Microeconomics – Elasticity & Its Applications

Elasticity measures how much buyers and sellers respond to changes in market conditions. Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of that good. Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

Determinants for elasticity include: the availability of close substitutes, necessities versus luxuries, definition of the market, and time horizon. Elasticity tends to rise when there are many close substitute, a good is a luxury, the market is defined narrowly, and the longer the time period. In most markets, supply is more elastic in the long run than in the short run. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.

Price elasticity of demand = % change in quantity demanded / % change in price. Mid point formula = (Q2 – Q1) / [(Q2 + Q1)/2] / (P2 – P1) / [(P2 + P1)/2].

  • Strong Elastic >1
  • Proportionate Unit = 1
  • Weak Inelastic <1
  • Perfectly elastic =
  • Perfectly inelastic = 0

Price elasticity of demand measures how much quantity demanded responds to the price, hence it is closely related to the slope of the demand curve. Total revenue is the amount paid by buyers and is the amount received by sellers. TR is calculated by price of a good times quantity of a good, TR = P x Q.

With an inelastic demand curve -> increase in price -> proportionally smaller decrease in quantity -> total revenue increases. With an elastic demand curve -> increase in price -> proportionally larger decrease in quantity -> total revenue decreases.

Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is calculated as the percentage change in the quantity demanded divided by the percentage change in income. Income increases, if quantity demanded increases the good is normal, if quantity demanded decreases the good is inferior. Goods consumers regard as necessities tend to be income inelastic, can be food, fuel, clothing, and utilities. Goods consumers regard as luxuries tend to be income elastic, can be expensive goods, designer clothes, and private planes.

Income elasticity of demand = % change in quantity demanded / percentage change in income.

Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. The percentage change in quantity supplied divided by the percentage change in price.

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