Elasticity I Defining and Measuring Elasticity A The price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in the price as one moves along the demand curve change in quantity demanded change in price price elasticity of demand B Using the midpoint method to calculate elasticities 1 Midpoint formula we calculate changes in a variable compared with the average or midpoint of the starting and final values The midpoint method gives the same elasticities for rising and falling prices Q2 Q1 Q1 Q2 2P2 P1 P1 P2 2 Price elasticity of demand 1 elastic demand Price elasticity of demand 1 inelastic demand Price elasticity of demand unit elastic demand 2 For convenience the minus sign is dropped because the price elasticity of demand is always negative and it would be inconvenient to repeatedly write a minus sign Price elasticity values are effectively reported in absolute value terms II Interpreting the Price Elasticity of Demand A How elastic is elastic 1 Demand can be elastic if the price elasticity of demand is greater than 1 inelastic if the price elasticity of demand is less than 1 and unit elastic if the price elasticity of demand is exactly 1 These are illustrated in text Figure 6 3 shown below 1 B Elasticity affects total revenue 1 Except in the rare case of a good with perfectly elastic or perfectly inelastic demand when a seller raises the price of a good two effects are present a A price effect After a price increase each unit sells at a higher price which tends to raise revenue The price effect is the change in price times the new quantity b A quantity effect After a price increase fewer units are sold which tends to lower revenue The quantity effect is the change in quantity sold times the original price 2 The price elasticity of demand determines which effect dominates and therefore indicates what happens to total revenue when price changes a If demand for a good is elastic an increase in the good s price reduces total revenue a fall in price increases total revenue In this case the quantity effect is stronger than the price effect b If demand for a good is inelastic a higher price increases total revenue a fall in price results in a decrease in total revenue The price effect in this case is stronger than the quantity effect c If demand for a good is unit elastic an increase or a decrease in the good s price does not change total revenue Here the quantity effect and the price effect exactly offset each other 3 Total revenue is illustrated as an area below a demand curve price quantity sold C Elasticity changes as you move along a linear demand curve 1 At the top of a linear demand curve the price elasticity of demand is elastic between two price points As you move to the bottom of a linear demand curve the price elasticity of demand is more inelastic 2 At higher prices consumers are more sensitive to a price change because the purchase represents a larger share of the budget At lower prices the purchase is a smaller share of the budget and consumers are not as responsive to a price change D What factors determine the price elasticity of demand 1 The availability of close substitutes a The price elasticity of demand will tend to be high if there are close substitutes b The price elasticity of demand will tend to be low if there are no close substitutes 2 Whether the good is a necessity or a luxury a The price elasticity of demand tends to be low if the good is a necessity b The price elasticity of demand tends to be high if the good is a luxury 3 Share of income spent on the good a The higher the share of income spent on the good the more elastic the demand b The greater the share of income spent on a certain good the more elastic is the demand 4 Time a The long run price elasticity of demand is often higher than the short run elasticity 2 III Other Demand Elasticities A The cross price elasticity of demand 1 The cross price elasticity of demand between two goods measures the effect of the change in one good s price on the quantity demanded of the other good 2 The sign on the cross price elasticity value is important it indicates whether the two goods are complements or substitutes a When the cross price elasticity is positive the two goods are substitutes b When cross price elasticity is negative the two goods are complements c For substitutes the size of the cross price elasticity tells us how substitutable the two goods are for complements the size of the cross price elasticity tells us how strongly complementary the two goods are 1 The income elasticity of demand measures the responsiveness of quantity demanded to changes in income a Normal goods have a positive income elasticity e g cars new homes b Inferior goods have negative income elasticity e g macaroni and cheese c The demand for a normal good is income elastic if the income elasticity of demand is greater than 1 The demand for a normal good is income inelastic if the income elasticity of demand is less than 1 B The income elasticity of demand IV The Price Elasticity of Supply price of that good A The price elasticity of supply is a measure of the responsiveness of the quantity supplied to changes in the B There is perfectly inelastic supply when the price elasticity of supply is zero so that changes in the price of the good have no effect on the quantity supplied A perfectly inelastic supply curve is a vertical line C There is perfectly elastic supply when even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied so that the price elasticity of supply is infinite A perfectly elastic supply curve is a horizontal line D What factors determine the price elasticity of supply 1 The availability of inputs When inputs are readily available the price elasticity of supply will tend to be large when the inputs are difficult to obtain the price elasticity of supply will tend to be small Time The price elasticity of supply tends to be larger the longer the period that producers have to respond 2 to a price change Long run price elasticity of supply is often greater than short run price elasticity 3 Taxes I The Economics of Taxes A Preliminary View A The effect of an excise tax on quantities and prices 1 An excise tax imposed on the seller causes firms to increase the price for which they are willing to sell the good or service shifting the supply curve upward See text Figure 7 2 shown here 2 Consumers will end up paying a