The price elasticity of demand measures the responsiveness or sensitivity of consumers to changes in the price of a good. Price elasticity is the ratio of the percentage change in quantity demanded to the percentage change in the price of the good. Over a specified price range, demand is said to be either elastic, unitary elastic, or inelastic according to whether the absolute value of the price elasticity is greater than, equal to, or less than 1, respectively.

An extremely important relation in economic analysis relates the change in total revenue (due to a change in price) and the price elasticity of demand. If demand is elastic for a given change in price, an increase in price causes total revenue to fall. A decrease in price causes total revenue to rise if demand is elastic over the price range. If demand is inelastic for a given price change, an increase in price causes total revenue to rise, while a decrease in price causes total revenue to fall.

Several factors affect the price elasticity of demand. The most important of these is the availability of close substitutes. The better and more numerous the substitutes for a good, the more elastic the demand for the good. Demand elasticity is directly related to the percentage of the consumers' budgets spent on the good. Also, the longer the time period that consumers have to adjust to price changes, the more responsive they will be, and the more elastic is demand.

Calculating price elasticity of demand can be accomplished by multiplying the slope of demand (Δ Q / Δ P) by the ratio of price divided by quantity P/Q):

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Elasticity can be measured either (1) over an interval (or arc) along demand or (2) at a specific point on the demand curve depending on the length of demand over which Eis measured. If the change in price is relatively small (large), then a point (interval) measure is usually chosen.

In general, the price elasticity of demand varies along a demand curve. For linear demand curves, price and |E| vary directly: The higher (lower) the price, the more (less) elastic is demand. For a curvilinear demand, there is no general rule about the relation between price and elasticity, except for the special case of Q = aP^b, which has a constant price elasticity (equal to b) for all prices.

Two other important elasticities are income elasticity (E_M), which measures the responsiveness of quantity purchased to changes in income, and cross-price elasticity (EXR), which measures the responsiveness of quantity purchased to changes in the price of related goods (substitutes or complements). In the case of income elasticity, the elasticity measure is positive if the good is normal; negative if the good is inferior. In the case of cross-price elasticity, the elasticity measure is positive if the two goods are substitutes; negative if they are complements.

Now that we have presented the theory of consumer demand, we will show you in the next chapter how to use real-world data to estimate demand functions and forecast future demand conditions. You will use the techniques of regression analysis to estimate empirical demand equations that can be used in managerial decision making.