Chapter 5: Elasticity
Elasticity is a measure of how much buyers and sellers respond to changes in market conditions.
Types of Price Elasticity
- Factors that affect how people respond to different changes in price of a good.
o Large number of substitutes?
o Is it a luxury or a necessity?
o How narrowly defined is the market
o What about the time?
- Quantity demand (Qd) does not
respond strongly to price changes
- Steep demand curve
- % change in Qd < % change in P
- Ep < 1
- Example: textbooks.
- Quantity demanded (Qd) responds
strongly to price changes.
- Flat demand curve
- % change in Qd > % change in P
- Ep > 1
Perfectly Inelastic Demand
- Qd does not respond to price
changes at all.
- Demand curve is vertical
- Ep = 0
- Example: prescription heart
Perfectly Elastic Demand
- Qd changes infinitely with an change
- Ep = infinity
- Demand curve is horizontal
- Example: supplier raises price of
wheat; you go get it somewhere else Unit Elastic
- Qd changes by same percentage as price
- Ep = 1
- Demand curve is non-linear
- Example: none really exist.
Ep Demand Curve Example
Inelastic <1 Steep Textbooks
Elastic >1 Flat Most products
Perfectly Inelastic = 0 Vertical Heart medication
Perfectly Elastic = infinity Horizontal Wheat prices
Unit Elastic = 1 Non-linear None exist
Midpoint Formula (preferable):
Ep = ((Q2 – Q1) / ([Q2+Q1]/2)) / ((P2 – P1) / ([P2 + P1]/2))
Generalities about Elasticities and Their Determinants
1. Necessities tend to have inelastic demand
a. Ex. Insulin and dentist office visits
2. Luxuries tend to have elastic demand
a. Plasma TVs, vacations
3. Goods that have close substitutes have elastic demand
a. Coke and Pepsi
4. Goods tend to have more elastic demand over longer time horizons
a. You can find substitutes in the long run where you can’t in the short run.
5. How you define the market makes a difference
a. Food is inelastic, vegetables are more elastic, broccoli is even more elastic
b. The more narrowly defined the market is, the more elastic the demand is
6. How much of your budget you spend on a good determines elasticity.
a. Large proportion of budget on a good Elastic demand (ex. Car)
b. Small proportion of budget on a good Inelastic (ex. Coffee)
Elasticity is not constant along a linear demand curve. It is not equivalent to slope. Slope measures rates
of change, while elasticity measures percentage changes. Price Elasticity and Total Revenue
Total revenue (TR) = P*Q
Inelastic If you raise price, TR increases when
customers will stay price increases
Elastic If you lower prices, TR increases when
new customers will price decreases
Unit Elastic Changes in price will TR will be maximum
not affect revenue when Ep = 1
(TR area is square)
Income Elasticity of Demand
Income elasticity of demand measures how much the quantity demanded of a good responds to a
change in consumers’ income.
It is denoted Ei.
If given percent changes in income and corresponding changes in quantity demanded (Qd):
If given 2 levels of income and their corresponding Qd’s: