 Hello and welcome to the session in which we will explain the price elasticity of the demand. Well, the price elasticity of the demand measures the responsiveness of quantity demanded due to changes in the price of a product or service. Let me give you a simple example. My current subscription for forehead lectures is $29.99 per month. What is the price elasticity for my demand? How do I measure this? Well, I want to find out what happened if I raise my prices to $35. What would happen to my subscription? Will I have more subscribers or less? Or let's assume I drop my subscription from $29.99 to $25. What will be the effect on my revenue? What will be the effect on my total subscribers? Will I have more or less? So the price elasticity of demand is to quantify how sensitive consumers are to price changes. How sensitive are you? Am I going to have more or less subscribers as I change my prices? In accounting, this is called the term that we use sensitivity analysis and we do sensitivity analysis or in Excel, we do there's a function called what if basically we're doing what if analysis, but in economics, we call it price elasticity of demand. We're going to go ahead and look at the formulas at the factor that affect price elasticity. We're going to look at a few examples. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, foreheadlectures.com. forehead accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions as well as exercises. Go ahead, start your free trial today. First is the formula. How do we compute the price elasticity of demand? Well, the formula takes the following factors. It's the percentage change in quantity demanded divided by the percentage change in price. Simply put, I'm going to change my price and as a result, my quantity demanded will change. Find the percentage change in the quantity demanded, divide that by the percentage of change in price. Now, if we don't know how to compute, they calculate the price change, the percentage change, not the price change, the percentage change, here are the steps. Subtract the initial value or the old value from the final value or the new value. Take the result and divide by the initial value or the new value. Then multiply the answer by 100. Let me show you real quick just in case you don't know how to compute this. What happened? What's the percentage change if you have a price of a product that increased from 50 to 60 dollars? Well, find the difference between the increase and the decrease. Well, 50 minus 60 equal to negative 10, it doesn't matter. We can say negative 10, then we'll divide it by the initial value of 50. Negative 50 divided by 50, which is the 50, is the initial value. It's negative 20. Now, what we say is the percentage is 20 percent, negative two or the percentage is 20 percent. Now, it might be negative. You're looking for the absolute value. Now, this is not the same thing as if we went from 60 to 50. If the price drops from 60 to 50, it's not 20 percent. Again, find the difference between, find the difference, the difference is 10. Now you'll take the difference and you divide the difference by the initial, by the initial value, which is 60. Well, if we take 10 divided by 60, 10 divided by 60, that's 16.66, 16.67 percent. So notice, when the price goes from 50 to 60, it's not the same percentage as if the price went dropped from 60 to 50. So make sure you're aware of this. So this is how you compute your percentage change and same thing for quantity. You will take the difference and you will divide the difference by the initial value, what you started with, and you'll find your percentage, your percentage change. The result of this formula is typically a negative number since price and quantity usually move in the opposite direction. However, for simplicity, we consider the absolute value of the result, making it a positive value, then we'll make a decision whether it's elastic or an elastic. But this is the formula itself. Now, the best way to do what is to look at an example using the formula to see how it works. Let's assume we are selling chocolate bars and the current price is $2 and the quantity demanded for $2 is 100 units per day. Let's assume we decided to reduce the price from $2 to a dollar. Well if that happened and the quantity demanded increased to 200 unit, this is per day. Let's compute the price elasticity of demand. First, we want to compute the price percentage change. We went from 2 to 1. So 1 minus 2 divided by the initial value of 2 equal to 0.5 or 50%. It means we dropped the price by 50%. That's the price dropped by 50%. Let's compute the change in quantity. The quantity went from 100 to 200. So the difference is 100 divided by the initial value of 100 will give us 1 or 100%. So the change in quantity is 100%. Now we compute the price elasticity. And if we take 1 or 100%, changes in quantity demanded, 1 or 100%, divided by the percentage change in price, which is 50%, the answer is negative 2. As I said, we say it is 2. We use the absolute value 2. So in this example, the answer is 2. What does 2 mean? Indicating that the demand is elastic. What does that mean? What does elastic mean? Well, before we kind of explain elasticity, could you tell me what happened? In your opinion, just using simple logic, what I did is this. I dropped my prices by 50%. I dropped my prices by 50%. Notice the price change, the percentage price and change in 50%. My demand increased by 100%. Do you think dropping the price positively affected influence my demand? And the answer is yes, because a small change, a 50% change in the price increase my quantity demanded by 100%. Forget about positive, scratch out positive. So a small increase in the price led to a larger change in quantity. Because if that's the case, we say that demand is elastic. The demand is sensitive. The demand is sensitive. So a 50% decrease in price leads to a doubling in quantity demanded. This means that a consumer are highly responsive to price changes. So simply put, what we can say is, when it comes to chocolate bar, people are sensitive to price. If you reduce the price, they will buy more. But the opposite is true, too. If you increase the price because it's elastic, your quantity demanded will go down. So if you increase your price from 2 to 3 or from 2 to 250, the quantity demanded, it's going to decrease as well. And you will measure that and you will find out, whether it's elastic or an elastic. But if this holds true for increase and decrease, then we say it's elastic. And most likely, unless you have a really, really loyal following and if you're selling chocolate bars, the chocolate bar is an elastic item. And we're going to see why later. Because there are many substitutes for buying chocolate. This means that the consumer are highly responsive to price changes for chocolate bar. And a decrease in price result in an increase in quantity demanded. Let's take a look at another example to illustrate now the inelasticity of demand. So let's assume we're selling medication and the price of the medication is $200 per month. And based on this price, the demand is 1,000 unit per month. Let's assume we decided to increase the prices from 200 to 220, which is increasing the price by real quick, 10%. We're increasing 20 divided by 200 is 10%. And the quantity demanded because we increased the price went to 9.50. Now we could also compute the increase in the change in quantity, which is 50. The change is 50 divided by 1,000 equal to 5%. So notice what happened real quick, without even making any further computation. I increase my price by 10%. The quantity only decreased by 5%. It seems my increase in price did not really affect things. So let's compute this. So first, the percentage change in price. I increase my price by 10%. The quantity demanded is reduced by only 5%. Let's compute the elasticity. If we take the change, the percentage change in quantity divided by the percentage change in price will get 0.5, negative 0.5. As I said, we'll take the absolute value. And the absolute value is 0.5. We put less than 1, because it's less than 1. Less than 1. The price elasticity of demand indicating the demand is inelastic. What does it mean inelastic? It means an increase in 10% led to a 5% decrease in quantity demanded. Now as a business, let me ask you this. Do you want your product to be elastic or inelastic? I want it to be inelastic. Inelastic means I can increase my price by a percentage, and the drop in demand will be less than that percentage. This means that the consumer are not very responsive to price changes for this prescription medication. And usually that's the case for a prescription medication. Even if you increase the price, people need their medication. Some people might cut back, find an alternative, or just go without medication. But the majority of people would react and they will adopt. And that's why things like medication, you have government involvement, because by its nature, the product is inelastic. So if you let the market run it, some companies might try to take advantage. So the percentage change in quantity demanded is smaller than the percentage change in price. The quantity demanded is 5%. The price change is 10%, indicating inelastic demand. It suggests that even an increase in price, the quantity for this medication would not drop proportionally, will drop less. So the demand for this particular product is relatively inelastic, insensitive. Well, same thing, inelastic or insensitive, the price changes, as it is an essential for managing a chronic condition. And consumer are less likely to adjust their consumption significantly, giving the price fluctuation. So hopefully you're getting the picture. And think about chocolate bar. Well, you know, there's so many options, okay? Versus prescription drugs, okay? And there's, you know, you can take this in between. Now we need to interpret, to interpret the elasticity. If the answer is greater than one, it means the product that we're selling is sensitive. Sensitive to what? It means elastic, the price, any price changes will make a difference to the demand, okay? Elastic demand, the elasticity is greater than one. When the price elasticity of demand is greater than one, it indicated the quantity demanded is highly responsive to changes in prices. A small change, a small percentage change in price leads to a relatively larger percentage change in quantity. Going back to the chocolate bar, we increase the price by 50%, the increase in quantity by 100%. So it's greater, the demand, the quantity demanded was greater. For example, if the price of a product increase by 10, and as a result, the quantity demanded decrease by 20, the price elasticity would be two, and total revenue would drop. Now, bear in mind, the opposite is true. If a price of a product decrease by 10, and the result, the quantity demanded increase because the price increase by 20, the price elasticity of demand will be two, and the total revenue will increase. So it's basically sensitive. This is what we're trying to say, it is sensitive. Okay, sensitive means elastic, the product is elastic. So if it's a greater than one, the product is elastic, whether it's only going up or going down. In this case, the demand is considered elastic for this product. So the price, any changes in price will affect the demand disproportionately, up or down, not proportionally, disproportionately. Let's take a look at when elasticity is less than one. Again, here, we're looking at the drug or prescription medication. It means elasticity is, there is no elasticity, inelasticity. So the price changes is inelastic. When the price elasticity of demand is less than one, it implies that the quantity demanded is not very responsive to price changes. So when you make the price changes, the demand is not in proportion less. Okay, a percentage change in price leads to a relatively smaller percentage in quantity demanded. For instance, if the price of a product increase by 10%, and as a result, the quantity demanded decrease by five, it's the same example that I showed you, the price elasticity of the demand is 0.5. Now, total revenue will increase, total revenue will increase. Now, again, the opposite is true as well, the opposite is true as well. So here, the demand is inelastic. We could also have E equal to one, and kind of, you know what this is. When the price elasticity is exactly one, it implies that percentage change in quantity is equal to the percentage change in price. For example, if the price of a product increase by 10%, and the quantity demanded decrease by 10%, the price elasticity of demand will be one, and total revenue will be the same, because you increased your price by 10%, but the quantity demanded decrease by 10% over all your revenue is the same. We say the demand is considered unitary elastic in this case. Now, what factors could influence this elasticity of demand? There are many factors, let's go over some of them. First is the availability of substitute. If there are many substitute for the product that you are pricing, consumer have more options and can easily switch to alternative when prices change. So what does that mean? The most classic example is Pepsi and Coke. Well, if the Pepsi increased their prices, or Coke, the red, if Coke increased their prices, consumer can easily switch to Pepsi. So the product is price sensitive, because if there's an easy substitute, what's gonna happen, the quantity demanded, it's gonna go down. For example, if the price of a particular brand of coffee increased, consumer may switch to a different brand, or even tea. In this case, the demand for the original brand is more likely to be elastic. Elastic means sensitivity in prices is dangerous. In other words, if you increase your prices, your quantity demanded might go down if there's a substitute. Another factor will be, is this product necessity versus luxury? The nature of the product itself could also impact its price elasticity. Necessities like food, water, and basic health care tend to have less elastic demand. Why? Because the consumer are less likely to change their consumption pattern in response to changes, okay? So if the prices of food goes up a little, you may not cut your budget. But if it went up a lot, you may cut your budget a little bit. On other hand, if you are buying luxury goods or non-essential item, those have more elastic demand. Why? Because the consumer can either postpone or forget about the purchase because it's not necessary. But with food, with water, with basic health care, even if they increase the price a little bit by 5%, you may not cut exactly by five. You may cut by one or two. But for luxury items, you'd say, for instance, if a price of high-end phones increased significantly, you would say, okay, I may either delay my consumption, upgrading, or opt for cheaper alternative, because it's a luxury item. So luxury items, well, also it depends for luxury items. We're gonna see later that sometime you might have a brand loyalty. But generally speaking, necessity versus luxury, if it's a necessity, you can increase the prices and the demand will not change a lot. For luxury item, if you increase your prices, unless there is loyalty, we'll look at that later. Also what could influence elasticity of demand is how much time you have to switch from one product to the other. So the time available for consumer to adjust their price behavior can affect price elasticity. For some product in the short run, demand will be relatively inelastic because the consumer, they cannot switch quickly. They have limited time to respond to price changes. However, in the long run, if you give the consumer more time, they will adjust and they will find another alternative. So over the long run, consumers can adjust their consumption pattern, search for alternative, or change their preferences, leading to your product to be more elastic demand. An example will be if the price of gasoline jumped, okay? Consumer may initially continue to purchase the same amount because they cannot find alternative solution immediately. However, in the long run, they may switch maybe to a fuel efficient vehicles, but you're not gonna buy a fuel efficient vehicle the following day, or you might start to use public transportation. Maybe a week or two later, you can say this is way too much. Let me try to see if I can find public transportation. Then it will make your product more elastic. But in the short run, it did not change, but you give consumer more time, they will find alternative. Also, how much of your income is being spent on that item will affect the elasticity of the item. So the proportion of income spent on a particular product or services can impact its price sensitivity. For example, if a product represent a significant, a large portion of your consumer income, a large portion, the demand tend to be more elastic, okay? For example, if the price of houses increases substantially, it may significantly affect consumers budget leading to a more elastic demand for housing. If the prices go up, people cannot keep on buying them because buying a home represent a large portion of your budget. Therefore, it's elastic, it's elastic. You cannot just spend more because the prices went up. You just kind of have to slow down because that's a large portion of your budget. Let's go back to the Pepsi versus Coke and also the iPhone luxury. Factor influencing elasticity could be brand loyalty and habit. If the consumer are loyal to a particular brand and have a strong preference for it, they may be less responsive to price changes and exhibit less elastic demand. If we go back to the iPhone to the phone, some people they're willing to pay for the iPhone extra because they have brand loyalty. Same thing, you might have a brand loyalty for Coke versus Pepsi and even if the price goes up, you may stick with it. So brand loyalty will matters as well. Also habitual purchases where the consumer buy certain product out of habit without much consideration. For example, you always buy Pepsi Coke. So even if the price is a little bit higher, you don't care, okay? Every day you buy a bagel. Now the bagel prices went up by 25% by 25 cent or 50 cent or a dollar. Just because you have that habit, you don't care, okay? For example, I buy a cup of coffee from Wawa every day. Most likely if they increase the price, I'm not going to switch, okay? Just it's a habit that I have and it's a brand loyalty as well. For example, if a consumer is highly loyal to a specific brand of soft drink, they may be less likely to switch even if the price increases. Again, I'm telling you, my Wawa, my Wawa coffee, you know, it's Wawa as one of the cheapest coffee out there, I buy a cup of coffee every day. Even if the price change a little, I'm not going to switch. Although again, it's one of the cheapest. I mean, I can find maybe a cheaper coffee if I shop a little. For one thing, it's not worth my time too. I like my Wawa coffee and I enjoy going to the store and I enjoy looking at the headlines of the newspaper every day. New York Times, Washington Post, Chicago Tribune, Philadelphia Inquirer because they have all of them. So I just like to look at the, see what the newspaper headline is for the day and the local paper as well. Yeah, I avoid local papers. I don't want to know what's going on in my area. Anyway, what should you do now? Go to Farhat Lectures, work MCQs, multiple choice questions. That's going to help you understand this topic better. The economic section of the CPA exam is our easy points. Just invest the time in it. That's all you have to know. Certain items, master it, perfect it, get those points, good luck and invest in yourself.