Chapter 6: Elasticity – Microeconomics Study Notes

Chapter 6: Elasticity

Introduction

Elasticity is a fundamental concept in microeconomics that measures how one variable responds to changes in another. It is especially important for understanding consumer behavior, shaping public policy, and predicting the effects of price changes on markets.

Elasticity

Definition and Importance

• Elasticity quantifies the response in one variable when another variable changes.

• In economics, it is often used to measure how quantity demanded or quantity supplied responds to changes in price, income, or the price of other goods.

• Understanding elasticity helps policymakers and businesses predict the effects of taxes, subsidies, and price changes.

Example: Imposing a tax on cigarettes to discourage teen smoking requires knowing how much quantity demanded will decrease as price increases.

Price Elasticity of Demand

Definition and Formula

• Price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in its price.

• It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

Formula (Midpoint Method):

$\text{Price Elasticity of Demand} = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Price}}$

Using the midpoint formula for more accuracy:

$\text{Elasticity} = \frac{(Q_2 - Q_1) / [(Q_2 + Q_1)/2]}{(P_2 - P_1) / [(P_2 + P_1)/2]}$

• Elasticity is usually negative due to the law of demand (as price increases, quantity demanded decreases), but the absolute value is often used for interpretation.

Worked Example (from table):

Qd	A = (Q2-Q1)/Avg Q	B = (P2-P1)/Avg P	Elasticity	Type
50 to 30	$\frac{30-50}{(30+50)/2} = -\frac{20}{40} = -0.5$	$\frac{10-20}{(10+20)/2} = -\frac{10}{15} \approx -0.67$	$\frac{-0.5}{-0.67} \approx 0.75$	Inelastic
30 to 20	$\frac{20-30}{(20+30)/2} = -\frac{10}{25} = -0.4$	$\frac{20-30}{(20+30)/2} = -\frac{10}{25} = -0.4$	$\frac{-0.4}{-0.4} = 1$	Unitary Elastic
20 to 10	$\frac{10-20}{(10+20)/2} = -\frac{10}{15} \approx -0.67$	$\frac{30-40}{(30+40)/2} = -\frac{10}{35} \approx -0.29$	$\frac{-0.67}{-0.29} \approx 2.33$	Elastic

Types of Elasticity

Inelastic Demand

• Some responsiveness in quantity demanded, but not a great deal.

• Percentage change in Qd is less than the percentage change in P.

• Elasticity value: $0 < |\varepsilon_d| < 1$

• Example: Cigarettes (elasticity ≈ 0.5)

Elastic Demand

• Demand is very responsive to price changes.

• Percentage change in Qd is greater than the percentage change in P.

• Elasticity value: $|\varepsilon_d| > 1$

• Example: Bananas

Unitary Elastic Demand

• Percentage change in Qd is equal to the percentage change in P.

• Elasticity value: $|\varepsilon_d| = 1$

• Example: Beef

Perfectly Inelastic Demand

• Quantity demanded does not respond to price changes at all.

• Elasticity value: $|\varepsilon_d| = 0$

• Example: Insulin, chemotherapy, drug addiction

Perfectly Elastic Demand

• Any change in price will drop quantity demanded to zero.

• Elasticity value: $|\varepsilon_d| = \infty$

Graphical Rule of Thumb

• Steeper demand curves are more inelastic; flatter demand curves are more elastic.

• Elasticity changes along a straight-line demand curve: at higher prices (left side), demand is more elastic.

Determinants of Elasticity

Availability of Close Substitutes

• The most important determinant of price elasticity of demand.

• Demand is more elastic if there are many substitutes available.

• Example: Bananas (many substitutes, elastic); Oil (few substitutes, inelastic)

Time Dimension

• Demand becomes more elastic over time as consumers adjust their behavior.

• Short run: demand is more inelastic; long run: demand is more elastic.

• Example: Switching from peanuts to almonds over time as price changes.

Necessities vs. Luxuries

• Necessities tend to have inelastic demand; luxuries have more elastic demand.

Definition of the Market

• The more narrowly a market is defined, the more elastic the demand (due to more available substitutes).

The Importance of Being Unimportant (Share of Budget)

• Goods that constitute a small share of a consumer's budget tend to have inelastic demand.

• Big-ticket items (cars, furniture) have more elastic demand.

Elasticity and Total Revenue

Relationship Between Elasticity and Total Revenue

• Total Revenue (TR) is calculated as $TR = P \times Q$.

• If demand is elastic ($|\varepsilon_d| > 1$), a price increase decreases total revenue.

• If demand is inelastic ($|\varepsilon_d| < 1$), a price increase increases total revenue.

• If demand is unitary elastic ($|\varepsilon_d| = 1$), total revenue remains unchanged as price changes.

Example: If the price of a George Foreman Grill drops from $15 to $7 and demand is elastic, total revenue increases.

Other Important Elasticities

Income Elasticity of Demand

• Measures the responsiveness of demand to changes in consumer income.

• Normal goods: Positive income elasticity (demand increases as income rises).

• Inferior goods: Negative income elasticity (demand decreases as income rises).

• Luxuries: Income elasticity > 1 (e.g., college education, premium chocolate).

• Necessities: Income elasticity between 0 and 1 (e.g., salt, bread).

Cross Price Elasticity of Demand

• Measures the response of the quantity demanded for one good to a change in the price of another good.

• Formula: $\text{Cross Price Elasticity} = \frac{\%\ \text{Change in Qd of Good X}}{\%\ \text{Change in Price of Good Y}}$

• Substitutes: Positive cross price elasticity.

• Complements: Negative cross price elasticity.

Elasticity of Supply

• Measures the responsiveness of quantity supplied to a change in price.

• Similar calculation as price elasticity of demand, but focuses on supply side.

Estimated Real-World Price Elasticities of Demand (Selected Examples)

Product	Estimated Elasticity
Water (essential)	0.3
Chicken	0.3
Gasoline	0.2
Beef	0.6
Salt	0.1
Bananas	1.5
Bran	2.5
Cigarettes	0.5

Additional info: These values illustrate that necessities and goods with fewer substitutes tend to have lower (more inelastic) elasticities, while luxuries and goods with many substitutes have higher (more elastic) elasticities.