Chapter 5 Elasticity and Its Application I The Elasticity of Demand Elasticity A measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants a The Price Elasticity of Demand and 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 Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the percentage change in price the price Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price i Availability of Close Substitutes 1 Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others a Butter Margarine A small increase in the price of butter causes the quantity of butter sold to fall by a large amount b Eggs Do not have a close substitute so the demand for eggs is less elastic than the demand for butter ii Necessities versus Luxuries 1 Necessities have inelastic demands a The doctor s visit rises people will not dramatically reduce the number of times they go to the doctor because it is viewed as a necessity 2 Luxuries have elastic demands a If a sailboat s price rises the quantity of sailboats demanded falls substantially because it is viewed as a luxury iii Definition of the Market 1 Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods good substitutes a Food a broad category has a fairly inelastic demand because there are no b Ice cream a narrower category has a more elastic demand because it is easy to substitute other desserts for ice cream iv Time Horizon 1 Goods tend to have more elastic demand over longer time horizons a The price of gasoline rises so the quantity of gasoline demanded falls only slightly in the first few months b Over time with this price increasing people will take long term actions by buying fuel efficient cars switch to public transportation and move closer to where they work b Computing the Price Elasticity of Demand i Economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price 1 EXAMPLE a Suppose that 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 Calculate elasticity of demand as Price of elasticity of demand 20 percent 10 percent 2 i The elasticity is 2 reflecting that the change in the quantity demanded is proportionately twice as large as the change in price b Because the quantity demanded of a good is negatively related to its price the percentage change in quantity will always have the opposite sign as the percentage change in price i In this book drop the minus sign and report all price elasticities of demand as positive numbers c The Midpoint Method A Better Way to Calculate Percentage Changes and Elasticities i Use midpoint method to calculate elasticities when A B and B A are different 1 For instance 5 is the midpoint between 4 and 6 Therefore a change from 4 to 6 is considered a 40 rice because 6 4 5 x 100 40 Midpoint Price 5 Quantity 100 The following formula expresses the midpoint method for calculating the price elasticity of demand between two points denoted Q1 P1 and Q2 P2 d The Variety of Demand Curves i Demand is considered elastic when the elasticity is greater than 1 which means the quantity moves proportionately more than the price ii Demand is considered inelastic when the elasticity is less than 1 which means the quantity moves proportionately less than the price iii If the elasticity is exactly 1 the quantity moves the same amount proportionately as the price and demand is said to have unit elasticity 1 These are related to the slope of the demand curve because the price elasticity of demand measures how much quantity demanded response to the change in price e Total 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 i In any market total revenue is P x Q the price of the good times the quantity of the good sold We can show total revenue graphically as in Figure 2 ii The examples in Figure 3 illustrate some general rules 1 When demand is inelastic a price elasticity less than 1 price and total revenue move in the same direction 2 When demand is elastic a price elasticity greater than 1 price and total revenue move in opposite directions 3 If demand is unit elastic a price elasticity exactly equal to 1 total revenue remains constant when the price changes f Elasticity of Total Revenue along a Linear Demand Curve i Slope is defined as rise over run which here is the ratio of the change in price rise to the change in quantity run ii Even though the slope of a linear demand curve is constant the elasticity is not 1 Because the slope is the ratio of changes in the two variables 2 And the elasticity is the ratio of percentage changes in the two variables iii The linear demand curve illustrates that the price elasticity of demand need not be the same as all points on a demand curve A constant elasticity is possible but it is not always the case g Other Demand Elasticities i The Income Elasticity of Demand Income elasticity of demand a measure of how much the quantity demanded of a good response to a change in consumers income computed as the percentage change in quantity demanded divided by the percentage change in income 1 Normal goods higher income raises the quantity demanded Because quantity demanded and income move in the same direction normal goods have positive income elasticities 2 Inferior goods Higher income lowers the quantity demanded Because quantity demanded and income move in opposite directions inferior goods have negative income elasticities 3 Income elasticities vary substantially in size a Necessities food clothing tend to have small income elasticities because consumers choose to buy some of these goods even when their incomes are low b Luxuries caviar diamonds tend to have large income elasticities because consumers feel that they can do without these goods all together if their incomes are too low ii The Cross Price Elasticity of Demand Cross price elasticity of demand a
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