Microeconomics 28/9/22

 Elasticity and its application

Elasticity = measure of the responsiveness of quantity demanded/supplied to a change in one of its determinants

Price elasticity of demand

- How much the quantity demanded of a good responds to a change in the price of that good

- percentage change in quantity demanded divided by the percentage change in price

- PED = |(Q2-Q1)/((P2-P1)|

Elastic demand

Quantity demanded responds substantially to price change

Inelastic demand

Quantity demanded responds only slightly to price change

Determinants of PED

- Availability of close substitutes (more substitutes = more elastic)

- Necessities vs luxuries (necessities = inelastic, luxuries = elastic)

- Definition of the market (narrowly defined markets = more elastic)

- Time horizon (longer time horizon = more elastic)

Computing PED

- Percentage change in quantity demanded divided by percentage change in price

- Midpoint method

Variety of demand curves

- Demand is elastic (PED > 1)

- Demand is inelastic (PED < 1)

- Demand has unit elasticity (PED = 1)

- Demand is perfectly inelastic (PED = 0)

- Demand is perfectly elastic (PED = infinity)

The flatter the demand curve the greater the PED

Total revenue (TR)

- Amount paid by buyers and received by sellers of a good

- Price of the good times the quantity sold (P x Q)

For a price increase

- If demand is inelastic, TR increases

- If demand is elastic, TR decreases

When demand is inelastic (PED < 1)

- P and TR move in the same direction (if P increase, TR increase)

When demand is elastic (PED > 1)

- P and TR move in opposite directions (if P increase, TR decrease)

If demand is unit elastic (PED = 1)

- TR remains constant when price changes

Linear demand curve

- Constant slope

- Different price elasticities

Income elasticity of demand

- How much the quantity demanded of a good responds to a change in consumer's income

- Percentage change in quantity demanded divided by percentage change in income

Normal goods

- Positive income elasticity

- Necessities (smaller income elasticities)

Inferior goods

- Negative income elasticity

Cross-price elasticity of demand

- How much the quantity demanded of one good responds to a change in the price of another good

- Percentage change in quantity demanded of the first good divided by the percentage change in price of the second good

Substitutes

- Positive cross-price elasticity

Complements

- Negative cross-price elasticity

Price elasticity of supply

- How much the quantity supplied of a good responds to a change in the price of that good

- Percentage change in quantity supplied divided by the percentage change in price

- Depends on flexibility of sellers to change amount of goods they produce

Elastic supply

- Quantity supplied responds substantially

Inelastic supply

- Quantity supplied responds only slightly

Determinant of PES

- Time period (supply more elastic in the long run)