Chapter 5: Elasticity and its application

Price elasticity of demand and its determinants

availability of close substitutes: good with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others

necessities versus luxuries: necessities tend to have inelastic demand whereas goods that are luxuries have elastic demands

definition of the market: narrowly defined markets tend to have more elastic demand than broadly defined markets (i.e: market for food and ice- cream)

time horizon: goods tend to have more elastic demand over longer time horizons because people need time to adapt to the change

Price elasticity of demand

Price elasticity of demand = % change in quantity demanded/ % change in price

Demand is elastic when the elasticity is > 1

Demand is inelastic when the elasticity is < 1

Demand is said to have unit elasticity when elasticity = 1

Perfectly inelastic demand: elasticity = 0, demand curve is vertical

Perfectly elastic demand: elasticity = 0, demand curve is horizontal

Total revenue and the price elasticity of demand

Total revenue = Price x Quantity

with an inelastic demand curve, as the price increases, total revenue will increase because fall in quantity demanded is small

with an elastic demand curve, as the price increases, total revenue will decrease because there is a large fall in quantity demanded

Elasticity along a linear demand curve

at points with low price and high quantity, the demand curve is inelastic

at points with high price and low quantity, the demand curve is elastic

The income elasticity of demand

The income elasticity of demand = %change in quantity demanded/ %change in income

Normal goods have positive income elasticity

Inferior goods have negative income elasticity

Necessities tend to have small income elasticity

Luxuries tend to have large income elasticity

The cross- price elasticity of demand

Cross- price elasticity of demand = % change in quantity demanded of good 1/ % change in price of good 2

Substitutes goods have positive elasticity

Complement goods have negative elasticity

The elasticity of supply

Price elasticity of supply = %change in quantity supplied/ % change in price

Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low level of quantity supplied and very low at high level of quantity supplied

Increase in amount of supply while the quantity demanded unchanged causes to decrease in price(i.e: good news for farming be bad news for farmers)

OPEC fail to keep the price of oil high because in the long run, people have time to adapt for the change => the supply and demand curves are inelastic

Drug prohibition reduces the supply of drugs, even as the amount of drug use falls, the total amount paid by drug users rises => the sellers have more motivate to sell the drugs. The best way to reduce the amount of drugs is through education