Introduction

After you have worked through this section of the learning unit, you should be able to:

  • explain in words and with the aid of a diagram the relationship between household spending and price elasticity of demand

One of the reasons we study the demand for a good or service is to help us understand the determinants of spending by households. How much households spend on a good or service and, in particular, what happens to their spending if the price changes, are important issues that we need to investigate further.

From the law of demand, we know that if the price of a good or service decreases, people will demand a higher quantity of it, and if the price increases, they will demand a lower quantity of it. But what happens to their total spending if the price changes?

  • Does an increase in the price of a good or service cause households to increase or decrease their total spending on the good or service?
  • Does a decrease in the price of a good or service cause households to increase or decrease their total spending on the good or service?

What do you think would happen to the total spending of households on petrol in the following examples?

The price of petrol increases.

  • Households will spend more on petrol
  • Households will spend less on petrol

The price of petrol decreases.

  • Households will spend more on petrol
  • Households will spend less on petrol

What do you think would happen to the total spending of households on petrol in the following examples?

The price of restaurant meals increases.

  • Households will spend more on restaurant meals
  • Households will spend less on restaurant meals

The price of restaurant meals decreases.

  • Households will spend more on restaurant meals
  • Households will spend less on restaurant meals

Intuitively, people believe that if the price of something increases, their total spending on that good or service will increase as well. In the next sections, we will show that this is not necessarily the case. Whether we spend more or less depends on the price elasticity of demand.

Total spending by households on a good or service is equal to the price (P) they paid for the good or service times the quantity (Q) they bought. In symbols, this is written as:

$$\text{Total Spending} = {P \times Q}$$

What we want to know is what happens to total spending if the price changes. Remember that as the price changes, so does the quantity demanded – both P and Q change. It is the price elasticity that will tell us by how much the quantity demanded changes, and thus what happens to total spending.

We have identified two main types of price elasticity, namely inelastic and elastic. Now, let's see what happens to total spending if we have a price inelastic demand.