How will consumers respond to a price change? Sales will increase if price falls, but by how much? Will a higher price lead most people to buy a substitute instead? And if they do, is it possible that the seller’s revenue might actually decrease? The price elasticity of demand, E_d, is a measure of buyer responsiveness to price changes. It equals the ratio of the percentage change in quantity demanded to the percentage change in the price. If the quantity change exceeds the price change in percentage terms, E_d is greater than one (in absolute value) and we say demand is elastic. Demand is inelastic if the quantity change is less than the price change in percents; E_d is less than one. The elasticity of demand varies from one product to another. It may even vary for the same product: demand for a product may be more elastic at high prices than at low prices and is usually more elastic in the long run than in the short run.

Click here to open a new window containing the interactive graphs.

The graph illustrates the demand for soft drinks at a large grocery store. At the current price of $3, sales are 3000 cases per week, generating total sales revenue of $9,000. By dragging the green price triangle on the demand curve, you can observe the relationship between the price, quantity demanded, and total revenue. Click on the Elasticity button to calculate the price elasticity over the selected range of the demand curve.

1. What is the elasticity of demand over the $4 to $5 price range?
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2. What is the elasticity of demand over the $1 to $2 price range?
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3. Experiment on your own. Over what range of the demand curve is demand elastic? Is there a price range over which E_d is 1, or "unit elastic?"
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4. Select an elastic range of the demand curve. What happens to total revenue when price is increased through this range?
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5. Select an elastic range of the demand curve. What happens to total revenue when price is increased through this range?
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Graphing Exercise: Price Ceilings and Price Floors

Government authorities often feel political pressure that a market price is either unfairly high to buyers or unfairly low to sellers. Sometimes the government responds by establishing a legal limit on how high or low the price may go. Prices at or below an established ceiling and prices at or above a floor are legal but disrupt the rationing function of prices by creating either shortages or surpluses.

Exploration: How do price controls affect the ability of markets to allocate goods and services?

Click here to open a new window containing the interactive graphs.

The graph shows a typical market in equilibrium at price P_e. To illustrate the impact of an effective price floor, click inside the red box; click inside the blue box to illustrate an effective price ceiling. Once a ceiling or floor has been established, you can drag on the green triangle price slider to adjust prices within the legal range.

1. How will a price floor affect a competitive market?
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2. How will a price ceiling affect a competitive market?
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3. Experiment on your own. After establishing a floor or ceiling with the mouse, click on the level just established and drag it within the box to change its level. What generalizations can you draw regarding the level of the floor or ceiling and the size of the resulting surplus or shortage?
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