Chapter 6 Elasticity of Demand
Why is it so important?
In 2004, the price of gasoline started to rise.
California gas producers shut down some
Consumer advocates accused them of doing this to gain profit.
And if they were not in some evil conspiracy, why did the price rise so far
and so fast?
Vermont dairy farmers are facing record low revenues and profits due to – yes –
improvements in the quantity of milk they are producing.
Other producers gain
profits when output increases.
In the last chapter, we saw that as price rises, the quantity consumers demand of a good
will increase and as price falls, the quantity demanded will increase.
happens to revenues depends on how much consumers respond to the price change.
price decrease causes a strong response from consumers, revenues will actually increase.
For example, Ralphs recently had a special on strawberries, selling them for $2.50 a pint.
The manager said that the store made twice as much on strawberries as they did the
previous week when the price was $3.50.
In the case of milk, however, consumers
bought more milk, but not very much more and the total revenues for Vermont farmers
Price Elasticity of Demand
In a market system, buyers and sellers interact indirectly:
price and quantity sold act as
incentives for each side to adjust its behavior, which in turn affects the outcome.
degree of responsiveness of buyers or sellers to various changes is called
examples above involve the responsiveness of consumer demand to price, which is called
It is very important to producers since it determines the change in
revenues as price rises or falls.
If producers have some power to set price, the price
elasticity affects the incentive for producers to raise prices.
At the same time, it is
important to consumers, since their expenditure on a good, which is equal to revenues to
producers, is similarly affected.
As we will see when we look at the complete market,
price elasticity determines how much of a cost increase or a tax is borne by the
consumers and how much by the producers.
Measuring price elasticity
How should we measure price elasticity?
Think of what happens in demand.
from the Law of Demand that if price decreases, the quantity that consumers demand will
If demand is more elastic, consumers would be more responsive, that
increase will be relatively larger.
If demand is less elastic, consumers would be less
responsive, that decrease will be relatively larger.
The Figure below shows
curves that have the same quantity (Q1) demanded at the the same price (P1).
graph to the left, as the price decreases to P3, consumers increase the quantity they