Price Elasticity of Demand

An important characteristic of demand is the relationship among market price, quantity demand and consumer expenditure. The nature of demand is such that a reduction in market price will usually lead to an increase in quantity demanded. Given that consumer expenditure is the product of these two variables, the effect of a price reduction will have an uncertain impact on this expenditure. In some cases a reduction in price will be more than offset by a large increase in quantity demanded -- a situation where demand is price sensitive or price elastic.

(P_mkt) (Q_demanded) = Expenditure

In other cases, the reduction in price results in a proportionally smaller increase in quantity demanded-- a situation where demand is price insensitive or price inelastic.

(P_mkt) (Q_demanded) = Expenditure

This relationship between price and quantity (for a linear demand function) can demonstrated in the diagram below (use the scrollbar to see changes in market price):

When the price falls from $150 to $125 -- a 16.6% reduction, quantity demanded increases by 50% (50 units to 75 units). Thus

%DQ_d > %DP_mkt

and Expenditure increases. However, when the price falls from $75 to $50 (a 33.3% reduction -- same $25 price change with a smaller base number), quantity demanded only increases by 20% and expenditure falls.

On a linear demand function, all points on the upper half of the function represent price-quantity combinations where demand is price elastic. Points on the lower half represent combinations where demand is price inelastic.

Also note that at a price of zero (the horizontal intercept), the price elasticity of demand is equal to zero.

Numerically, the price elasticity of demand 'h_p' represents the following ratio:

h_p = (%DQ)/ (%DP)

such that

if (%DQ) > %(DP) then |h_p| > 1.0 and demand is price elastic

if the opposite is true then

|h_p| < 1.0 and demand is price inelastic

This relationship between price changes and expenditure can be summarized in the following table:

Elasticity	Demand is Price Elastic: \|h_p\| > 1.0	Demand is Price Inelastic: \|h_p\| < 1.0
Price Reduction	Expenditure increases	Expenditure decreases
Price Increase	Expenditure decreases	Expenditure increases

* Tutorial: Price Elasticity of Demand *

Concepts for Review:

(Consumer) Expenditure
Linear Demand
Price Elastic Demand
Price Inelastic Demand
Price Elasticity
(Sales) Revenue
Unitary Elastic Demand