Principles of Economics: Elasticity, Demand, Supply, and Market Analysis

Elasticity

Measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants.

Price elasticity of demand

Measures how much the quantity demanded responds to a change in the price.

Elastic demand

Quantity demanded responds substantially to price changes.

Inelastic demand

Quantity demanded responds only slightly to price changes.

Availability of close substitutes

Elastic demand: Goods with close substitutes; Inelastic demand: Goods with no close substitute.

Necessities and luxuries

Elastic demand: Luxuries; Inelastic demand: Necessities.

Defining the market broadly or narrowly

Elastic demand: Narrowly defined markets; Inelastic demand: Broadly defined markets.

Time horizon

More elastic demand: Longer time horizons; Less elastic demand: Shorter time horizons.

Computing the price elasticity of demand

Percentage change in quantity demanded divided by percentage change in price.

The Midpoint Method

The midpoint method divides the change by the midpoint (or average) of the initial and final levels.

Price elasticity of demand > 1

Demand is elastic.

Price elasticity of demand < 1

Demand is inelastic.

Price elasticity of demand = 1

Demand has unit elasticity.

Price elasticity of demand = 0

Demand is perfectly inelastic; demand curve is vertical.

Price elasticity of demand = infinity

Demand is perfectly elastic; demand curve is horizontal.

% change in P

[($600 - $400)/$500] × 100 = 40%.

% change in Qd

[(8,400 - 10,600)/9,500] × 100 = -23.16%.

Price elasticity of demand calculation

Price elasticity of demand = % change in Qd / % change in P = 23.16/40 = 0.58 (ignoring the minus sign).

Total Revenue

Amount paid by buyers and received by sellers of a good

Unit elastic demand

When price changes, total revenue remains constant

Impact of a price change on total revenue

Depends on the elasticity of demand

Inelastic demand curve

A price increase leads to a proportionately smaller decrease in quantity demanded, so total revenue increases

Elastic demand curve

A price increase leads to a proportionately larger decrease in quantity demanded, so total revenue decreases

Elasticity along a Linear Demand Curve

The slope of a linear demand curve is constant, but its elasticity is not

Income elasticity of demand

A measure of how much the quantity demanded of a good responds to a change in consumers' income

Normal goods

Have a positive income elasticity

Inferior goods

Have a negative income elasticity

Cross-price elasticity of demand

A measure of how much the quantity demanded of one good responds to a change in the price of another good

Substitutes

Have a positive cross-price elasticity

Complements

Have a negative cross-price elasticity

Price elasticity of supply

Measures how much the quantity supplied of a good responds to a change in the price of that good

Elastic supply

Quantity supplied responds substantially to price changes

Inelastic supply

Quantity supplied responds only slightly to price changes

Determinants of Price Elasticity of Supply

Depends on the flexibility of sellers to change the amount they produce

Short run

Quantity supplied is not very responsive to changes in price

Long run

Quantity supplied responds substantially to price changes

Computing the Price Elasticity of Supply

Percentage change in quantity supplied divided by percentage change in price

Use midpoint method

A method for calculating percentage changes

Supply is elastic

Price elasticity of supply > 1

Supply is inelastic

Price elasticity of supply < 1

Supply has unit elasticity

Price elasticity of supply = 1

Supply is perfectly inelastic

Price elasticity of supply = 0

Supply curve is vertical

Indicates perfectly inelastic supply

Supply is perfectly elastic

Price elasticity of supply = infinity

Supply curve is horizontal

Indicates perfectly elastic supply

Maximum capacity for production

Limits the elasticity of supply at high levels of quantity supplied

Increase in price from $3 to $4

Increases the quantity supplied from 100 to 200

67% increase in quantity supplied

Calculated with the midpoint method

5 percent increase in quantity supplied

Occurs when the price rises from $12 to $15

Total revenue falls

Occurs when demand is inelastic and supply increases

Technological advance increases wheat supply

Shifts the supply curve from S1 to S2, causing price to fall

Short-run supply and demand

Are inelastic leading to a large price increase

Long-run supply and demand

Are elastic leading to a smaller price increase

Drug interdiction

Would increase drug-related crime in the short run but decrease it in the long run

Higher prices do not substantially affect drug use

Indicates inelastic demand over short periods