UNIT 8: Elasticity Lecture Notes

Overview of Elasticity

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. It allows economists to analyze supply and demand with greater precision.

Key Concepts

• Price Elasticity of Demand (PED): Measures how much quantity demanded responds to a change in price.

  • Formula: PED = % change in quantity demanded / % change in price.
  • Interpretations:
    • If PED > 1, demand is elastic.
    • If PED < 1, demand is inelastic.
    • If PED = 1, demand is unit elastic.

• Price Elasticity of Supply (PES): Measures how much quantity supplied responds to a change in price.

  • Formula: PES = % change in quantity supplied / % change in price.
  • Interpretations:
    • If PES > 1, supply is elastic.
    • If PES < 1, supply is inelastic.
    • If PES = 1, supply is unit elastic.

• Income Elasticity of Demand: Measures how the quantity demanded changes as consumer income changes.

  • Formula: Income Elasticity = % change in quantity demanded / % change in income.
  • Interpretations:
    • Positive elasticity indicates a normal good.
    • Negative elasticity indicates an inferior good.

• Cross-price Elasticity of Demand: Measures the response in quantity demanded of a good to a change in the price of another good.

  • Formula: Cross-price Elasticity = % change in quantity demanded of Good A / % change in price of Good B.
  • Interpretations:
    • Positive cross-price elasticity indicates substitute goods.
    • Negative cross-price elasticity indicates complementary goods.

Factors Influencing Elasticity

• Availability of Substitutes: More substitutes make demand more elastic.
• Necessity vs. Luxury: Necessities tend to have inelastic demand, while luxuries have more elastic demand.
• Time Horizon: Elasticity can vary over time; demand is usually more elastic in the long run.
• Definition of the Market: Narrowly defined markets tend to have more elastic demand.

Elasticity and Total Revenue

• Revenue Implications: Understanding elasticity helps predict how changes in price affect total revenue.
  • Elastic Demand: A price increase leads to a decrease in total revenue.
  • Inelastic Demand: A price increase leads to an increase in total revenue.

Applications of Elasticity

• Policy Making: Helps in understanding the impact of taxes, subsidies, and price controls.
• Business Strategy: Assists companies in setting pricing policies and making strategic decisions.

Conclusion

Elasticity is a crucial concept in economics that provides insights into how various factors affect supply and demand. Understanding elasticity helps in making informed decisions in both public and private sectors.