# Price Elasticity: From Tires to Toothpicks

### EDUCATOR'S VERSION

Posted July 12, 2004

Standards: 7, 8

Author: Cheryl McGaughey

Posted: July 12, 2004

Updated: October 11, 2007

### DESCRIPTION

Students gain an understanding of price elasticity of demand and why different goods have different degrees of elasticity. Students learn how to calculate price elasticity of goods.

### STUDENTS WILL

• Apply the law of demand to the price elasticity of demand.
• Be able to define price elasticity of demand.
• Understand the factors that determine whether the price elasticity of demand is elastic or inelastic.
• Compare the elasticities of different goods.
• Calculate the price elasticity of a good.

### INTRODUCTION

Price elasticity of demand measures changes in the quantity demanded when prices change. Some goods are very elastic and others are very inelastic.

NOTE: The example in the student version is about on person's decision regarding price changes and a price change might not affect a group in the same way. For example, if 3 people shared a pizza, a \$3 increase would only be a \$1 per person in crease and might not affect their decision.

### PROCESS

The price elasticity of demand, a measure of the responsiveness of quantity demanded to a price change, may cause a change in price to have a small or large impact on quantity demanded. Inelastic goods such as gasoline are still purchased in approximately the same quantity even when prices rise. Elastic goods such as restaurant meals, movie tickets, and luxury items usually follow the law of demand and will see a drop in quantity demanded when prices rise.

Students should see the connection between the following factors and elasticity. These factors are the number of good substitutes, the degree of necessity, the proportion of a purchaser's budget consumed by the item, and the time period involved. If a good has a large number of substitutes, the more elastic it is. The fewer the substitutes, the greater the inelasticity. If the good is highly desired with few substitutes it may be more inelastic. If the good represents a small proportion of a person's budget, price changes do not greatly affect the amount purchased.

Gasoline is considered inelastic (meaning price changes have little effect on the quantity we buy).

Restaurant meals, on the other hand, are very elastic (meaning price changes greatly affect our purchase of them).

NOTE: This site offers definitions and additional graphs to help with instruction, and explanation of quantity demanded .

So very small items like a package of gum or an ice cream cone bought once or twice a month will likely be inelastic. In the short run, many goods are fairly inelastic but in the long run, the elasticity increases because consumers have time to change their consumption habits. Students compare two very different goods - gasoline and restaurant meals by completing the following checklist.

Students will complete the interactive activity about inelasticity. Students will be asked which of the two items would be the most inelastic [gasoline], and what factors make it more inelastic than restaurant meals [it is a want, not many quality substitutes and you must make the decision now as you are out of fuel. Restaurant meals would be the most elastic good as they are not required, have a number of substitutes, and you may be able to delay the decision.]

In response to the questions about the website, the actual price elasticity of short-run gasoline and restaurant meals are 0.2 and 2.3, respectively. This confirms the site information about price elasticity.

### ASSESSMENT ACTIVITY

Have students compare the elasticity of the different goods on the Mackinac Center for Public Policy website. Then, have them complete the following activity. The answers to the questions are below.

1. Which products are the most inelastic? [Inelastic goods are salt, matches, toothpicks, short-run airline travel, gasoline, residential natural gas, coffee, fish, tobacco, legal services, physician services, taxi service, automobiles]

2. What factors would most likely explain why salt is very inelastic? [Salt is inelastic because there are no good substitutes, it is a necessity to most people, and it represents a small proportion of most people's budget.]

3. Why would the demand for tooth picks be inelastic? [Toothpicks are inelastic because they cost very little and represent a small percentage of a typical grocery budget and have few substitutes.]

4. Although both short-run and long-run gasoline are both inelastic, why is short-run gasoline more inelastic than long-run gasoline? [Short-run gasoline is more inelastic than long-run because in the short run, we have to buy gas to keep our car going. In the long run, we can switch to more fuel-efficient cars (including hybrid), ride the bus or walk more. But the short-run, those options are not available.]

5. What factors would likely explain why Chevrolet cars are very elastic? [Chevrolet cars would be very elastic because we don't have to buy that brand of car - we have lots of substitutes.]

6. Why would tires have unitary elasticity while gasoline is inelastic? [Even though tires are a want if we drive a car, the decision to buy them is not as immediate as buying gas (unless we have a flat and must buy one to get back on the road). You can shop around for the best price as there are a number of brands and stores that sell tires. You can buy new or used tires so you have some substitutes. So even though we think of tires as wants, there is a greater flexibility in buying tires than in buying gasoline. This contributes to the higher elasticity of tires over gasoline.]

### CONCLUSION

The price elasticity of demand is a useful indicator of how we would expect the quantity demanded for a good to change if the price of the good changes. Producers would want to know the price elasticity of demand before they changed the price. If they were considering a price increase, they would prefer an inelastic demand so that consumers would still buy approximately the same quantity at the higher price which would raise your profits. If the good were very elastic and you raised prices, you would sell fewer goods and possibly see a decrease in overall profits.

### EXTENSION ACTIVITY

[NOTE: The following activities are excellent supports to the above lesson. It is strongly urged that you consider requiring students to do these activities as well]

Students calculate the actual price elasticity of demand for a good based on the formula below.

Price elasticity of demand = Percentage change in quantity demanded
divided by Percentage change in price
The percentage of change in quantitiy demanded is:
[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
The percentage of change in price is: [Price(NEW) - Price(OLD)] / Price(OLD)

Based on the following information, calculate the price elasticity of demand for paper towels. At a price of \$1, the quantity demanded is 10. At a price of \$1.50, the quantity demanded is 3.

[Answer: percentage change in quantity demanded = (3 - 10) /10= .70
percentage change in price = (1.5 - 1) /1 = .50
price elasticity of demand for paper towels = .70/.50 = 1.4]

Students are asked if the good is elastic or inelastic [elastic] and if the answer supports what they have learned about elasticity [yes]. We would expect paper towels to be elastic because while they are very widely used, they are not required to complete a task, you can put delay the decision somewhat (unlike short term gasoline) and they have some substitutes such as cloth kitchen towels. However, they are not as elastic as such luxury items as movie tickets because paper towels are considered by many to be a want and they represent a fairly small percentage of a typical grocery budget.