Price Elasticity of Demand

• Elasticity measures the sensitivity of an economic variable with respect to another, where the former is the outcome of the latter.
• Elasticity is a number that describes a "% change to a % change.”
• Elasticity can be positive, negative, or zero.
• The absolute value of elasticity can be greater than, less than, or equal to 1.

Price Elasticity of Demand

• Measured by how much the quantity demanded of a good responds to a change in the price of that good.
• Computed as the percentage change in quantity demanded divided by the percentage change in price.
• Notation must always be negative according to the Law of Demand.

Influences on the Elasticity of Demand

• Availability of close substitutes will result in a greater price elasticity of demand if there are already existing close substitutes.
• Luxury goods will have a greater elasticity than necessities (e.g., expensive jewelry vs. food).
• The need for a specifically defined good usually has greater elasticity than a loosely defined category (e.g., chocolate vs. food).
• Longer time horizons lead to more options, and thus greater elasticity.

Computing Price Elasticity of Demand

• When the price of an ice cream cone increases by 10%, the amount of ice cream purchased falls by 20 percent.
• The elasticity is -2, meaning that the change in the quantity demanded is proportionately twice as large as the change in price, negatively.
• Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price

The Midpoint Method

• When calculating the price elasticity of demand between two points on a demand curve, the elasticity from point A to point B will differ from point B to point A.
• Example:
  • Point A: Price = $4, Quantity = 120
  • Point B: Price = $6, Quantity = 80
  • From point A to point B, the price rises by 50%, and the quantity falls by 33%; price elasticity of demand = -0.66.
  • From point B to point A, the price falls by 33%, and the quantity rises by 50%; price elasticity of demand= -1.52.

The Midpoint Method Solution

[(Q2-Q1)/[(Q2 + Q1)/2] / (P2 - P₁)/[(P2 + P1)/2]

• With the midpoint method, averages of both prices and quantities are used.
• At Price = $5, Quantity = 100
• From point A to point B, the price rises by 40% and the quantity falls by 40%.
• From point B to point A, the price falls by 40% and the quantity rises by 40%.
• In both directions, price elasticity of demand = -1.

Variety of Demand Curves

• Demand curves are classified according to their elasticity
• Demand is elastic when the elasticity is greater than 1 in absolute value, quantity moves proportionately more than the price
• Demand is inelastic when the elasticity is less than 1 in absolute value, so that quantity moves proportionately less than the price
• If the elasticity is exactly 1 in absolute value, so that quantity moves the same amount proportionately as price, demand is said to have unit elasticity

Total Revenue and Price Elasticity of Demand

• Total revenue in a market is the amount paid by buyers and received by sellers.
• Calculated as the price of the goods times the quantity sold.
• Total revenue changes when moving along the demand curve, contingent upon the price elasticity of demand.

Total Revenue Changes

• In the case of inelastic demand, price and total revenue move in the same direction.
• In the case of elastic demand, price and total revenue move in opposite directions.
• If demand is unit elastic, total revenue remains constant when the price changes.

Elasticity and Total Revenue

• A straight line has a constant slope.
• The slope of a linear demand curve is constant, but the elasticity is not.
• The slope is the ratio of changes in the two variables.
• The elasticity is the ratio of percentage changes in the two variables.

Other Demand Elasticities

• Income elasticity of demand = Percentage change in quantity demanded / Percentage change in income
• Cross price elasticity of demand = Percentage change in quantity demanded of good 1 / percentage change in price of good 2

Elasticity of Supply

• Price elasticity of supply is how much the quantity supplied of a good responds to a change in the price of that good.
• It is computed as the percentage change in quantity supplied divided by the percentage change in price.
• Price elasticity of supply must be positive according to the Law of Supply.
• Its absolute value can also be greater than, smaller than, or equal to 1:
• Price elasticity of supply = Percentage change in quantity supplied / Percentage change in price*
• If the quantity supplied responds substantially to changes in the price, supply of a good is elastic.
• If the quantity supplied responds only slightly to changes in the price, supply of a good is inelastic.
• Supply is usually more elastic in the long run than in the short run.

Elasticity assesses an economic variable's sensitivity to another, reflecting outcome changes. It's a number indicating percentage changes and can be positive, negative, or zero. Price elasticity of demand measures quantity demanded's response to price changes.