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Chapter 6: Elasticity

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ElasticityA measure of the responsiveness of one

variable (usually quantity demanded or

supplied) to a change in anothervariable

Most commonly used elasticity: price

elasticity of demand, defined as:

Price elasticity of demand =

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Price elasticity of demand Demand is said to be:

elastic when Ed > 1,

unit elastic when Ed = 1, and

inelastic when Ed < 1.

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Perfectly elastic demand

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Perfectly inelastic demand

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Elasticity & slope a price increase from $1 to $2 represents a 100%

increase in price,

a price increase from $2 to $3 represents a 50%increase in price,

a price increase from $3 to $4 represents a 33%increase in price, and

a price increase from $10 to $11 represents a 10%increase in price.

Notice that, even though the price increases by $1 ineach case, the percentage change in price becomessmaller when the starting value is larger.

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Elasticity along a linear demand

curve

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Elasticity along a linear

demand curve

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Arc elasticity measure

where:

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Example Suppose that quantity demanded falls from

60 to 40 when the price rises from $3 to $5.

The arc elasticity measure is given by:

In this interval, demand is inelastic (since elasticity < 1).

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Elasticity and total revenue Total revenue = price x quantity

What happens to total revenue if theprice rises?

Price elasticity of demand =

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Elasticity and TR (cont.)

A reduction in price will lead to:

an increase in TR when demand is elastic. a decrease in TR when demand is inelastic.

an unchanged level of total revenue when

demand is unit elastic.

Price elasticity of demand =

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Elasticity and TR (cont.)

In a similar manner, an increase in price will

lead to: a decrease in TR when demand is elastic.

an increase in TR when demand is inelastic.

an unchanged level of total revenue when demand

is unit elastic.

Price elasticity of demand =

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Price discrimination different customers are charged

different prices for the same product,

due to differences in price elasticity ofdemand

higher prices for those customers whohave the most inelastic demand

lower prices for those customers whohave a more elastic demand.

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Price discrimination (cont.) customers who are willing to pay the

highest prices are charged a high price,

and customers who are more sensitive to

price differentials are charged a low

price.

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Determinants of price

elasticityPrice elasticity is relatively high when:

close substitutes are available,

the good or service is a large share ofthe consumer's budget, and

a longer time period is considered.

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Cross-price elasticity of

demand The cross-price elasticity of demand

between two goods jand kis defined

as:

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Cross-price elasticity (cont.)

cross-price elasticity is positive if and

only if the goods are substitutes cross-price elasticity is negative if and

only if the goods are complements.

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Income elasticity of demand

A good is a normal good if incomeelasticity > 0.

A good is an inferior good if incomeelasticity < 0.

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Income elasticity of demand

A good is a luxury good if incomeelasticity > 1.

A good is a necessity good if incomeelasticity < 1.

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Price elasticity of supply

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Perfectly inelastic supply

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Perfectly elastic supply

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Determinants of supply

elasticity short run- period of time in which

capital is fixed

all inputs are variable in the long run

supply will be more elastic in the longrun than in the short run since firms

can expand or contract their capital inthe long run.

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