E&S Topic 2

Why do we not use slope as a measure of elasticity?

Slope depends on the units used to measure price and quantity, so it is not comparable across goods or graphs. Elasticity uses percentage changes, making it unit-free.

What is price elasticity of demand (PED / εp)?

A measure of the responsiveness of quantity demanded of a good to a change in its own price, holding all other demand determinants constant.

Why is the sign of PED negative?

Because price and quantity demanded have an inverse relationship under the law of demand. Usually, we discuss PED using its absolute value.

What is the formula for PED?

εp = % change in quantity demanded ÷ % change in price = (%ΔQd) / (%ΔP).

What is the value of PED for an elastic, inelastic, and unit-elastic good?

Elastic: εp < −1. Unit elastic: εp = −1. Inelastic: −1 < εp < 0. Using absolute values: elastic > 1, unit elastic = 1, inelastic < 1.

What happens to total revenue when price rises for an elastic good?

Total revenue falls because the decrease in quantity demanded is proportionally larger than the increase in price. The quantity effect dominates.

What happens to total revenue when price rises for an inelastic good?

Total revenue rises because the decrease in quantity demanded is proportionally smaller than the increase in price. The price effect dominates.

What happens to total revenue when price rises for a unit-elastic good?

Total revenue does not change because the price and quantity effects exactly offset each other.

What factors affect PED?

Availability of Subs = more elastic

Larger % of consumers budget = more elastic

Longer time period of adjustment = more elastic

What is the midpoint formula for PED?

εp = [(Q2 − Q1) ÷ ((Q1 + Q2) ÷ 2)] ÷ [(P2 − P1) ÷ ((P1 + P2) ÷ 2)].

Why is the midpoint method used?

It gives the same elasticity regardless of whether price rises or falls between two points.

What is income elasticity of demand (YED / εM)?

A measure of the responsiveness of quantity demanded to a change in income, holding price and all other demand determinants constant.

What is the formula for YED?

εM = % change in quantity demanded ÷ % change in income.

What is YED for a normal good?

εM > 0: quantity demanded rises when income rises.

What is YED for an inferior good?

εM < 0: quantity demanded falls when income rises.

What is YED for an income-elastic and income-inelastic good?

Income elastic: εM > 1, usually a luxury. Income inelastic: 0 < εM < 1, usually a necessity.

What is cross-price elasticity of demand (XED / εXR)?

A measure of the responsiveness of quantity demanded of good X to a change in the price of related good R, holding the price of X and other demand determinants constant.

What is the formula for XED?

εXR = % change in quantity demanded of X ÷ % change in the price of R.

What is XED for substitutes?

εXR > 0. When the price of one good rises, demand for its substitute rises.

What is XED for complements?

εXR < 0. When the price of one good rises, demand for its complement falls.

What is price elasticity of supply (PES / εs)?

A measure of the responsiveness of quantity supplied to a change in the good’s own price, holding all other supply determinants constant.

What is the formula for PES?

εs = % change in quantity supplied ÷ % change in price.

What factors influence PES?

Resource substitution possibility = more elastic

Longer time period of adjustment = more elastic

/spare production capacity

What is a perfectly inelastic demand or supply curve?

A vertical curve. Quantity does not change when price changes, so elasticity equals 0.

What is a perfectly elastic demand or supply curve?

A horizontal curve. A tiny price change causes an extremely large change in quantity, so elasticity is infinite in magnitude.

What is a binding price ceiling?

A legal maximum price set below the equilibrium price.

What is the impact of a binding price ceiling on consumer surplus and producer surplus?

Consumer surplus may rise or fall, depending on the sizes of the gain from lower prices and the loss from fewer units traded. Producer surplus falls. Deadweight loss arises from mutually beneficial trades that no longer occur.

What is a binding price floor?

A legal minimum price set above the equilibrium price.

What is the impact of a binding price floor on consumer surplus and producer surplus?

Consumer surplus falls. Producer surplus may rise for sellers who still sell, but there is excess supply and deadweight loss from lost trades.

What is a minimum wage?

A price floor in the labour market: firms are not allowed to pay below the legal minimum wage.

What does a binding minimum wage cause?

Unemployment: quantity of labour supplied exceeds quantity of labour demanded. It also creates deadweight loss.

What is a specific tax?

A tax of a fixed amount of money per unit sold.

What happens when a specific tax is imposed?

Buyers pay a higher price, sellers receive a lower price, quantity traded falls, the government receives tax revenue, and deadweight loss arises.

Who bears more of a tax imposed on sellers?

The side of the market that is relatively more inelastic bears more of the tax burden. It does not depend on whether the tax is legally imposed on buyers or sellers.

How do demand and supply elasticities affect tax incidence?

If demand is relatively inelastic, buyers bear more of the tax. If supply is relatively inelastic, sellers bear more. The more elastic side bears less.

Are a tax on buyers and a tax on sellers economically equivalent?

Yes. Although they shift different curves, both lead to the same equilibrium quantity, buyer price, seller price, tax revenue, and tax burden.

Why can a tax have zero deadweight loss?

If quantity traded does not fall after the tax, such as with perfectly inelastic supply or demand. The tax redistributes surplus but does not eliminate mutually beneficial trades.

What is a subsidy?

A payment that reduces the buyer’s price below the seller’s price; it is like a negative tax.

What are the effects of a subsidy?

Buyers pay less, sellers receive more, quantity traded rises, the government incurs expenditure, and a deadweight loss can arise from overproduction.

A decrease in supply will cause the largest increase in equilibrium price when…

Both demand and supply are price inelastic. Buyers barely reduce quantity demanded and producers cannot adjust quantity supplied much, so the market adjusts mainly through a large price rise.