Elasticity in Microeconomics

Introduction to Elasticity

Elasticity is a fundamental concept in microeconomics that measures how responsive one variable is to changes in another variable. In the context of markets, elasticity helps us understand how quantity demanded or supplied responds to changes in price, income, or the price of related goods.

• Price Elasticity of Demand: Measures how much the quantity demanded of a good responds to a change in its price.

• Income Elasticity of Demand: Measures how much the quantity demanded of a good responds to a change in consumer income.

• Cross Elasticity of Demand: Measures how much the quantity demanded of one good responds to a change in the price of another good.

• Elasticity of Supply: Measures how much the quantity supplied of a good responds to a change in its price.

Price Elasticity of Demand

Definition and Calculation

The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price, holding all other influences constant.

• Formula:

• To avoid issues with units, elasticity is calculated using percentage changes based on the average of the initial and new values (the midpoint method).

Calculating Percentage Changes

• Percentage change in quantity demanded:

• Percentage change in price:

Interpreting Elasticity Values

• Elastic Demand (): Quantity demanded changes by a greater percentage than price.

• Inelastic Demand (): Quantity demanded changes by a smaller percentage than price.

• Unit Elastic Demand (): Quantity demanded changes by the same percentage as price.

• Perfectly Inelastic Demand (): Quantity demanded does not change as price changes (vertical demand curve).

• Perfectly Elastic Demand (): Any small change in price leads to an infinite change in quantity demanded (horizontal demand curve).

Graphical Representation

• A steep demand curve indicates inelastic demand.

• A flat demand curve indicates elastic demand.

• Elasticity varies along a linear demand curve: above the midpoint, demand is elastic; below, it is inelastic; at the midpoint, it is unit elastic.

Factors Influencing Price Elasticity of Demand

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

• Proportion of Income Spent: Goods that take a larger share of income have more elastic demand.

• Time Elapsed Since Price Change: Demand becomes more elastic over time as consumers adjust.

Examples

• Necessities (e.g., food, housing): Generally inelastic demand.

• Luxuries (e.g., exotic vacations): Generally elastic demand.

Total Revenue and Elasticity

Total revenue is the product of price and quantity sold. The effect of a price change on total revenue depends on the elasticity of demand:

• If demand is elastic, a price decrease increases total revenue.

• If demand is inelastic, a price decrease decreases total revenue.

• If demand is unit elastic, total revenue remains unchanged when price changes.

Total Revenue Test

• If a price cut increases total revenue, demand is elastic.

• If a price cut decreases total revenue, demand is inelastic.

• If a price cut leaves total revenue unchanged, demand is unit elastic.

Income Elasticity of Demand

Definition and Calculation

The income elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in income, holding other factors constant.

• If income elasticity > 1: Demand is income elastic; the good is a normal good (luxury).

• If 0 < income elasticity < 1: Demand is income inelastic; the good is a normal good (necessity).

• If income elasticity < 0: The good is an inferior good.

Cross Elasticity of Demand

Definition and Calculation

The cross elasticity of demand measures the responsiveness of the demand for a good to a change in the price of a substitute or complement, holding other factors constant.

• If cross elasticity > 0: The goods are substitutes.

• If cross elasticity < 0: The goods are complements.

Elasticity of Supply

Definition and Calculation

The elasticity of supply measures the responsiveness of the quantity supplied of a good to a change in its price, holding all other influences constant.

Types of Supply Elasticity

• Perfectly Inelastic Supply (): Quantity supplied does not change as price changes (vertical supply curve).

• Unit Elastic Supply (): Quantity supplied changes by the same percentage as price (linear supply curve through the origin).

• Perfectly Elastic Supply (): Any small change in price leads to an infinite change in quantity supplied (horizontal supply curve).

Factors Influencing Elasticity of Supply

• Resource Substitution Possibilities: The easier it is to substitute among resources, the greater the elasticity of supply.

• Time Frame for Supply Decision:

  • Momentary supply: Perfectly inelastic immediately after a price change.

  • Short-run supply: Somewhat elastic.

  • Long-run supply: Most elastic.

Glossary of Elasticities