -75% (3/4) and the percent change in price is 67% (2/3), so the elasticity is -3/4 divided by 2/3 = -9/8. The sign is dropped so the elasticity is expressed as 9/8. It is greater than 1, and thus is described as having an “elastic demand” rather than an “inelastic demand” (inelastic demand is a value less than 1). When the price elasticity of demand equals 1, then it is called “unit elasticity of demand.” |
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| | What does it mean to a company if its goods have “elastic demand”? It means the company should be cautious in raising prices. Look at what happens to the revenue to the airlines due to the elastic demand for seats on their planes. The initial revenue was price times quantity, which is PxQ, or PQ. The revenue after the pricing change is (5/3)(P)(1/4)(Q) = (5/12)PQ. Its revenue fell to 5/12 of its initial revenue due to the price increase. The airlines lost over half of its revenue by increasing its price! Uh oh, that requires laying off many employees, reporting losses to the investors, and firing the persons responsible for that price increase. | | What does it mean to a company if its goods have “elastic demand”? It means the company should be cautious in raising prices. Look at what happens to the revenue to the airlines due to the elastic demand for seats on their planes. The initial revenue was price times quantity, which is PxQ, or PQ. The revenue after the pricing change is (5/3)(P)(1/4)(Q) = (5/12)PQ. Its revenue fell to 5/12 of its initial revenue due to the price increase. The airlines lost over half of its revenue by increasing its price! Uh oh, that requires laying off many employees, reporting losses to the investors, and firing the persons responsible for that price increase. |
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| − | In that prior example, however, consider price increases on the same route that are due only to increases in fuel costs. Will they have the same elasticity? (No, because the alternative of travelling by car increases in cost by a similar amount. However, some people will simply stay at home rather than travel.) | + | In this example, however, consider price increases on the same route that are due only to increases in fuel costs. Will those price increases have the same elasticity? (No, because the alternative of traveling by car increases in cost by a similar amount. But demand will decrease anyway, because some people will simply stay at home rather than travel.) |
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| − | Take a straight line demand curve and consider what the shape the total revenue has as a function of price. It has the shape of a semi-oval opening downward: it starts at zero revenue (when quantity is 0) and ends at zero revenue (when price is 0).
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| | ==Income Elasticity== | | ==Income Elasticity== |