sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part V

Elasti ity and Its Appli ation

� Elasti ity: A measure of the responsiveness of quantity demanded or quantity supplied to a hange in one of

its determinants.

� A good is said to be elasti if the quantity demanded or supplied rea ts strongly to a hange and inelasti if

this hange is not strong.

� Pri e Elasti ity of Demand: A measure of how mu h the quantity demanded of a good responds to a hange

in the pri e of that good, omputed as the per entage hange in quantity demanded divided by the per entage

hange in pri e.

� The following fa tors a�e t elasti ity of demand:

1. Availability of Close Substitutes

(a) A good with plentiful substitutes will have more elasti demand. Consumers will respond to a pri e

hange by demanding a signi� antly lower quantity due to the availability of lose substitutes/

2. Ne essities vs. Luxuries

(a) A ne essity will have more inelasti demand than a luxury.

3. De�nitions of the Market (Narrowness)

(a) A good with a broad de�nition (food) will have more inelasti demand than a good with a narrow

de�nition (tomatoes)

4. Time Horizon

(a) Over long periods of time, goods generally have more elasti demand

5. Proportion of In ome

(a) A good that takes up a larger per entage of in ome will have more elasti demand.

i. Example: A pa k of gum vs. a ar � It is mu h easier to deal with a 10% in rease in the pri e of a

pa k of gum vs. a ar. Thus, the ar will have a more elasti response.

Computing the Pri e Elasti ity of Demand:

Pri e Elasti ity of Demand =

%1Demand

%1Pri e

Be ause the quantity demanded of a good is negatively related to its pri e, the per entage hange in quantity

demanded will always have the opposite sign as the per entage hange in pri e. Thus, the elasti ity of

demand will always be negative. However, the onvention is to drop the negative sign as it has no real meaning

or impa t on the interpretation of the elasti ity. It is straightforward to determine the pri e elasti ity of demand if

the per entage hanges in demand and pri e are given:

� %△Demand = 20%

� %△Price = 10%

� Pri e Elasti ity of Demand:

20% 10%

= 2

� An elasti ity measure of 2 indi ates that the hange in quantity demanded is proportionately twi e as large

as the hange in pri e.

Cal ulate Pri e Elasti ity of Demand with Varying Levels of Quantity Demanded and Pri e:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

..

The Midpoint Method:

-The midpoint method does not su�er from the same problems as the traditional method of al ulating per entage

hanges. This is be ause the average of the initial and se ond point is used. Thus, �moving in either dire tion� will

result in the same al ulation of elasti ity. Given two points (Q1, P1) & (Q2, P2), the midpoint method is:

Pri e Elasti ity of Demand =

(Q2−Q1)/[(Q1+Q2)/2] (P2−P1)/[(P1+P2)/2]

Example:

The Variety of Demand Curves:

� The shape and slope of the demand urve indi ates the level of elasti ity.

� If elasti ity is greater than 1, demand is onsidered elasti . The result is a �atter demand urve.

� If elasti ity is less than 1, demand is onsidered inelasti . The result is a steeper demand urve.

� If elasti ity is exa tly equal to 1, demand is onsidered unit elasti . The response by QD is exa tly propor- tionately equal to the per entage hange in pri e.

� If the demand urve is a �at line with a slope of 0, demand is perfe tly elasti .

� If the demand urve is a verti al line with an unde�ned slope, demand is perfe tly inelasti .

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Total Revenue and the Pri e Elasti ity of Demand:

� Total Revenue: The amount paid by buyers and re eived by sellers of a good, omputed as the pri e of the

good times the quantity sold.

� The hange in total revenues is dire tly related to how elasti the good is:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� When demand is inelasti , pri e and total revenue move in the same dire tion.

� When demand is elasti , pri e and total revenue move in opposite dire tions.

� If demand is unit elasti , total revenue remains onstant when the pri e hanges.

Elasti ity and Total Revenue along a Linear Demand Curve:

Elasti ity varies along a linear demand urve:

When the demand urve is a straight line, the slope is onstant. This is be ause the slope represents the ratio

of the hanges in the two variables. However, the elasti ity is the ratio of per entage hanges in the two variables.

The numbers also indi ate the relationship between total revenue and elasti ity. As the pri e is lowered, the total

revenue in reases until rea hing the unit elasti point on the demand urve. From this point forward, total revenue

de reases (due to being on the inelasti portion of the demand urve).

Other Demand Elasti ities:

� In ome Elasti ity of Demand: Measures how mu h the quantity demanded of a good responds to a hange

in onsumer's in ome, omputed as the per entage hange in quantity demanded divided by the per entage

hange in in ome �

� In ome Elasti ity of Demand =

% △ Qd % △ Income

� Most goods are onsidered normal and a hange Qd will move in the same dire tion as the hange in in ome. Thus, the in ome elasti ity of demand will be positive. However, if the good is inferior, then the movements

in Qd and in ome will move in opposite dire tions. Thus, the in ome elasti ity of demand will be negative.

� In ome elasti ity will also depend on luxuries vs. ne essities. Goods that are ne essities will have smaller

in ome elasti ities due to the need by onsumers while luxury goods will have a stronger response.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Cross-Pri e Elasti ity of Demand: A measure of how mu h the quantity demanded of one good responds

to a hange in the pri e of another good, omputed as the per entage hange in quantity demanded of the

�rst good divided by the per entage hange in the pri e of the se ond good.

� Cross-Pri e Elasti ity of Demand =

% △ Qd of good 1 % △ in the price of good 2

� This measure of elasti ity of demand will be positive or negative dependent on whether or not the goods are

substitutes or omplements.

� If the goods are substitutes, ross-pri e elasti ity of demand will be positive.

� If the goods are omplements, ross-pri e elasti ity of demand will be negative.

Elasti ity of Supply:

� Pri e Elasti ity of Supply: A measure of how mu h the quantity supplied of a good responds to a hange in

the pri e of that good, omputed as the per entage hange in quantity supplied divided by the per entage

hange in pri e.

� The following fa tors a�e t elasti ity of supply:

1. Time period � Supply is generally more elasti in the long run than the short run. Over short periods of

time, �rms an not easily hange the amount that they produ e in response to a hange in the pri e.

2. How easy it is for the seller to hange the amount of good they produ e. (bea hfront land vs.

manufa tured goods).

(a) Bea hfront land will have more inelasti supply as it is mu h more di� ult for the produ er to hange

QS.

Computing the Pri e Elasti ity of Supply:

The omputation of the Pri e Elasti ity of Supply is as so:

Pri e Elasti ity of Supply =

%1QS %1Pri e

Be ause the quantity supplied of a good is positively related to its pri e, the per entage hange in quantity

supplied will always have the same sign as the per entage hange in pri e. Thus, the elasti ity of supply will always

be positive. The midpoint method should be employed to determine the elasti ity of supply:

The Variety of Supply Curves:

� The shape and slope of the supply urve indi ates the level of elasti ity.

� If elasti ity is greater than 1, supply is onsidered elasti . The result is a �atter supply urve.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� If elasti ity is less than 1, supply is onsidered inelasti . The result is a steeper supply urve.

� If elasti ity is exa tly equal to 1, supply is onsidered unit elasti . The response by QS is exa tly propor- tionately equal to the per entage hange in pri e.

� If the supply urve is a �at line with a slope of 0, demand is perfe tly elasti .

� If the supply urve is a verti al line with an unde�ned slope, demand is perfe tly inelasti .

� Due to the fa t that �rms often have a maximum apa ity for produ tion, the elasti ity of supply may be

very high at low levels of quantity supplied and very low at high levels of quantity supplied:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Sin e many �rms have a maximum level of output, a hange in market pri e at high levels of quantity

supplied will result in a more inelasti response (the �rm would like to in rease QS more but does not have the ability to do so).

� Thus, a supply urve may likely be �atter at lower levels of quantity supplied and steeper at higher

levels of quantity supplied. This is a re�e tion of di�erent levels of elasti ity depending on the level of

produ tion.

Appli ations of supply, demand, and elasti ity:

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