Chap 5: Elasticity and Its Application

1. Definition of Elasticity

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. It helps in understanding how sensitive quantity demanded or quantity supplied is to changes in price, income, or other factors.

• Price Elasticity of Demand: The percentage change in quantity demanded resulting from a 1% change in price.

  • Formula: 

• Elastic demand (|Elasticity| > 1): Quantity demanded responds significantly to price changes.

• Inelastic demand (|Elasticity| < 1): Quantity demanded responds only slightly to price changes.

• Unit elastic demand (|Elasticity| = 1): Quantity demanded changes by exactly the same percentage as the price.

2. Determinants of Price Elasticity of Demand

Several factors influence the price elasticity of demand:

• Availability of close substitutes: Goods with many substitutes tend to have more elastic demand.

• Necessities vs. Luxuries: Necessities tend to have inelastic demand, while luxuries have more elastic demand.

• Definition of the market: Narrowly defined markets (e.g., specific brands) have more elastic demand than broadly defined markets (e.g., food).

• Time horizon: Demand tends to be more elastic over longer time horizons.

3. Total Revenue and Price Elasticity of Demand

Total revenue is the amount paid by buyers and received by sellers of a good, calculated as price multiplied by quantity sold.

• When demand is elastic, a price increase causes total revenue to decrease because the percentage decrease in quantity demanded is larger than the percentage increase in price.

• When demand is inelastic, a price increase causes total revenue to increase because the percentage decrease in quantity demanded is smaller than the percentage increase in price.

• When demand is unit elastic, total revenue remains constant when the price changes.

4. Other Elasticities

• Income Elasticity of Demand: Measures how much the quantity demanded of a good responds to a change in consumers’ income.

  • Formula: 

• Normal goods have positive income elasticities, while inferior goods have negative income elasticities.

• Cross-Price Elasticity of Demand: Measures how much the quantity demanded of one good responds to a change in the price of another good.

  • Formula: 

• If the cross-price elasticity is positive, the two goods are substitutes; if it’s negative, the goods are complements.

5. Price Elasticity of Supply

The price elasticity of supply measures how much the quantity supplied responds to changes in the price of a good.

• Formula: 

• Elastic supply: Producers can easily change production levels, making supply more responsive to price changes.

• Inelastic supply: Producers find it difficult to adjust production quickly in response to price changes.

• Determinants of elasticity of supply include:

  • Flexibility of producers: Goods that can be easily produced have higher elasticity.

  • Time horizon: Supply becomes more elastic over time as producers have more time to adjust production.

6. Application of Elasticity

Understanding elasticity is essential for policymakers, businesses, and consumers. Elasticity helps:

• Policymakers predict the effects of price controls, taxes, and subsidies on markets.

• Businesses make pricing decisions to maximize revenue.

• Consumers make informed decisions based on changes in prices and incomes.

7. Elasticity and Tax Incidence

Elasticity plays a crucial role in determining the burden of a tax. The tax burden falls more heavily on the side of the market (buyers or sellers) which is less elastic because that side of the market has fewer alternatives to avoid the tax.

• If demand is inelastic and supply is elastic, consumers bear most of the tax burden.

• If supply is inelastic and demand is elastic, producers bear most of the tax burden.