Chapter 5 Elasticity and its Application

What is Elasticity? Measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

Price Elasticity of Demand Measure of how much quantity demanded responds to a change in price Can be computed as % change in quantity demanded divided by % change in price

Determinants of Price Elasticity of Demand Availability of Close Substitutes: More substitutes available, more elastic demand is Necessities vs. Luxuries: Necessities are less elastic Definition of the market: Narrowly defined are more elastic than broadly defined ones Time Horizon: Goods tend to be more elastic over longer time periods

Let’s practice: Put the following into its likely order from most elastic to least elastic: Beef Salt European Vacation Steak New Honda Accord Dijon mustard

Answers European Vacation New Honda Accord Steak Dijon Mustard Beef Salt

Computing Price Elasticity of Demand Formula is: Price Elasticity of Demand = % Change in Quantity Demanded % Change in Price So… if the price of of ice cream rises by 10% and quantity demanded falls by 20% Price elasticity of demand = 2

Of the following, what will have the greatest elastic effect on demand? Good A, which has few if any substitutes Good A, which has many substitutes Good A, which is seen as a necessity Good A, which is defined very broadly (like market for soap) None of the above

A 5 percent decrease in the price of good X leads to a 20 percent increase in the quantity demanded of Good X. The elasticity coefficient of demand is: 24 4 .25 2.25 1

Put the following in order from most elastic to least elastic: Eggs Rice Beef Mountain Dew Healthcare Housing Restaurant Meals

Midpoint Method The elasticity is calculated by going from one point to another on demand curve, which will be different at different parts on curve So, you get around it using midpoint method Price Elasticity of Demand = (Q2 – Q1)/{(Q1+Q2)/2} (P2 – P1)/{(P1+P2)/2} Rarely, need to use this – big idea is that you use it to counteract differences in elasticities

Midpoint Method Example: Calculate Price Elasticity of Demand if the price rises from $4 to $6 and the resulting quantity demanded falls from 120 to 80 Answer = 1

Variety of Demand Curves Demand is elastic if elasticity is greater than 1 Demand is inelastic if elasticity is less than 1 Demand is unit elastic if elasticity is exactly 1

Rule of Thumb for Elasticity Flatter the demand curve, the greater the price elasticity of demand The steeper the curve, the smaller the price elasticity of demand

Special Cases Perfectly Elastic Perfectly Inelastic

Of the following, which is not a factor that will determine elasticity of a good? Percent of income spent on a good How the market is defined Time in which the market is viewed Number of substitutes available Change in income

If any change in price leads to no change in quantity demanded, then demand for this good: Is relatively elastic Is perfectly inelastic Is relatively inelastic Is perfectly elastic The answer cannot be determined based on the information given

A good that may be perfectly inelastic is: Toothpaste Bottled Water Pencils Insulin Granny Smith apples

Total Revenue Total Revenue = Amount paid by buyers and received by sellers of the good (P x Q) Rules about TR as it relates to Elasticity When demand is inelastic, price & total revenue move in the same direction When demand is elastic, price & total revenue move in opposite directions If demand is unit elastic, total revenue remains constant as price changes

Linear Demand Curves Slope is constant, but elasticity isn’t

Income Elasticity of Demand Income Elasticity Demand = % Change in Quantity Demanded % Change in Income Normal = positive income elasticity Inferior = negative income elasticity Necessities = small income elasticity Luxuries = large income elasticity

Cross-Price Elasticity of Demand Shows if goods are substitutes or complements % Change in Quantity Demanded of Good 1 % Change in Price of Good 2 Substitutes = Positive Cross-Price Elasticity Complements = Negative Cross-Price

Price Elasticity of Supply % Change in Quantity Supplied % Change in Price Depends on flexibility of sellers to change the amount of the good they produce Time period is key determinant (more elastic in long run)

Variety of Supply Curves Flat supply curves show more elasticity; more vertical supply curve is more inelastic Perfectly Inelastic = Vertical; Perfectly Elastic = Horizontal