Page of3 O ELASTICITY OF DEMAND The sensitivity of demand to changes in price varies with the product. For example, a change in the price of light bulbs may not affect the demand for light bulbs much, because people need light bulbs no matter what their price. However, a change in the price of a particular make of car may have a signicant effect on the demand for that car, because people can switch to another make. We want to nd a way to measure this sensitivity of demand to price changes Our measure should work for products as diverse as light bulbs and cars. The prices of these two items are so different that it makes little sense to talk about absolute changes in price: Changing the price of light bulbs by $1 is a substantial change, whereas changing the price of a car by $1 is not. Instead, we use the percent change in price. How, for example, does a 1% increase in price affect the demand for the product? Let 4;) denote the change in the price p of a product and Aq denote the corresponding change in quantity q demanded. The percent change in price is Ap/p and the percent change in quantity demanded is Aq/q. We assume that Ap and Aq have opposite signs (because increasing the price usually decreases the quantity demanded). Then the effect of a price change on demand is measured by the absolute value of the ratio. Aq Percent change in demandl 7 Aq p p Aq Percent change in price _ _ q Ap _ q Ap P For small changes in p, we approximate Z by the derivative 23;. We dene: The elasticity of demand for a product, E, is given approximately by ZOOM + Page of3 measured by the absolute value of the ratio. Percent change in demand q Aq p p Aq Percent change in price For small changes in p, we approximate 2: by the derivative E. am We dene: The elasticity of demand for a product, E, is given approximately by Aq/ d Em _q ,orexactlybyE= E -q AP/P q dp Increasing the price of an item by 1% causes a drop of approximately E % in the quantity of goods demanded, - If E> 1, Then a 1% increase in price causes the demand to drop more than 1%, and the demand is elastic 0 If 0 S E 1, demand is elastic, and revenue is increased by lowering the price. 0 E = 1 occurs at critical points of the revenue function Solve: After writing your summary use what you have learned to answer the following. 1. There is only one company offering internet service in a town. Would you expect the elasticity of demand for internet service to be high or low? Explain. O ZOOM +