Monopolistic Competition – definition, diagram

and examples
27 February 2019 by Tejvan Pettinger

Definition: Monopolistic competition is a market structure which combines

elements of monopoly and competitive markets. Essentially a monopolistic
competitive market is one with freedom of entry and exit, but firms can
differentiate their products. Therefore, they have an inelastic demand curve
and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to
normal profits in the long term.
A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers
because the good is highly differentiated
 Firms make normal profits in the long run but could make
supernormal profits in the short term
 Firms are allocatively and productively inefficient.
Diagram monopolistic competition short run

In the short run, the diagram for monopolistic competition is the same as for
a monopoly.

The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to supernormal
profit

Monopolistic competition long run

Demand curve shifts to the left due to new firms entering the market.
In the long-run, supernormal profit encourages new firms to enter. This reduces demand for existing
firms and leads to normal profit. I

Efficiency of firms in monopolistic competition

Allocative inefficient. The above diagrams show a price set above marginal cost

Productive inefficiency. The above diagram shows a firm not producing on the lowest point of AC curve

Dynamic efficiency. This is possible as firms have profit to invest in research and development.

X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide better
products.

Examples of monopolistic competition

Restaurants – restaurants compete on quality of food as much as price. Product differentiation is a key
element of the business. There are relatively low barriers to entry in setting up a new restaurant.

Hairdressers. A service which will give firms a reputation for the quality of their hair-cutting.

Clothing. Designer label clothes are about the brand and product differentiation

TV programmes – globalisation has increased the diversity of tv programmes from networks around the
world. Consumers can choose between domestic channels but also imports from other countries and
new services, such as Netflix.

Limitations of the model of monopolistic competition

Some firms will be better at brand differentiation and therefore, in the real world, they will be able to
make supernormal profit.

New firms will not be seen as a close substitute.

There is considerable overlap with oligopoly – except the model of monopolistic competition assumes no
barriers to entry. In the real world, there are likely to be at least some barriers to entry

If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier to entry. A
new firm can’t easily capture the brand loyalty.

Many industries, we may describe as monopolistically competitive are very profitable, so the assumption
of normal profits is too simplistic.

……………..

Equilibrium under Monopolistic Competition

Before determining a firm’s equilibrium under Monopolistic Competition, it is important to note that
there are two possible demand curves – both sloping downwards. In this article, we will look at a firm’s
short-run and long-run equilibrium under Monopolistic Competition.

Equilibrium under Monopolistic Competition

The two types of demand curves of a firm under monopolistic competition are due to the following
reasons:

When a firm revises the price of its product, the rival firms don’t always increase the prices of their
products too. Therefore, the demand curve has a smaller slope and the demand for the product is more
elastic.

If the rival firms follow the price revision by the first firm, then the demand for its product becomes less
elastic. In such cases, the firm needs to slash its prices further to achieve an increase in demand. In this
case, the demand curve has a steeper slope.

A Firm’s Short-Run Equilibrium under Monopolistic Competition

Under Monopolistic Competition, the revenue curves are downward sloping (like under Monopoly). This
is because, in order to sell more, the firm has to decrease the price.

A firm under Monopolistic Competition can either earn normal profits, super-normal profits, or incur
losses. Also, like under Monopoly, a firm earns super-normal profits if the demand for its product is very
high.

Also, in the short-run, new firms cannot enter the group and enhance the supply of the product group.
Therefore, they cannot compete away the super-normal profits of the firm. Also, in the short-run, a firm
faces certain fixed costs. These can include production as well as selling costs.

In the figure above, you can see that the AR and MR curves of the firm have negative slopes. Further, the
AVC curve includes the production costs as well as the variable components of selling expenses.
Furthermore.

The MC curve cuts the AVC curve at its lowest point. Also, the ATC curve represents the average of the
total cost of the firm including the fixed selling expenses.

The MC c”rve intersects the MR curve from below at point I. Hence, the firm decides to produce a
quantity of OM and charge a price of EM per unit.
By doing so, the firm earns a profit of EK per unit and the entry of rival firms do not compete it out.
However, based on the relative location of the cost and revenue curves, it is possible that the firm is in
equilibrium with:

Only normal profit

Covering a part of fixed costs. Therefore, incurring a loss less than its fixed costs

Loss equal to the fixed costs (where AR is tangent to the AVC curve)

Group Equilibrium

Group equilibrium is the simultaneous equilibrium of all the firms in the group. We know that the cost
and demand conditions of individual firms differ from each other.

Further, they produce differentiated products making it impossible to derive demand and supply curves
for the group as a whole.

Chamberlin assumed that all firms in the group have identical demand and cost conditions. Therefore,
when in equilibrium, all firms produce the same quantities of their respective products and sell them at
the same prices.

This, however, is a little unrealistic assumption. For all practical purposes, it is important to determine a
firm’s equilibrium under Monopolistic Competiton individually.

A Firm’s Long-Run Equilibrium under Monopolistic Competition

To discuss a firm’s long-run equilibrium under Monopolistic Competition, it is important to remember

the following points:

There are no fixed costs in the long-run. The firm can vary its inputs as well as its selling costs. Further,
the firm can choose between various product qualities.

There is no compulsion on a firm to operate at a loss. It can leave the industry whenever it wants. When
a firm leaves the industry, the absolute market shares of the remaining firms, increase. Further, their
demand curve shifts right and upwards. This continues until other firms can produce without incurring a
loss.

On the other hand, if the demand is so strong that the existing firms make super-normal profits, then
new firms can enter the group.
They produce close substitutes of the existing products and increase the total product supply. Therefore,
the demand shares of the existing firms reduce. Hence, the demand curve of a firm cannot stay above its
long-run average cost curve.

All firms operating under Monopolistic Competition can make a choice between combinations of:

Product quality

Product Differentiation

Selling costs

A firm must consider the fact that any variation of price on its part can attract a reaction from its rivals.
Therefore, it faces a much steeper demand curve.

Therefore, under Monopolistic Competition, a firm is exposed to constant interaction with the rest of the
firms in the group. Its decisions are not independent of the decisions of the other firms.

Further, the firm’s demand curve depends on its actions AS WELL AS on the actions of its rivals.
Therefore, it must consider different combinations of its cost components pertaining to the product
quality and its selling expenses, etc. This helps the firm estimate the slope and position of the demand
curve.

Let’s say that the LAC curve in Fig. I represent the product quality and selling expenses that a firm
selects. This has a corresponding long-term MC curve (LMC) which intersects the MR curve from below
at point I.

Therefore, the firm decides to produce a quantity of OM and sell it a per unit price of EM. This gets a
profit of EK per unit. However, soon new firms enter the market and start offering close substitutes and
bring the profit down.

Therefore, there is a reduction in the market shares of the existing firms. The firm’s AR curve shifts left
until it becomes tangent to the LAC curve at point E as shown in Fig. ii. This ensures that the firm earns
only normal profit. Once this stage is reached, there is no incentive for new firms to enter the market.

This results in the firm’s long-term equilibrium under Monopolistic Competition. The equilibrium is given
by the point of tangency between the firm’s AR curve and LAC curve, which is at point E in Fig. ii.
Therefore, in the long-run, under monopolistic competition, firms earn only normal profits.

Q1. Why does a firm have two types of demand curves under Monopolistic Competition?
Answer: Under Monopolistic Competition, a firm has two types of demand curves due to the following
reasons:

When a firm revises the price of its product, the rival firms don’t always increase the prices of their
products too. Therefore, the demand curve has a smaller slope and the demand for the product is more
elastic.

If the rival firms follow the price revision by the first firm, then the demand for its product becomes less
elastic. In such cases, the firm needs to slash its prices further to achieve an increase in demand. In this
case, the demand curve has a steeper slope.

Chapter4

Price Elasticity of Demand Meaning, Types, and Factors That Impact It

By THE INVESTOPEDIA TEAM Updated May 09, 2023

Reviewed by MARGARET JAMES

Fact checked by SUZANNE KVILHAUG

What Is Price Elasticity of Demand?

Price elasticity of demand is a measurement of the change in the consumption of a product in relation to
a change in its price. Expressed mathematically, it is:

Economists use price elasticity to understand how supply and demand for a product change when its
price changes.

Like demand, supply also has an elasticity, known as price elasticity of supply. Price elasticity of supply
refers to the relationship between change in supply and change in price. It’s calculated by dividing the
percentage change in quantity supplied by the percentage change in price. Together, the two elasticities
combine to determine what goods are produced at what prices.

KEY TAKEAWAYS

Price elasticity of demand is a measurement of the change in consumption of a product in relation to a

change in its price.

A good is perfectly elastic if the price elasticity is infinite (if demand changes substantially even with
minimal price change).

If price elasticity is greater than 1, the good is elastic; if less than 1, it is inelastic.
If a good’s price elasticity is 0 (no amount of price change produces a change in demand), it is perfectly
inelastic.

If price elasticity is exactly 1 (price change leads to an equal percentage change in demand), it is known
as unitary elasticity.

The availability of a substitute for a product affects its elasticity. If there are no good substitutes and the
product is necessary, demand won’t change when the price goes up, making it inelastic.

Understanding Price Elasticity of Demand

Economists have found that the prices of some goods are very inelastic.

That is, a reduction in price does not increase demand much, and an increase in price does not hurt
demand, either. For example, gasoline has little price elasticity of demand. Drivers will continue to buy as
much as they have to, as will airlines, the trucking industry, and nearly every other buyer.

Other goods are much more elastic, so price changes for these goods cause substantial changes in their
demand or their supply.

Not surprisingly, this concept is of great interest to marketing professionals.

It could even be said that their purpose is to create inelastic demand for the products that they market.
They achieve that by identifying a meaningful difference in their products from any others that are
available.

If the quantity demanded of a product changes greatly in response to changes in its price, it is elastic.
That is, the demand point for the product is stretched far from its prior point. If the quantity purchased
shows a small change after a change in its price, it is inelastic. The quantity didn’t stretch much from its
prior point.

Factors That Affect Price Elasticity of Demand

Availability of Substitutes

The more easily a shopper can substitute one product for another, the more the price will fall. For
example, in a world in which people like coffee and tea equally if the price of coffee goes up, people will
have no problem switching to tea, and the demand for coffee will fall. This is because coffee and tea are
considered good substitutes for each other.

Urgency
The more discretionary a purchase is, the more its quantity of demand will fall in response to price
increases. That is, the product demand has greater elasticity.

Say you are considering buying a new washing machine, but the current one still works; it’s just old and
outdated. If the price of a new washing machine goes up, you’re likely to forgo that immediate purchase
and wait until prices go down or the current machine breaks down.

The less discretionary a product is” the less its quantity demanded will fall. Inelastic examples include
luxury items that people buy for their brand names. Addictive products are quite inelastic, as are
required add-on products, such as inkjet printer cartridges.

TRADE

TABLE OF CONTENTS

CORPORATE FINANCE FINANCIAL RATIOS

Price Elasticity of Demand Meaning, Types, and Factors That Impact It

By THE INVESTOPEDIA TEAM Updated May 09, 2023

Reviewed by MARGARET JAMES

Fact checked by SUZANNE KVILHAUG

What Is Price Elasticity of Demand?

Price elasticity of demand is a measurement of the change in the consumption of a product in relation to
a change in its price. Expressed mathematically, it is:

Price Elasticity of Demand = Percentage Change in Quantity Demanded ÷ Percentage Change in Price

Economists use price elasticity to understand how supply and demand for a product change when its
price changes.

Like demand, supply also has an elasticity, known as price elasticity of supply. Price elasticity of supply
refers to the relationship between change in supply and change in price. It’s calculated by dividing the
percentage change in quantity supplied by the percentage change in price. Together, the two elasticities
combine to determine what goods are produced at what prices.
KEY TAKEAWAYS

Price elasticity of demand is a measurement of the change in consumption of a product in relation to a

change in its price.

A good is perfectly elastic if the price elasticity is infinite (if demand changes substantially even with
minimal price change).

If price elasticity is greater than 1, the good is elastic; if less than 1, it is inelastic.

If a good’s price elasticity is 0 (no amount of price change produces a change in demand), it is perfectly
inelastic.

If price elasticity is exactly 1 (price change leads to an equal percentage change in demand), it is known
as unitary elasticity.

The availability of a substitute for a product affects its elasticity. If there are no good substitutes and the
product is necessary, demand won’t change when the price goes up, making it inelastic.

Price Elasticity of Demand

Theresa Chiechi / Investopedia

Understanding Price Elasticity of Demand

Economists have found that the prices of some goods are very inelastic.

That is, a reduction in price does not increase demand much, and an increase in price does not hurt
demand, either. For example, gasoline has little price elasticity of demand. Drivers will continue to buy as
much as they have to, as will airlines, the trucking industry, and nearly every other buyer.

Other goods are much more elastic, so price changes for these goods cause substantial changes in their
demand or their supply.

Not surprisingly, this concept is of great interest to marketing professionals.

1
It could even be said that their purpose is to create inelastic demand for the products that they market.
They achieve that by identifying a meaningful difference in their products from any others that are
available.

If the quantity demanded of a product changes greatly in response to changes in its price, it is elastic.
That is, the demand point for the product is stretched far from its prior point. If the quantity purchased
shows a small change after a change in its price, it is inelastic. The quantity didn’t stretch much from its
prior point.

Factors That Affect Price Elasticity of Demand

Availability of Substitutes

The more easily a shopper can substitute one product for another, the more the price will fall. For
example, in a world in which people like coffee and tea equally if the price of coffee goes up, people will
have no problem switching to tea, and the demand for coffee will fall. This is because coffee and tea are
considered good substitutes for each other.

Urgency

The more discretionary a purchase is, the more its quantity of demand will fall in response to price
increases. That is, the product demand has greater elasticity.

Say you are considering buying a new washing machine, but the current one still works; it’s just old and
outdated. If the price of a new washing machine goes up, you’re likely to forgo that immediate purchase
and wait until prices go down or the current machine breaks down.

The less discretionary a product is” the less its quantity demanded will fall. Inelastic examples include
luxury items that people buy for their brand names. Addictive products are quite inelastic, as are
required add-on products, such as inkjet printer cartridges.

One thing all these products have in common is that they lack good substitutes. If you really want an
Apple iPad, then a Kindle Fire won’t do. Addicts are not dissuaded by higher prices, and only HP ink will
work in HP printers (unless you disable HP cartridge protection).
Duration of Price Change

The length of time that the price change lasts also matters.

Demand response to price fluctuations is different for a one-day sale than for a price change that lasts
for a season or a year.

Clarity of time sensitivity is vital to understanding the price elasticity of demand and for comparing it
with different products. Consumers may accept a seasonal price fluctuation rather than change their
habits.

Types of Price Elasticity of Demand

Price elasticity of demand can be categorized according to the number calculated by dividing the
percentage change in quantity demanded by the percentage change in price. These categories include
the following:

TRADE

TABLE OF CONTENTS

CORPORATE FINANCE FINANCIAL RATIOS

Price Elasticity of Demand Meaning, Types, and Factors That Impact It

By THE INVESTOPEDIA TEAM Updated May 09, 2023

Reviewed by MARGARET JAMES

Fact checked by SUZANNE KVILHAUG

What Is Price Elasticity of Demand?

Price elasticity of demand is a measurement of the change in the consumption of a product in relation to
a change in its price. Expressed mathematically, it is:

Price Elasticity of Demand = Percentage Change in Quantity Demanded ÷ Percentage Change in Price

Economists use price elasticity to understand how supply and demand for a product change when its
price changes.
1

Like demand, supply also has an elasticity, known as price elasticity of supply. Price elasticity of supply
refers to the relationship between change in supply and change in price. It’s calculated by dividing the
percentage change in quantity supplied by the percentage change in price. Together, the two elasticities
combine to determine what goods are produced at what prices.

KEY TAKEAWAYS

Price elasticity of demand is a measurement of the change in consumption of a product in relation to a

change in its price.

A good is perfectly elastic if the price elasticity is infinite (if demand changes substantially even with
minimal price change).

If price elasticity is greater than 1, the good is elastic; if less than 1, it is inelastic.

If a good’s price elasticity is 0 (no amount of price change produces a change in demand), it is perfectly
inelastic.

If price elasticity is exactly 1 (price change leads to an equal percentage change in demand), it is known
as unitary elasticity.

The availability of a substitute for a product affects its elasticity. If there are no good substitutes and the
product is necessary, demand won’t change when the price goes up, making it inelastic.

Price Elasticity of Demand

Theresa Chiechi / Investopedia

Understanding Price Elasticity of Demand

Economists have found that the prices of some goods are very inelastic.

That is, a reduction in price does not increase demand much, and an increase in price does not hurt
demand, either. For example, gasoline has little price elasticity of demand. Drivers will continue to buy as
much as they have to, as will airlines, the trucking industry, and nearly every other buyer.

Other goods are much more elastic, so price changes for these goods cause substantial changes in their
demand or their supply.

2
Not surprisingly, this concept is of great interest to marketing professionals.

It could even be said that their purpose is to create inelastic demand for the products that they market.
They achieve that by identifying a meaningful difference in their products from any others that are
available.

If the quantity demanded of a product changes greatly in response to changes in its price, it is elastic.
That is, the demand point for the product is stretched far from its prior point. If the quantity purchased
shows a small change after a change in its price, it is inelastic. The quantity didn’t stretch much from its
prior point.

Factors That Affect Price Elasticity of Demand

Availability of Substitutes

The more easily a shopper can substitute one product for another, the more the price will fall. For
example, in a world in which people like coffee and tea equally if the price of coffee goes up, people will
have no problem switching to tea, and the demand for coffee will fall. This is because coffee and tea are
considered good substitutes for each other.

Urgency

The more discretionary a purchase is, the more its quantity of demand will fall in response to price
increases. That is, the product demand has greater elasticity.

Say you are considering buying a new washing machine, but the current one still works; it’s just old and
outdated. If the price of a new washing machine goes up, you’re likely to forgo that immediate purchase
and wait until prices go down or the current machine breaks down.

The less discretionary a product is” the less its quantity demanded will fall. Inelastic examples include
luxury items that people buy for their brand names. Addictive products are quite inelastic, as are
required add-on products, such as inkjet printer cartridges.
One thing all these products have in common is that they lack good substitutes. If you really want an
Apple iPad, then a Kindle Fire won’t do. Addicts are not dissuaded by higher prices, and only HP ink will
work in HP printers (unless you disable HP cartridge protection).

Duration of Price Change

The length of time that the price change lasts also matters.

Demand response to price fluctuations is different for a one-day sale than for a price change that lasts
for a season or a year.

Clarity of time sensitivity is vital to understanding the price elasticity of demand and for comparing it
with different products. Consumers may accept a seasonal price fluctuation rather than change their
habits.

Types of Price Elasticity of Demand

Price elasticity of demand can be categorized according to the number calculated by dividing the
percentage change in quantity demanded by the percentage change in price. These categories include
the following:

Types of Price Elasticity of Demand

If the percentage change in quantity demanded divided by the percentage change in price equals:
It is known as: Which means:

Infinity Perfectly elastic Changes in price result in demand declining to zero

Greater than 1 Elastic Changes in price yield a significant change in demand

1 Unitary Changes in price yield equivalent (percentage) changes in demand

Less than 1 Inelastic Changes in price yield an insignificant change in demand

0 Perfectly inelastic Changes in price yield no change in demand

Example of Price Elasticity of Demand

As a rule of thumb, if the quantity of a product demanded or purchased changes more than the price
changes, then the product is considered to be elastic (for example, the price goes up by 5%, but the
demand falls by 10%).

If the change in quantity purchased is the same as the price change (say, 10% ÷ 10% = 1), then the
product is said to have unit (or unitary) price elasticity.

Finally, if the quantity purchased changes less than the price (say, -5% demanded for a +10% change in
price), then the product is deemed inelastic.

To calculate the elasticity of demand, consider this example: Suppose that the price of apples falls by 6%
from $1.99 a bushel to $1.87 a bushel. In response, grocery shoppers increase their apple purchases by
20%. The elasticity of apples is thus: 0.20 ÷ 0.06 = 3.33. The demand for apples is quite elastic.

ANOTHER

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Main content

How do quantities supplied and demanded react to changes in price?

Key points

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change
in its price. It is computed as the percentage change in quantity demanded—or supplied—divided by the
percentage change in price.

Elasticity can be described as elastic—or very responsive—unit elastic, or inelastic—not very responsive.

Elastic demand or supply curves indicate that the quantity demanded or supplied responds to price
changes in a greater than proportional manner.

An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller
percentage change in quantity demanded or supplied.

Unitary elasticity means that a given percentage change in price leads to an equal percentage change in
quantity demanded or supplied.

What is price elasticity?

Both demand and supply curves show the relationship between price and the number of units
demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity
demanded,

\[\text{Q}_d\], or supplied,

\[\text{Q}_s\], and the corresponding percent change in price.

The price elasticity of demand is the percentage change in the quantity demanded of a good or service
divided by the percentage change in the price. The price elasticity of supply is the percentage change in
quantity supplied divided by the percentage change in price.

Elasticities can be usefully divided into five broad categories: perfectly elastic, elastic, perfectly inelastic,
inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than
one, indicating a high responsiveness to changes in price. An inelastic demand or inelastic supply is one
in which elasticity is less than one, indicating low responsiveness to price changes. Unitary elasticities
indicate proportional responsiveness of either demand or supply.

Perfectly elastic and perfectly inelastic refer to the two extremes of elasticity. Perfectly elastic means the
response to price is complete and infinite: a change in price results in the quantity falling to zero.
Perfectly inelastic means that there is no change in quantity at all when price changes.

If . . . It Is Called .

Table

Using the midpoint method to calculate elasticity

To calculate elasticity, instead of using simple percentage changes in quantity and price, economists
sometimes use the average percent change in both quantity and price. This is called the Midpoint
Method for Elasticity:

Formula

The advantage of the midpoint method is that we get the same elasticity between two price points
whether there is a price increase or decrease. This is because the formula uses the same base for both
cases. The midpoint method is referred to as the arc elasticity in some textbooks.

Using the point elasticity of demand to calculate elasticity

A drawback of the midpoint method is that as the two points get farther apart, the elasticity value loses
its meaning. For this reason, some economists prefer to use the point elasticity method. In this method,
you need to know what values represent the initial values and what values represent the new values.

Formula
Main content

How do quantities supplied and demanded react to changes in price?

Key points

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change
in its price. It is computed as the percentage change in quantity demanded—or supplied—divided by the
percentage change in price.

Elasticity can be described as elastic—or very responsive—unit elastic, or inelastic—not very responsive.

Elastic demand or supply curves indicate that the quantity demanded or supplied responds to price
changes in a greater than proportional manner.

An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller
percentage change in quantity demanded or supplied.

Unitary elasticity means that a given percentage change in price leads to an equal percentage change in
quantity demanded or supplied.

What is price elasticity?

Both demand and supply curves show the relationship between price and the number of units
demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity
demanded,

\[\text{Q}_d\], or supplied,

\[\text{Q}_s\], and the corresponding percent change in price.

The price elasticity of demand is the percentage change in the quantity demanded of a good or service
divided by the percentage change in the price. The price elasticity of supply is the percentage change in
quantity supplied divided by the percentage change in price.

Elasticities can be usefully divided into five broad categories: perfectly elastic, elastic, perfectly inelastic,
inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than
one, indicating a high responsiveness to changes in price. An inelastic demand or inelastic supply is one
in which elasticity is less than one, indicating low responsiveness to price changes. Unitary elasticities
indicate proportional responsiveness of either demand or supply.

Perfectly elastic and perfectly inelastic refer to the two extremes of elasticity. Perfectly elastic means the
response to price is complete and infinite: a change in price results in the quantity falling to zero.
Perfectly inelastic means that there is no change in quantity at all when price changes.

If . . . It Is Called . . .
\[\dfrac{\mathrm{\% ~ change~ in~ quantity}}{\mathrm{\% ~ change~ in~ price}}=\infty\]
Perfectly elasti

\[\dfrac{\mathrm{\% ~ change~ in~ quantity}}{\mathrm{\% ~ change~ in~ price}}>1\] Elastic

\[\dfrac{\mathrm{\% ~ change~ in~ quantity}}{\mathrm{\% ~ change~ in~ price}}=1\] Unitary

\[\dfrac{\mathrm{\% ~ change~ in~ quantity}}{\mathrm{\% ~ change~ in~ price}}<1\] Inelastic

\[\dfrac{\mathrm{\% ~ change~ in~ quantity}}{\mathrm{\% ~ change~ in~ price}}=0\] Perfectly

inelastic

Using the midpoint method to calculate elasticity

To calculate elasticity, instead of using simple percentage changes in quantity and price, economists
sometimes use the average percent change in both quantity and price. This is called the Midpoint
Method for Elasticity:

\[\text{Midpoint method for elasticity} =\dfrac{\dfrac{Q_2 – Q_1}{(\dfrac{Q_2+Q_1}{2})}}{\dfrac{P_2-

P_1}{(\dfrac{P_2+P_1}{2})}}\]

The advantage of the midpoint method is that we get the same elasticity between two price points
whether there is a price increase or decrease. This is because the formula uses the same base for both
cases. The midpoint method is referred to as the arc elasticity in some textbooks.

Using the point elasticity of demand to calculate elasticity

A drawback of the midpoint method is that as the two points get farther apart, the elasticity value loses
its meaning. For this reason, some economists prefer to use the point elasticity method. In this method,
you need to know what values represent the initial values and what values represent the new values.
\[\text{Point elasticity } = \dfrac{\dfrac{\text{new }Q - \text{initial }Q}{\text{initial }Q}}{\dfrac{\
text{initial }P - \text{new }P}{\text{initial }P}}\]

Calculating price elasticity of demand

Let’s apply these formulas to a practice scenario. We’ll calculate the elasticity between points

\[\text{A}\] and

\[\text{B}\] in the graph below.

The graph shows a downward sloping line that represents the price elasticity of demand.

The graph shows a downward sloping line that represents the price elasticity of demand.

Image credit: Figure 1 in “Price Elasticity of Demand and Price Elasticity of Supply” by OpenStaxCollege,
CC BY 4.0

First, apply the formula to calculate the elasticity as price decreases from $70 at point

\[\text{B}\] to $60 at point

\[\text{A}\]:

\[\begin{array}{ccc}

\mathrm{\% ~ change in quantity} & = & \frac{3,000–2,800}{\left (3,000+2,800\right )/2}~ \times ~ 100\\

& = & \frac{200}{2,900}~ \times ~ 100\\

& = & 6.9\\

\mathrm{\% change in price} & = & \frac{60–70}{\left (60+70\right )/2}~ \times ~ 100\\

& = & \frac{–10}{65}~ \times ~ 100\\

& = & –15.4\\

\text{Price elasticity of demand} & = & \frac{~ ~ ~ ~ 6.9\% }{–15.4\% }\\

& = & 0.45

\end{array}\]

The elasticity of demand between point

\[\text{A}\] and point

\[\text{B}\] is

\[\frac{~ ~ ~ ~ 6.9\% }{–15.4\% }\], or 0.45. Because this amount is smaller than one, we know that the
demand is inelastic in this interval.

Wait a minute! Shouldn’t the price elasticity of demand be negative here?

This means that, along the demand curve between point

\[\text{B}\] and point

\[\text{A}\], if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the
price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase
in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will
result in only a 4.5% increase in the quantity demanded.

I’d like to do another practice problem.

Calculating the price elasticity of supply

Now let’s try calculating the price elasticity of supply. We use the same formula as we did for price
elasticity of demand:

\[\begin{array}{ccc}

\text{Price elasticity of supply} & = & \frac{\mathrm{\% ~ change ~in ~quantity}}{\mathrm{\% ~ change~
in ~price}}

\end{array}\]

Assume that an apartment rents for $650 per month and, at that price, 10,000 units are rented—you can
see these number represented graphically below. When the price increases to $700 per month, 13,000
units are supplied into the market.

By what percentage does apartment supply increase? What is the price sensitivity?

Relating Elasticity to Changes in Total Revenue

When the price of a good or service changes, the quantity demanded changes in the opposite direction.
Total revenue will move in the direction of the variable that changes by the larger percentage. If the
variables move by the same percentage, total revenue stays the same. If quantity demanded changes by
a larger percentage than price (i.e., if demand is price elastic), total revenue will change in the direction
of the quantity change. If price changes by a larger percentage than quantity demanded (i.e., if demand
is price inelastic), total revenue will move in the direction of the price change. If price and quantity
demanded change by the same percentage (i.e., if demand is unit price elastic), then total revenue does
not change.

When demand is price inelastic, a given percentage change in price results in a smaller percentage
change in quantity demanded. That implies that total revenue will move in the direction of the price
change: a reduction in price will reduce total revenue, and an increase in price will increase it.

Consider the price elasticity of demand for gasoline. In the example above, 1,000 gallons of gasoline
were purchased each day at a price of $4.00 per gallon; an increase in price to $4.25 per gallon reduced
the quantity demanded to 950 gallons per day. We thus had an average quantity of 975 gallons per day
and an average price of $4.125. We can thus calculate the arc price elasticity of demand for gasoline:

Percentage change in quantity demanded = -50/975 = -5.1%

Percentage change in price=0.25/4.125=6.06%

Price elasticity of demand = -5.1%/6.06% = -.084

The demand for gasoline is price inelastic, and total revenue moves in the direction of the price change.
When price rises, total revenue rises. Recall that in our example above, total spending on gasoline (which
equals total revenues to sellers) rose from $4,000 per day (=1,000 gallons per day times $4.00) to
$4037.50 per day (=950 gallons per day times $4.25 per gallon).

When demand is price inelastic, a given percentage change in price results in a smaller percentage
change in quantity demanded. That implies that total revenue will move in the direction of the price
change: an increase in price will increase total revenue, and a reduction in price will reduce it.

Consider again the example of pizza that we examined above. At a price of $9 per pizza, 1,000 pizzas per
week were demanded. Total revenue was $9,000 per week (=1,000 pizzas per week times $9 per pizza).
When the price rose to $10, the quantity demanded fell to 900 pizzas per week. Total revenue remained
$9,000 per week (=900 pizzas per week times $10 per pizza). Again, we have an average quantity of 950
pizzas per week and an average price of $9.50. Using the arc elasticity method, we can compute:

Percentage change in quantity demanded = -100/950 = -10.5%

Percentage change in price = $1.00/$9.50 = 10.5%

Demand is unit price elastic, and total revenue remains unchanged. Quantity demanded falls by the
same percentage by which price increases.

Consider next the example of diet cola demand. At a price of $0.50 per can, 1,000
cans of diet cola were purchased each day. Total revenue was thus $500 per day
(=$0.50 per can times 1,000 cans per day). An increase in price to $0.55 reduced the
quantity demanded to 880 cans per day. We thus have an average quantity of 940
cans per day and an average price of $0.525 per can. Computing the price elasticity of
demand for diet cola in this example, we have:
Percentage change in quantity demanded = -120/940 = -12.8%

Percentage change in price = $0.05/$0.525 = 9.5%

Price elasticity of demand = -12.8%/9.5% = -1.3

………

When the coefficient of PED < 1, then a rise in price will increase total revenue. For example, if PED = -
0.3, this means demand is price inelastic

When the coefficient of PED > 1, then a price fall will increase total revenue. For example, if PED = -2.5,
this means demand is price elastic

When the coefficient of PED = 1, then demand is unitary elastic. This means a price change will leave
total revenue unchanged

When demand is price inelastic, consumers are less sensitive to the price being charged. They have a lot
of consumer surplus which businesses can possibly extract into extra revenue – perhaps as a result of
price discrimination.