Microeconomics: Elasticity

elasticity

measures the responsiveness to a change in a market condition:

• applies to both supply and demand

• measures the response to a change in:

- price of the good

- price of another good

- income

- etc.

demand slope is not a good tool to gauge consumers’ sensitivity

problem 1: magnitude big vs small slope: objective

problem 2: comparisons (slope is measured in units of the good)

any elasticity concept consists of understanding how:

• demand or supply for some good Y changes when

• smth else (X) changes x could be price of good Y, income, price of another good, etc.

formula remains the same

change in % of Y / change in % of X

price elasticity of demand

measures how the demand for x changes when the price of x changes

Ed: percent change in q / percent change in p

Determinants of price elasticity of demand

factors impacting consumer’s responsiveness to price changes:

• availability of substitutes many → easy to switch → high elasticity

• degree of necessity very necessary → low elasticity

• cost relative to income expensive → high elasticity

• adjustment time long time → high elasticity

• scope of market

elastic

a change in price causes a relatively large percentage change in quantity demanded (price sensitive)

inelastic

a change in price causes a relatively small percentage change in quantity demanded (price insensitive)

perfectly elastic

any price change = zero quantity demanded (horizontal line) Ed = infinity

perfectly inelastic

at any price, quantity demanded is the same |Ed| = 0

elastic number

|Ed| > 1 % change in quantity demanded outweighs % change in price

inelastic number

|Ed| < 1 % change in price outweighs % change in quantity demanded

if demand is elastic, a small price increase will affect demand a lot

• the firm does not have much power

• less need for regulation

if demand is inelastic, the firm can increase prices as much as it wishes without losing customers

firm has market power (more need for intervention)

Total revenue

price * quantity sold

tradeoff: increasing price will lower quantity, so it is not always certain revenue will increase

when demand is elastic,

customers are price sensitive, so the percent change in quantity demanded > percent change in price

• decreasing price increases revenue

• increasing price decreases revenue

when demand is inelastic,

customers are price insensitive, so the percent change in price > percent change in quantity demanded

• increasing price increases revenue

• decreasing price decreases revenue

price elasticity of supply

measures producer’s responsiveness (in quantity) to a change in price

• same mid point formula Qd → Qs

• Es: percent change in quantity supplied / percent change in price

  • elastic: Es > 1

  • inelastic Es < 1

Determinants of price elasticity of supply

• availability of inputs. unavailable inputs → inelastic supply

• flexibility of the production process

• adjustment time long adj. time → inelastic supply

  • short adj. time → elastic supply

cross price elasticity of demand

measures how the quantity demanded of one good changes when the price of a different good changes

E a, b = % change in quantity demanded of good A / % change in price of good B

E a, b > 0: goods are subs

E a, b < 0: goods are complements

income elasticity of demand

measure of how much quantity demanded changes in response to a change in consumer’s incomes

E i = % change in quantity demanded / % change in income

can be positive or negative

Ei > 0, the good is normal

• Ei > 1: good is a luxury

Ei < 0, the good is inferior

point elasticity

Ed = 1/b * P/Q