Microeconomics3e-Ch05

Chapter 5: Elasticity

5.1 Price Elasticity of Demand and Price Elasticity of Supply

• Elasticity Definition: Measures the responsiveness of one variable to changes in another.

• Price Elasticity: The ratio of the percentage change in quantity demanded (Qd) or supplied (Qs) relative to the percentage change in price.

  • Price Elasticity of Demand (PED):

    • Formula: Percentage change in Qd / Percentage change in price.

  • Price Elasticity of Supply (PES):

    • Formula: Percentage change in Qs / Percentage change in price.

5.2 Polar Cases of Elasticity and Constant Elasticity

• Elastic Case: Elasticity > 1; high responsiveness to price changes.

• Inelastic Case: Elasticity < 1; low responsiveness to price changes.

• Unitary Elastic Case: Elasticity = 1; proportional responsiveness.

• Infinite Elasticity: Horizontal curves; infinite change in Qd or Qs for any price change.

• Perfect Inelasticity: Vertical curves; no change in Qd or Qs regardless of price changes.

• Constant Unitary Elasticity:

  • Demand curve is a curve where 1% price change leads to 1% quantity change.

  • Supply curve is a straight line from the origin, indicating constant elasticity between price and quantity.

5.3 Elasticity and Pricing

• Businesses aim to lower production costs for higher profits; the impact of costs on pricing is crucial.

• Cost Savings from Technology:

  • Inelastic demand: Larger price drop with greater quantity supplied.

  • Elastic demand: Smaller price drop despite increased quantity supplied.

• Higher Costs and Taxes:

  • Supply shifts left; effects depend on elasticity of demand:

    • Inelastic demand: Costs passed to consumers as higher prices with stable quantity.

    • Elastic demand: Results in lower quantities sold and higher prices passed.

5.4 Elasticity in Areas Other Than Price

• Income Elasticity of Demand: How quantity demanded changes as income changes.

  • Generally positive: increased income leads to higher quantity demanded.

• Cross-Price Elasticity of Demand: Impact of changes in one good's price on another good's demand.

  • Formula: Percentage change in Qd of good A / Percentage change in price of good B.

• Elasticity in Labor:

  • Wage Elasticity of Labor Supply: Changes in labor supplied in response to wage changes.

  • Wage Elasticity of Labor Demand: Changes in labor demanded due to wage changes.

• Elasticity in Financial Markets:

  • Interest Rate Elasticity of Savings: Response of savings to interest changes.

  • Interest Rate Elasticity of Borrowing: Response of borrowing to interest changes.

Example: Netflix and Economic Elasticity

• Price Increase Impact:

  • Initial subscriber count: 24.6 million before a 60% price increase in 2011.

  • Result: 810,000 cancellations, but increased subscriptions to 36 million by mid-2013.

  • Misjudgments by Netflix Management:

    • Underestimated demand elasticity due to close substitutes (Vudu, Amazon Prime, Hulu).

    • Overestimated preference for streaming over physical DVDs.