Elasticity and Consumer Behavior
Core concepts
Price elasticity of demand (PED) measures responsiveness of quantity demanded to price: PED = % change in quantity demanded ÷ % change in price. Demand is elastic if |PED| > 1, inelastic if |PED| < 1, unit elastic if = 1. Use the midpoint (arc) formula to avoid direction bias: divide the change by the average of the two values.
Determinants: availability of substitutes (more substitutes = more elastic), share of budget, necessity vs. luxury, time horizon (longer run = more elastic).
Related elasticities: income elasticity (normal > 0, inferior < 0), cross-price elasticity (positive for substitutes, negative for complements). Supply elasticity depends on production flexibility and time.
Total revenue test: if demand is elastic, a price cut raises revenue; if inelastic, a price cut lowers revenue. Revenue is maximized at unit elasticity.
Consumer behavior: utility maximization subject to a budget constraint; marginal utility diminishes; consumers equate marginal utility per dollar across goods. Indifference curves and budget lines illustrate substitution and income effects.
Common traps
- Using the simple percentage formula and getting different answers for price rises vs. falls; use the midpoint method.
- Assuming steep demand means inelastic - check the actual responsiveness.
- Forgetting that elasticity varies along a linear demand curve (elastic at high prices, inelastic at low prices).
- Confusing income elasticity with cross-price elasticity.
Worked example
Price falls from $10 to $8; quantity rises from 100 to 130. Midpoint: %ΔQ = 30/115 ≈ 26.1%; %ΔP = −2/9 ≈ −22.2%. PED ≈ −1.18 (elastic). Because demand is elastic, the price cut raises total revenue (from $1,000 to $1,040).
Rule of thumb
More substitutes, more time, and larger budget share make demand more elastic. Elastic → price and revenue move opposite; inelastic → they move together.