">
Home
Oct 7, 2017 Employment Explosion
June 26, 2017 Why's the FED Panicking?
May 25, 2017 LFPR anyone?
Apr 26, 2017 What's up with the FED?
March 10, 2017 Feb Employment Situation
Oct 10, 2016 Tax Burden
Aug 1, 2016 Here Comes the Debt
June 26, 2016 Moribund US Economy
June 16 2016 Labor Update
Mar 10, 2016 Spring Renewal for Labor Markets?
Feb 21, 2016 GDP Gap
Feb 16, 2016 FED and Monetary Policy
Jan 19, 2016 Employment Gap Age Groups LFPR
Jan 10, 2016 A look at the Employment Situation
Dec 30, 2015 Fed Funds Rate up 25 Basis points...so what?
Dec 15, 2015 Fed Funds on the rise? Has Yellen 'Fell-in'?
Oct 15, 2015 Labor Markets Seven years of misery
Oct 6, 2015 Sept: Horrible Month for Labor
Sept 30, 2015 The FED: Interest Rate Angst
Sept 11, 2015 FED on the Monetary Policy Front
July 31, 2015 Trade and Foreign Exchange Rates
July 20, 2015 Economic Growth?
July 10, 2015 Labor Picture by Age Group
July 2, 2015 Disastrous Month in Labor Rpt
June 19, 2015 Minimum Wage - Income Distribution
Jun 5, 2015 Encouraged Worker Effect
May 8, 2015 Updated Employment Situation for April
May 4, 2015 Languishing Labor Markets
Apr 7, 2015 LFPR Doldrums on the Labor Front
March 8, 2015 Less than Zero Interest Rates - Trade War
2014 Articles
2013 Articles
2012 Articles
2011 & 2010 Articles
Introduction
About us
Links of Interest
Straw Poll
Definitions & Miscellaneous
Price Elasticity of Demand
Productivity
 

Price Elasticity of Demand

Download Current Write-up
 



Price Elasticity 2011.pdf


The relationship of the price to quantity demanded and how it relates to total revenue is technically called the price and elasticity of demand. 
 

Technically, the percentage change in quantity demanded divided by the percentage change in the price that caused the change in the quantity demanded
 

(QD1 – QD2)/QD1
/

(P1 – P2) / P1

The upper portion – above the midpoint (dotted line), is the elastic range where price increase causes revenue to fall. 


The lower half and the inelastic range, price increase causes revenue to rise.  This is counterintuitive to most people.



Price Elasticity.jpg

 



Price Elasticity and Movement along Demand curve.jpg


Further on Price Elasticity of Demand: Shifting; flattening and/or steepening; increasing competition, rotating the demand curve to a flatter position (price elasticity at each price increases)

When demand curve shifts to the right, price elasticity decreases with each price --- (greater ability to increase revenue with price increase)

Product differentiation (advertising) aims to reduce competition/ substitution effect --- (greater ability to increase revenue with price increase)

As just explained, the relationship of the price of a good to the quantity demanded, (QD) of that good is normally negative and thus has an inverse relationship – when price rises, the quantity demanded of that good falls and price falls, quantity demanded of that good rises. The degree to which QD responds to price depends upon substitution effects & income effects. As we saw, most goods are normal, so more often than not, the income effect does reinforce the substitution effect.

TR = P X QD

The total revenue a firm receives from selling a product depends upon the product of Price times Quantity Demanded (P X QD)…price times quantity demanded equals revenue (P X QD = Revenue). Now you have to stop and pause and think about this.

 

… All else equal (ceteris paribus),


Profits = Revenue – Expense (cost)

When revenue rises, profits rise

When revenue falls, profits fall



…ignoring cost for the moment…

 

Again, technically, the percentage change in quantity demanded divided by the percentage change in the price that caused the change in the quantity demanded

 

(QD1 – QD2)/QD1
/
(P1 – P2) / P1

Note:  In other words we have to rule out all the factors that influence the quantity demanded. If we don’t, then we don’t have price elasticity of demand – that has to be understood. 

So if you are trying to do this in real life – measure price elasticity, you would have to have complicated statistical routines which were able to mute the effects of all the changes that influence quantity demanded other than the price of that good itself.


 

Average and Total Revenue.jpg



Marginal Revenue

Marginal revenue is the incremental revenue as the quantity sold changes by one unit.    




Marginal Revenue.jpg

 


Substitution Effect (competition and its effect)
 

In flattening, the demand curve becomes more price elastic at each price (see figure below: movement from D1 to D2).  


Competition increases, at a given price, demand becomes more price elastic at each price.  
 

If the price elasticity increases to such an extent, that what was formerly price inelastic is now price elastic, an increase in price will cause a fall in revenue.  



Flattening Demand Curve.jpg

 


Price Elasticity in Demand (when demand shifts)
 

When demand increases, more or less a parallel shift, price elasticity demand decreases and price increases in that range are more revenue enhancing. 

So, if the good in question is a normal good, and income is rising, it is going to shift the demand curve to the right.  



Demand Shift.jpg


Change in Quantity Demanded

Now we should stop here and point out when we say the demand curve we are talking about the relationship of the price of that good to the quantity and demand of that good, everything else held constant (see figure: higher price…movement from QD1 to QD2).  


 

Change in Quantity Demanded.jpg

 
Shift in the Demand Curve

If it is a normal good and income rises, it will cause the demand curve to shift rightward (higher income: shift in demand D1 to D2). 

Changes in income, population distribution, wealth, etc., change (shift) demand the demand curve, not just quantity demanded.



Demand shift (Income).jpg


The aim of advertising is to reduce the substitution effect; thereby causing the demand curve to become steeper or more parallel to the price axis, and thus reduces price elasticity demand of each price (this is the opposite of what we saw earlier).  


 

Flattening Demand Curve.jpg


Summary (Price Elasticity of Demand)

So we have several reasons why price elasticity can change, one is that when you move along the demand curve (almost all the demand curves, linear and curvilinear up to a point where they become hyperbolic), it means that you change the price; price elasticity decreases because you go down the demand curve and increases as you go up. 

Starting from the quantity axis (X-axis) you go through an inelastic range, where a price increase causes revenue to rise but at a decreasing rate.  You reach the midpoint where price elasticity is unitary (or one), where price increases in that narrow range (or decreases) do not change the revenue.  Then into the upper half of the demand curve (be it a linear curve or curvilinear), where price increases cause total revenue to fall.  That’s the basic concept of price elasticity for a given demand curve.  

 

Further on Price Elasticity of Demand: Shifting; flattening and/or steepening

· When competition increases, rotating the demand curve to a flatter position, price elasticity at each price increases

· When demand curve shifts to the right, price elasticity decreases with each price

· Product differentiation (advertising) is, in effect, a reduction in competition, reducing the substitution effect; convincing people that other goods are not as substitutable and that causes the curve to rotate and become steeper and more parallel to the price axis

· This is extremely important because the basic business decision to know what to produce, how much to produce, when to expand, when to contract production, etc., depends upon the relationship of revenue, cost, and profits (Profit = Revenue – cost)