MRU - Elasticity and its applications

Elasticity of demand

  • The law of demand tells us that when price goes up, quantity demanded goes down and viceversa.
    • But how much does quantity demanded change when price changes?
  • A demand curve is said to be elastic when an increase in price redices que quantity demanded a lot.
    • When the same increase in price reduces quantity demanded just a little, then the demand curve is inelastic.
  • Elasticity is a measure of how responsive quantity demanded is to a change in the price.    
  • Elasicity is not the same as slope
  • Flatter is more elastic
  • Factors that determine elasticity:
    • availability of substitutes: this is the fundamental determinant. the more substitutes the more elastic
    • for goods with many substitutes, switing brands when price change is easy, so demand is elastic
    • time horizon: immediately following a price increase, consumers may not be able to alter their consumption patterns, making demand inelastic
    • over time, however, consumers can adjust their behavior by finding substitutes
    • the longer the time horizon, the more ability to adjust
    • category of product: the broader the classification, the more likely they are able to find a substitute, making it inelastic
    • necessities vs luxiries: for necessities, consumers do not change quantity demamnded much when the price changes.
    • purchase size, relative to the consumer's budget: consumers are less concerned about price changes when the good feels cheap, making demand inelastic. they might not even notice if it goes up.      

Calculating elasticity of demand

  • Elasticity of demand: percentage change in quantity demanded divided by the percentage change in price.    
  • Ed < 1, inelastic
  • Ed > 1, elastic
  • Ed = 1, unit elastic
  • Midpoint formula:

   

  • A firm's revenues are equal to price times quantity sold
    • revenue = price * quantity sold

Elasticity of supply

  • Elasticity of supply: how responsive the quantity supplied is to a change in price    
  • determinants of elasticity of supply
    • change in per unit costs with increased production: this is the main determinant if increased production requires higher csots, then the supply curve will be inelastic
    • time horizon: immediately following a price increase, producers can expand output only using their current capacity, making supply inelastic
    • share of market for inputs: supply is elastic when the industry is a small demander in its input markets because supply can be expanded without causing a big increase in the demand for the industry's inputs.
    • example: we can double the supply of toothpicks without making a much bigger demand for wood
    • geographic scope: the narrower the scope of the market, the more elasstic its supply      
  • we use the midpoint formula to calculate it too.