Chapter 6 Elasticity: The Responsiveness of Demand and Supply

6.1 The Price Elasticity of Demand and Its Measurement

• Definition of Elasticity: Elasticity is a measure of how much one economic variable responds to changes in another economic variable, based on percentage changes in the variables.
• Price Elasticity of Demand: The responsiveness of the quantity demanded to a change in price.
  Price\, elasticity\, of\, demand = \frac{Percentage\, change\, in\, quantity\, demanded}{Percentage\, change\, in\, price}
• The price elasticity of demand is a negative number because price and quantity change in opposite directions on the demand curve.
• Elastic Demand: Demand is elastic if its price elasticity of demand is larger (in absolute value) than 1. A 10% increase in price would result in a greater than 10% decrease in quantity demanded.
• Inelastic Demand: Demand is inelastic if its price elasticity of demand is less than 1.
• Unit-Elastic Demand: Demand is unit-elastic if the price elasticity of demand is exactly equal to 1. A given percentage change in price produces the same percentage change in demand.
• Midpoint Formula: Used to calculate percentage changes to ensure the elasticity from point A to B is the same as from B to A.
  Percentage\, change = \frac{QB - QA}{(QA+QB)/2} \times 100
• Midpoint Formula for Elasticity:
  Price\, elasticity\, of\, demand = \frac{\frac{Q2 - Q1}{(Q1 + Q2)/2}}{\frac{P2 - P1}{(P1 + P2)/2}}
• Solved Problem Example:
  • Price of Coca-Cola cut from $1.50 to $1.30 per bottle.
  • Sales increase from 2,000 to 2,500 gallons per day.
  • Average quantity = 2,250
  • Average price = $1.40
  • Percentage change in quantity demanded = 22.2%
  • Percentage change in price = -14.3%
  • Price elasticity of demand = -1.6
  • Demand is price elastic in this range since 1.6 > 1.
• A vertical demand curve is perfectly inelastic, meaning quantity demanded does not change as price changes, so elasticity is zero.
• A horizontal demand curve is perfectly elastic, meaning quantity demanded is infinitely responsive to price changes, so elasticity is infinite.

6.2 The Determinants of the Price Elasticity of Demand

• Availability of Close Substitutes: More substitutes lead to more elastic demand.
  • Gasoline has few substitutes, so its price elasticity of demand is low.
  • Nikes have many substitutes, so their price elasticity of demand is high.
• Passage of Time: Elasticity is higher in the long run than the short run because people can adjust their buying habits more easily.
  • If the price of gasoline rises, people may buy a more fuel-efficient car or move closer to work over time.
• Luxury vs. Necessity: Price elasticity of demand is higher for luxuries.
  • Milk and bread are necessities, so demand is less sensitive to price.
• Definition of the Market: The more narrowly defined the market, the more elastic is demand.
  • Demand for jeans in general might be inelastic, but demand for a specific brand of jeans can be elastic.
• Share of a Good in a Consumer’s Budget: Goods that are a small portion of the budget tend to have very inelastic demand.

6.3 The Relationship between Price Elasticity of Demand and Total Revenue

• Total revenue: The total amount of funds a seller receives from selling a good or service, calculated by multiplying price per unit by the number of units sold.
• If demand is relatively price inelastic, decreasing the price will not gain enough additional customers to compensate for the lost revenue, so overall revenue goes down.
• If demand is relatively price elastic, decreasing the price will gain many additional customers, more than compensating for the lost revenue, so overall revenue goes up.

6.4 Other Demand Elasticities

• Cross-Price Elasticity of Demand: The percentage change in the quantity demanded of one good divided by the percentage change in the price of another good.
  • Measures the strength of substitute or complement relationships between goods.
• Substitutes have a positive cross-price elasticity of demand.
• Complements have a negative cross-price elasticity of demand.
• Unrelated goods have a cross-price elasticity of zero.
• Income Elasticity of Demand: A measure of the responsiveness of the quantity demanded to changes in income, measured by the percentage change in the quantity demanded divided by the percentage change in income.
• Normal goods have a positive income elasticity of demand.
• Inferior goods have a negative income elasticity of demand.

6.5 Using Elasticity to Analyze the Disappearing Family Farm

• Rapid increases in farm productivity have led to a large shift to the right in the supply curve for wheat.
• Income elasticity of demand for wheat is low, so demand for wheat increased little over time.
• Demand for wheat is also inelastic, so the large shift in the supply curve and the small shift in the demand curve resulted in a sharp decline in the price of wheat.

6.6 The Price Elasticity of Supply and Its Measurement

• Price elasticity of supply: The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price.
• The time period is critically important for determining the price elasticity of supply.
• If a supply curve is a vertical line, it is perfectly inelastic (elasticity of supply equals zero).
• If a supply curve is a horizontal line, it is perfectly elastic (elasticity of supply equals infinity).
• Knowing the price elasticity of supply can help predict the effect that a change in demand will have