Elasticity: The Responsiveness of Demand and Supply (Microeconomics Chapter 6 Study Notes)

Elasticity: The Responsiveness of Demand and Supply

6.1 The Price Elasticity of Demand and Its Measurement

Elasticity measures how much one economic variable responds to changes in another, based on percentage changes. The price elasticity of demand quantifies the responsiveness of quantity demanded to a change in price.

• Definition: Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

• Formula: $\text{Price elasticity of demand} = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}$ Midpoint formula: $\text{Price elasticity of demand} = \frac{(Q_2 - Q_1)}{(Q_2 + Q_1)/2} \div \frac{(P_2 - P_1)}{(P_2 + P_1)/2}$

• Interpretation: Elasticity is usually negative due to the inverse relationship between price and quantity demanded, but the absolute value is used for classification.

Price Elasticity of Demand Terminology

• Elastic demand: Absolute value of elasticity > 1. Quantity demanded changes a lot in response to price changes.

• Inelastic demand: Absolute value of elasticity < 1. Quantity demanded changes little in response to price changes.

• Unit elastic demand: Elasticity = 1. Percentage change in price equals percentage change in quantity demanded.

Example

• Cutting the price of Coca-Cola from $1.50 to $1.30 increases sales from 2,000 to 2,500 gallons.$\text{Average Quantity} = \frac{2,000 + 2,500}{2} = 2,250\text{Average Price} = \frac{1.50 + 1.30}{2} = 1.40\text{Percentage change in quantity} = \frac{2,500 - 2,000}{2,250} \times 100 = 22.2\%\text{Percentage change in price} = \frac{1.30 - 1.50}{1.40} \times 100 = -14.3\%\text{Elasticity} = \frac{22.2}{-14.3} = -1.6$ (elastic demand)

6.2 The Determinants of the Price Elasticity of Demand

Several factors influence the price elasticity of demand for a good:

• Availability of close substitutes: More substitutes make demand more elastic.

• Passage of time: Elasticity is higher in the long run as consumers adjust their behavior.

• Whether the good is a luxury or necessity: Luxuries have higher elasticity than necessities.

• Definition of the market: Narrowly defined markets have more elastic demand due to more substitutes.

• Share of a good in a consumer's budget: Goods that take up a small portion of the budget tend to have inelastic demand.

6.3 The Relationship between Price Elasticity of Demand and Total Revenue

Total revenue is the product of price and quantity sold. The effect of price changes on total revenue depends on the price elasticity of demand.

• Total Revenue Formula: $\text{Total Revenue} = \text{Price} \times \text{Quantity}$

• Elastic demand: Lowering price increases total revenue (quantity increases more than price decreases).

• Inelastic demand: Lowering price decreases total revenue (quantity increases less than price decreases).

• Unit elastic demand: Total revenue remains unchanged when price changes.

Table: Relationship between Price Elasticity and Revenue

If demand is...	then...	because...
Elastic	Price decrease increases revenue	Quantity increases proportionally more than price decreases
Inelastic	Price decrease reduces revenue	Quantity increases proportionally less than price decreases
Unit elastic	Price change does not affect revenue	Quantity changes proportionally the same as price

6.4 Other Demand Elasticities

Other types of elasticities measure responsiveness to factors other than price.

• Cross-price elasticity of demand: Measures the percentage change in quantity demanded of one good in response to a percentage change in the price of another good. $\text{Cross-price elasticity} = \frac{\text{Percentage change in quantity demanded of Good A}}{\text{Percentage change in price of Good B}}$ Positive value: Substitutes Negative value: Complements

• Income elasticity of demand: Measures the percentage change in quantity demanded in response to a percentage change in income. $\text{Income elasticity} = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in income}}$ Positive value: Normal goods Negative value: Inferior goods

6.5 Using Elasticity to Analyze the Disappearing Family Farm

Elasticity concepts help explain economic phenomena such as the decline in family farms. Increased productivity in farming has led to a large increase in supply, but because demand for agricultural products is inelastic and has low income elasticity, prices have fallen sharply, reducing profitability and the number of farmers.

• Inelastic demand: Large supply increases cause significant price drops.

• Low income elasticity: Demand does not rise much as incomes increase.

6.6 The Price Elasticity of Supply and Its Measurement

The price elasticity of supply measures the responsiveness of quantity supplied to a change in price.

• Formula: $\text{Price elasticity of supply} = \frac{\text{Percentage change in quantity supplied}}{\text{Percentage change in price}}$

• Determinants:

  • Ability of firms to change production

  • Time period considered (elasticity is higher in the long run)

• Polar cases:

  • Perfectly inelastic supply: Vertical supply curve, elasticity = 0

  • Perfectly elastic supply: Horizontal supply curve, elasticity = infinity

Table: Summary of Elasticities

Elasticity Type	Formula
Price Elasticity of Demand	$\frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}$
Cross-Price Elasticity of Demand	$\frac{\text{Percentage change in quantity demanded of Good A}}{\text{Percentage change in price of Good B}}$
Income Elasticity of Demand	$\frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in income}}$
Price Elasticity of Supply	$\frac{\text{Percentage change in quantity supplied}}{\text{Percentage change in price}}$

Additional info:

• Elasticity is a central concept in microeconomics, used to analyze consumer and producer behavior, market outcomes, and policy effects.

• Examples such as soda taxes, law enforcement policy, and agricultural markets illustrate the practical applications of elasticity.