Chapter 5 - Elasticity and Its Application

Elasticity

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

price elasticity of demand

measures how much quantity demanded responds to a change in price

if quantity demanded or supplied responds SIGNIFICANTLY to changes in price…

demand is ELASTIC

if quantity demanded or supplied responds ONLY SLIGHTY to changes in price…

demand is INELASTIC

goods with close substitutes have…

elastic demand (easier to find another good that is similar)

necessities have…

inelastic demand

luxuries have…

elastic demand

narrowly defined markets have…

elastic demand

broadly defined markets have…

inelastic demand

Price Elasticity of Demand (Formula)

PEOD = % change in quantity demanded ÷ % change in price

midpoint method

averages the starting and ending prices and quantities to avoid issues with percentage changes

midpoint method (formula)

demand or supply is elastic when…

greater than 1

demand or supply is inelastic when…

less than 1

demand or supply has unit elasticity when…

1

the flatter the demand curve, the…

more elastic the demand

the steeper the demand curve, the…

less elastic the demand (inelastic)

what happens when demand is perfectly elastic?

consumers buy any quantity at a specific price and will NOT purchase at any other price (quantity demanded = infinite)

what happens with demand is perfectly inelastic?

consumers buy the same quantity regardless of price changes (quantity demanded stays constant)

total revenue

amount paid by buyers and received by sellers of a good

total revenue (formula)

PRICE X QUANTITY = TOTAL REVENUE

if demand is inelastic, an increase in price causes…

increase in revenue (gain from increase in price > loss from consumers buying less)

if demand is elastic, an increase in price causes…

decrease in revenue (loss from consumers buying less from increase in price > gain from increase in price)

the slope of a linear demand curve is constant, does this apply to elasticity?

No, elasticity varies along the curve, depending on the price level & quantity demanded; it can be elastic at some points and inelastic at others

income elasticity of demand

measures how the quantity demanded changes as a consumer income changes

income elasticity of demand (formula)

normal goods have…

positive income elasticities (quantity demanded and income both move up and right)

inferior goods have…

negative income elasticities (quantity demanded and income move in opposite directions; as income increases, quantity demanded decreases)

cross price elasticity of demand

measures how the quantity demanded of one good responds to a change in price of another good

cross price elasticity of demand (formula)

substitutes have…

positive cross price elasticities; an increase in the price of one good leads to an increase in the quantity demanded of the other

compliments have…

negative cross price elasticities; an increase in the price of one good leads to a decrease in the quantity demanded of the other

price elasticity of supply

measures how much quantity supplied responds to a change in price

in the short run, quantity demanded and supplied is…

inelastic (not very responsive to price)

in the long run, quantity demanded and supplied is…

elastic (responds substantially to price)

why does price elasticity of supply depend on how easily producers can adjust production levels?

greater flexibility allows for more significant changes in quantity supplied (e.g. manufactured goods are easier to make more of to respond to price increase, resulting in elastic supply, while a beachfront is not, resulting in inelastic supply)

price elasticity of supply (formula)

PEOS = % change in quantity supplied ÷ % change in price

the flatter the supply curve, the…

more elastic the supply (elastic)

the steeper the supply curve, the…

less elastic the supply (inelastic)

what happens when supply is perfectly elastic?

producers will supply any quantity at a specific price and will NOT supply at any other price (quantity supplied = infinite)

what happens when supply is perfectly inelastic?

Producers supply the same quantity regardless of price changes (quantity supplied stays constant)

for low levels of quantity supplied…

elasticity of supply is high, where firms respond substantially to changes in price (firms have capacity for production that that is not being used)

as quantity supplied rises…

firms begin to reach max capacity, supply gets more inelastic