6/4/12

Is it elastic or inelastic? Understanding the price elasticity of demand measure.




In economics you are required to understand how to calculate the price elasticity of demand.  But at the same time you need to understand the intuition behind the measure, in particular what the numbers mean and the implications behind them.

For review, you should understand what elasticity means to economists, and how to use the midpoint formula to calculate elasticity measures.  If you understand that, then you can figure out how the price elasticity of demand, and interpret it using the table below:

PEoD < -1 means that the good has an ELASTIC PEoD
PEoD = -1 means that the good has a UNIT ELASTIC PEoD
PEoD > -1 means that the good has an INELASTIC PEoD

An elastic PEoD means that quantity demanded is very responsive to changes in the price, so a small price change will have a large effect on the quantity demanded.
A unit elastic PEoD means that the percentage change in quantity will be the same as the percentage change in price, so a 10% increase in price will cause a 10% in quantity demanded.
An inelastic PEoD means that quantity demanded is unresponsive to changes in the price, so you will have to see a large price change to get any significant change in quantity demanded.

Sometimes, books and instructors will use the absolute value of the PEoD measure, if that is the case the associated measures will look like:

PEoD > 1 means that the good has an ELASTIC PEoD
PEoD = 1 means that the good has a UNIT ELASTIC PEoD
PEoD < 1 means that the good has an INELASTIC PEoD

We can now look at some examples of common goods available in the market to see whether they have an elastic, unit elastic, or inelastic price elasticity of demand measure and what the implications are for possible government policies.

Different economic studies have estimated the price elasticity of demand for these certain goods.
Product price elasticity of demand:

Starbucks coffee
-3.00
-Pepsi
-1.28
Clothing
-1.00
Cigarettes
-0.25
Beer
-0.23
Gasoline
-0.06

Based on the above calculations of price elasticity of demand measures, we know that Starbucks coffee has a PEoD that is elastic, as does Pepsi.  This means that quantity demanded is very responsive to changes in the price and this is partly caused by the availability of substitutes.  For example, you could buy another brand of coffee instead of Starbucks, or you could buy Coke instead of Pepsi.

The PEoD measure for Clothing is unit elastic.  This means that an associated percentage decrease(increase) in the price level will have an identical increase(decrease) in the quantity demanded.

Cigarettes, beer, and gasoline have inelastic PEoD measures, which means that the quantity demanded is unresponsive to changes in the price.  Because they are not responsive to changes in their price, they are prime candidates for a tax.  Because a tax will increase the price of the taxed good, it makes sense for the government to tax goods that are not responsive to changes in price.

This is why we see such high taxes on things like cigarettes, beer, and gasoline vs low taxes on other types of goods that people could choose to consume less of. 

The elasticity measure can also explain why things like medicine (prescription drugs) and diamonds are so expensive.  It is because their associated PEoD measures are inelastic meaning that people will buy regardless of the price.



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