Description of price elasticity of demand

After you have worked through this section of the learning unit, you should be able to:

• describe the concept price elasticity of demand with the aid of a demand curve

Before we give a description of the concept of price elasticity, we need to recap what we have learned about the law of demand, since the concept of price elasticity is closely related to the law of demand.

From the law of demand we know that if the price changes, the quantity demanded changes. According to this law, an increase in price will decrease the quantity demanded, and a decrease in price will increase the quantity demanded.

Study the following diagram and make sure you know what happens if the price changes.

If the price increases from P3 to P4, the quantity demanded will (increase; decrease) from Q3 to Q2.

Think again.  If the price increases from P3 to P4, the quantity demanded decreases, since an inverse relationship exists between the price and the quantity demanded. The decrease is from Q3 to Q2.

Correct.  If the price increases from P3 to P4, the quantity demanded decreases, since an inverse relationship exists between the price and the quantity demanded. The decrease is from Q3 to Q2.

If the price decreases from P4 to P2, the quantity demanded will (increase; decrease) from Q2 to Q4.

Correct.

If the price decreases from P4to P2, the quantity demanded increases, since an inverse relationship exists between the price and the quantity demanded. The increase is from Q2to Q4.

Think again.  If the price decreases from P4 to P2, the quantity demanded increases, since an inverse relationship exists between the price and the quantity demanded. The increase is from Q2 to Q4.

From the law of demand, we know that if the price of a good or service increases, the quantity demanded will decrease; and if the price decreases, the quantity demanded increases.

The question we are dealing with is:

By how much would the quantity demanded change if the price were to change? In other words, we wish to measure the impact of a change in the price on the quantity demanded.

It is the concept of price elasticity of demand that gives us a measure of how sensitive or responsive the quantity demanded is to a change in the price of a good or service.

Here we are moving from theoretical economics to empirical economics. When we dealt with the theory of demand, supply and prices, we simply indicated the direction of change. We argued that if, say, the supply of a good or service increases, the price decreases, which increases the quantity demanded.

In empirical economics, we want to measure by how much the price decreases and by how much the quantity demanded increases.

In the following diagram, we can see that an increase in supply will decrease the price from R4 to R2 and, in turn, will increase the quantity demanded from 500 to 600.

Price elasticity

We now have a basis to measure how sensitive or responsive the quantity demanded is to a change in the price. In other words, we can measure the price elasticity of demand.

PQd
R4 to R2 → 500 to 600

The topic of the next section is how to measure price elasticity on the basis of the data provided.

Before you continue to the section on the measurement of price elasticity, do the following activity to make sure that you grasp the meaning of the concept of price elasticity.

Indicate whether the following statements relating to price elasticity of demand is true or false:

The price elasticity of demand provides us with a measure of how sensitive or responsive the price of a good or service is to a change in demand.

Think again. The statement is false.

It provides a measure of how sensitive or responsive the quantity demanded is to a change in the price of a good or service. Note that the causality is from a change in the price to a change in quantity demanded.

PQd

Correct. The statement is false.

It provides a measure of how sensitive or responsive the quantity demanded is to a change in the price of a good or service. Note that the causality is from a change in the price to a change in quantity demanded.

PQd

If you know what the price elasticity of petrol is, you will know how sensitive or responsive the quantity demanded of petrol is to a change in the price of petrol.

Correct. The statement is true.

You will indeed know what will happen to the quantity demanded of petrol if the price of petrol changes.

Think again. The statement is true.

You will indeed know what will happen to the quantity demanded of petrol if the price of petrol changes.

If you know what the price elasticity of petrol is, all you will be able to say is that an increase in the price of petrol will reduce the quantity of petrol demanded.

Think again. The statement is false.

If you know the value of the price elasticity of petrol, you will be able to say by how much the quantity demanded will change in relation to a given change in the price. You already know from the law of demand that an increase in price reduces the quantity demanded.

Correct. The statement is false.

If you know the value of the price elasticity of petrol, you will be able to say by how much the quantity demanded will change in relation to a given change in the price. You already know from the law of demand that an increase in price reduces the quantity demanded.

If you know what the price elasticity of petrol is, you will be able to predict what happens to the price of petrol if the demand for petrol changes.

Think again. The statement is false.

To predict what would happen to the price of petrol, you would need to know the demand and supply functions of petrol. What you would be able to predict is by how much the quantity of petrol would change if the price of petrol were to change.

Correct. The statement is false.

To predict what would happen to the price of petrol, you would need to know the demand and supply functions of petrol. What you would be able to predict is by how much the quantity of petrol would change if the price of petrol were to change.

If the price elasticity of ice cream is greater than the price elasticity of petrol, it means that households are more responsive or sensitive to a change in the price of ice cream than to a change in the price of petrol.

Correct. The statement is true.

The greater the price elasticity, the bigger the impact will be of a change in the price on the quantity demanded. If, for instance, the price of ice cream and petrol increases, households will respond by reducing their quantity demanded of ice cream and petrol, but their decrease in the quantity demanded of ice cream will be relatively larger.

Think again. The statement is true.

The greater the price elasticity, the bigger the impact will be of a change in the price on the quantity demanded. If, for instance, the price of ice cream and petrol increases, households will respond by reducing their quantity demanded of ice cream and petrol, but their decrease in the quantity demanded of ice cream will be relatively larger.

People become more upset about an increase in the price of petrol compared to an increase in the price of ice cream. This implies that they are more responsive or sensitive to a change in the price of petrol than a change in the price of ice cream.

Think again. The statement is false.

The phrase "sensitivity or responsiveness to" relates to how people adjust their quantity demanded if the price changes and not how upset they are if the price changes. The reason why people are upset if the price of petrol changes is because they find it difficult to reduce their quantity of petrol demanded. In other words, it is because their quantity demanded is insensitive or unresponsive that they are upset.

Correct. The statement is false.

The phrase "sensitivity or responsiveness to" relates to how people adjust their quantity demanded if the price changes and not how upset they are if the price changes. The reason why people are upset if the price of petrol changes is because they find it difficult to reduce their quantity of petrol demanded. In other words, it is because their quantity demanded is insensitive or unresponsive that they are upset.

If a business knows what the price elasticity of demand for its product is, it will be able to predict what will happen to its sales if the price of the product changes.

Correct. The statement is true.

Since price elasticity tells us what happens to the quantity demanded by households, the business will be able to predict what will happen to the quantity sold (its sales).

Think again. The statement is true.

Since price elasticity tells us what happens to the quantity demanded by households, the business will be able to predict what will happen to the quantity sold (its sales).

If a supplier of fresh tomatoes knows what the price elasticity of fresh tomatoes is, the supplier will be able to predict what will happen to his or her total revenue from the sale of fresh tomatoes if the price of fresh tomatoes changes.

Correct. The statement is true.

If you know the price elasticity of fresh tomatoes, you know what will happen to your sales (the quantity demanded), and since your revenue depends on your sales, you will know what will happen to your revenue. In other words, if you know that a decrease in price will increase the quantity demanded by 100, and the price is R10 per packet, your sales as well as your revenue will increase by R1 000.

P → ∆Qd → ∆Sales → ∆TR

Think again.  The statement is true.

If you know the price elasticity of fresh tomatoes, you know what will happen to your sales (the quantity demanded), and since your revenue depends on your sales, you will know what will happen to your revenue. In other words, if you know that a decrease in price will increase the quantity demanded by 100, and the price is R10 per packet, your sales as well as your revenue will increase by R1 000.

P → ∆Qd → ∆Sales → ∆TR

Study the diagrams below. Which diagram represents what we are going to measure through price elasticity?

a.

b.

Think again. It is diagram b.

In diagram b we have an increase in price due to a decrease in supply. As the price increases an upward movement along the demand curve takes place which leads to a decrease in the quantity demanded. It is this impact of a change in price on quantity demanded that we will measure.

Diagram a represents the impact of a change in demand on the price and the quantity. This is not what we will measure.

Correct. It is diagram b.

In diagram b we have an increase in price due to a decrease in supply. As the price increases an upward movement along the demand curve takes place which leads to a decrease in the quantity demanded. It is this impact of a change in price on quantity demanded that we will measure.

Diagram a represents the impact of a change in demand on the price and the quantity. This is not what we will measure.