Principles of Microeconomics Chapter 5 Elasticity & Its Application

Ch. 5 - Elasticity and Its Application

5-1 The Elasticity of Demand

• The Price Elasticity of Demand and Its Determinants

  • Price elasticity of demand: measures how much the quantity demanded responds to a change in price

  • Elastic demand means that quantity demanded responds substantially, whereas inelastic demand means that quantity demanded responded slightly

  • A demand curve’s elasticity is determined by: 

    • 1. Availability of close substitutes: more close substitutes means more elastic because consumers can switch goods easily

    • 2. Necessities vs. luxuries: necessities are inelastic, whereas luxuries are elastic

    • 3. Definition of the market: narrowly defined markets are more elastic (such as the ice cream market), whereas broadly defined markets are more inelastic (such as the food market) 

    • 4. Time horizon: demand is more elastic over longer time horizons 

• Computing the price elasticity of demand

  • Price elasticity of demand = % change in quantity demanded divided by the % change in price

  • “A 1% change in price leads to a _____% change in quantity demanded” 

• The Midpoint Method: a better way to calculate the % changes and elasticities

  • Elasticity is not the same in both directions (ex. Elasticity from A to B is not equal to elasticity from B to A), so use the midpoint method

  • Price elasticity of demand using the midpoint method = (Q2-Q1)/[(Q2+Q1)/2] / (P2-P1)/[(P2+P1)/2]

• The Variety of Demand Curves

  • Elastic when elasticity > 1; inelastic when elasticity < 1; unit elasticity when elasticity = 1

  • The flatter the demand curve through a given point, the greater the PEOD (price elasticity of demand) and vice versa

  • Vertical curve = perfectly inelastic; horizontal curve = perfectly elastic

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• Total Revenue and the Price Elasticity of Demand

  • Total revenue: the amount paid by buyers and received by sellers of a good

  • Total revenue = P * Q (price * quantity sold)

  • Inelastic: increase in price leads to an increase in total revenue (fall in Q is proportionately smaller than rise in P) and the opposite is true when it is elastic

  • INELASTIC (PE < 1): price and total revenue move in SAME direction

  • ELASTIC (PE > 1): price and total revenue move in OPPOSITE directions

  • UNIT ELASTIC (PE = 1): total revenue remains constant when price changes

• Elasticity and Total Revenue along a Linear Demand Curve

  • With a linear demand curve, slope may be constant, but elasticity is not 

  • Points with low price and high quantity = inelastic; points with high price and low quantity = elastic

• Other Demand Elasticities

  • Income elasticity of demand: measures how the quantity demanded changes as consumer income changes

  • Income elasticity of demand = % change in quantity demanded divided by the % change in income

  • Normal goods: (+) income elasticities; inferior goods: (-) income elasticities

  • Necessities have small income elasticities (ex. food)

  • Income elasticity < 1 = necessity, income elasticity > 1 = luxury 

  • Cross-price elasticity of demand: measures how the quantity demanded of 1 good responds to a change in price of another good 

  • Cross-price elasticity of demand = % change in quantity demanded of good 1 divided by the % change in the price of good 2

  • Substitutes: CP elasticity of demand is (+) and move in same direction

  • Complements: CP elasticity of demand is (-) and move in opposite direction

5-2 The Elasticity of Supply

• The Price Elasticity of Supply and Its Determinants

  • Price elasticity of supply: measures how much the quantity supplied responds to changes in price

  • Elastic: QS responds substantially to changes in price; inelastic: QS responds slightly

  • PEOS (price elasticity of supply) depends on flexibility of sellers to change amount sold

  • Key determinant with PEOS: time; usually more elastic in the long run 

• Computing the PEOS

  • Price elasticity of supply = % change in quantity supplied divided by the % change in price

• The Variety of Supply Curves

  • Flatter supply curve means it is more elastic

  • Vertical line: perfectly inelastic; horizontal line: perfectly elastic

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  • Elasticity of supply is NOT constant in some markets 

  • Elasticity of supply is high for low levels of QS because there is idle equipment, so increase in price make it profitable for firms. Once full capacity is used, further increase in production means new construction (extra expenses means prices must rise more to incur this extra expenses and therefore supply becomes more inelastic)

5-3 Three Applications of Supply, Demand, and Elasticity

• Can good news for farming be bad news for farmers? 

  • Improvement in farm technology can be bad for farmers (supply curve shifts right → price falls → less total revenue because food is inelastic → farmers quit), but it is good for consumers who pay less for food

• Why did OPEC fail to keep the price of oil high? 

  • Supply and demand for oil are relatively inelastic in the short-run, elastic in the long-run

• Does Drug Interdiction Increase/Decrease Drug-Related Crime? 

  • Drug interdiction/intervention → raises costs for selling drugs (supply curve shifts left) → decreases drug use BUT since drugs are inelastic, increase in price raises total revenue (aka drug users pay more) → because of higher price, drug-related crime increases