1. Chapter 18
Elasticity

2. 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

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

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

5. 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

6. 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.

7. 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

8. 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

9. 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

10. 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)

11. 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

12. 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

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

14. 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

15. 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

16. 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