Douglas A. Ruby
Revised: 01/17/2003

Demand-Side Shocks

Other Elasticity Measures

Microeconomic Theory
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.
(Pmkt) (Qdemanded) = 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.
(Pmkt) (Qdemanded) = 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
%DQd > %DPmkt
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 'hp' represents the following ratio:

hp = (%DQ)/ (%DP)
such that
if (%DQ) > %(DP) then |hp| > 1.0 and demand is price elastic
if the opposite is true then
|hp| < 1.0 and demand is price inelastic
This relationship between price changes and expenditure can be summarized in the following table:

 Elasticity Demand is PriceElastic: |hp| > 1.0 Demand is PriceInelastic: |hp| < 1.0 Price Reduction Expenditureincreases Expendituredecreases Price Increase Expendituredecreases Expenditureincreases

Concepts for Review:
• (Consumer) Expenditure
• Linear Demand
• Price Elastic Demand
• Price Inelastic Demand
• Price Elasticity
• (Sales) Revenue
• Unitary Elastic Demand