Responding to the Price Elasticity of Demand

Part of the Managerial Economics For Dummies Cheat Sheet

Elasticity measures how responsive quantity is to a change in another variable. For example, the price elasticity of demand measures the responsiveness of quantity demanded to a change in the good’s price.

The price elasticity of demand, η, for a segment of the demand curve is calculated using the following formula:

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In the formula, P0 and Q0 represent the initial or starting price/quantity combination, and P1 and Q1 represent the ending price/quantity combination.

Once calculated, the price elasticity of demand indicates how responsive quantity demanded is to a change in the good’s price:

  • Perfectly inelastic: The price elasticity of demand equals zero, indicating that quantity demanded doesn’t change in response to a change in the good’s price.

  • Inelastic: The price elasticity of demand is between –1 and 0, indicating that quantity demanded isn’t very responsive to a change in the good’s price.

  • Unitary elastic: The price elasticity of demand equals –1, indicating the percentage change in quantity demanded equals the percentage change in price.

  • Elastic: The price elasticity of demand is less than –1, indicating that quantity demanded is very responsive to a change in the good’s price.

  • Perfectly elastic: If demand is perfectly elastic, the demand curve is a horizontal line instead of the usual downward-sloping demand curve.

Once calculated, the price elasticity of demand is used to determine the relationship between price changes and changes in total revenue. If demand is inelastic, price and total revenue are directly related, so increasing price increases total revenue. If demand is elastic, price and total revenue are inversely related, so increasing price decreases total revenue.

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