Agriculture Reference
In-Depth Information
Table 3.3
Interpretation of price elasticity of demand
Absolute value of price
elasticity of demand
coeffi cient
Demand is
Effect on total revenue
of a price increase
Effect on total revenue
of a price decrease
Greater than 1.0 (| ε
d
| > 1.0)
Elastic
Total revenue decreases
Total revenue increases
Equal to 1.0 (| ε
d
| = 1.0)
Unit elastic
Total revenue is
unchanged
Total revenue is
unchanged
Less than 1.0 (| ε
d
| < 1.0)
Inelastic
Total revenue increases
Total revenue decreases
On the other hand, if the absolute value of price elasticity of demand is between 0 and 1.0,
demand is said to be
price inelastic
. Here a change in price has a relatively small impact
upon the quantity demanded. A price decline for an elastic demand means that consumers do
not respond, and total revenue will actually fall. Goods that fi t into this category are typically
necessities, products that account for a very small part of the consumer's budget, or products
that have no close substitutes. The demand for natural gas to run and heat a large production
facility is fairly inelastic—it is essential to the effi cient production process and, at least in the
short run, it has no substitutes. Thus, this production facility may have no option but to pay
higher natural gas bills during the winter to maintain production capacity of the facility.
However, over the longer term, the fi rm may switch from natural gas to oil, electricity, or
some other alternative fuel source. So, the period of time under consideration also affects the
price elasticity of demand.
The other two types of demand elasticity—
income
and
cross price elasticity of
demand
—are calculated in a similar manner as for price elasticity of demand. A manager is
most interested in the sign for these two elasticities. Thus, we do not take the absolute
value.
For most products,
income elasticity of demand
will have a positive sign and these
products are classifi ed as
normal goods
. This means that the quantity demanded of these
goods will rise as income increases. However, for a few goods, income elasticity will have a
negative sign and are classifi ed as inferior goods. In this case, the quantity demanded will
fall as income increases. Examples of inferior goods include staples of a college student's
diet, like Ramen noodles or tuna. These are the last things a recent graduate will purchase
and consume as they start their career because they can now afford better food.
The cross price elasticity of demand is used to classify how demand relates to price
changes in other goods. The relationship between two goods can be classifi ed as comple-
ments, independent, or substitutes. Grocers, for one, carefully study these relationships as
they determine how to adjust orders of different items as they put certain goods on sale
each week.
Cross price elasticity of demand
Complement goods
< 00
Cross
price elasticity of demand
Independent goods
= 00
Cross pr
Substitute goods
i
ice elasticity of demand
> 00
If the sign for cross price elasticity of demand is negative, the two goods are deemed to be
complements, like hamburgers and buns. This means if the price of buns is on sale, consum-
ers will also buy complementary goods that are eaten with the buns, like hamburger meat,
