Chapter 6: Elasticity The Responsiveness of Demand and Supply

Elasticity: a measure of how much one economic variable responds to changes in another economic
variable
- Price elasticity of demand: how quantity demanded changes as price changes
- Price elasticity of supply: how quantity supplied changes as price changes
Price elasticity of Demand = Percentage change in quantity demanded / Percentage change in price
* PE
D
NOT the same as slope of demand curve
* Always negative, but more interested in comparing relative sizes so we compare their absolute values
Elastic Demand: when percentage change in quantity demanded is greater than the percentage change
in price (PE
D
> 1 in absolute value)
Inelastic Demand: when percentage change in quantity demanded is less than the percentage change in
price (PE
D
< 1 in absolute value)
Unit Elastic: when percentage change in quantity demanded is equal to the percentage change in price
(PE
D
= 1 in absolute value)
Midpoint Formula: ensures that we have only one value of the price elasticity of demand between the
same two points on a demand curve
- Price elasticity of demand = {(Q
2
Q
2
)/[(Q
1
+ Q
2
)/ 2]} / {(P
2
P
2
)/[(P
1
+ P
2
)/ 2]}
Properties:
- If two curves intersect, flatter curve is more elastic
- Perfectly elastic = horizontal
- Perfectly inelastic = vertical
Determinants of Price Elasticity of Demand:
- Availability of close substitutes: more substitutes = more elastic demand for normal goods
- Passage of time: more elastic as more time passes (increased time to find substitutes)
- Luxuries versus necessities: luxuries more elastic
- Definition of the market: more narrowly defined market = more elastic demand (more
substitutes available
- Share of the good in the consumers budget: demand more elastic the larger the share of
the good in the budget
Price Elasticity & Total Revenue
Total revenue: the total amount of funds receive by a seller of a good or service, calculated by
multiplying price per unit by the number of units sold
- If inelastic, price and total revenue more in same direction
- If elastic, as price increases, total revenue decreases & vice versa
- Along a linear demand curve, elasticity is high at high prices and low quantities, but inelastic
at low prices and high quantities
Cross Price Elasticity: percentage change in quantity demanded of one good / percentage change in
price of another good
- Substitutes: positive cross price elasticity
- Complements: negative cross price elasticity
- Unrelated: zero
- Important because it allows firm managers to measure whether products sold by other firms
are close substitutes for their products
Income elasticity: percentage change in quantity demanded / percentage change in income
- Normal Good & necessity: positive and less than 1
- Normal good & luxury: positive and greater than 1
- Inferior good: negative
Price Elasticity of Supply:
- Price elasticity = percentage change to quantity supplied / percentage change in price
- <1 : inelastic
- >1 : elastic
- =1 : unit elastic
- Determinants: ability and willingness of firms to alter the quantity of products they produce
as price increases
- Generally, as more time passes, supply of a good becomes elastic as able to buy more
resources (exception: fixed supply of resources)
- Perfectly inelastic: vertical line
- Perfectly elastic: horizontal line