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Chapter 5: Elasticity and its application (Price elasticity of demand…
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