Microeconomics Study Notes: Chapter 6 – Demand and Supply Elasticity

Chapter 6: Demand and Supply Elasticity

Introduction to Elasticity

Elasticity is a central concept in microeconomics, measuring how responsive quantity demanded or supplied is to changes in price, income, or the price of related goods. Understanding elasticity helps firms and policymakers predict the effects of market changes and set effective pricing strategies.

• Elasticity quantifies responsiveness in economic variables.

• Key types: Price Elasticity of Demand, Income Elasticity of Demand, Cross Price Elasticity of Demand, and Price Elasticity of Supply.

• Elasticity affects total revenue and market outcomes.

Objectives of the Chapter

• Define price elasticity of demand.

• Explain the relationship between price elasticity of demand and total revenue.

• Identify factors that determine price elasticity of demand.

• Describe cross price elasticity of demand and income elasticity of demand.

• Discuss supply elasticities and how the length of time affects price elasticity of supply.

Price Elasticity of Demand

Definition and Interpretation

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

• Formula:

$E_p = \frac{\%\,\text{change in quantity demanded}}{\%\,\text{change in price}}$

• If $E_p = -0.2$, a 1% increase in price leads to a 0.2% decrease in quantity demanded.

• The value is usually negative due to the law of demand (inverse relationship), but the negative sign is often ignored in reporting.

Calculating Price Elasticity of Demand

Elasticity is calculated using percentage changes, often with average values to avoid unit dependence.

• Midpoint (Arc) Formula:

$E_p = \frac{Q_2 - Q_1}{(Q_2 + Q_1)/2} \div \frac{P_2 - P_1}{(P_2 + P_1)/2}$

• Use averages to ensure consistency regardless of units.

• Example: If price increases from $75,000 to $130,000 and quantity decreases from 500 to 30, calculate using the midpoint formula.

Ranges of Price Elasticity of Demand

Elasticity values are classified to describe consumer responsiveness:

• Elastic Demand ($E_p > 1$): Quantity demanded is highly responsive to price changes.

• Unit-Elastic Demand ($E_p = 1$): Percentage change in quantity equals percentage change in price.

• Inelastic Demand ($E_p < 1$): Quantity demanded is less responsive to price changes.

Extreme Cases of Elasticity

• Perfectly Inelastic Demand ($E_p = 0$): Quantity demanded does not change with price (vertical demand curve).

• Perfectly Elastic Demand ($E_p = \infty$): Any price increase drops quantity demanded to zero (horizontal demand curve).

Elasticity and Total Revenue

Relationship Between Elasticity and Revenue

Total revenue (TR) is the product of price and quantity sold. Elasticity determines how changes in price affect total revenue.

• Formula: $TR = P \times Q$

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

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

• If demand is unit-elastic ($E_p = 1$), total revenue remains unchanged when price changes.

Elasticity of Demand ($E_p$)	Price Decrease	Price Increase
Elastic ($E_p > 1$)	TR increases	TR decreases
Unit-Elastic ($E_p = 1$)	No change in TR	No change in TR
Inelastic ($E_p < 1$)	TR decreases	TR increases

Determinants of Price Elasticity of Demand

Main Factors

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

• Share of Budget: Goods that take a larger share of the consumer's budget tend to have more elastic demand.

• Time Horizon: Demand is more elastic in the long run as consumers have more time to adjust their behavior.

Example: Demand for salt (small budget share, few substitutes) is inelastic; demand for a European vacation (large budget share, many substitutes) is elastic.

Cross Price Elasticity of Demand

Definition and Application

Cross price elasticity measures the responsiveness of demand for one good to changes in the price of another good.

• Formula: $E_{xy} = \frac{\%\,\text{change in quantity demanded of X}}{\%\,\text{change in price of Y}}$

• If $E_{xy} > 0$, goods are substitutes.

• If $E_{xy} < 0$, goods are complements.

Income Elasticity of Demand

Definition and Application

Income elasticity measures how quantity demanded changes as consumer income changes, holding price constant.

• Formula: $E_I = \frac{\%\,\text{change in quantity demanded}}{\%\,\text{change in income}}$

• If $E_I > 0$, the good is normal (demand increases with income).

• If $E_I < 0$, the good is inferior (demand decreases with income).

Example: If income rises from $4,000 to $6,000 and quantity demanded of digital apps rises from 6 to 8, use the midpoint formula to calculate$E_I$.

Price Elasticity of Supply

Definition and Calculation

Price elasticity of supply (Es) measures the responsiveness of quantity supplied to changes in price.

• Formula: $E_s = \frac{\%\,\text{change in quantity supplied}}{\%\,\text{change in price}}$

• Elastic supply: $E_s > 1$

• Inelastic supply: $E_s < 1$

• Unit-elastic supply: $E_s = 1$

Determinants of Price Elasticity of Supply

• Availability of Raw Materials: Limited resources make supply inelastic.

• Flexibility of Production: Complex processes and immobile labor reduce elasticity.

• Capacity and Inventories: Greater capacity and inventories increase elasticity.

• Time Horizon: Supply is more elastic in the long run as firms can adjust production more fully.

Extreme Cases of Supply Elasticity

• Perfectly Inelastic Supply: Quantity supplied does not change with price (vertical supply curve).

• Perfectly Elastic Supply: Any price decrease drops quantity supplied to zero (horizontal supply curve).

Summary Table: Elasticity Types and Their Interpretation

Elasticity Type	Formula	Interpretation
Price Elasticity of Demand ($E_p$)	$\frac{\%\,\text{change in Qd}}{\%\,\text{change in P}}$	Responsiveness of quantity demanded to price changes
Cross Price Elasticity ($E_{xy}$)	$\frac{\%\,\text{change in Qd of X}}{\%\,\text{change in P of Y}}$	Identifies substitutes ($E_{xy} > 0$) and complements ($E_{xy} < 0$)
Income Elasticity ($E_I$)	$\frac{\%\,\text{change in Qd}}{\%\,\text{change in income}}$	Distinguishes normal ($E_I > 0$) and inferior ($E_I < 0$) goods
Price Elasticity of Supply ($E_s$)	$\frac{\%\,\text{change in Qs}}{\%\,\text{change in P}}$	Responsiveness of quantity supplied to price changes

Key Takeaways

• Elasticity is crucial for understanding market reactions to price, income, and related goods.

• Elasticity affects firm revenue and informs pricing strategies.

• Determinants of elasticity include substitutes, budget share, and time for adjustment.

• Supply elasticity depends on production flexibility, resources, and time horizon.

Additional info: Some examples and formulas have been expanded for clarity and completeness.