Chapter 5 - Elasticities of Demand and Supply

Income elasticity of demand

A measure of the responsiveness of the demand for a good to a change in income when other things remain the same. Income elasticity of demand = Percentage change in quantity demanded / Percentage change in income The income elasticity of demand falls into three ranges: • Greater than 1 (normal good, income elastic) • Between zero and 1 (normal good, income inelastic) • Less than zero (inferior good) As our incomes increase: items that have • An income elastic demand take an increasing share of income • An income inelastic demand take a decreasing share of income • A negative income elasticity of demand take an absolutely smaller amount of income.

Price elasticity demand

A measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers' plans remain the same.

Computing the Price Elasticity of Demand

To determine whether the demand for a good is elastic, unit elastic, or inelastic, we compute a numerical value for the price elasticity of demand by using the following formula: Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price • If the price elasticity of demand is greater than 1, demand is elastic. • If the price elasticity of demand equals 1, demand is unit elastic. • If the price elasticity of demand is less than 1, demand is inelastic.

Elastic demand

When the percentage change in the quantity demanded exceeds the percentage change in price. Being elastic, the good has plenty of convenient substitutes (such as other brands of latte) and takes only a small proportion of buyers' incomes.

Influences on the Price Elasticity of Demand

• Availability of substitutes • Proportion of income spent

3 Define the cross elasticity of demand and the income elasticity of demand, and explain the factors that influence them.

• Cross elasticity of demand shows how the demand for a good changes when the price of one of its substitutes or complements changes. • Cross elasticity is positive for substitutes and negative for complements. • Income elasticity of demand shows how the demand for a good changes when income changes. For a normal good, the income elasticity of demand is positive. For an inferior good, the income elasticity of demand is negative.

The relationship between the price elasticity of demand and total revenue

• If price and total revenue change in opposite directions, demand is elastic. • If a price change leaves total revenue unchanged, demand is unit elastic. • If price and total revenue change in the same direction, demand is inelastic.

Influences on the Price Elasticity of Supply

• Production possibilities • Storage possibilities

1 Define the price elasticity of demand, and explain the factors that influence it and how to calculate it.

• The demand for a good is elastic if, when its price changes, the percentage change in the quantity demanded exceeds the percentage change in price. • The demand for a good is inelastic if, when its price changes, the percentage change in the quantity demanded is less than the percentage change in price. • The price elasticity of demand for a good depends on how easy it is to find substitutes for the good and on the proportion of income spent on it. • Price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price. • If demand is elastic, a rise in price leads to a decrease in total revenue. If demand is unit elastic, a rise in price leaves total revenue unchanged. And if demand is inelastic, a rise in price leads to an increase in total revenue.

Price elasticity of supply

A measure of the responsiveness of the quantity supplied of a good to a change in its price when all other influences on sellers' plans remain the same.

Total revenue test

A method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (with all other influences on the quantity sold remaining unchanged).

The Midpoint Method

In this formula, the numerator, (New price − Initial price), is the same as before. The denominator, (New price + Initial price) ÷ 2, is the average of the new price and the initial price. Because the average price is the same regardless of whether the price rises or falls, the percentage change in price calculated by the midpoint method is the same (absolute value or magnitude) for a price rise and a price fall.

Total revenue

The amount spent on a good and received by its seller and equals the price of the good multiplied by the quantity sold. For example, suppose that the price of a Starbucks latte is $3 and that 15 cups an hour are sold. Then total revenue is $3 a cup multiplied by 15 cups an hour, which equals $45 an hour.

Percentage Change in Price

The change in price is the new price minus the initial price. The percentage change is calculated as the change in price divided by the initial price, all multiplied by 100. The formula for the percentage change is Percentage change in price = new price - initial price / initial price X 100

Inelastic demand

When the percentage change in the quantity demanded is less than the percentage change in price. Being inelastic, the good does NOT have convenient substitutes (such as other products for gasonline)

Perfectly inelastic demand

When the percentage change in the quantity demanded is zero for any percentage change in the price.

Unit elastic supply

When the percentage change in the quantity supplied equals the percentage change in price.

Elastic supply

When the percentage change in the quantity supplied exceeds the percentage change in price.

Inelastic supply

When the percentage change in the quantity supplied is less than the percentage change in price.

Perfectly inelastic supply

When the percentage change in the quantity supplied is zero for any percentage change in the price.

Perfectly elastic demand

When the quantity demanded changes by a very large percentage in response to an almost zero percentage change in price.

Perfectly elastic supply

When the quantity supplied changes by a very large percentage in response to an almost zero percentage change in price.

Cross elasticity of demand

A measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement when other things remain the same. Cross elasticity of demand = Percentage change in quantity demanded of a good / Percentage change in price of one of its substitutes or complements

Computing the Price Elasticity of Supply

Price elasticity of supply = Percentage change in quantity supplied / Percentage change in price • If the price elasticity of supply is greater than 1, supply is elastic. • If the price elasticity of supply equals 1, supply is unit elastic. • If the price elasticity of supply is less than 1, supply is inelastic.

Unit elastic demand

When the percentage change in the quantity demanded equals the percentage change in price.

2 Define the price elasticity of supply, and explain the factors that influence it and how to calculate it.

• The supply of a good is elastic if, when its price changes, the percentage change in the quantity supplied exceeds the percentage change in price. • The supply of a good is inelastic if, when its price changes, the percentage change in the quantity supplied is less than the percentage change in price. • The main influences on the price elasticity of supply are the flexibility of production possibilities and storage possibilities.

Elastic of Demand Possibilities

• When the percentage change in the quantity demanded exceeds the percentage change in price, demand is elastic. • When the percentage change in the quantity demanded equals the percentage change in price, demand is unit elastic. • When the percentage change in the quantity demanded is less than the percentage change in price, demand is inelastic.