Elasticity in Microeconomics

Introduction to Elasticity

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

• Price Elasticity of Demand: Responsiveness of quantity demanded to price changes.

• Income Elasticity of Demand: Responsiveness of quantity demanded to changes in consumer income.

• Cross Elasticity of Demand: Responsiveness of quantity demanded to changes in the price of substitutes or complements.

• Elasticity of Supply: Responsiveness of quantity supplied to price changes.

Price Elasticity of Demand

Definition and Calculation

The price elasticity of demand is a units-free measure of how much the quantity demanded of a good changes in response to a change in its price, holding all other factors constant.

• Formula:

• To calculate, use the average price and average quantity between the initial and new values.

Example Calculation

• Initial price of pizza: $20.50; Quantity demanded: 9 pizzas/hour.

• New price: $19.50; New quantity demanded: 11 pizzas/hour.

• Average price: $20; Average quantity: 10 pizzas.

• Percentage change in quantity:

• Percentage change in price:

• Elasticity:

Properties of Elasticity

• Units-Free: Elasticity is a ratio of percentages, so it does not depend on the units of measurement.

• Absolute Value: The formula yields a negative value (due to the law of demand), but the magnitude (absolute value) is used for interpretation.

Types of Price Elasticity of Demand

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

• Unit Elastic Demand: Elasticity = 1; percentage change in quantity equals percentage change in price (curved demand curve).

• Inelastic Demand: Elasticity < 1; quantity demanded changes less than price.

• Elastic Demand: Elasticity > 1; quantity demanded changes more than price.

• Perfectly Elastic Demand: Elasticity = ∞; quantity demanded changes infinitely with a tiny price change (horizontal demand curve).

Factors Influencing Price Elasticity of Demand

• Closeness of Substitutes: More substitutes make demand more elastic. Necessities (few substitutes) are inelastic; luxuries (many substitutes) are 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.

Elasticity Along a Linear Demand Curve

• Elasticity varies along a straight-line demand curve.

• At the midpoint: unit elastic.

• Above midpoint: elastic.

• Below midpoint: inelastic.

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 elasticity:

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

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

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

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.

Your Expenditure and Elasticity

• If your demand is elastic, a price cut increases your expenditure.

• If your demand is inelastic, a price cut decreases your expenditure.

• If your demand is unit elastic, your expenditure does not change.

More Elasticities of Demand

Income Elasticity of Demand

The income elasticity of demand measures how quantity demanded responds to changes in income.

• Formula:

• If elasticity > 1: demand is income elastic (normal good).

• If 0 < elasticity < 1: demand is income inelastic (normal good).

• If elasticity < 0: the good is inferior.

Cross Elasticity of Demand

The cross elasticity of demand measures how quantity demanded of one good responds to changes in the price of another good (substitute or complement).

• Formula:

• For substitutes: cross elasticity is positive.

• For complements: cross elasticity is negative.

Elasticity of Supply

Definition and Calculation

The elasticity of supply measures the responsiveness of quantity supplied to changes in price, holding other factors constant.

• Formula:

Types of Elasticity of Supply

• Perfectly Inelastic Supply: Elasticity = 0; supply curve is vertical.

• Unit Elastic Supply: Elasticity = 1; supply curve passes through the origin.

• Perfectly Elastic Supply: Elasticity = ∞; supply curve is horizontal.

Factors Influencing Elasticity of Supply

• Resource Substitution Possibilities: Easier substitution among resources increases elasticity.

• Time Frame for Supply Decision:

  • Momentary supply: perfectly inelastic.

  • Short-run supply: somewhat elastic.

  • Long-run supply: most elastic.

Glossary of Elasticity Measures

Additional info: The notes are based on textbook slides from Michael Parkin's 'Economics', 14th Edition, covering Chapter 4: Elasticity, which is a core topic in college-level microeconomics.