Microeconomics Chapter 6

Key points

  • Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded—or supplied—divided by the percentage change in price.
  • Elasticity can be described as elastic—or very responsive—unit elastic, or inelastic—not very responsive.
  • Elastic demand or supply curves indicate that the quantity demanded or supplied responds to price changes in a greater than proportional manner.
  • An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied.
  • Unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

What is price elasticity?

Both demand and supply curves show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded,  Qd, or supplied,  Qs, and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.

Elasticities can be usefully divided into three broad categories: elastic, inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. An Inelastic demand or inelastic supply is one in which elasticity is less than one, indicating low responsiveness to price changes. Unitary elasticitiesindicate proportional responsiveness of either demand or supply.

To calculate elasticity, instead of using simple percentage changes in quantity and price, economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity:

Example:

Rules in Elasticity:

Price Elasticity of Demand:

Elastic: If the price elasticity of demand greater than1.

Inelastic: If the price elasticity of demand less than 1.

Unit elastic: I the price elasticity of demand equal 1.

Income Elasticity:

Luxury good: If the income elasticity greater than 1.

Normal good: If the income elasticity greater than 0.

Inferior good: If the income elasticity less than 0.

Cross-price Elasticity:

Goods are substitutes: If the cross-price elasticity greater than 0.

Goods are complements: If the cross-price elasticity less than 0.

 

Factors Affecting the Price Elasticity of Demand

1. Substitutes:

If there is a greater availability of substitutes, then the good is likely to be more elastic. For example, if the price of one soda brand goes up, people can turn to other brands. So, a small change in price is likely to cause a greater fall in quantity demanded.

2. Necessities:

If a good is a necessity, then the demand tends to be inelastic. For example, if the price for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since drinking water is a necessity.

3. Time:

Over time, a good tends to become more elastic because consumers and businesses have more time to find alternatives or substitutes. For example, if the price of gasoline goes up, over time people will adjust for the change, i.e., they may drive less or use public transportation or form carpools.


business | chapter 6 | microeconomic

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