Elasticity in Economics

Elasticity

• Elasticity measures responsiveness of quantity demanded or quantity supplied to a change in one of their determinants (price, income etc.).
• Price Elasticity of Demand (Ed) measures how much the quantity demanded of a good responds to a change in the price of that good.
  • Formula: Ed = % change in Qd / % change in P
  • Interpretation: A value of Ed = 2 indicates that for each 1% change in the price of the good, we expect a 2% change in the quantity demanded.
• Classifying Ed:
  • Ed < 1 is inelastic – consumers are NOT responsive to price changes.
  • Ed > 1 is elastic – consumers are responsive to price changes.
  • Ed = 1 is unit elastic – balances between inelastic and elastic.
  • Ed = 0 is perfectly inelastic – quantity demanded does not change regardless of price changes.
  • Ed = infinity is perfectly elastic – any price increase results in zero quantity demanded.
• Calculating Ed using the Midpoint Method:
  • Formula: Ed = [(Qd2–Qd1) / ((Qd2+Qd1)/2)] / [(P2–P1) / ((P2+P1)/2)]
  • This method calculates the elasticity between two points on a demand curve, providing the same answer regardless of the starting point.
• Determinants of Ed:
  • Availability of Substitutes: More available substitutes lead to higher Ed.
  • Time Horizon: Ed tends to be more elastic over longer time periods as consumers have more time to adjust.
  • Definition or Scope of the Market: Narrower market definitions tend to have higher Ed, as more substitutes are available within the narrower scope.
  • Necessity or Luxury: Necessities have low Ed, while luxuries have higher Ed.

Other Demand Elasticities

• Income Elasticity of Demand measures how quantity demanded changes relative to a change in consumer income.
  • Formula: Income Elasticity = % change in Qd / % change in income
  • Normal Goods: Positive income elasticity – quantity demanded increases with increasing income.
  • Inferior Goods: Negative income elasticity – quantity demanded decreases with increasing income.
• Cross Price Elasticity measures the change in quantity demanded of one good (X) relative to the change in the price of another related good (Y).
  • Formula: Cross Price Elasticity = % change Qd_X / % change P_Y
  • Complements: Negative cross price elasticity – an increase in the price of one good leads to a decrease in the demand for the other.
  • Substitutes: Positive cross price elasticity – an increase in the price of one good leads to an increase in the demand for the other.

Elasticity of Supply

• Elasticity of Supply (Es) measures the responsiveness of producers to a change in the price of their product.
  • Formula: Es = % change in Qs / % change in P
  • Es tends to be larger in industries with less specialized inputs and longer time horizons.

Applications of Elasticity

• Elasticity of Demand and Total Revenue:
  • Ed > 1 (elastic) – Reducing price increases total revenue.
  • Ed < 1 (inelastic) – Increasing price increases total revenue.
  • Total revenue is maximized when Ed = 1.
• Elasticity and Trade: Elasticity helps understand the impact of taxes or trade barriers on firms and consumers.
  • Industries with inelastic demand are more likely to pass on the cost of taxes to consumers.
  • Industries with elastic demand are less likely to pass on the cost of taxes, as consumers have more options to switch to substitutes.

This quiz focuses on the concept of elasticity in economics, specifically price elasticity of demand. It explores how the quantity demanded responds to changes in price and includes various classifications of elasticity. Test your understanding of the calculations and interpretations of elasticity values.