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© 19992003
Douglas A. Ruby
Revised: 01/17/2003
DemandSide Shocks
Other Elasticity Measures
Microeconomic Theory

Price Elasticity of Demand
An important characteristic of demand is the relationship among
market price, quantity demand and consumer expenditure. The nature of demand is such
that a reduction in market price will usually lead to an increase in quantity demanded.
Given that consumer expenditure is the product of these two variables, the effect
of a price reduction will have an uncertain impact on this expenditure. In some
cases a reduction in price will be more than offset by a large increase in quantity
demanded  a situation where demand is price sensitive or
price elastic.
(P_{mkt})
(Q_{demanded})
= Expenditure
In other cases, the reduction in price results in a proportionally smaller increase in
quantity demanded a situation where demand is price insensitive
or price inelastic.
(P_{mkt})
(Q_{demanded})
= Expenditure
This relationship between price and quantity (for a linear demand function) can
demonstrated in the diagram below (use the scrollbar to see changes in market price):
When the price falls from $150 to $125  a 16.6%
reduction,
quantity demanded increases by 50% (50 units to 75 units). Thus
%DQ_{d} >
%DP_{mkt}
and Expenditure increases. However, when the price falls from $75 to $50
(a 33.3% reduction  same $25 price change with a smaller base number),
quantity demanded only increases by 20% and expenditure falls.
On a linear demand function, all points on the upper half of the function
represent pricequantity combinations where demand is price elastic. Points
on the lower half represent combinations where demand is price inelastic.
Also note that at a price of zero (the horizontal intercept), the price
elasticity of demand is equal to zero.
Numerically, the price elasticity of demand 'h_{p}' represents the following ratio:
h_{p} = (%DQ)/
(%DP)
such that
if (%DQ) >
%(DP) then
h_{p} > 1.0 and demand is price elastic
if the opposite is true then
h_{p} < 1.0 and demand is price inelastic
This relationship between price changes and expenditure can be summarized
in the following table:
Elasticity

Demand is Price Elastic: h_{p} > 1.0

Demand is Price Inelastic: h_{p} < 1.0

Price Reduction 
Expenditure increases

Expenditure decreases

Price Increase 
Expenditure decreases

Expenditure increases

Concepts for Review:
 (Consumer) Expenditure
 Linear Demand
 Price Elastic Demand
 Price Inelastic Demand
 Price Elasticity
 (Sales) Revenue
 Unitary Elastic Demand
