ECN Chapter 5 - Elasticity and its Application

Elasticity of a Linear Demand Curve

At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic. The linear demand curve illustrates that the price elasticity of demand need not be the same at all points on a demand curve.

Price elasticity of supply equation

Economists compute the price elasticity of supply as the percentage change in the quantity supplied divided by the percentage change in the price.

Farm technology or farm policy

Keep in mind that what is good for farmers is not necessarily good for society as a whole. Improvement in farm technology can be bad for farmers because it makes farmers increasingly unnecessary, but it is surely good for consumers who pay less for food. Similarly, a policy aimed at reducing the supply of farm products may raise the incomes of farmers, but it does so at the expense of consumers.

Price elasticity of supply

Measures how much the quantity supplied responds to changes in the price. Elastic if the quantity supplied responds substantially to changes in the price. Inelastic if the quantity supplied responds only slightly to changes in the price.

Income elasticity of demand

Measures how the quantity demanded changes as consumer income changes. It is calculated as the percentage change in quantity demanded divided by the percentage change in income.

Cross-price elasticity of demand

Measures how the quantity demanded of one good responds to a change in the price of another good. It is calculated as the percentage change in quantity demanded of good 1 divided by the percentage change in the price of good 2.

Normal vs. Inferior goods

Normal goods: Higher income raises the quantity demanded. Because quantity demanded and income move in the same direction, they have positive income elasticities. Inferior goods: Higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, they have negative income elasticities.

Variety of supply curves

Perfectly inelastic: zero elasticity and the supply curve is vertical. In this case, the quantity supplied is the same regardless of the price. Perfectly elastic: This occurs as the price elasticity of supply approaches infinity and the supply curve becomes horizontal, meaning that very small changes in the price lead to very large changes in the quantity supplied.

Substitutes vs. complements

Substitutes: goods that are typically used in place of one another, the cross-price elasticity is positive. Complements: complements are goods that are typically used together, the cross-price elasticity is negative.

Total revenue

The amount paid by buyers and received by sellers of a good. TR = P x Q, the price of the good times the quantity of the good sold.

Key determinant of the price elasticity of supply

The time period being considered. Supply is usually more elastic in the long run than in the short run.

Rules about demand and elasticity

When demand is inelastic (less than 1), price and total revenue move in the same direction: If the price increases, total revenue also increases. When demand is elastic (greater than1 ), price and total revenue move in opposite directions: If the price increases, total revenue decreases. If demand is unit elastic (exactly equal to 1), total revenue remains constant when the price changes.