Chapter 5 – Elasticity and Its ApplicationThe 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 onlyslightly 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 buttero 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 substantiallyo 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 categoryo Time Horizon Goods tend to have more elastic demand over longer time horizons 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 towhere 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 priceo 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%=2The number 2 means that the change in the quantity demanded is proportionately twice as large as the change in priceThe 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 verticalTotal Revenue and the Price Elasticity of Demand- 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 changesElasticity 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 2variables 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 Demando Measures how the quantity demanded changes as consumer income changes, computed as the percentage change in quantity demanded divided by the percentage change in incomeo Higher income raises the quantity demanded for normal goods Because quantity demanded and income move in the same direction, normal goods have positive income elasticitieso 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 Demando A measure of how much the quantity demanded of one good responds to a change in the price of another goodo Computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good.The Elasticity of Supply- The Price Elasticity of Supply and its Determinantso The price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price ofthat goodo Computed as the percentage change in the quantity supplied divided by the percentage change in priceo Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the priceo 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 suppliesbecause firms that produce them can run their factories longer in response to a higher
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