Economics Midterm Summary

ECONOMICS
CHAPTER 5 – Elasticity and Its Applications

The Elasticity of Demand
Elasticity of demand: measures how responsive the quantity
demanded is to a change in price; more responsive quantity
demanded is to a change in price, the more elastic the demand
curve is.
- Elasticity is not the same thing as slope.
- Elasticity rule: if two linear demand (or supply) curves run
through a common point, then at any given quantity the
curve that is flatter is more elastic.

Determinants of the Elasticity of Demand
- The fundamental determinant of the elasticity of demand is how easy it is
to substitute one good for another.
- Demand for oil is inelastic. The demand for oil tends to become more
elastic over time because the more time people have to adjust to a price
change, the better they can substitute one good for another. There are
more substitutes for oil in the long run than in the short run.
- The demand for a specific brand of a product is more elastic than demand
for a product category.
- The more and the better (buyer’s preferences/subjective) the substitutes,
the more elastic the demand.
- Higher income makes demand less inelastic.

Calculating the Elasticity of Demand
- The elasticity of demand is the percentage change in quantity demanded divided by the percentage change in
price.
"#$%#&'()# %+(&)# ,& -.(&','/ !#0(&!#! %∆4!"#$%!"!
- 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝐸! = =
"#$%#&'()# %+(&)# ,& 1$,%# %∆ "$,%#
- E.g. if price increases by 10% and the quantity demanded decreases by 5%, then the elasticity of demand is -0.5
(0.5 in absolute terms).
- Elasticities of demand are always negative because when the price goes up, the quantity demanded goes down.
1. |𝐸! | > 1– elastic
2. |𝐸! | < 1– inelastic
3. |𝐸! | = 1– unit elastic
- Using the midpoint method to calculate the elasticity of demand:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑄56'#$ − 𝑄7#68$#
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 (𝑄56'#$ + 𝑄7#68$# )/2
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝐸! = =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑃56'#$ − 𝑃7#68$#
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑖𝑐𝑒 (𝑃56'#$ + 𝑃7#68$# )/2
Total Revenues and the Elasticity of Demand
- Revenue (R) = Price (P) x Quantity (Q)
- Relationship between elasticity and revenue:
1. If the demand curve is inelastic, then revenues
go up when the price goes up and the revenues
go down when the price goes down.
2. If the demand curve is elastic, then revenues go
down when the price goes up and the revenues
go up when the price goes down.
3. When price increases or decreases when the
demand curve is unit elastic, nothing happens.

,Applications of Demand Elasticity




The Elasticity of Supply
Elasticity of supply: measures how responsive the quantity supplied is
to a change in price.

Determinants of the Elasticity of Supply
- The fundamental determinant of the elasticity of supply is how
quickly per-unit costs increase with an increase in production. If
increased production requires much higher per-unit cost costs,
then supply will be inelastic.
- Supply for oil is inelastic as an increase in price does not mean
that the suppliers can quickly respond and increase production as
it takes time.
- The supply is more elastic when the industry can be expanded
without causing a big increase in the demand for that industry’s
outputs.
- The local supply of a good is much more elastic than the global
supply.
- Supply is more elastic in the long run than in the short run,
because in the long run, suppliers have more time to adjust.

, Calculating the Elasticity of Supply
- The elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.
"#$%#&'()# %+(&)# ,& -.(&','/ 9.11:,#! %∆4&'(()*"!
- 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 = 𝐸9 = "#$%#&'()# %+(&)# ,& 1$,%#
= %∆ "$,%#
- E.g. if price of cocoa increases by 10% and quantity supplied increases by 3%, then the elasticity of supply for
cocoa is 0.3.
- Using the midpoint method to calculate the elasticity of demand:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑄56'#$ − 𝑄7#68$#
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 (𝑄 56'#$ + 𝑄7#68$# )/2
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 = 𝐸9 = =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑃56'#$ − 𝑃7#68$#
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑖𝑐𝑒 (𝑃56'#$ + 𝑃7#68$# )/2

Applications of Supply Elasticity
- Important issues in public policy: gun buybacks and slave redemption.




Cross-Price Elasticity of Demand
"#$%#&'()# %+(&)# ,& -.(&','/ !#0(&!#! 86 )88! 5 %∆4!"#$%!"!,,
- 𝐶𝑟𝑜𝑠𝑠 − 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = "#$%#&'()# %+(&)# ,& 1$,%# 86 )88! 7
= %∆ "$,%#,7
6,92"5 : 68"9;5"
-.$%/" *% 1'$%2*23 !"#$%!"! ,
,4"5$/" 6'$%2*23 , (6,92"5 = 68"9;5" )/@
- 𝐶𝑟𝑜𝑠𝑠 − 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = -.$%/" *% (5*7" 8 = A,92"5 : A8"9;5"
,4"5$/" (5*7" 8 (A,92"5 = A8"9;5" )/@

- If the cross-price elasticity > 0 / positive, then goods A and B are substitutes.
- If the cross-price elasticity < 0 / negative, then goods A and B are complements.

Income Elasticity of Demand
"#$%#&'()# %+(&)# ,& -.(&','/ !#0(&!#! %∆4!"#$%!"!
- 𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = "#$%#&'()# %+(&)# ,& ,&%80#
= %∆ <&%80#
6,92"5 : 68"9;5"
-.$%/" *% 1'$%2*23 !"#$%!"!
,4"5$/" 6'$%2*23 (6,92"5 = 68"9;5" )/@
- 𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = -.$%/" *% *%7;#" = B,92"5 : B8"9;5"
,4"5$/" *%7;#" (B,92"5 = B8"9;5" )/@

- If the income elasticity > 0 / positive, then the good is a normal good.
- If the income elasticity < 0 / negative, then the good is an inferior good.
- If the income elasticity > 1 / positive, then the good is a luxury good.