(See related pages)
|
|
|
| Elasticity and Revenue
How will consumers respond to a price change? Sales will increase if price falls, but by how much? Will a higher price lead most people to buy a substitute instead? And if they do, is it possible that the seller’s revenue might actually decrease?
The price elasticity of demand, Ed, is a measure of buyer responsiveness to price changes. It equals the ratio of the percentage change in quantity demanded to the percentage change in the price. If the quantity change exceeds the price change in percentage terms, Ed is greater than one (in absolute value) and we say demand is elastic. Demand is inelastic if the quantity change is less than the price change in percents; Ed is less than one. The elasticity of demand varies from one product to another. It may even vary for the same product: demand for a product may be more elastic at high prices than at low prices and is usually more elastic in the long run than in the short run.
Now click here to view an interactive exercise. This exercise is from the website for Begg and Ward Economics for Business. This will open a new browser window. Then answer the questions below. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. 1. What is the elasticity of demand over the £4 to £5 price range? AnswerDrag the green price triangle to £4 and release. This will establish an initial price. Now drag the triangle to £5 to establish this range of the demand curve and click on the Elasticity button. The percentage change in price is 22%: (5-4)/4.5 = .22, while the percentage change in quantity demanded is 67%: (2000-1000)/1500 = .67. The quantity change is three times the price change; the elasticity of demand is 3 and demand is elastic. 2. What is the elasticity of demand over the £1 to £2 price range? AnswerDrag the green price triangle to £1 and release to establish an initial price. Now drag the triangle to £2 and click on the elasticity button. The percentage change in price is 67%: (2-1)/1.5 = .67. The percentage change in the quantity demanded over this range is 22%: (5000-4000)/4500 = .22. The quantity change is one-third the price change; the elasticity of demand is 1/3 and demand is inelastic. 3. Experiment on your own. Over what range of the demand curve is demand elastic? Is there a price range over which Ed is 1, or "unit elastic?" AnswerDemand is elastic over ranges in the upper half of the demand curve, and inelastic of ranges in the lower half of the demand curve. By defining a range with a middle price point of £3 (which happens to be the middle point of the demand curve) you will discover that Ed is 1 over this range. 4. Select an elastic range of the demand curve. What happens to total revenue when price is increased through this range? AnswerMove the slider to a price above £3. Release and drag the slider again to define a range in the upper half of the demand curve. Click on the Elasticity button to verify that demand is elastic (greater than one) over this range. Click on the Elasticity button again to remove the calculation from the screen. As you drag the slider through this range of prices, observe that revenue falls as price increases and revenue rises as price falls. This inverse relationship between price and revenue is because the quantity change is larger than, and in the opposite direction from, the price change. 5. Select an elastic range of the demand curve. What happens to total revenue when price is increased through this range? AnswerMove the slider to a price below £3. Release and drag the slider again to define a range in the lower half of the demand curve. Click on the Elasticity button to verify that demand is inelastic (less than one) over this range. Click on the Elasticity button again to remove the calculation from the screen. As you drag the slider through this range of prices, observe that revenue rises as price increases and revenue falls as price falls. This direct relationship between price and revenue is because the quantity change is smaller than the price change that brought it about. |