3.1 Price elasticity of demand and supply

Price elasticity measures how quantity demanded or supplied changes with price. It's crucial for businesses to understand customer reactions to price changes and adjust strategies accordingly.

Elasticity values help firms predict revenue changes from price adjustments. Elastic demand means lower prices increase revenue, while inelastic demand allows for higher prices without losing customers. This knowledge guides pricing decisions.

Price Elasticity of Demand and Supply

Defining Price Elasticity

• Price elasticity of demand measures responsiveness of quantity demanded to price changes calculated as percentage change in quantity demanded divided by percentage change in price
• Price elasticity of supply measures responsiveness of quantity supplied to price changes calculated as percentage change in quantity supplied divided by percentage change in price
• Determinants of price elasticity of demand include availability of substitutes, proportion of income spent on good, time horizon, and necessity versus luxury status (luxury cars)
• Determinants of price elasticity of supply include time horizon, availability of inputs, production capacity, and ability to store inventory (perishable goods)
• Formula for price elasticity expressed as absolute value ensures positive number allowing easier interpretation and comparison across goods and markets
• Price elasticity values typically negative for demand (inverse price-quantity relationship) and positive for supply (direct price-quantity relationship)

Factors Affecting Elasticity

• Availability of substitutes impacts demand elasticity (gasoline vs electric cars)
  • More substitutes lead to higher elasticity
  • Fewer substitutes result in lower elasticity
• Time horizon affects both demand and supply elasticity
  • Longer time periods allow for greater adjustments, increasing elasticity
  • Short-term elasticity tends to be lower than long-term elasticity
• Proportion of income spent on good influences demand elasticity (groceries vs luxury watches)
  • Higher proportion leads to higher elasticity
  • Lower proportion results in lower elasticity
• Production capacity and input availability impact supply elasticity (manufacturing plants)
  • Greater capacity and readily available inputs increase elasticity
  • Limited capacity and scarce inputs decrease elasticity

Calculating and Interpreting Elasticity

Elasticity Calculation Methods

• Formula for calculating price elasticity $|Percentage change in quantity / Percentage change in price|$
• Midpoint formula for percentage changes
  • Quantity: $(Q2 - Q1) / [(Q1 + Q2) / 2]$
  • Price: $(P2 - P1) / [(P1 + P2) / 2]$
• Arc elasticity method using midpoint formula provides more accurate measure over price range compared to point elasticity method
• Cross-price elasticity measures responsiveness to related goods' price changes (coffee and tea)
• Income elasticity calculates responsiveness to consumer income changes (luxury goods vs necessities)

Interpreting Elasticity Values

• Elastic demand/supply occurs when $|E| > 1$ indicating percentage change in quantity greater than percentage change in price
• Inelastic demand/supply occurs when $|E| < 1$ indicating percentage change in quantity less than percentage change in price
• Unit elastic demand/supply occurs when $|E| = 1$ indicating percentage change in quantity equals percentage change in price
• Higher elasticity value for demand indicates greater price sensitivity (luxury goods)
• Higher elasticity value for supply indicates greater production responsiveness to price changes (mass-produced items)

Elastic, Inelastic, and Unitary Elasticity

Types of Elasticity

• Elastic demand or supply $|E| > 1$ percentage change in quantity greater than percentage change in price (electronics)
• Inelastic demand or supply $|E| < 1$ percentage change in quantity less than percentage change in price (prescription medications)
• Unitary elastic demand or supply $|E| = 1$ percentage change in quantity equals percentage change in price
• Perfectly elastic demand or supply $|E| = ∞$ represents horizontal demand or supply curve quantity changes infinitely with any price change (perfectly competitive markets)
• Perfectly inelastic demand or supply $|E| = 0$ represents vertical demand or supply curve quantity remains constant regardless of price changes (life-saving drugs)

Elasticity and Curve Shapes

• Shape of demand and supply curves reflects elasticity
  • Steeper curves indicate more inelastic relationships (necessities)
  • Flatter curves indicate more elastic relationships (luxury items)
• Demand curve examples
  • Steep curve for water consumption
  • Flatter curve for restaurant meals
• Supply curve examples
  • Steep curve for limited edition collectibles
  • Flatter curve for mass-produced clothing

Elasticity and Total Revenue

Total Revenue and Elasticity Relationship

• Total revenue calculated as price multiplied by quantity sold $TR = P × Q$
• Elastic demand $|E| > 1$ price decrease leads to total revenue increase price increase leads to total revenue decrease
• Inelastic demand $|E| < 1$ price increase leads to total revenue increase price decrease leads to total revenue decrease
• Unit elastic demand $|E| = 1$ total revenue remains constant regardless of price changes
• Total revenue test determines price elasticity of demand by observing revenue changes with price changes

Business Applications of Elasticity

• Profit maximization requires consideration of both total revenue and total costs
• Pricing strategies may differ from those solely based on elasticity and revenue maximization
• Understanding elasticity-revenue relationship crucial for businesses in setting optimal prices (airline ticket pricing)
• Elasticity insights guide effective pricing strategies (peak vs off-peak pricing for utilities)
• Revenue management techniques utilize elasticity concepts to maximize profits (hotel room pricing)
• Market segmentation strategies often based on differing elasticities among consumer groups (student discounts)