Bryan Becher 2/3/10 EC 111

Chapter 5: Elasticity of Demand and Supply

- In a market economy, prices tell producers and consumers about the relative scarcity of
products and resources
- A firm’s success or failure often depends on how much it knows about the demand for its
product
- The price elasticity of demand measures, in a standardized way, how responsive consumers
are to a change in price
- Measures the percentage change in quantity demanded divided by the percentage
change in price
- = Percentage change in quantity demanded / Percentage change in price
- Price elasticity formula – Percentage change in quantity demanded divided by the percentage
change in price; the average quantity and the average price are used as bases for computing
percentage changes in quantity and in price
- ED = (Δq / ((q + q1) / 2)) / (Δp / ((p + p1) / 2))
- Elasticity expresses a relationship between two amounts: the percentage change in quantity
demanded and the percentage change in price
- In the elasticity formula, the numerator and the denominator have opposite signs, leaving the
price elasticity of demand with a negative sign
- Inelastic demand – A change in price has relatively little effect on quantity demanded; the
percentage change in quantity demanded is less than the percentage change in price; the resulting
price elasticity has an absolute value less than 1.0
- Unit-elastic demand – The percentage change in quantity demanded equals the percentage
change in price; the resulting price elasticity has an absolute value of 1.0
- Elastic demand – A change in price has a relatively large effect on quantity demanded; the
percentage change in quantity demanded exceeds the percentage change in price; the resulting
price elasticity has an absolute value exceeding 1.0
- Knowledge of price elasticity of demand is especially valuable to producers
- Indicates the effect of a price change on total revenue
- Total revenue (TR) – Price multiplied by the quantity demanded at that price
- TR = p x q
- If the positive effect of a greater quantity demanded more than offsets the negative
effect of a lower price, then total revenue rises
- If demand is elastic, the percentage increase in quantity demanded exceeds the
percentage decrease in price, so total revenue increases
- If demand is unit elastic, the percentage increase in quantity demanded just equals the
percentage decrease in price, so total revenue remains unchanged
- If demand is inelastic, the percentage increase in quantity demanded is more than offset
by the percentage decrease in price, so total revenue decrease
- Linear demand curve – A straight-line demand curve; such a demand curve has a constant
slope but usually has a varying price elasticity
- A given decrease in price always causes the same unit increase in quantity demanded
- If the demand curve is linear, consumers are more responsive to a given price change when the
initial price is high than when it’s low
- Demand becomes less elastic as one moves down the curve
- A point halfway down the linear demand curve divides a linear demand curve into an elastic
upper half and an inelastic lower half
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- A price decline increases total revenue if demand is elastic, has no effect on total revenue if
demand is unit elastic, and decreases total revenue if demand is inelastic
- The slope of a demand curve is not the same as the price elasticity of demand
- Perfectly elastic demand curve – A horizontal line reflecting a situation in which any price
increase would reduce quantity demanded to zero; the elasticity has an absolute value of infinity
- Perfectly inelastic demand curve – A vertical line reflecting a situation in which any price
change has no effect on the quantity demanded; the elasticity value is zero
- Unit-elastic demand curve – Everywhere along the demand curve, the percentage change in
price causes an equal but offsetting percentage change in quantity demanded, so total revenue
remains the same; the elasticity has an absolute value of 1.0
- Constant-elasticity demand curve – The type of demand that exists when price elasticity is
the same everywhere along the curve; the elasticity value is unchanged
- The greater the availability of substitutes and the more similar these substitutes are to the good
in question, the greater that good’s price elasticity of demand
- The more narrow the definition, the more substitutes, and, thus, the more elastic the demand
- The more important the item is as a share of the consumer’s budget, other things constant the
greater is the income effect of a change in price, so the more price elastic is the demand for the
item
- The longer the period of adjustment, the more responsive the change in quantity demanded is to
a given change in price
- When estimating price elasticity, economists often distinguish between a period during which
consumers have little time to adjust, the short run, and a period during which consumers can
more fully adjust to a price change, the long run
- The price elasticity of demand is greater in the long run because consumers have more time to
adjust
- Price elasticity of supply – A measure of the responsiveness of quantity supplied to a price
change; the percentage change in quantity supplied divided by the percentage change in price
- The percentage change in price and the percentage change in quantity supplied move in
the same direction, so the price elasticity of supply is usually a positive number
- ES = (Δq / ((q + q1) / 2)) / (Δp / ((p + p1) / 2))
- Inelastic supply – A change in price has relatively little effect on quantity supplied; the
percentage change in quantity supplied is less than the percentage change in price; the price
elasticity of supply has a value less than 1.0
- Unit-elastic supply – The percentage change in quantity supplied equals the percentage change
in price; the price elasticity of supply equals 1.0
- Elastic supply – A change in price has a relatively large effect on quantity supplied; the
percentage change in quantity supplied exceeds the percentage change in price; the price
elasticity of supply exceeds 1.0
- Constant-elasticity supply curves – Supply curves whose elasticity does not change along the
curves
- Perfectly elastic supply curve – A horizontal line reflecting a situation in which any price
decrease drops the quantity supplied to zero; the elasticity value is infinity
- Perfectly inelastic supply curve – A vertical line reflecting a situation in which a price change
has no effect on the quantity supplied; the elasticity value is zero
- Unit-elastic supply curve – A percentage change in price causes an identical percentage
change in quantity supplied; depicted by a supply curve that is a straight line from the origin; the
elasticity value equals 1.0
- The elasticity of supply indicates how responsive producers are to a change in price
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- Their response depends on how easy it is to alter quantity supplied when the price
changes
- Just as demand becomes more elastic over time as consumers adjust to price changes, supply
also becomes more elastic over time as producers adjust to price changes
- The longer the adjustment period under consideration, the more able producers are to
adapt to a price change
- The elasticity of supply is typically greater the longer the period of adjustment
- The ability to increase quantity supplied in response to a higher price differs across industries
- Income elasticity of demand – The percentage change in demand divided by the percentage
change in consumer income; the value is positive for normal goods and negative for inferior
goods
- Normal goods with income elasticities less than 1 are called income inelastic
- Necessities often have income elasticities greater than 1
- Luxuries – Have income inelasticities greater than 1
- Because demand is price inelastic, total revenue falls when the price falls
- Cross-price elasticity of demand – The percentage change in demand of one good divided by
the percentage change in the price of another good; it’s negative for substitutes, positive for
complements, and zero for unrelated goods
- The responsiveness of the demand for one good to change in the price of another good
- If an increase in the price of one good leads to an increase in the demand for another good, their
cross-price elasticity is positive
- The two goods are substitutes
- If an increase in the price of one good leads to a decrease in the demand for another, their
cross-price elasticity is negative
- The goods are complements
- Most pairs of goods selected at random are unrelated, so their cross-price elasticity is zero
- Elasticity measures the willingness and ability of buyers and sellers to alter their behavior in
response to changes in their economic circumstances
- Firms try to estimate the price elasticity of demand for their products
- Governments also have an ongoing interest in various elasticities