Elasticity Textbook Notes Chapter 5 To measure how much consumers respond to changes in variables economists use the concept of elasticity Elasticity a measure of the responsiveness of quantity demanded or quantity supplied to a chance in one of it s determinants Price elasticity of demand a measure of how much the quantity demanded of a good responds to a chance in the price of that good computed as the percentage change in quantity demanded divided by the percentage change in price Demand for a good is said to be ELASTIC if the quantity demanded responds substantially to changes in the price Demand for a good is said to be INELASTIC if the quantity demanded responds only slightly to changes in the price Price elasticity for any good measures the how willing consumers are to buy less of the good as it s price rises Influences of price elasticity of Demand AVAILABILITY OF CLOSE SUBSTITUTES Goods with close substitutes tend to have more elastic demand because it s easier for consumers to switch from that good to others ex butter and margarine Small increase in price of butter assuming margarine price remains fixed causes quantity of butter to fall by large amt However b c eggs are a food without a close substitute demand for eggs is LESS ELASTIC than demand for butter NECESSITIES VERSUS LUXURIES necessities tend to have inelastic demands and luxuries tend to have elastic demands When the price of a doctor s visit rides people will not dramatically reduce the number of times they go to the doctor they might go somewhat less often When the price of sailboats rides the quantity demanded falls substantially Doctor visits necessity sailboats luxury A good s determinants of necessity vs luxury depends on the preference of the buyer Computing the price elasticity of demand Price elasticity of demand percentage change in quantity demanded percentage change in price Ex Suppose the a 10 percent increase in the price of an ice cream cone causes the amount of ice cream you buy to fall by 20 percent We calculate your elasticity of demand as Price elasticity of demand 20 percent 10 percent 2 Elasticity would 2 reflecting that the change in quantity demanded is proportionately twice as large as the change in the price Because the quantity demanded of a good is negatively related to it s price the percentage change in quantity will always have the opposite sign as the percentage change in price Ex the percentage change in the price of ice cream is a positive 10 percent reflecting an increase in price and the percentage change in quantity demanded is a negative 20 percent reflecting a decrease in demand THE MIDPOINT METHOD Trying to calculate the price elasticity of demand between two points on a demand curve Considering these numbers Point A Price 4 Quantity 120 Point B Price 6 Quantity 80 Standard procedure to calculate a percentage change is to divide the change by the initial level The Midpoint method calculates a percentage change by dividing the change by the midpoint or average of the initial and final levels Ex 5 is the midpoint between 4 and 6 So according to the midpoint method a change from 4 to 6 is considered a 40 percent ride because 6 4 5 x 100 40 The 40 represents the 40 percent fall To calculate price elasticity of demand using midpoint method Price elasticity of demand quantity 2 quantity 1 quantity 2 quantity 1 2 price 2 price 1 price 2 price 1 2 Demand is considered elastic when the elasticity is greater than 1 which means the quantity moves proportionately MORE than the price Demand is considered inelastic when the elasticity is less than 1 which means the quantity moves proportionately LESS than the price If the elasticity is exactly 1 the quantity moves THE SAME AMOUNT proportionately as the price and demand is said to have unit elasticity The flatter the demand curve that passes through a given point the greater price elasticity of demand The steeper the demand curve that passes through a given point the smaller the price elasticity of demand Perfectly inelastic demand curve vertical Inelastic curves look like the letter I Total Revenue the amount paid by buyers and received by sellers of a good computed as the price of the good times the quantity sold If demand is inelastic an increase in the price will cause an increase in the total revenue Only if the increase in price is proportionately larger than the decrease in quantity For inelastic demand curves total revenue moves in the same direction as the price For elastic demand curves total revenue moves in the opposite direction as the price General Rules of Price Elasticity Total Revenue Graphs When demand is inelastic a price elasticity less than 1 price and total revenue move in the same direction When demand is elastic a price elasticity greater than 1 price and total revenue move in opposite directions If demand is unit elastic a price elasticity exactly equal to 1 total revenue remains constant when the price changes Income elasticity of demand measures how the quantity demanded changes as consumer income changes It is calculated percentage change in quantity demanded percentage change in income Cross price elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good It is calculated percentage change in quantity demanded of good 1 percentage change in the price of good 2 price elasticity of supply measures how much the quantity supplies responds to changes in the price Calculated percentage change in quantity supplied percentage change in price If quantity supplied moves proportionately less than the price then the elasticity is less than 1 and supply is said to be inelastic If quantity supplied moves proportionately more than the price then the elasticity is greater than 1 and supply is said to be elastic This elasticity often depends on the time horizon under consideration In most markets supply is more elastic in the long run than in the short run SUPPLY DEMAND GOVERNMENT POLICIES Price ceiling is a legal maximum on the price of a good or service An example is rent control If the price ceiling is below the equilibrium price then the price ceiling is binding and the quantity demanded exceeds the quantity supplied Because of the resulting shortage sellers must in some way ration the good or service among buyers A price floor is a legal minimum on the price of a good or service An example is the minimum wage If the price floor is above the equilibrium price
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