Chapter 18 Elasticity Price Elasticity of Demand Elasticity

Chapter 18 Elasticity

Price Elasticity of Demand • Elasticity measures the responsiveness (sensitivity) of consumers to a change in price • Formula: E = %ΔQ / %ΔP • Absolute Value – eliminate the negative sign

Elastic Demand • E>1 • A small change in price leads to a large change in quantity demanded • Example – Restaurant Meals

Inelastic Demand • E<1 • A change in price has little effect on quantity demanded • Examples – electricity, milk, gas, cigarettes

Special Situations • E = 1 : unit elasticity • Perfectly Elastic Demand – An increase in price results in sales of 0 – Horizontal demand curve Perfectly Inelastic Demand - A change in price has no influence on quantity demanded. - Vertical demand curve - Examples – Insulin, Heroin

• Elasticity varies over various parts of the demand curve. • Demand is more elastic in the upper left portion of the demand curve. • Graph • Note - Slope does not measure elasticity.

Total Revenue Test • TR = P×Q • If demand is elastic, a decrease in price will increase TR. • If demand is inelastic, a decrease in price will decrease TR. • If demand is unit elastic, a decrease in price will not change TR • Graph

Determinants of Elasticity • Substitutability: more substitutes = greater elasticity of demand – Lowering trade barriers increases substitutes, increasing elasticity – Elasticity varies depending on how narrowly a product is defined. • The demand for Honda’s is more elastic than the demand for automobiles

Determinants (cont. ) • Proportion of Income: The demand for low priced items tends to be inelastic • Luxuries vs. Necessities: The demand for most necessities is inelastic • Time : Elasticity increases over time – people develop tastes for substitutes

Elasticity of Supply • If producers are responsive to price changes, then supply is elastic. If they are unresponsive to price changes, then supply is inelastic. • E = %ΔQs / %ΔP • E>1 : supply is elastic • E<1: supply is inelastic • E will not be negative (law of supply)

Time – The Main Determinant of Supply • Market Period – producers are unable to change output, supply is perfectly inelastic • Short Run – plant size is fixed, but the firm is able to use its plant more or less intensively • Long Run – All resources are variable, firms may enter or exit the market

Cross Elasticity of Demand • Cross Elasticity measures the effect of a change in price of one good on the quantity demanded of a different good • E = %ΔQ of y / %ΔP of x • Substitute Goods – Cross Elasticity is positive • Complementary Goods – Cross Elasticity is negative • Independent Goods – Cross Elasticity is 0 or near 0

Income Elasticity • E = %ΔQ / %Δ in income • Normal Goods – Income Elasticity is positive • Inferior Goods – Income Elasticity is negative

Consumer Surplus • The difference between what a consumer (or consumers) is willing to pay for a unit of a product or service and its market price. • Graph

Producer Surplus • The difference between market price and the price at which a producer (or producers) is willing to sell a unit of a good or service. • Graph

Efficiency Loss • Also called Deadweight loss • When a good is either over produced or under produced there is a loss of consumer and producer surplus. • Graph