Price Elasticity of Demand

Definition

Price elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to a change in its price. It quantifies how much the quantity demanded changes when the price changes, and is a fundamental concept in microeconomics and consumer theory.

5 Must Know Facts For Your Next Test

1. The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
2. Goods with close substitutes tend to have more elastic demand, while goods with few substitutes tend to have more inelastic demand.
3. The price elasticity of demand can be used to predict the effect of a price change on total revenue, with elastic demand leading to an increase in total revenue and inelastic demand leading to a decrease in total revenue.
4. Logarithmic transformations are often used to estimate price elasticity of demand from regression models, as the coefficient on the log of price directly gives the elasticity.
5. The interpretation of the regression coefficient on the log of price in a log-log model is the price elasticity of demand, holding all other factors constant.

Review Questions

• Explain how the price elasticity of demand is calculated and what it measures.
  • The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. This measure quantifies the responsiveness of the quantity demanded to changes in the price of a good or service. It indicates how much the quantity demanded will change when the price changes by a certain percentage. For example, a price elasticity of demand of -0.5 means that a 1% increase in price will lead to a 0.5% decrease in quantity demanded.
• Describe how the concept of price elasticity of demand is used in the interpretation of regression coefficients, particularly in the context of log-log models.
  • In the context of regression analysis, the price elasticity of demand is often estimated using a log-log model, where the dependent variable is the log of quantity demanded and the independent variable is the log of price. In this case, the regression coefficient on the log of price can be directly interpreted as the price elasticity of demand, holding all other factors constant. This is because the coefficient represents the percentage change in quantity demanded for a 1% change in price. This interpretation of the regression coefficient is a key application of the price elasticity of demand concept in the analysis of demand relationships.
• Analyze how the price elasticity of demand can be used to predict the effect of a price change on total revenue, and explain the implications for firms' pricing decisions.
  • The price elasticity of demand can be used to predict how a change in price will affect a firm's total revenue. If demand is elastic (price elasticity < -1), a decrease in price will lead to a larger percentage increase in quantity demanded, resulting in higher total revenue. Conversely, if demand is inelastic (price elasticity > -1), a decrease in price will lead to a smaller percentage increase in quantity demanded, resulting in lower total revenue. Firms can use this knowledge to set prices that maximize their total revenue, with elastic demand favoring lower prices and inelastic demand favoring higher prices. Understanding price elasticity is therefore a crucial input into firms' pricing strategies and decisions.

Related terms

Demand Curve: A graphical representation of the relationship between the price of a good or service and the quantity demanded, showing how quantity demanded changes as price changes.

Inelastic Demand: A situation where the quantity demanded changes by a smaller percentage than the price change, indicating low responsiveness to price changes.

Elastic Demand: A situation where the quantity demanded changes by a larger percentage than the price change, indicating high responsiveness to price changes.