Microeconomics: Elasticity
Chapter 6: Elasticity - The Responsiveness of Demand and Supply
Key Topics:
- Price Elasticity of Demand and Its Measurement
- Determinants of the Price Elasticity of Demand
- Relationship between Price Elasticity of Demand and Total Revenue
- Other Demand Elasticities
- Using Elasticity to Analyze Economic Issues
- Price Elasticity of Supply and Its Measurement
Introduction to Elasticity
- Elasticity measures how much one economic variable responds to changes in another economic variable.
- Key focus: Price elasticity of demand and supply.
Price Elasticity of Demand
- Definition: Responsiveness of quantity demanded to a change in price.
- Formula: ( \text{Price Elasticity of Demand} = \frac{% \text{ change in quantity demanded}}{% \text{ change in price}} )
- Interpretation:
- Elastic demand: Elasticity > 1 (quantity demanded changes significantly with price changes).
- Inelastic demand: Elasticity < 1 (quantity demanded changes little with price changes).
- Unit-elastic demand: Elasticity = 1.
Calculating Elasticity: The Midpoint Formula
- Midpoint Formula: Avoids direction-dependence in percentage changes.
- Formula: ( \frac{(Q_2 - Q_1) / ((Q_2 + Q_1)/2)}{(P_2 - P_1) / ((P_2 + P_1)/2)} )
- Example: Price drop in Coca-Cola leads to a change in sales.
Determinants of Price Elasticity of Demand
- Availability of Substitutes: More substitutes mean more elastic demand.
- Passage of Time: Elasticity is higher in the long run.
- Luxury vs. Necessity: Luxuries have higher elasticity.
- Market Definition: Narrowly defined markets have more elastic demand.
- Budget Share: Smaller budget items tend to be less elastic.
Relationship Between Price Elasticity and Total Revenue
- Total Revenue: Calculated as price per unit times the number of units sold.
- Impact on Revenue:
- Elastic demand: Price decreases can increase revenue.
- Inelastic demand: Price decreases can reduce revenue.
Other Demand Elasticities
- Cross-Price Elasticity:
- Measures the effect of the price change of one good on the quantity demanded of another.
- Substitutes: Positive elasticity.
- Complements: Negative elasticity.
- Income Elasticity:
- Measures responsiveness of quantity demanded to changes in income.
- Normal goods: Positive elasticity.
- Inferior goods: Negative elasticity.
Price Elasticity of Supply
- Definition: Responsiveness of the quantity supplied to a change in price.
- Formula: ( \frac{% \text{ change in quantity supplied}}{% \text{ change in price}} )
- Determinants:
- Ability and willingness of firms to change production levels.
- Time period: Long-term supply is often more elastic.
Applications and Examples
- Case Studies:
- Soda taxes and their effects on consumption and revenue.
- Amazon and Netflix pricing strategies.
- Elasticity in the agricultural sector and its impact on family farms.
- Oil prices and their instability due to inelastic supply and demand.
Conclusion
Understanding elasticity is crucial for analyzing consumer behavior, making pricing decisions, and understanding market dynamics. Elasticity helps businesses, policymakers, and economists predict changes in demand and supply in response to price changes, thereby forming an essential part of microeconomic study.