[PRINECON] Module 3: Elasticity and Its Application

Elasticity

Measure of the responsiveness of quantity demanded or quantity supplied; To a change in one of its determinants

Price elasticity of demand

How much the quantity demanded of a good responds to a change in the ____ of that good; Percentage change in quantity demanded divided by the percentage change in ___.

Elastic demand

Quantity demanded responds substantially to changes in price

points with high price and low quantity

Inelastic demand

Quantity demanded responds only slightly to changes in price

points with low price and high quantity

–Availability of close substitutes

–Necessities versus luxuries

Determinants of price elasticity of demand (2)

•Necessities: inelastic demand

•Luxuries: elastic demand

•Necessities: ____ demand

•Luxuries: _____ demand

Time horizon

Demand is more elastic over longer _____.

Computing the price elasticity of demand

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

–Use absolute value (drop the minus sign)

Formula of Price Elasticity of Demand

Demand/Supply is elastic

Price elasticity of demand/supply > 1

In Demand: P and TR move in opposite directions

•If P ↑, TR ↓

Demand/Supply is inelastic

Price elasticity of supply/demand < 1

In Demand: P and TR move in the same direction

•If P ↑, TR also ↑

Demand/Supply has unit elasticity

Price elasticity of supply/demand = 1

In Demand: Total revenue remains constant when the price changes

Demand is perfectly inelastic

•Price elasticity of demand/supply = 0

•Supply/Demand curve is vertical

Demand/Supply is perfectly elastic

•Price elasticity of demand/supply = infinity

•Demand/supply curve is horizontal

Total revenue, TR

–Amount paid by buyers and received by sellers of a good

–Price of the good times the quantity sold (P × Q)

–If demand is inelastic, TR increases

–If demand is elastic, TR decreases

Income elasticity of demand

–How much the quantity demanded of a good responds to a change in consumers’ income

–Percentage change in quantity demanded

•Divided by the percentage change in income

Normal goods

–Positive income elasticity

–Necessities

–Luxuries

Necessities

Smaller income elasticities

Luxuries

Large income elasticities

Inferior goods

Negative income elasticities

Cross-price elasticity of demand

–How much the quantity demanded of one good responds to a change in the price of another good

–Percentage change in quantity demanded of the first good

•Divided by the percentage change in price of the second good

Substitutes

–Goods typically used in place of one another

–Positive cross-price elasticity

Complements

–Goods that are typically used together

–Negative cross-price elasticity

Price elasticity of supply

–How much the quantity supplied of a good responds to a change in the price of that good

–Percentage change in quantity supplied

•Divided by the percentage change in price

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

Elastic supply

Quantity supplied responds substantially to changes in the price

Inelastic supply

Quantity supplied responds only slightly to changes in the price

Computing price elasticity of supply

–Percentage change in quantity supplied divided by percentage change in price

–Always positive

Formula of Price Elasticity of Supply

Points with low price and low quantity

–Elastic supply

–Capacity for production not being used

Points with high price and high quantity

–Inelastic supply