ECO 1104 - Chapter 4

What is elasticity?

A measure of how strongly consumers and producers respond to a change in market conditions. It is based on percentage changes, allowing comparisons across goods with different units

What are the four main measures of elasticity discussed in this chapter?

1. Price elasticity of demand (PED)

2. Price elasticity of supply (PES)

3. Cross-price elasticity of demand

4. Income elasticity of demand

What does Price Elasticity of Demand (PED) measure?

Consumers' responsiveness to a change in the price of a good.

What is the formula for PED?

PED = % change in quantity demanded / % change in price

Why is PED normally a negative number?

Because price and quantity demanded move in opposite directions (law of demand). If price goes up, quantity demanded goes down.

If an economist says the elasticity of demand is 0.5, what do they actually mean?

They mean -0.5. Economists often drop the negative sign and refer to PED by its absolute value (size) because it is always negative.

What is the Midpoint Method formula for % change?

% change in X = (X₂ - X₁) / [(X₁ + X₂) / 2]

What is the full Midpoint Method formula for PED?

PED = [(Q₂ - Q₁) / ((Q₁ + Q₂) / 2)] ÷ [(P₂ - P₁) / ((P₁ + P₂) / 2)]

Why do we use the midpoint method?

It avoids getting a different percentage change depending on which point is treated as the starting point.

If |PED| > 1, demand is ________.

Elastic. Quantity changes by a larger percentage than price.

If |PED| < 1, demand is ________.

Inelastic. Quantity changes by a smaller percentage than price.

If |PED| = 1, demand is ________.

Unit-elastic. Quantity changes by the same percentage as price.

What is perfectly elastic demand?

Elasticity is infinite; the demand curve is horizontal.

What is perfectly inelastic demand?

Elasticity is 0; the demand curve is vertical, and quantity demanded does not change when price changes.

How does the availability of close substitutes affect PED?

More close substitutes → more elastic demand (consumers can switch easily).
Fewer substitutes → more inelastic demand.

How does necessity vs. luxury affect PED?

Necessities → more inelastic demand (consumers continue buying even when price rises).
Luxuries → more elastic demand (consumers can cut back or postpone).

How does cost relative to income affect PED?

Goods that take a small share of income → less elastic demand.
Large purchases → more elastic demand (price changes matter more to the budget).

How does adjustment time affect PED?

Demand is generally more elastic in the long run than in the short run because consumers have more time to adjust.

How does the scope of the market affect PED?

Narrowly defined goods (e.g., one brand of tea) → more elastic demand (more substitutes).
Broadly defined goods (e.g., tea in general) → less elastic demand.

What is Total Revenue (TR)?

TR = Price × Quantity sold.

What are the two competing effects of a price change on total revenue?

1. Price effect: A higher price raises revenue per unit sold.

2. Quantity effect: A higher price reduces quantity demanded and therefore reduces units sold.

If demand is elastic, what happens to TR when price increases?

Total revenue decreases. The quantity effect is larger than the price effect. (Price ↑ → TR ↓; Price ↓ → TR ↑)

If demand is inelastic, what happens to TR when price increases?

Total revenue increases. The price effect is larger than the quantity effect. (Price ↑ → TR ↑; Price ↓ → TR ↓)

If demand is unit elastic, what happens to TR when price changes?

Total revenue stays the same. The price and quantity effects exactly offset.

What is the shortcut for remembering the relationship between price, TR, and elasticity?

Elastic → price and total revenue move in opposite directions.
Inelastic → price and total revenue move in the same direction.

Does a straight-line demand curve have the same elasticity at every point?

No. A linear demand curve has a constant slope but changing elasticity.

Where is demand more elastic on a linear demand curve?

At high-price, low-quantity points (the top of the curve).

Where is demand more inelastic on a linear demand curve?

At low-price, high-quantity points (the bottom of the curve).

At what point on a linear demand curve is total revenue maximized?

At the point where PED = -1 (unit elastic).

Above the unit-elastic point, lowering price ________ total revenue.

Increases

Below the unit-elastic point, lowering price ________ total revenue.

Decreases

What does Price Elasticity of Supply (PES) measure?

Producers' responsiveness to a change in the price of a good.

What is the formula for PES?

PES = % change in quantity supplied / % change in price

Why is PES normally a positive number?

Because price and quantity supplied move in the same direction.

If PES > 1, supply is ________.

Elastic

If PES < 1, supply is ________.

Inelastic

If PES = 1, supply is ________.

Unit-elastic

What is perfectly elastic supply?

Horizontal supply curve.

What is perfectly inelastic supply?

Vertical supply curve.

How does the availability of inputs affect PES?

If firms can easily obtain additional inputs → more elastic supply.
Specialized or scarce inputs → less elastic supply.

How does the flexibility of the production process affect PES?

If firms can easily switch machinery or capacity between products → more elastic supply.
Highly specialized production equipment → less elastic supply.

How does adjustment time affect PES?

Supply is generally more elastic in the long run than in the short run.
Short run: capacity and number of firms are fixed.
Long run: firms can expand plants and new firms can enter.

What does Cross-Price Elasticity measure?

How quantity demanded of good A responds to a change in the price of good B.

What is the formula for Cross-Price Elasticity?

Cross-Price Elasticity = % change in Q demanded of good A / % change in price of good B

If cross-price elasticity is positive, the two goods are ________.

Substitutes

If cross-price elasticity is negative, the two goods are ________.

Complements

What does Income Elasticity measure?

How quantity demanded changes when consumer income changes.

What is the formula for Income Elasticity?

Income Elasticity = % change in quantity demanded / % change in income

If income elasticity > 0, the good is a ________.

Normal good.

If 0 < income elasticity < 1, the good is a ________.

Necessity (income-inelastic normal good).

If income elasticity > 1, the good is a ______.

Luxury (income-elastic normal good).

If income elasticity < 0, the good is an ________.

Inferior good. Demand falls when income rises and rises when income falls.

What is the summary table for the four elasticities?

• PED: More elastic over time, for substitutable goods, luxuries. Less elastic in short run, for unique/necessary items.

• PES: More elastic over time, with flexible production. Less elastic in short run, with production constraints.

• Cross-Price: More elastic for near-perfect substitutes and strong complements.

• Income: More elastic for luxury items. Less elastic for unique and necessary items.