Chapter 4 - Elasticity

Elasticity

A measure of how much consumers and producers respond to a change in market conditions (a change in the good's price, a related good's price, or income). It helps decision makers anticipate how others will respond

Own-price elasticity (what 'elasticity of demand or supply' means)

If you see 'elasticity of demand or supply' with no other label, it refers to the own-price elasticity

Price elasticity of demand: formula

% change in quantity demanded / % change in price

[MIDTERM] Elasticity midpoint formula

Elasticity = [(Q2 - Q1) / ((Q1 + Q2)/2)] / [(P2 - P1) / ((P1 + P2)/2)]. Use the averages of old and new values as the base

Why use the midpoint method?

It uses the average of the old and new values as the base, so you get the same answer going up or down

Price elasticity of demand: sign

Always negative (price and quantity demanded move in opposite directions). We often drop the negative sign and use the absolute value

What does a price elasticity of -1.38 mean?

A 1% increase in price lowers quantity demanded by 1.38% (and a 1% decrease raises it by 1.38%)

Elastic demand

|Elasticity| greater than 1. The % change in quantity is larger than the % change in price. Common for goods with close substitutes, luxuries, and goods that take a big part of income

Inelastic demand

|Elasticity| less than 1. The % change in quantity is smaller than the % change in price. Common for necessities, goods without close substitutes, and goods that are cheap relative to income

Unit elastic demand

|Elasticity| equals 1. Quantity changes by the same percentage as price

[MIDTERM] Perfectly elastic demand (graph)

Elasticity is infinite: a small price change causes an extreme reaction. The demand curve is a horizontal line (what a price taker faces)

[MIDTERM] Perfectly inelastic demand (graph)

Elasticity = 0: the same quantity is demanded no matter the price. The demand curve is a vertical line

Elasticity and slope of the demand curve

The steeper the curve, the LESS elastic demand is (vertical = perfectly inelastic, horizontal = perfectly elastic)

[MIDTERM] Price effect vs. quantity effect on total revenue

Price effect = more revenue from a higher price on each unit sold. Quantity effect = less revenue from selling fewer units. Revenue = P x Q

[MIDTERM] Elastic demand: effect of a price change on total revenue

Quantity effect is bigger than price effect. Price up = revenue falls. Price down = revenue rises

[MIDTERM] Inelastic demand: effect of a price change on total revenue

Price effect is bigger than quantity effect. Price up = revenue rises. Price down = revenue falls

[MIDTERM] Unit elastic demand: effect of a price change on total revenue

The effects offset each other, so total revenue does not change

Shortcut: price and revenue directions

Inelastic: price and revenue move in the SAME direction. Elastic: they move in OPPOSITE directions

[MIDTERM] Elasticity along a straight-line demand curve

Elastic at the top (high prices), inelastic at the bottom (low prices), and unit elastic (-1) at the point in between

Elasticity and a monopolist's pricing

A monopolist always chooses a price in the elastic portion of the demand curve. In the inelastic portion, raising price always increases profit

Factors that make demand MORE elastic

Close substitutes available, not a necessity, big share of income, longer adjustment time, and a narrower market (ex: one brand of tea vs. tea in general)

Factors that make demand LESS elastic

No close substitutes, necessities, small share of income (ex: salt), short adjustment time, and a broad market definition (ex: fruit vs. bananas)

Adjustment time and demand elasticity

Demand is more elastic in the long run than the short run (ex: gasoline: drive less now, move closer to work or buy an electric vehicle later)

Price elasticity of supply: formula

% change in quantity supplied / % change in price (use the midpoint method). Always positive

Classifying price elasticity of supply

Elastic > 1, inelastic < 1, unit elastic = 1, perfectly elastic = any quantity at one price, perfectly inelastic = quantity stays the same at any price

Determinants of price elasticity of supply

Available inputs, flexibility of the production process, and adjustment time (supply is more elastic in the long run, when new firms can enter)

A linear supply curve has…

Constant slope but changing elasticity

Cross-price elasticity of demand: formula

% change in quantity demanded of good A / % change in price of good B (use the midpoint method)

Cross-price elasticity: substitutes vs. complements

Substitutes = positive (price of B and quantity of A move the same way, ex: Tim's and Starbucks coffee). Complements = negative (move in opposite directions, ex: coffee and donuts)

[MIDTERM] Income elasticity of demand: formula

% change in quantity demanded / % change in income

Income elasticity: normal, necessity, luxury

Positive = normal good. Positive but less than 1 = necessity (income inelastic). Greater than 1 = luxury (income elastic)

Income elasticity: inferior good

Negative: quantity demanded and income move in opposite directions

Summary: signs of the four elasticities

Own-price demand: always negative. Own-price supply: always positive. Cross-price: positive for substitutes, negative for complements. Income: positive for normal goods, negative for inferior goods

How do governments use elasticity?

To see how much a price must rise to make people buy less (ex: taxes on oil, tobacco and alcohol) and how workers and investors react to taxes on income

How to do a midpoint elasticity calculation (steps)

1) % change in Q = (Q2 - Q1) / average of Q1 and Q2. 2) % change in P = (P2 - P1) / average of P1 and P2. 3) Divide (Q over P). 4) Use the absolute value for demand. 5) Compare with 1

Elasticity from percentages: price up 30%, quantity demanded down 60%

-60% / 30% = -2, so the price elasticity of demand is -2 (elastic)

An economist reports a price elasticity of demand of 0.4. What does that mean?

It means -0.4. Economists usually drop the negative sign for own-price elasticity of demand, since it is always negative

Price falls and total revenue rises. Is demand elastic or inelastic?

Elastic (price and revenue move in opposite directions)

Price falls and total revenue falls. Is demand elastic or inelastic?

Inelastic (price and revenue move in the same direction)

Why do airlines charge different prices for similar seats?

They consider the elasticity of demand. Business travellers (necessary trips) have low elasticity and pay more. Students and lower-income travellers have high elasticity and will change plans to save

The terms elastic, inelastic and unit elastic apply to...

Any elasticity (demand, supply, cross-price, income), not just the price elasticity of demand

If two goods are substitutes, their cross-price elasticity will be

Positive

Demand is elastic if elasticity is

Greater than 1