Understanding Own-Price Elasticity of Demand | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Some of you may have already studied economics during your undergraduate years, but the CFA curriculum is quite detailed and demanding, so don’t neglect it! In this first lesson, we’ll be discussing elasticity, specifically the own-price elasticity of demand.

What is Own-Price Elasticity of Demand?

Imagine you’re in the market for some apples. When the price is low, you probably want to buy more. When the price is high, you might want to buy less. If everyone behaves like you, we can plot a downward-sloping demand curve of price against the quantity demanded.

Own-price elasticity of demand measures the percentage change in quantity demanded when the price changes by 1%. When the demand curve is downward-sloping, own-price elasticity is negative.

Formula for Own-Price Elasticity of Demand:

E_p = (%ΔQ_d) / (%ΔP)

Elastic vs. Inelastic Demand

Elastic demand occurs when the quantity demanded is very responsive to a change in price. The absolute value of elasticity is greater than 1. This usually happens when goods have close substitutes. For instance, if Uber rides become more expensive, demand might drop significantly because commuters can use other ride-hailing services or opt for taxis and public buses.

An extreme example is perfectly elastic demand, where the demand curve is fully horizontal, and elasticity is infinite.

Inelastic demand, on the other hand, occurs when the quantity demanded isn’t very responsive to a change in price. The absolute value of elasticity is less than 1. This is often the case when there are no close substitutes for a product, like a unique pharmaceutical drug. Even if the price increases substantially, demand might only drop slightly, as the drug is necessary for consumers to maintain their health.

An extreme example is perfectly inelastic demand, where the demand curve is fully vertical, and elasticity is equal to zero.

Elasticity Coefficient, Demand Function, and Demand Curve

It’s important to understand the distinctions between elasticity, the elasticity coefficient, the demand function, and the demand curve. Let’s dive in.

Elasticity vs. Slope of the Demand Curve

Elasticity and the slope of a demand curve are not the same thing. Elasticity is based on percentage changes, while the graph of a demand curve is based on absolute values.

Elasticity Coefficient

The ratio of the change in price to the change in quantity demanded is known as the elasticity coefficient. It is also the slope of the demand function, but not the slope of the demand curve.

Demand Function vs. Demand Curve

The demand function is a mathematical equation that describes the relationship between the price of a good and the quantity demanded. The demand curve, on the other hand, is a graphical representation of the demand function. The slope of the demand curve is the reciprocal of the elasticity coefficient.

Example: Let’s consider the demand curve for apples: P = 15 + (-0.5)Q. We can rearrange this equation to obtain the demand function for apples: Q = 30 + (-2)P. The demand elasticity coefficient for apples is -2. Note that the own-price elasticity of demand for apples depends on the specific point along the curve we’re examining.

Understanding Elasticity Variability

Elasticity is not constant along a demand curve. It varies depending on the specific point we’re examining. For instance:

• At a high price of $10, the quantity demanded is 10 units, and the price elasticity is -2.
• At a low price of $5, the quantity demanded is 20 units, and the price elasticity is -0.5.

Unitary Elasticity Point

For a downward-sloping demand curve, there is a unique point where the elasticity is -1, called the unitary elasticity point. At this point, total revenue is maximized. The unitary elasticity point also serves as the dividing point between the elastic and inelastic regions of the demand curve:

• An increase in price moves us to the elastic region, where the percentage decrease in quantity demanded is greater than the percentage increase in price, resulting in a decrease in total revenue.
• A decrease in price moves us to the inelastic region, where the percentage increase in quantity demanded is less than the percentage decrease in price, again resulting in a decrease in total revenue.

Example: Calculating Own-Price Elasticity of Demand

Factors Affecting Own-Price Elasticity of Demand

Let’s end this lesson by discussing some of the factors that affect the own-price elasticity of demand for a good:

1. Availability of close substitutes: When there are many close substitutes, demand is highly elastic, and when substitutes are limited, demand is highly inelastic.
2. Portion of income spent on the good: The larger the proportion of income spent on a good, the more highly elastic is an individual’s demand for that good.
3. Time period since the price change: The elasticity of demand tends to be greater in the long-run than in the short-run, as consumers can take time to adjust their consumption habits.
4. Necessity of the product: Necessities like bread, eggs, and milk are less price elastic than discretionary goods like restaurant meals and health supplements.

That concludes our first lesson on own-price elasticity of demand. In the next lesson, we’ll cover other types of elasticities.