Economics Chapter: Price Elasticity of Demand

Essential Foundations of Economics

• This is the ninth edition of the textbook.
• Authors are Bade and Parkin.

Price Elasticity of Demand

• Price elasticity of demand measures how quantity demanded changes when price changes.
• To calculate, compare percentage change in quantity demanded with percentage change in price.
• The midpoint method averages the initial and new prices to calculate percentage change, eliminating directional bias.
• A rise in price leads to a decrease in quantity demanded, and vice-versa.
• Demand is elastic if quantity demanded changes more than the price.
• Demand is unit elastic if quantity demanded changes exactly as much as the price.
• Demand is inelastic if quantity demanded changes less than the price.
• Perfectly elastic demand means quantity demanded changes drastically with a slight price change.
• Perfectly inelastic demand means quantity demanded remains constant despite price changes.
• Availability of substitutes, income spent, and time elapsed influence demand elasticity.
• Luxury goods have elastic demand, while necessities have inelastic demand. Narrowly defined goods have elastic demand, broadly defined goods have inelastic demand.

Calculating Elasticity

• Price elasticity of demand = Percentage change in quantity demanded ÷ Percentage change in price (Formula)

Total Revenue

• Total revenue is the product of price times quantity.
• Elasticity affects total revenue:
  • Elastic demand: Price increase leads to total revenue decrease.
  • Inelastic demand: Price increase leads to total revenue increase.
  • Unit elastic demand: Price change has no impact on total revenue.
• Total revenue tests observe revenue changes corresponding to price changes.

Applications

• Orange prices and total revenue: When supply decreases (due to a frost) and demand remains the same, price elasticity is 0.4; inelastic demand causes farmer's total revenue to increase.
• Addiction and elasticity: Demand for addictive substances has different types of elasticities.
  • Non-users have elastic demand (a price in crease leads to reduced use).
  • Existing users demand is inelastic ( a price increase has a modest effect in lowering use)
• High taxes on cigarettes and alcohol reduce young adult use; established users' consumption is less impacted.

Price Elasticity of Supply

• Measures the extent to which quantity supplied changes when price changes.
• Perfectly elastic supply: A small price change leads to a huge change in quantity supplied.
• Elastic supply: Quantity supplied changes more than the price.
• Unit elastic supply: Quantity supplied changes proportionally to the price.
• Inelastic supply: Quantity supplied changes less than the price.
• Perfectly inelastic supply: Quantity supplied doesn't change at all despite price.

Calculating Supply Elasticity

• Price elasticity of supply = Percentage change in quantity supplied ÷ Percentage change in price (Formula)

Influences on Supply Elasticity

• Production possibilities
• Storage possibilities
• Time
• Production possibilities: goods made at a constant opportunity cost have elastic supply, while those with a fixed quantity supplied have inelastic supplies
• Storage possibilities: Goods that can be stored easily have elastic supply.

Cross Elasticity of Demand

• Measures how demand for one good changes when the price of a related good changes.
• Substitute goods: Positive cross elasticity (price of one good goes up => less demand for substitute)
• Complementary goods: Negative cross elasticity (price of one good goes up => less demand for complementary good)

Income Elasticity of Demand

• Measures how demand for a good changes when income changes.
• Normal goods: Positive income elasticity (income goes up => more demand)
• Inferior goods: Negative income elasticity (income goes up => less demand)

EYE on Elasticity at the Coffee Shop

• People's responses to a price increase of a good like a latte depend on:
• Availability of good substitutes
• Extent to which good is a necessity
• Elasticity depends on the level of substitutes available.
• For goods with many substitutes, it's likely that price elasticity of demand is elastic.