Consuming within limits

62 Part II: Considering Which Side You’re On in the Decision-Making Process

✓ Proportion of income spent: Customers also respond to how much income they spend on a good. When you buy a new car, you tend to shop around. A 10 percent difference in price means a lot. For a $30,000 car, it means $3,000. In this case, your demand is elastic; you’re very responsive to price differences. But a 10 percent difference in the price of a pizza might mean spending $11 rather than $10. This percentage difference is the same as for a car, but you’re not likely to drive all over town trying to save a dollar. In this case, because pizza takes less of your income, you’re not as responsive to the 10 percent price difference as with the car. ✓ Time: The longer the period of time since the price change, the easier it is to adjust your spending. When the price of gasoline increases, you can’t do very much right away. The day after the price increases, you still have to get to work from where you live. Your demand is inelastic.

But over a longer period of time, you may be able to join a car pool or move closer to work or find a new job. Thus, over a longer period of time, adjusting becomes easier, and your demand becomes more elastic.

These four factors determine whether customers respond to higher prices by purchasing a lot less, in other words, demand is elastic, or a little less, demand is inelastic.

Think about a local store trying to decide whether or not to raise the prices on the high-definition televisions it sells. How will customers respond? If a large number of other stores exist in the area, a high degree of substitutability occurs. Most customers are likely to think buying a new television is a luxury. Televisions are a big-ticket item; they tend to take a large proportion of your income. Finally, televisions are used over a very long period of time. You can wait for a sale before buying one. Each of these factors indicates that the demand for high-definition televisions will be elastic. Customers will buy a lot fewer televisions at the higher price.

Identifying the bottom line, almost: The price elasticity of demand and revenue

Total revenue equals the good’s price multiplied by the quantity sold. Because the price elasticity of demand shows the relationship between price and quantity sold, the elasticity number captures all the information you need to anticipate changes in total revenue.

If demand is inelastic (the price elasticity of demand is between 0 and –1), the quantity sold does not change very much when price changes. As a result, a higher price causes a very small decrease in the quantity sold and total revenue increases. (The higher price you receive for the goods you sell more than offsets the slightly smaller number you sell.) On the other hand, charging a lower price does not cause much of an increase in quantity demanded; total revenue decreases.