ECON201 - Chapter 4

Chapter 4: Elasticity

4.1 Price Elasticity of Demand

• Definition: Price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price.

• Types of Demand:

  • Elastic Demand: Quantity demanded is highly responsive to price changes.

  • Inelastic Demand: Quantity demanded is relatively unresponsive to price changes.

• Implications:

  • When demand is elastic, shifts in supply lead to less change in equilibrium price but greater change in equilibrium quantity.

4.2 Price Elasticity of Supply

• Definition: Price elasticity of supply indicates responsiveness of quantity supplied to changes in the product's price.

• Types of Supply:

  • Elastic Supply: Quantity supplied responds significantly to price changes.

  • Inelastic Supply: Quantity supplied responds minimally to price changes.

4.3 Elasticity Matters for Excise Taxes

• Excise Tax: A tax on specific products (e.g., gasoline) affects the prices paid by consumers and the revenue received by producers.

• Tax Incidence: The way the burden of a tax is shared among participants in a market depends on the elasticities of demand and supply.

4.4 Other Demand Elasticities

• Income Elasticity of Demand:

  • Formula: ηY = Percentage change in quantity demanded / Percentage change in income

  • Normal Good: ηY > 0

  • Inferior Good: ηY < 0

• Cross Price Elasticity of Demand:

  • Formula: ηXY = Percentage change in quantity demanded of good X / Percentage change in price of good Y

  • Substitute Goods: ηXY > 0

  • Complement Goods: ηXY < 0

Measurement of Price Elasticity

Price Elasticity Formula

• η = (Percentage change in quantity demanded) / (Percentage change in price)

• Characteristics:

  • Demand curve is negatively sloped, implying elasticity is usually reported as positive, ignoring negative sign.

Numerical Example of Price Elasticity

• Given Example:

  • Original Price: $5.00, New Price: $3.00

  • Original Quantity: 116250, New Quantity: 123750

  • Average Price and Quantity calculated for elasticity measurement.

Factors Determining Elasticity of Demand

Availability of Substitutes

• Close substitutes lead to elastic demand. No close substitutes lead to inelastic demand. More narrowly defined products are more elastic.

Importance in Consumer Budgets

• Products that constitute a small budget share tend to be inelastic. Those constituting a large share are elastic.

Time Horizon

• Demand elasticity increases over time; long-run demand is generally more elastic than short-run demand.

Elasticity and Total Expenditure

Overview

• Total Expenditure = Price × Quantity

• Changes in total expenditure depend on demand elasticity:

  • Elastic Demand: Price decrease → Total expenditure rises; Price increase → Total expenditure falls.

  • Inelastic Demand: Price decrease → Total expenditure falls; Price increase → Total expenditure rises.

  • Unit Elastic Demand: No change in total expenditure on price changes.

Price Elasticity of Supply

Definition and Measurement

• Formula: ηs = (Percentage change in quantity supplied) / (Percentage change in price)

• Elasticity of supply indicates how quantity supplied responds to price.

Determinants of Supply Elasticity

• Ease of Substitution: Easier substitution → More elastic supply.

• Short Run vs Long Run: Short-run supply is less elastic due to immediate capacity constraints.

Conclusion

• Understanding elasticity is crucial for determining how varying price affects supply and demand, influencing total revenues and market behavior.