Elasticity of Demand

Cheatsheet Content

### Introduction to Elasticity - **Definition:** Measures the responsiveness of quantity demanded (or supplied) to a change in price or other factors. - **Key Concept:** Helps understand market behavior and pricing strategies. ### Price Elasticity of Demand (PED) - **Formula:** $PED = \frac{\% \Delta Q_d}{\% \Delta P}$ - $\% \Delta Q_d = \frac{Q_2 - Q_1}{(Q_2 + Q_1)/2}$ - $\% \Delta P = \frac{P_2 - P_1}{(P_2 + P_1)/2}$ (Midpoint Method) - **Interpretation:** - $PED > 1$: Elastic Demand - $PED ### Elastic Demand ($PED > 1$) - **Characteristics:** - Consumers are highly responsive to price changes. - A small change in price leads to a proportionally larger change in quantity demanded. - **Examples:** Luxury goods, goods with many substitutes (e.g., specific brands of soda). - **Implication for Firms:** Price increases lead to a significant drop in total revenue; price decreases lead to a significant rise in total revenue. ### Inelastic Demand ($PED ### Factors Affecting PED 1. **Availability of Substitutes:** More substitutes = more elastic. 2. **Necessity vs. Luxury:** Necessities = more inelastic; Luxuries = more elastic. 3. **Proportion of Income:** Goods that are a large portion of income = more elastic. 4. **Time Horizon:** Longer time horizon = more elastic (consumers have more time to find substitutes). 5. **Definition of the Market:** Narrowly defined markets (e.g., "blue pens") = more elastic; Broadly defined markets (e.g., "writing instruments") = more inelastic. ### Total Revenue Test - **Concept:** Relates changes in price to changes in total revenue to determine elasticity. - **Elastic Demand:** Price $\uparrow$, Total Revenue $\downarrow$; Price $\downarrow$, Total Revenue $\uparrow$. - **Inelastic Demand:** Price $\uparrow$, Total Revenue $\uparrow$; Price $\downarrow$, Total Revenue $\downarrow$. - **Unit Elastic Demand:** Price change, Total Revenue remains unchanged.