Theater is losing money, but Ernesto thinks he knows how to make
it profitable again: lower ticket prices.
may be wondering how lowering the ticket price could help the
Drive-In become more profitable. If Wong's Drive-In is
losing money, shouldn't Mr. Wong raise ticket prices?
raising prices is sometimes a good way to increase profits, it
doesn’t always work. If Mr. Wong raises the ticket price,
he'll sell fewer tickets. The higher price might cause his
revenue to go up, but selling fewer tickets might cause it to go
down. To be sure about the effect of a change of price on a
firm's revenue, we have to look more closely at the demand
curve─in particular, its elasticity.
Elasticity measures the responsiveness of something to a change in
something else. For example, snow cone sales tend
to be very responsive to changes in the temperature outside, so we
can say that snow cone sales are elastic
with respect to temperature. Dog food sales, however, hardly
respond at all to changes in temperature. Dog food sales are
therefore inelastic with respect to temperature.
are especially interested in how the quantity demanded of a good
responds to changes in its price. This kind of elasticity is
called the price elasticity of demand. Take Dr. Kenisha
Maddox’s demand for bridge crossings, for example. Dr.
Maddox lives across the bridge from
, where she works five days a week. The price (or toll) for
crossing the bridge into the city is $3, and there is no price for
the return crossing. At that price, Dr. Maddox crosses the
bridge into the city five times a week.
Dr. Maddox would also cross the bridge into the city five times a
week if the price were $1, or $10, or even $25. Her demand
for bridge crossings into the city isn’t very responsive to
changes in the price, so we say that her demand is inelastic with
respect to price. More generally, we say that demand is price
inelastic if a change in price results in a smaller percentage
change in quantity demanded.
Next consider the demand for gasoline at Oakdale's Arco station,
as shown below. Arco currently charges $2.50 per gallon and
sells 15,000 gallons per day. The Shell station across the
street charges the same price and sells about the same number of
gallons. Now suppose that Arco raised its price to $2.75,
but Shell didn't. (Remember, if Shell raised its price, too,
then Arco's demand curve would shift to the right. When
measuring elasticity, we are interested in how quantity demanded
responds to a change in price, other things being equal.)
How would consumers respond?
Since Arco's gas is very similar to the gas at the Shell station
across the street, few customers would continue buying gas there
if the price was that much higher. Quantity demanded would
fall off by quite a bit, say to 1,000 gallons a day. Since
the change in price caused a larger percentage change in quantity
demanded, we say that the demand for Arco gas in Oakdale is price
Price inelastic demand
Economists are interested in the price elasticity of demand curves
because it tells them how changes in price affect the revenue
received by producers. Recall that revenue is equal to the
price times the quantity sold of a good.
A demand curve for coffee is shown below. Notice that when
the price goes from $1 to $2 (a large percentage increase), the
quantity falls from 10 billion pounds per year to 8 billion pounds
per year (a small percentage decrease). Since the quantity
demanded isn’t very responsive to a large percentage increase in
price, demand is price inelastic. Assume that the price is
initially $1 a pound and the quantity is 10 billion pounds, as
shown at point A. At that equilibrium, the revenue received
by coffee growers would be $1 times 10 billion pounds, or $10
suppose that the coffee-growing regions worldwide have a bad
winter and frost destroys much of the coffee crop. This
would cause the supply curve to shift from S to S' and move the
equilibrium to point B. At B, the price is $2 and the
quantity is 8 billion. The revenue, then, becomes $2 times 8
billion, or $16 billion.
may want to read the last two paragraphs again, for they lead to a
remarkable conclusion. If frost destroys part of the coffee
crop, then the revenue received by coffee growers will actually go
up. In fact,
, which used to produce the vast majority of the world’s coffee,
used to deliberately destroy part of its crops during those years
in which it was not lucky enough to experience frost.
The reason an increase in price caused an increase in revenue for
coffee is that its demand is price inelastic. In this
example, as the table below shows, the increase in price had a
greater effect on revenue than the decrease in quantity demanded.
If the price goes up by a larger percentage than the quantity goes
down, then the product of the two, revenue, will increase.
(billions of pounds per year)
(billions per year)
table also shows what
would happen if the price of coffee were to fall from $2 to $1.
The quantity demanded would increase from 8 billion pounds to 10
billion pounds, and revenue would decrease, from $16 billion to
Let's summarize what we've learned so far:
demand is inelastic with respect to price, an increase in price
will result in an increase in revenue, and a decrease in price
will result in a decrease in revenue.
Does this mean that all producers of goods with price inelastic
demand curves should cut back on production or destroy their goods
in order to increase their revenues? Suppose Farmer Brown,
an Oakdale wheat farmer, was to do that. Wheat is price
inelastic, as shown below.
Brown produces 10,000 bushels of wheat per year. But that
amount is very small compared with the average total
wheat production of about 2,000,000,000 bushels per year. If
Farmer Brown were to destroy her crops, then the market supply
curve would hardly shift back at all. And even if Farmer
Brown was able to nudge the price up slightly, she wouldn't be
able to benefit if she had no crops to sell. Instead, other
wheat farmers would gain at her expense.
only makes sense to restrict the output of a good with price
inelastic demand if a single firm, group, or country is the main
, for example, used to supply up to 90% of the world's coffee.
destroyed some of its crops, the benefits of the higher price for
coffee were confined mostly to
Price elastic demand
Now let's see how price changes affect revenue when demand is
price elastic. Look again at the demand curve for Oakdale
Arco gas. Notice that when the price increases from $2.50 to
$2.75, the quantity demanded decreases from 15,000 gallons per day
to 1,000 gallons per week.
shows what happens to the revenue received by Oakdale's Arco
station when the price of their gas goes up. Revenue at a
price of $2.50 is 15,000 gallons per week. If the price is
increased to $2.75, then the quantity demanded drops by such a
large amount that revenue declines to $2,750 per week.
($ per gallon)
(gallons per week)
revenue declines when the price goes up because there is a large
decrease in the quantity demanded. Similarly, if the price
were to go down, then the quantity demanded would rise by a larger
percentage amount and cause revenue to increase. In other
demand is elastic with respect to price, then an increase in
price will result in a decrease in revenue, and a decrease in
price will result in an increase in revenue.
Here's an easy note-taking trick that will help you keep all of
a tall arrow represents a large percentage change and a short one
a small change. With inelastic demand curves, price changes
elicit just small percentage changes in quantity, so the price
change has a more dominant influence on revenue. With
elastic demand curves, it's the quantity change that has the
geometry of revenue
Elastic or inelastic? The rectangle test
an easy way to tell at a glance whether the demand for a good is
elastic or inelastic. Let’s look again at the demand curve
for world coffee. At point A, the price of coffee is $1.00,
and the quantity demanded is 10 billion. Revenue equals
price times quantity, or $10 billion.
is also equal to the area of the red rectangle in the figure.
The area of a rectangle is equal to its height times its width.
Here, the height of the rectangle is $1, the price of coffee, and
the width of the rectangle is 10 billion, or the quantity sold at
that price. The height times the width of the rectangle
gives its area, $10 billion, which is also the revenue at point A.
When the price rises to $2, we saw that revenue increases to $16
billion, which is the price times the new quantity, 8 billion.
This new revenue also can be represented as the area of the blue
rectangle. Since the blue rectangle lying below point B is
larger than the red rectangle lying below point A, we know that
revenue has gone up in response to a price increase, and that
demand is price inelastic.
Let’s also look again at the Oakdale Arco gas demand curve.
The revenue for the Arco station is given by the red rectangle
when the price per gallon is $2.50. When the price rises to
$2.75 per gallon, revenue shrinks to the size of the blue
rectangle. Since a price increase has caused a decrease in
revenue, we know that the price elasticity of demand for Arco gas
curves can be elastic at some prices and inelastic at others.
Consider the demand for hotdogs at
. The revenue received by the firm at a price of $1.50 per
hotdog is equal to the area of the red rectangle, or $4.50.
If the price is lowered to $1, then revenue increases to the area
of the blue rectangle, or $5. The demand curve is clearly
elastic between the prices of $1.50 and $1.
But now lower the price still further, to $.50. The firm's
revenue drops down to the area of the orange rectangle, or $4.50.
Between the prices of $1 and $.50, the demand curve is clearly
inelastic, since a drop in price causes revenue to fall.
rectangle test: Draw revenue rectangles for two points on
a demand curve. If a price increase makes the revenue
rectangle become larger, then the demand curve is price
inelastic between those two points. If a price increase
makes the revenue rectangle smaller, then the demand curve is
price elastic between those two points.
Where is revenue highest? The midpoint test
quick way to determine the elastic and inelastic ranges of a
demand curve is to make use of the following rule:
a linear demand curve is drawn from the vertical axis to the
horizontal axis, the demand curve is price elastic between any
two points above the midpoint of that line, and price inelastic
the following figure, point X is the midpoint of a line drawn
between point A and point B. The demand curve is price
elastic between any two points above X, and price inelastic below.
rule gives us a quick way of figuring out how to maximize a firm's
revenue. Since the demand curve is price elastic above point
X, then as we come down the demand curve towards point X, the
firm's revenue is increasing as its price goes down. But
below point X, the demand curve is price inelastic. That
means the lowering the price further will decrease revenue.
X, then, marks the spot. The point that divides the demand
curve into its elastic and inelastic ranges is also the point at
which the firm's revenues are greatest.
midpoint test: If a linear demand curve is drawn from the
vertical axis to the horizontal axis, the firm's revenue is
greatest at the midpoint of that line.
We've seen that the demand for a good tends to become more elastic
as its price goes up, and less elastic as its price goes down.
The prices of most goods, though, don't vary that much, and tend
to stay either in the elastic or inelastic range. The demand
for bridge tolls, for example, is price inelastic in its normal
price range, so economists usually only draw the inelastic portion
of its demand curve.
The demand for goods, then, can often be classified as either
price elastic or price inelastic. You can often guess
whether the demand for a good is price elastic or price inelastic
by considering the good's characteristics.
Goods that have close substitutes tend to be more price elastic
than goods that do not. We saw that the demand for Arco gas is
price elastic. This is because Arco customers could switch
to a substitute, Shell gas, if Arco's price went up. On the
other hand, Dr. Maddox’s demand for bridge crossings is price
inelastic because there aren't any good substitutes available.
that are luxuries tend to have more elastic demands than goods
that are necessities. New parents would not cut back much on
milk and diaper‑rash ointment -- both necessities -- even if
their prices increased by a large amount. But they would buy
fewer luxuries -- like stuffed animals -- if their prices went up.
Share of budget
If you're like most people, you don't comparison shop for pencils.
If you need a pencil, you just go to the nearest store and pay
whatever it charges. In fact, you might even pocket your
change without ever having found out the price.
It's not like that with cars, though. People will spend many
days comparing different models and driving to different
dealerships in search of the best deal.
The reason people comparison shop for cars, but not for pencils,
is because they spend a larger portion of their budgets on them.
If someone earns $20,000 a year, a $10,000 car is a major expense
and it's worthwhile to spend some time searching for a good deal.
If you shopped around for a bargain pencil you'd end up saving
only a few cents.
People tend to be more sensitive to prices when making large
purchases. If car prices were to double, then car sales
probably would fall sharply. A lot of people who can afford a
$10,000 car wouldn't be able to afford a $20,000 car. They
would simply have to make do with their old cars or public
transportation. Demand for cars and other "big-ticket
items," then, tends to be price elastic.
On the other hand, if the price of pencils were to double,
sales probably wouldn't change that much. People would just
shrug and pay the higher price. Goods like pencils that use
up just a small share of a person's budget tend to be price
Wong’s Theater lower its prices?
the demand schedule for tickets to Wong’s Theater:
(tickets per day)
here’s a graph of it:
Wong is now charging $3 per ticket. As the following table
shows, if he raised the ticket price to $4, his revenue would
decrease. The demand curve is elastic in this range.
It’s also elastic between the prices of $3 and $2, since if he
lowered the price to $2 per ticket, his revenue would increase.
He should lower his price to that level. Mr. Wong
shouldn’t lower the price to $1 per ticket, though, since his
revenue would decrease. The demand curve is inelastic in
(tickets per day)
© Lori Alden, 2005-7. All
rights reserved. You may download the content, provided you
only use the content for your own personal, non-commercial use.
Lori Alden reserves complete title and full intellectual property
rights in any content you download from this web site. Except as
noted above, any other use, including the reproduction,
modification, distribution, transmission, republication, display,
or performance, of the content on this site is strictly