Bryan Becher2/3/10EC 111

Chapter 5: Elasticity of Demand and Supply

- In a market economy, prices tell producers and consumers about the relative scarcity of products and resources- A firm’s success or failure often depends on how much it knows about the demand for its product- The

price elasticity of demand

measures, in a standardized way, how responsive consumersare to a change in price- Measures the percentage change in quantity demanded divided by the percentagechange in price- = Percentage change in quantity demanded / Percentage change in price-

Price elasticity formula

– Percentage change in quantity demanded divided by the percentagechange in price; the average quantity and the average price are used as bases for computing percentage changes in quantity and in price- E

D

= (Δq / ((q + q

1

) / 2)) / (Δp / ((p + p

1

) / 2))- Elasticity expresses a relationship between two amounts: the percentage change in quantitydemanded and the percentage change in price- In the elasticity formula, the numerator and the denominator have opposite signs, leaving the price elasticity of demand with a negative sign-

Inelastic demand

– A change in price has relatively little effect on quantity demanded; the percentage change in quantity demanded is less than the percentage change in price; the resulting price elasticity has an absolute value less than 1.0-

Unit-elastic demand

– The percentage change in quantity demanded equals the percentagechange in price; the resulting price elasticity has an absolute value of 1.0-

Elastic demand

– A change in price has a relatively large effect on quantity demanded; the percentage change in quantity demanded exceeds the percentage change in price; the resulting price elasticity has an absolute value exceeding 1.0- Knowledge of price elasticity of demand is especially valuable to producers- Indicates the effect of a price change on total revenue-

Total revenue (TR)

– Price multiplied by the quantity demanded at that price- TR = p x q- If the positive effect of a greater quantity demanded more than offsets the negativeeffect of a lower price, then total revenue rises- If demand is elastic, the percentage increase in quantity demanded exceeds the percentage decrease in price, so total revenue increases- If demand is unit elastic, the percentage increase in quantity demanded just equals the percentage decrease in price, so total revenue remains unchanged- If demand is inelastic, the percentage increase in quantity demanded is more than offset by the percentage decrease in price, so total revenue decrease-

Linear demand curve

– A straight-line demand curve; such a demand curve has a constantslope but usually has a varying price elasticity- A given decrease in price always causes the same unit increase in quantity demanded- If the demand curve is linear, consumers are more responsive to a given price change when theinitial price is high than when it’s low- Demand becomes less elastic as one moves down the curve- A point halfway down the linear demand curve divides a linear demand curve into an elasticupper half and an inelastic lower half

Bryan Becher2/3/10EC 111- A price decline increases total revenue if demand is elastic, has no effect on total revenue if demand is unit elastic, and decreases total revenue if demand is inelastic- The slope of a demand curve is not the same as the price elasticity of demand-

Perfectly elastic demand curve

– A horizontal line reflecting a situation in which any priceincrease would reduce quantity demanded to zero; the elasticity has an absolute value of infinity-

Perfectly inelastic demand curve

– A vertical line reflecting a situation in which any pricechange has no effect on the quantity demanded; the elasticity value is zero-

Unit-elastic demand curve

– Everywhere along the demand curve, the percentage change in price causes an equal but offsetting percentage change in quantity demanded, so total revenueremains the same; the elasticity has an absolute value of 1.0-

Constant-elasticity demand curve

– The type of demand that exists when price elasticity isthe same everywhere along the curve; the elasticity value is unchanged- The greater the availability of substitutes and the more similar these substitutes are to the goodin question, the greater that good’s price elasticity of demand- The more narrow the definition, the more substitutes, and, thus, the more elastic the demand- The more important the item is as a share of the consumer’s budget, other things constant thegreater is the income effect of a change in price, so the more price elastic is the demand for theitem- The longer the period of adjustment, the more responsive the change in quantity demanded is toa given change in price- When estimating price elasticity, economists often distinguish between a period during whichconsumers have little time to adjust, the short run, and a period during which consumers canmore fully adjust to a price change, the long run- The price elasticity of demand is greater in the long run because consumers have more time toadjust-

Price elasticity of supply

– A measure of the responsiveness of quantity supplied to a pricechange; the percentage change in quantity supplied divided by the percentage change in price- The percentage change in price and the percentage change in quantity supplied move inthe same direction, so the price elasticity of supply is usually a positive number - E

S

= (Δq / ((q + q

1

) / 2)) / (Δp / ((p + p

1

) / 2))-

Inelastic supply

– A change in price has relatively little effect on quantity supplied; the percentage change in quantity supplied is less than the percentage change in price; the priceelasticity of supply has a value less than 1.0-

Unit-elastic supply

– The percentage change in quantity supplied equals the percentage changein price; the price elasticity of supply equals 1.0-

Elastic supply

– A change in price has a relatively large effect on quantity supplied; the percentage change in quantity supplied exceeds the percentage change in price; the priceelasticity of supply exceeds 1.0- Constant-elasticity supply curves – Supply curves whose elasticity does not change along thecurves-

Perfectly elastic supply curve

– A horizontal line reflecting a situation in which any pricedecrease drops the quantity supplied to zero; the elasticity value is infinity-

Perfectly inelastic supply curve

– A vertical line reflecting a situation in which a price changehas no effect on the quantity supplied; the elasticity value is zero-

Unit-elastic supply curve

– A percentage change in price causes an identical percentagechange in quantity supplied; depicted by a supply curve that is a straight line from the origin; theelasticity value equals 1.0- The elasticity of supply indicates how responsive producers are to a change in price