Chapter 5 Elasticity and Its Application The Elasticity of Demand Elasticity a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants Price elasticity of demand a measure of how much the quantity demanded of a good responds to a change 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 price Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price What determines the price elasticity of demand o Availability of close substitutes goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others Ex Butter and margarine an increase in price of butter causes butter sales to fall by large amount But there is no substitute for eggs so the demand for eggs is less elastic than the demand for butter o Necessities versus Luxuries Necessities have inelastic demands When price of doctor s visit rises people will not dramatically reduce number of times they go to the doctor Luxuries have elastic demands When price of sailboats rises the quantity of sailboats demanded falls substantially o Definition of the market Narrowly demand markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods Example Food a broad category has an inelastic demand because there are no good substitutes for food Ice cream a narrower category has a more elastic demand because it is easy to substitute other deserts Vanilla ice cream is a very narrow category o Time Horizon time horizons Goods tend to have more elastic demand over longer When price of gasoline rises quantity of gasoline demanded falls only slightly in the first few months Over time however people buy more fuel efficient cars switch to public transportation and move closer to where they work so in several years the quantity of gasoline demanded falls more substantially Computing the Price Elasticity of Demand Price elasticity of demand percentage change In quantity demanded percentage change in price o Ex Suppose that a 10 increase in the price of an ice cream cone causes the amount of ice cream you buy to fall by 20 Elasticity of demand 20 10 2 The number 2 means that the change in the quantity demanded is proportionately twice as large as the change in price The Midpoint Method A Better Way to Calculate Percentage Changes and Elasticities The midpoint method for calculating price elasticity of demand between 2 points denoted Q1 P1 and Q2 P2 Q2 Q1 Q2 Q1 2 divided by P2 P1 P2 P1 2 Numerator is the percentage change in quantity computed using midpoint method and denominator is percentage change in price computed using midpoint method The Variety of Demand Curves Demand is considered elastic when the elasticity is greater than 1 which means the quantity moves proportionately more than 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 the have unit elasticity The flatter the demand curve that passes through a given point the greater the price elasticity of demand The steeper the demand curve that passes through a given point the smaller the price elasticity of demand Demand is perfectly inelastic if demand curve is vertical 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 In any market total revenue is PxQ the price of the good times the quantity of the good sold When demand is inelastic price elasticity less than 1 price and total revenue move in same direction When demand is elastic price elasticity greater than 1 price and total revenue move in opposite directions If demand is unit elastic price elasticity equal to 1 total revenue remains constant when price changes Total Revenue and the Price Elasticity of Demand Elasticity and Total Revenue Along a Linear Demand Curve Even though slope of a linear demand curve is constant the elasticity is not This is because the slope is the ratio of changes in the 2 variables whereas elasticity is ratio of percentage changes in the 2 variables At points with low price and high quantity demand curve is inelastic At points with high price and low quantity demand curve is elastic Other Demand Elasticities The Income Elasticity of Demand The Elasticity of Supply The Price Elasticity of Supply and its Determinants o Measures how the quantity demanded changes as consumer income changes computed as the percentage change in quantity demanded divided by the percentage change in income o Higher income raises the quantity demanded for normal goods Because quantity demanded and income move in the same direction normal goods have positive income elasticities o Higher income lowers quantity demanded for inferior goods Because quantity demanded and income move in opposite directions inferior goods have negative income elasticities The Cross Price Elasticity of Demand o A measure of how much the quantity demanded of one good responds to a change in the price of another good o Computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good o The price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good o Computed as the percentage change in the quantity supplied divided by the percentage change in price o Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price o Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price o Price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce Beachfront land has an inelastic supply because it is almost impossible to produce more if it Manufactured goods such as books cars and TVs have elastic supplies because firms that produce them can run their factories longer in response to a higher price Computing the Price Elasticity of Supply o Percentage change in quantity supplied divided by percentage change in price o Ex
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