Elasticity in Microeconomics

Introduction to Elasticity

Elasticity is a central concept in microeconomics that measures how much the quantity demanded or supplied of a good responds to changes in price, income, or the price of related goods. Understanding elasticity helps businesses and policymakers predict the effects of pricing, taxation, and market changes on total revenues and market outcomes.

Price Elasticity of Demand

Definition and Calculation

• Price Elasticity of Demand is the responsiveness of the quantity demanded of a good to a change in its price.

• It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

• The value is typically negative due to the law of demand, but the sign is often ignored by convention.

Example: If the price of oil increases by 10% and the quantity demanded decreases by 2%, the price elasticity of demand is .

Interpretation of Elasticity Values

• Elastic Demand: Elasticity > 1. Quantity demanded is highly responsive to price changes.

• Inelastic Demand: Elasticity < 1. Quantity demanded is not very responsive to price changes.

• Unit Elastic Demand: Elasticity = 1. Percentage change in quantity demanded equals percentage change in price.

• Perfectly Inelastic Demand: Elasticity = 0. Quantity demanded does not change with price (vertical demand curve).

• Perfectly Elastic Demand: Elasticity approaches infinity. Any price increase drops quantity demanded to zero (horizontal demand curve).

Business Applications

• Businesses use elasticity to predict how changes in price will affect total revenue.

• If demand is elastic, increasing price decreases total revenue; if inelastic, increasing price increases total revenue.

Example: A 1.5% increase in tuition at private colleges led to a 1.9% decrease in freshman enrollments, indicating elastic demand.

Elasticity and Total Revenues

Relationship Between Price, Elasticity, and Revenue

• Total Revenue (TR) is calculated as price times quantity sold ().

• When demand is elastic, price and total revenue move in opposite directions.

• When demand is inelastic, price and total revenue move in the same direction.

• When demand is unit-elastic, total revenue does not change with price.

Determinants of Price Elasticity of Demand

• Availability of Substitutes: More substitutes make demand more elastic.

• Share of Budget: Goods that take a larger share of the consumer’s budget have more elastic demand.

• Time Horizon: Demand is more elastic in the long run as consumers have more time to adjust.

Short Run vs. Long Run: In the short run, consumers cannot fully adjust to price changes, making demand less elastic. In the long run, adjustments are greater, increasing elasticity.

Cross Price and Income Elasticities of Demand

Cross Price Elasticity of Demand

• Measures the responsiveness of demand for one good to changes in the price of another good.

• Substitutes: Positive cross price elasticity (increase in price of X increases demand for Y).

• Complements: Negative cross price elasticity (increase in price of X decreases demand for Y).

Income Elasticity of Demand

• Measures the responsiveness of demand to changes in consumer income.

• Can be positive (normal goods) or negative (inferior goods).

Price Elasticity of Supply

Definition and Calculation

• Price Elasticity of Supply measures the responsiveness of quantity supplied to a change in price.

Classification of Supply Elasticities

• Elastic Supply: Elasticity > 1. Quantity supplied is highly responsive to price changes.

• Inelastic Supply: Elasticity < 1. Quantity supplied is not very responsive to price changes.

• Unit Elastic Supply: Elasticity = 1. Percentage change in quantity supplied equals percentage change in price.

• Perfectly Elastic Supply: Horizontal supply curve; any price decrease drops quantity supplied to zero.

• Perfectly Inelastic Supply: Vertical supply curve; quantity supplied does not change with price.

Time and Supply Elasticity

• The longer the time period for adjustment, the more elastic the supply.

• In the short run, firms cannot fully adjust production; in the long run, they can enter or exit the market, making supply more elastic.

Applications and Policy Examples

• Tax Incidence: When demand is highly elastic, consumers bear less of a per-unit tax, and producers bear more.

• Philadelphia Soft Drinks Tax: A 35% price increase led to a 45% decline in purchases, indicating elastic demand (elasticity = 1.3).

• Airline Ticket Taxes: A 1% price increase led to an 8% decrease in quantity demanded (elasticity = 8), so higher prices reduce total revenue.

Summary Table: Elasticity Concepts

Practice and Policy Questions

• How should a city set tolls to maximize revenue? In the inelastic portion of the demand curve, since price increases raise total revenue.

• How should MARTA set fares? Estimate elasticity from the demand schedule and recommend pricing where demand is inelastic to maximize revenue.