# 5 1 The Price Elasticity of Demand Principles of Economics

Conversely, when the changes in price and quantity are discrete and large, we need to calculate elasticity over an arc of the demand curve. Further, we use arc elasticity to determine price elasticity over some part of the demand curve, instead of a single point. In finer terms, with the help of the arc method, we can compute elasticity over a range of prices. We use the point elasticity method when the changes in price and quantity demanded is very small. And because changes are quite little, one can take the original price and quantity, as a base.

So, unlike the percentage or proportionate method, the total expenditure method is not the precise or exact method of measuring price elasticity. A movement from point E to point F also shows a reduction in price and an increase in quantity demanded. This time, however, we are in an inelastic region of the demand curve. Total revenue now moves in the direction of the price change—it falls. Notice that the rectangle drawn from point F is smaller in area than the rectangle drawn from point E, once again confirming our earlier calculation. Moving from point A to point B implies a reduction in price and an increase in the quantity demanded.

• So, it is important to measure the elasticity of demand to compare the elasticity of demand for different goods.
• Thus, in the case of a large change in price and quantity or a time-lagged change in price, the point method is not suitable to measure the price elasticity.
• As a result, it is particularly useful when there is a substantial change in price.
• When total expenditure decreases with fall in price and increases with rise in price, the value of PED will be less than 1.

Quantity demanded falls by the same percentage by which price increases. On a linear demand curve, the price elasticity of demand varies depending on the interval over which we are measuring it. For any linear demand curve, the absolute value of the price elasticity of demand will fall as we move down and to the right along the curve. In economics, arc elasticity is commonly used in relation to the law of demand to measure percentage changes between the quantity of goods demanded and prices. Therefore, it is true for small movements only from one point to another along the demand curve.

## New Formulas: Arc Price Elasticity of Demand

The latter is more useful when there is a significant change in price. There are two possible ways of calculating elasticity—price (or point) elasticity of demand and arc elasticity of demand. Price elasticity of demand measures the responsiveness of quantity demanded to a price. It takes the elasticity of demand at a particular point on the demand curve, or between two points on the curve.

• So, the elasticity of demand is more than unitary in such a case.
• In 1998, 2,000 people in the United States died as a result of drivers running red lights at intersections.
• We would expect, though, that the demand for a particular brand of gasoline will be much more price elastic than the demand for gasoline in general.
• Economist John C. B. Cooper estimated short- and long-run price elasticities of demand for crude oil for 23 industrialized nations for the period 1971–2000.
• We calculate those changes between two points on a demand curve.

For any linear demand curve, demand will be price elastic in the upper half of the curve and price inelastic in its lower half. At the midpoint of a linear demand curve, demand is unit price elastic. What happens to the price elasticity of demand when we travel along the demand curve? The answer depends on the nature of the demand curve itself.

The price elasticity of demand is the ratio of the percentage change in quantity to the percentage change in price. As we will see, when computing elasticity at different points on a linear demand curve, the slope is constant—that is, it does not change—but the value for elasticity will change. So, when total expenditure moves in the opposite direction to the change in price, the elasticity of demand is greater than unitary.

## Calculating Arc Elasticity of Demand

So, the elasticity of demand is more than unitary in such a case. Again, with a decrease in price from OP1 to OP2, the total outlay remains as it is or the same at the level of OM1. In the graph, total outlay or expenditure is measured on the X-axis while price is measured on the Y-axis. In the figure, the movement from point A to point B shows elastic demand as we can see that total expenditure has increased with fall in price.

Hence, to remove this confusion, we use an average of the two prices and quantities as a base. Arc elasticity is the elasticity of a variable in relation to another between two sets of points. This is used in the absence of any general function to define the relationship between two variables. We use this concept in two domains, i.e. mathematics and economics.

## What is Arc Elasticity?

On the other hand, if demand is inelastic, then price changes will have a minimal impact on the quantity demanded by buyers. Arc elasticity is commonly used in economics to determine the percentage of change between the demand for goods and their price. Elasticity can be calculated in two ways—price elasticity of demand and arc elasticity of demand.

The greater the absolute value of the price elasticity of demand, the greater the responsiveness of quantity demanded to a price change. What determines whether demand is more or less price elastic? The most important determinants of the price elasticity of demand for a good or service are the availability of substitutes, the importance of the item in household budgets, and time. Suppose the public transit authority is considering raising fares.

## Methods of Measurement of Price Elasticity of Demand

As we already mentioned earlier, this method measures the elasticity of demand considering the change in total spending incurred on a commodity as a result of the change in the price of the commodity. By using this method, we can sort three types of elasticities. The degree of price elasticity of demand for different goods is different. So, it is important to measure the elasticity of demand to compare the elasticity of demand for different goods. Economists have developed different, methods of measurement of price elasticity of demand.

In the case of the non-linear demand curve, the use of the arc method is more suitable. We have to keep in our mind that the arc elasticity measure takes into account the midpoint of the chord that connects the two points on the demand curve. Thus, when total expenditure moves with a change in price in a positive direction then it is inelastic demand. In another world, inelastic demand is the case in which there is a positive or direct relationship between the price of the good and the total expenditure of a buyer on that good.

## Price elasticity on a non-linear income demand curve

But at the high prices and low quantities on the upper part of the demand curve, the percentage change in quantity is relatively large, whereas the percentage change in price is relatively small. The absolute value of the price elasticity of demand is thus relatively large. Between points C and D, for example, the price elasticity of demand is −1.00, and between points E and F the price elasticity of demand is −0.33. With a downward-sloping demand curve, price and quantity demanded move in opposite directions, so the price elasticity of demand is always negative.

The price elasticity of demand for gasoline in the intermediate term of, say, three–nine months is generally estimated to be about −0.5. Since the absolute value of price elasticity is less than 1, it is price inelastic. We would expect, though, that the demand for a particular brand of gasoline will be much more price elastic than the demand for gasoline in general. In mathematics and economics, the arc elasticity is the elasticity of one variable with respect to another between two given points.

Should we charge the initial price or quantity as the starting point is a considerable matter? The answer depends in large part on how much time we allow for a response. If we are interested in the reduction in quantity demanded by tomorrow afternoon, we can expect that the response will be very small. But if we give consumers a year to respond to the price change, https://1investing.in/ we can expect the response to be much greater. We expect that the absolute value of the price elasticity of demand will be greater when more time is allowed for consumer responses. The demand curve in Panel (c) has price elasticity of demand equal to −1.00 throughout its range; in Panel (d) the price elasticity of demand is equal to −0.50 throughout its range.

## a) i) Using the Midpoint Formula, calculate the Price Elasticity of Demand when the price of a T-shirt

We have already made this point in the context of the transit authority. Consider the following three examples of price increases for gasoline, pizza, and diet cola. Unlike price of the product, consumer’s income share direct relationship with the demand for the product. This implies that higher the income, more will be the demand, and lower the income, fewer will be the demand of the commodity.

From here, it’s evident that a price increase and decrease of \$2 indicates the same sensitivity of demand for a company’s customers. At first, average of income as well as quantity demanded is measured. Notice that the value of Ep in example (ii) differs from that in example (i) depending on the direction in which we move.

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