Chapter 18 Elasticity

Price Elasticity of Demand Elasticity measures the responsiveness (sensitivity) of consumers to a change in price Formula: E = %ΔQ / %ΔP Absolute Value – eliminate the negative sign

Elastic Demand E > 1 A small change in price leads to a large change in quantity demanded Example – Restaurant Meals

Inelastic Demand E < 1 A change in price has little effect on quantity demanded Examples – electricity, milk, gas, cigarettes

Special Situations E = 1 : unit elasticity Perfectly Elastic Demand An increase in price results in sales of 0 Horizontal demand curve Perfectly Inelastic Demand - A change in price has no influence on quantity demanded. - Vertical demand curve - Examples – Insulin, Heroin

Elasticity varies over various parts of the demand curve. Demand is more elastic in the upper left portion of the demand curve. Graph Note - Slope does not measure elasticity.

Total Revenue Test TR = P×Q If demand is elastic, a decrease in price will increase TR. If demand is inelastic, a decrease in price will decrease TR. If demand is unit elastic, a decrease in price will not change TR Graph

Determinants of Elasticity Substitutability: more substitutes = greater elasticity of demand Lowering trade barriers increases substitutes, increasing elasticity Elasticity varies depending on how narrowly a product is defined. The demand for Honda’s is more elastic than the demand for automobiles

Determinants (cont.) Proportion of Income: The demand for low priced items tends to be inelastic Luxuries vs. Necessities: The demand for most necessities is inelastic Time : Elasticity increases over time – people develop tastes for substitutes

Elasticity of Supply If producers are responsive to price changes, then supply is elastic. If they are unresponsive to price changes, then supply is inelastic. E = %ΔQs / %ΔP E>1 : supply is elastic E<1: supply is inelastic E will not be negative (law of supply)

Time – The Main Determinant of Supply Market Period – producers are unable to change output, supply is perfectly inelastic Short Run – plant size is fixed, but the firm is able to use its plant more or less intensively Long Run – All resources are variable, firms may enter or exit the market

Cross Elasticity of Demand Cross Elasticity measures the effect of a change in price of one good on the quantity demanded of a different good E = %ΔQ of y / %ΔP of x Substitute Goods – Cross Elasticity is positive Complementary Goods – Cross Elasticity is negative Independent Goods – Cross Elasticity is 0 or near 0

Income Elasticity E = %ΔQ / %Δ in income Normal Goods – Income Elasticity is positive Inferior Goods – Income Elasticity is negative

Consumer Surplus The difference between what a consumer (or consumers) is willing to pay for a unit of a product or service and its market price. Graph

Producer Surplus The difference between market price and the price at which a producer (or producers) is willing to sell a unit of a good or service. Graph

Efficiency Loss Also called Deadweight loss When a good is either over produced or under produced there is a loss of consumer and producer surplus. Graph