Chapter 6 - Elasticity

Price Elasticity is similar to slope of the demand or supply curve. Is it more flat or vertical?, or how
flexible is quantity when price changes?, does it change a little or a lot?

Price Elasticity - how much supply or demand Quantity (Q) changes in reaction to Price (P) changes
ES/D = (% change in Q) = )Q/Q
(% change in P)
)P/P

[where Greek letter delta ) = change]

For demand elasticity ED - absolute value |E| used since a negative ratio.
More Elastic - quantity is more sensitive, or changes more, for an identical price change.
E=0
E<1
E=1
E>1
E=4

Perfect Inelasticity (vertical), quantity demanded/supplied is constant at all prices

Inelastic (little change in quantity when price changes)
Unit Elasticity
Elastic (large change in quantity when price changes)
Perfect Elasticity (horizontal or flat), any price change results in zero or an infinite quantity
demanded/supplied

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Demand Elasticity Determinants:

! Substitutability - if many close substitutes exist, then high elasticity
E.g. 1.) Same model cars with many different colors available for sale (very close substitutes)
E.g. 2.) Bud vs Miller beer at bar, Granny Smith versus Golden Delicious apples at grocery story
E.g. 3.) Two gas stations selling gas across street, if one raises price, many then buy from other
E.g. 4.) Electricity - Low demand elasticity since few close substitutes
! Necessities versus Luxuries - lower for former, need to have despite price
E.g. 1.) Medical services - Low Elasticity (or Inelastic)
E.g. 2.) Addictive drugs - Low Elasticity (or Inelastic)
E.g. 3.) Food at home - Low Elasticity (or Inelastic)
E.g. 4.) Restaurant meals - High Elasticity

Time - Longer market time periods have higher supply and demand price elasticities, shorter time
periods are more inelastic. [Quantity supplied or demanded is for a certain time period ...
could be day, week, month, year; for longer time periods, supply and demand are more elastic.]
Why? - More substitutes to consume/produce over longer time periods, so more elastic.
E.g. Demand - Home heating oil prices rise (fall),
short-run: few alternatives of which to consume more (or less);
long-run: switch to gas or electric heat (or oil for those using gas or electric), replace furnace.
E.g. Supply - Milk prices rise (fall) for dairy farmers,
short-run: higher production limited by herd size (few alternatives to otherwise produce);
long-run: breed more dairy cows (switch to pig production)
E.g. Supply - Gold prices rise (fall),
short-run: higher production capacity limited by existing mines (no alternative production with
existing capital);
long-run: explore, open new mines (switch to silver or oil production)
E.g. Supply - Residential Housing prices rise (fall),
short-run: supply fixed, cannot build new houses in a week (or switch production to building
office buildings); [if demand rises and supply is vertical, in short-run prices spike.]
long-run: build new houses, profitability attracts new construction companies (switch to
produce office buildings instead of housing)

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Total Revenue Test:

Total Revenue (TR) = PxQ or Price (P) times Quantity (Q)
!
!

If Inelastic Demand - P and TR change in same direction: P[ Y TR[

If Elastic Demand - P and TR change in opposite direction: P[ Y TR\

OTHER ELASTICITIES:

(Aside, literally) Proof:

Total Revenue = PQ so )(PQ) = Q( )P) + P( )Q)
If Inelastic, | ( )Q/Q) / ( )P/P) | < 1.
If ( )P/P) > 0, then ( )Q/Q) < 0 (i.e. Demand is
downwardly sloping)
so - 1 < ( )Q/Q) / ( )P/P) [< 0]
so - Q )P < P )Q (multiply by Q )P > 0)
so 0 < P )Q + Q )P (add Q )P)
so Total Revenue rises when )P > 0 and
Demand is Inelastic #
Similarly ..
If Elastic, | ( )Q/Q) / ( )P/P) | > 1.
so ( )Q/Q) / ( )P/P) < - 1
so P )Q < - Q )P (multiply by Q )P > 0)
so P )Q + Q )P < 0 (add Q )P)
so Total Revenue falls when )P > 0 and
Demand is Elastic #

Income Elasticity = (% Change in Quantity Demanded)/(% Change in Income)

If >
<
>
<

0 Normal Good (+ positive) Income rises, more purchased at same price.

0 Inferior Good (- negative) Income rises, less purchased at same price.
1 Luxury Good (demand is very sensitive to income, e.g. consumer durables cars, furniture)
1 Necessity

Cross-Price Elasticity = (% Change in Quantity Demanded)/(% Change in Price of other Good)

EA/B = (% change in QA) = )QA/QA
(% change in PB)
)PB/PB
Defines if Substitutes (+) or Complements (-) if Positive or Negative Sign
If EAB > 0 (+), A and B are Substitutes, Price of one rises, consumers buy more of other.
If EAB = 0
A and B are Independent Goods
If EAB < 0 (-), A and B are Complements, Price of one rises, consumers buy less of other.

Applications:
!

Large/Low Crop Yields - If a certain food has an Inelastic Demand, a low (high) yield or Quantity
produced drives up (down) Price and Total Revenue (PxQ) for market sellers for a small change in
supply. [This is an application of the Total Revenue Test]
(Ironic, a drought can make farmers better off, a bumper crop can make farmers worse off.)
Commodity spot and futures markets for inelastically demanded items such as orange juice and
coffee react quickly with a price spike to a freeze killing crops in anticipation of result on price.

Taxes - taxes on elastically demanded items have a large impact quantity demanded and tax increases
may raise little additional revenue for elastically taxed items, e.g. cigarettes near a state border since
substitutes exist (buy over border), a doubling of tax rates will less than double tax revenues since less
is purchased at higher after tax cost and tax revenue can even fall with higher tax rates. (And aside
this can cause more allocative inefficiency MC MB relative to low elastic goods taxed.)