5 - Elasticity and Its Applications

5 - Elasticity and Its Applications#

5.1 - The Elasticity of Demand#

Elasticity is a measure of the responsiveness of the quantity demanded or quantity supplied to a change in one of its determinants.

The Price Elasticity of Demand and Its Determinants#

The price elasticity of demand measures how much the quantity demanded responds to a change in the price. Demand for a good is said to be elastic, if the quantity demanded responds substantially to price changes. Demand is said to be inelastic if the quantity demanded responds only slightly to price changes.

Here are some of the factors that influence price elasticity:

  • Availability of close substitutes

  • Necessities and luxuries

  • Defining the market broadly or narrowly

    • For example, food has more inelastic demand than ice cream

  • Time horizon

The Price Elasticity of Demand, with Numbers#

\[ \text{Price elasticity of demand} = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}} \]

By some conventions, all values for price elasticity of demand only reported as the magnitude/absolue value.

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities#

The midpoint method calculates the price elasticity of demand as such:

\[ \text{Price elasticity of demand} = \frac{\frac{(Q_2 - Q_1)}{(Q_2 + Q_1)/2}}{\frac{(P_2 - P_1)}{(P_2 + P_1)/2}} \]

The Variety of Demand Curves#

When the elasticity is greater than 1, demand is said to be elastic. When elasticity is less than 1, demand is said to be inelastic. When elasticity is exactly 1, demand is said to have unit elasticity.

In the case of zero elasticity, the demand curve is vertical and the demand is said to be perfectly inelastic. As elasticity approaches infinty, the demand curve becomes horizontal and is said to be perfectly elastic.

Total Revenue and the Price Elasticity of Demand#

The variable we’re most interested in studying related to supply and demand in a market is the total revenue, which is given by \(P \times Q\).

Elasticity and Total Revenue along a Linear Demand Curve#

At points with a low price and high quantity, a linear demand curve is inelastic. At points with a high price and low quantity, a linear demand curve is elastic.

Other Demand Elasticities#

The income elasticity of demand measures how the quantity demanded changes as consumer income changes.

\[ \text{Income elasticity of demand} = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in income}} \]

The cross-price elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another.

\[ \text{Cross-price elasticity of demand} = \frac{\text{Percentage change in quantity demanded of good 1}}{\text{Percentage change in quantity demanded of good 2}} \]

5.2 - The Elasticity of Supply#

The Price Elasticity of Supply and Its Determinants#

The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

The Price Elasticity of Supply, with Numbers#

\[ \text{Price elasticity of supply} = \frac{\text{Percentage change in quantity supplied}}{\text{Percentage change in price}} \]

The Variety of Supply Curves#

The trends of supply curves follow the same as demand curves.

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