Chap 5: Elasticity and Its Application

Elasticity

A measure of how much buyers and sellers respond to changes in market conditions.

Price Elasticity of Demand

The percentage change in quantity demanded resulting from a 1% change in price.

Elastic demand

Quantity demanded responds significantly to price changes (|Elasticity| > 1).

Inelastic demand

Quantity demanded responds only slightly to price changes (|Elasticity| < 1).

Unit elastic demand

Quantity demanded changes by exactly the same percentage as the price (|Elasticity| = 1).

Availability of close substitutes

Goods with many substitutes tend to have more elastic demand.

Necessities vs. Luxuries

Necessities tend to have inelastic demand, while luxuries have more elastic demand.

Definition of the market

Narrowly defined markets have more elastic demand than broadly defined markets.

Time horizon

Demand tends to be more elastic over longer time horizons.

Total Revenue

The amount paid by buyers and received by sellers of a good, calculated as price multiplied by quantity sold.

Elastic demand effect on total revenue

A price increase causes total revenue to decrease.

Inelastic demand effect on total revenue

A price increase causes total revenue to increase.

Unit elastic demand effect on total revenue

Total revenue remains constant when the price changes.

Income Elasticity of Demand

Measures how much the quantity demanded of a good responds to a change in consumers’ income.

Normal goods

Have positive income elasticities.

Inferior goods

Have negative income elasticities.

Cross-Price Elasticity of Demand

Measures how much the quantity demanded of one good responds to a change in the price of another good.

Positive Cross-Price Elasticity

Indicates that two goods are substitutes.

Negative Cross-Price Elasticity

Indicates that goods are complements.

Price Elasticity of Supply

Measures how much the quantity supplied responds to changes in the price of a good.

Elastic supply

Producers can easily change production levels, making supply more responsive to price changes.

Inelastic supply

Producers find it difficult to adjust production quickly in response to price changes.

Flexibility of producers

Goods that can be easily produced have higher elasticity.

Application of Elasticity

Understanding elasticity helps policymakers, businesses, and consumers make informed decisions.

Elasticity and Tax Incidence

Determines the burden of a tax, falling more heavily on the side of the market that is less elastic.

Inelastic demand and tax burden

Consumers bear most of the tax burden if demand is inelastic and supply is elastic.

Inelastic supply and tax burden

Producers bear most of the tax burden if supply is inelastic and demand is elastic.