[MUSIC] Let's turn now to one of the most practical concepts in microeconomics, the price elasticity of demand. As we shall soon see, this concept has tremendous application in the pricing and marketing strategies of both businesses and government agencies. It also helps us to better understand many aspects of public policy. So let's start out by just thinking about the word elasticity. If you pull back on a rubber band and then let it go, it snaps forward pretty smartly. That's becasue it's pretty elastic. But if you pull back on a piece of string, it only snaps back a little bit. It's pretty inelastic. Well, the price elasticity of demand simply measures how much consumers will increase or decrease their quantity demanded in response to a price change. A big change means demand is elastic, like the rubber band, and a small change means demand is inelastic. There is of course a formula to calculate elasticity. But before we go down that road, let's really nail this down from an intuitive perspective. Take a look at these two demand curves and study the slopes of the curves very carefully. Note that in the first graph, the demand curve for crack cocaine is very steep. Almost vertical. In contrast, in the second graph, the demand curve for beef is almost flat or horizontal. Given the shape of these curves, in which market do you think the quantity demand will respond least and the most to a change in price? That is, in which market is demand least and most elastic? Did you get it right? The demand for crack cocaine is the least elastic and the demand for beef is most elastic. To see this, imagine that the price of crack cocaine rises by a dollar. In this case, the quantity demanded changes very little. In contrast, a dollar increase in the price of beef results in a huge decrease in the quantity demanded. Now here's the general price elasticity formula. It is simply the percentage change in the quantity demanded divided by the percentage change in price. Take a minute to study this. Now there is a question probably forming in your head right now. Why use percentages rather than absolute amounts in measuring consumer responsiveness? There are at least two good answers. First, the use of percentage changes for both price and quantity frees us from worrying about what the unit of measure is for different goods, pounds, bushels, tons, whatever, and what the measure is for price, say, pennies or dollars. To see what I mean, suppose that the price of cement falls from three dollars to two dollars and consumers increase their purchases from 60 to 100 pounds. It may appear that consumers are very sensitive to price changes, and therefore, the demand is elastic. After all, a price change of 1 has caused a change in the amount demanded of 40. But now, let's change the monetary unit from dollars to pennies. In this case, we could just as easily say, that a price change of 100 pennies caused a quantity change of 40 pounds, giving the impression that demand is inelastic. Using percentages resolves this choice of units problem. Second, the use of percentages allows us to solve the comparing products problem. For example, it makes little sense to compare the effects on the quantity demanded of a $1 increase in the price of a $10,000 car versus a $1 increase in the price of a $1 carton of milk. Here, the price of both products has risen by the same amount, but the price of milk has risen by 100%. While the price of the car has risen by a miniscule tenth of one percent. Better that we compare the price change of both products on the same percentage basis, say, 1%, to determine how consumers will respond to the price change. That's what the elasticity formula allows us to do. Now, here's the formula for calculating price elasticities. Looks pretty formidable, doesn't it? But let's break this formula down into smaller logical pieces. Let's start with the change in Q, call it delta Q. We can rewrite this as simply the quantity demanded before the price change, minus the quantity demanded after the price change, or, Q1 minus Q2. And, we can do the same for the change in P. Call it delta P. It is simply P1 minus P2. As for each of the two terms in the denominators, these are simply the averages of quantity and price. So, although this formula looks pretty forbidding. All you are doing is dividing a change by an average. Now, one more thing. If you're a math wizard, you might figure out pretty quickly that since price and quantity demanded are inversely related, the price elasticity coefficient will always be a negative number. For example, if price declines, then the quantity demanded will increase. This means that the numerator in our formula will be positive and the denominator negative yielding a negative price elasticity. Note, however that for simplicity, economists usually ignore the minus sign and present price elasticities as absolute values. We'll do that too. So just remember to ignore the minus sign. Now let's get back to our formula and use it to calculate the price elasticities along two different segments of this demand curve. By doing so, we'll not only do some sample calculations, we'll also prove that the price elasticity actually changes as we move along the demand curve. So take a minute now to calculate the elasticity for a move from point A to B as well as from C to D, and put your answers in the boxes. Did you get it right? If not, study the math here carefully and try it again. Let's identify now the three major categories of elasticity, as seen in this figure. First, demand is elastic if a given percentage change in price results in a larger percentage change in quantity demanded. For example, if a two percent fall in price results in a four percent change in quantity demanded. In this case, the elasticity is greater than one. Note that the curve is flat, as in our beef example. If the curve were horizontal, demand would be said to be perfectly elastic. Second, demand is inelastic if the price elasticity is less than 1. For example, if a 3% decline in price leads to just a 1% increase in quantity demanded. In this case, the percentage change in price is accompanied by a relatively smaller change in the quantity demanded. Note that the curve is steep, as in our crack cocaine example. If the curve were perfectly vertical, demand would be perfectly inelastic. Finally, demand is said to be unit elastic if the price elasticity equals 1. For example, if a 1% drop in price causes a 1% increase in quantity demanded, elasticity is exactly 1, or unity. This table lists the price elasticities for a variety of products. Note that necessities, like housing, electricity and bread, are very price-inelastic. On the other hand, goods that tend more towards being luxuries, like restaurant meals and glassware, are very price-elastic. These observations lead us to a discussion of what determines the elasticity of demand. Besides luxuries versus necessities, other important factors include substitutability, proportion of income, and time. The greater the number of substitutes for a good, the more elastic its demand will be. For example, beef has a lot of substitutes. Poultry, fish, and soy products. In contrast, crack cocaine has little or no substitutes. That's why a drug addict's demand is much more inelastic than a beef eater's. In this regard, the elasticity of demand also depends on how narrowly the product is defined. For example, which do you think has a more elastic demand, Chevron gas or gas? That's right. The demand for Chevron gas is much more elastic than the demand for gas because many brands, such as Shell and Texaco, can be substituted for Chevron, but there is no good substitute for gas. A third factor determining elasticities is the proportion of income. Other things equal, the higher the price of a good relative to your budget, the greater will be your elasticity of demand for it. For example, a 10% increase in the price of pencils will amount to only a few pennies, with little response in the amount you demand. But a 10% increase in the price of housing would have a significant impact on the quantity of house you would purchase. The fourth factor is time. In general, demand will tend to be more elastic in the longer run than in the short run. For example during the energy crisis of the 1970s the demand for oil was very inelastic in the short run. However, over time, businesses invested in energy-saving technologies while people started driving more fuel-efficient cars, and the demand elasticity increased. This table lists a number of short and long run elasticities. What do you think of demand for medical care remains inelastic between the short and long run, while for other goods, such as bus trips and movies, inelastic demand in the short run becomes highly elastic demand in the long run?