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Price Elasticity

Businesses know that they face demand curves, but rarely do they know what these curves look like. Yet sometimes a business needs to have a good idea of what part of a demand curve looks like if it is to make good decisions. If Rick's Pizza raises its prices by ten percent, what will happen to its revenues? The answer depends on how consumers will respond. Will they cut back purchases a little or a lot? This question of how responsive consumers are to price changes involves the economic concept of elasticity.

Elasticity is a measure of responsiveness. Two words are important here. The word "measure" means that elasticity results are reported as numbers, or elasticity coefficients. The word "responsiveness" means that there is a stimulus-reaction involved. Some change or stimulus causes people to react by changing their behavior, and elasticity measures the extent to which people react.1

The most common elasticity measurement is that of price elasticity of demand. It measures how much consumers respond in their buying decisions to a change in price. The basic formula used to determine price elasticity is

e= (percentage change in quantity) / (percentage change in price).

(Read that as elasticity is the percentage change in quantity divided by the percentage change in price.)

If price increases by 10% and consumers respond by decreasing purchases by 20%, the equation computes the elasticity coefficient as -2. The result is negative because an increase in price (a positive number) leads to a decrease in purchases (a negative number). Because the law of demand says it will always be negative, many economists ignore the negative sign, as we will in the following discussion.

An elasticity coefficient of 2 shows that consumers respond a great deal to a change in price. If, on the other hand, a 10% change in price causes only a 5% change in sales, the elasticity coefficient will be only 1/2. Economists would say in this case that demand is inelastic. Demand is inelastic whenever the elasticity coefficient is less than one. When it is greater than one, economists say that demand is elastic.

Products that have few good substitutes generally have lower elasticities of demand than products with many substitutes. As a result, more broadly defined products have lower elasticities than narrowly defined products. The price elasticity of demand for meat will be lower than the price elasticity of pork, and the price elasticity for soft drinks will be less elastic than the price elasticity for colas, which in turn will be less elastic than the price elasticity for Pepsi.

Time plays an important role in determining both consumer and producer responsiveness for many items. The longer people have to make adjustments, the more adjustments they will make. When the price of gasoline rose rapidly in the late 1970s as a result of the OPEC cartel, the only adjustment consumers could initially make was to drive less. With time, they could also move closer to work or find jobs closer to home, and switch to more fuel-efficient cars.

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1 The generic formula for elasticity, which may help make sense of the whole notion, is:
(% change in response) divided by (% change in stimulus).
Notice how all the specific elasticities that are discussed in these pages are instances of this general formula.

Copyright Robert Schenk