Elasticity: Understanding Responsiveness to Market Changes

Elasticity and Its Application

• Elasticity is a measure of responsiveness to market changes
• It measures the magnitude of effects, not just direction
• Gasoline price increases can be analyzed using elasticity
• Consumers typically buy less of a good when the price increases
• Elasticity measures the responsiveness of quantity demanded to price changes.
• Elastic demand: Quantity demanded responds significantly to price changes
• Inelastic demand: Quantity demanded responds slightly to price changes
• Close substitutes lead to more elastic demand
• Necessities have inelastic demand, luxuries have elastic demand
• The time horizon influences elasticity; long run is usually more elastic.
• The midpoint method calculates percentage changes to avoid base-related biases in elasticity calculations
• The slope of demand curve relates to elasticity (flatter = more elastic, steeper = less elastic)
• Perfectly inelastic demand: quantity demanded remains constant regardless of price (vertical curve)
• Perfectly elastic demand: quantity demanded changes infinitely with small price changes (horizontal curve)

Price Elasticity of Demand

• The law of demand states that a fall in price raises quantity demanded.
• Price elasticity measures responsiveness of quantity demanded to price.
• Elasticity is influenced by availability of substitutes, necessity vs. luxury, and time horizon.
• Availability of close substitutes makes demand more elastic
• Necessities have inelastic demand, while luxuries have elastic demand.

Computing Price Elasticity of Demand

• Calculate as the percentage change in quantity demanded divided by the percentage change in price
• Elasticity values reflect how quantity demanded changes compared to price changes
• Quantity demanded is often negatively correlated with price; percentage will have opposite signs

Total Revenue and Price Elasticity of Demand

• Total revenue is price multiplied by quantity
• Total revenue and price will move in the same direction with inelastic demand
• Total revenue and price will move in opposing directions with elastic demand
• Unit elasticity: Total revenue remains constant despite price changes

Other Demand Elasticities

• Income elasticity of demand measures the responsiveness of quantity demanded to income changes
  • Normal goods (positive elasticity): higher income leads to higher demand
  • Inferior goods (negative elasticity): higher income leads to lower demand
• Cross-price elasticity of demand measures the responsiveness of quantity demanded of one good to change in price of another
• Substitutes (positive elasticity): price increase in one good leads to higher demand in other
• Complements (negative elasticity): price increase in one good leads to lower demand in another

Elasticity of Supply

• Elasticity of supply measures how quantity supplied reacts to price changes
• Factors influencing elasticity include time and firm's ability to adjust production, new firm entry, etc
• Supply is typically more elastic in the long run than the short run, as firms have more time to adjust.
• Perfectly inelastic supply: Quantity supplied remains constant regardless of price (vertical supply curve)
• Perfectly elastic supply: Quantity supplied changes infinitely with small price changes (horizontal supply curve)

Three Applications of Supply, Demand, and Elasticity

• Good news for farmers can lead to lower farm revenue.
• OPEC's attempts to maintain high oil prices were impacted by changing supply and demand conditions.
• Drug interdiction and its impact on crime.

Explore the concept of elasticity and its applications in economics. Learn how elasticity measures responsiveness to market changes, particularly in relation to price. Understand elastic vs inelastic demand, factors influencing elasticity, and the midpoint method for calculation.