Price elasticity measures how quantity changes when prices shift. It's crucial for understanding market dynamics and making smart business decisions. Demand elasticity looks at buyer behavior, while supply elasticity focuses on seller responses.

Elasticity impacts revenue and pricing strategies. Elastic demand means price cuts boost sales significantly, while inelastic demand allows for price hikes without losing many customers. Businesses use this knowledge to maximize profits and stay competitive.

Price Elasticity of Demand and Supply

Defining Price Elasticity

• Price elasticity of demand measures the responsiveness of quantity demanded to changes in price
• Price elasticity of supply measures the responsiveness of quantity supplied to changes in price
• Price elasticity coefficient calculated as percentage change in quantity divided by percentage change in price
• Elasticity typically measured along demand or supply curve
  • Different points on curve may have different elasticities
• Concept applies to both increases and decreases in price
  • Magnitude may differ in each direction

Key Determinants of Elasticity

• Demand elasticity determinants include:
  • Availability of substitutes (more substitutes = more elastic)
  • Necessity vs. luxury goods (necessities tend to be inelastic)
  • Proportion of income spent (higher proportion = more elastic)
  • Time horizon for consumer adjustment (longer time = more elastic)
• Supply elasticity determinants include:
  • Production capacity (higher capacity = more elastic)
  • Time frame for supply adjustment (longer time = more elastic)
  • Availability of inputs (more readily available inputs = more elastic)
  • Storage capabilities for the product (better storage = more elastic)

Related Elasticity Concepts

• Cross-price elasticity measures demand responsiveness to changes in prices of other goods
  • Positive for substitutes (beef and chicken)
  • Negative for complements (cars and gasoline)
• Income elasticity measures demand responsiveness to changes in consumer income
  • Positive for normal goods (clothing)
  • Negative for inferior goods (public transportation)

Calculating Price Elasticity

Elasticity Formula and Midpoint Method

• Price elasticity formula: $\text{Elasticity} = \frac{\text{Percentage change in quantity}}{\text{Percentage change in price}}$
• Midpoint formula ensures consistency in calculations: $\text{Percentage change} = \frac{\text{Change in quantity}}{\text{Average quantity}} \times 100$
• Use absolute value of elasticity coefficient for interpretation
  • Negative sign for demand elasticity typically ignored

Interpreting Elasticity Coefficients

• Coefficient > 1 indicates elastic demand or supply
• Coefficient < 1 indicates inelastic demand or supply
• Demand elasticity example: coefficient of -2 means 1% price increase leads to 2% quantity demanded decrease
• Supply elasticity example: coefficient of 0.5 means 1% price increase leads to 0.5% quantity supplied increase

Types of Elasticity Measurements

• Arc elasticity calculates elasticity between two points on demand or supply curve
  • Used for larger price changes
• Point elasticity calculates elasticity at specific point on curve
  • Used for infinitesimal price changes
• Formula for arc elasticity: $E = \frac{(Q_2 - Q_1) / [(Q_2 + Q_1) / 2]}{(P_2 - P_1) / [(P_2 + P_1) / 2]}$

Elastic vs Inelastic Demand and Supply

Elasticity Classifications

• Elastic demand or supply: percentage change in quantity > percentage change in price (|E| > 1)
• Inelastic demand or supply: percentage change in quantity < percentage change in price (|E| < 1)
• Unitary elastic demand or supply: percentage change in quantity = percentage change in price (|E| = 1)
• Perfectly elastic demand or supply (|E| = ∞)
  • Represented by horizontal line on graph
  • Indicates infinite responsiveness to price changes
• Perfectly inelastic demand or supply (|E| = 0)
  • Represented by vertical line on graph
  • Indicates no responsiveness to price changes

Graphical Representations and Curve Shapes

• Shape of demand and supply curves reflects elasticity
  • Flatter curves indicate higher elasticity
  • Steeper curves indicate lower elasticity
• Elasticity often varies along curve
  • Demand typically more elastic for higher prices
  • Supply more elastic in long run
• Examples of elastic goods: luxury items (jewelry), non-essential goods (entertainment)
• Examples of inelastic goods: necessities (insulin), addictive products (cigarettes)

Price Elasticity and Total Revenue

Total Revenue and Elasticity Relationship

• Total revenue calculated as price multiplied by quantity sold (TR = P × Q)
• For elastic demand (|Ed| > 1):
  • Price decrease increases total revenue
  • Price increase decreases total revenue
• For inelastic demand (|Ed| < 1):
  • Price increase increases total revenue
  • Price decrease decreases total revenue
• For unitary elastic demand (|Ed| = 1):
  • Total revenue remains constant regardless of price changes

Total Revenue Test and Marginal Revenue

• Total revenue test determines demand elasticity by observing revenue changes with price changes
• Marginal revenue always positive for inelastic demand
• Marginal revenue negative for elastic demand
• Marginal revenue = 0 at point of unitary elasticity
• Relationship between elasticity and marginal revenue: $MR = P(1 + \frac{1}{E_d})$

Applications in Pricing Strategies

• Understanding elasticity-revenue relationship crucial for pricing strategies
• Profit maximization in various market structures depends on elasticity analysis
• Examples of elasticity-based pricing:
  • Airlines charging higher prices for business travelers (inelastic demand)
  • Grocery stores offering discounts on perishable items (elastic demand)
• Long-term vs. short-term elasticity considerations in strategic planning