Chapter 5 | Elasticity Flashcards
Elasticity
Elasticity measures how responsive quantity demanded is to a change in price.
The tool that businesses use to measure consumer responsiveness when making pricing decisions is
price elasticity of demand
which measures by how much quantity demanded responds to a change in price.
Formula for elasticity
Price elasticity of demand = % change in quantity demanded / % change in price
Midpoint Formula
The midpoint formula between any two points on a demand curve like (Q0, P0) and (Q1, P1) is:
Q1 - Q0 / (Q1+ Q0 / 2) / P1 - P0 / (P1+P0 /2 )
Inelastic demand
small response in quantity demanded when price rises.
– Example: Demand for insulin by a diabetic.
Value for formula is less than one.
– Low willingness to shop elsewhere.
Perfectly inelastic demand
price elasticity of demand equals zero; quantity demanded does not respond to a change in price.
Elastic demand
large response in quantity demanded when price rises.
– Example: Demand for blue earbuds.
– Value for formula is greater than one.
– High willingness to shop elsewhere.
Perfectly elastic demand
price elasticity of demand equals infinity; quantity demanded has an infinite response to a change in price.
Price Elasticity of demand of a product influences;
– available substitutes — more substitutes mean more elastic demand.
– time to adjust — longer time to adjust means more elastic demand.
– proportion of income spent — greater proportion of income spent on a product or service means more elastic demand.
What does elasticity determine?
Elasticity determines business pricing strategies to earn maximum total revenue — cut prices when demand is elastic and raise prices when demand is inelastic.
Total revenue
— all money a business receives from sales = price per unit (P) multiplied by quantity sold (Q).
– For businesses facing elastic demand, price cuts are the smart choice and increase total revenue.
– For businesses facing inelastic demand, price rises are the smart choice and increase total revenue.
Graph Stuff
As you move down a straight line demand curve, elasticity changes and is not the same as slope.
– Elasticity goes from elastic, to unit elastic, to inelastic.
– Total revenue increases, reaches a maximum when elasticity equals 1, and then decreases.
What does elasticity of supply measure?
Elasticity of supply measures the responsiveness of quantity supplied to a change in price, and depends on the difficulty, expense, and time involved in increasing production
Elasticity of supply
measures by how much quantity supplied responds to a change in price.
Elasticity of supply formula
Elasticity of supply = % change in quantity supplied / % change in price
Inelastic (Supply)
For inelastic supply, small response in quantity supplied when price rises. Difficult and expensive to increase production.
– Example: supply of mined gold.
– Value for formula is less than 1.
Perfectly inelastic supply
— price elasticity of supply equals zero; quantity supplied does not respond to a change in price.
Elastic (supply)
For elastic supply, large response in quantity supplied when price rises. Easy and inexpensive to increase production.
– Example: snow-shovelling services.
– Value for formula is greater than 1.
Perfectly elastic supply
price elasticity of supply equals infinity; quantity supplied has infinite response to a change in price.
Elasticity Supply influences:
– availability of additional inputs — more available inputs means more elastic supply.
– time production takes — less time means more elastic supply.
Elasticity of supply allows more accurate predictions of future outputs and prices, helping businesses avoid disappointing customers.
Elasticity of supply allows more accurate predictions of future outputs and prices, helping businesses avoid disappointing customers.
Cross elasticity of demand
measures the responsiveness of the demand for a product or service to a change in the price of a substitute or complement.
Cross elasticity of demand FORMULA
% Change in quantity demanded / % change in price of a substitute or complement
Cross elasticity of demand is a positive number for substitutes. The larger the number:
– the larger the change in demand.
– the larger the shift of the demand curve.
– the closer the products or services are to being perfect substitutes.
Cross elasticity of demand is a negative number for complements. The larger the number:
– the larger the change in demand.
– the larger the shift of the demand curve.
– the closer the products or services are to being perfect complements.
Income elasticity of demand
measures the responsiveness of the demand for a product or service to a change in income.
Income elasticity of demand
% Change in quantity demanded / % change in income
– Positive for normal goods;
increase in income increases demand for normal goods.
– Negative for inferior goods;
increase in income decreases demand for inferior goods.
Income inelastic demand
– income elasticity greater than 0 but less than 1
– percentage change in quantity is less than the percentage change in price
– normal goods that are necessities
Income elastic demand
– income elasticity greater than 1
– percentage change in quantity is greater than the percentage change in price
– normal goods that are luxuries
Tax incidence
the division of a tax between buyers and sellers; depends on elasticities of demand and supply
Elasticity of demand and tax incidence:
– perfectly inelastic demand — buyers pay all
– more inelastic demand — buyers pay more
– more elastic demand — sellers pay more
– perfectly elastic demand — sellers pay all
Elasticity of supply and tax incidence:
– perfectly inelastic supply — sellers pay all
– more inelastic supply — sellers pay more
– more elastic supply — buyers pay more
– perfectly elastic supply — buyers pay all
The more inelastic demand and supply are, the greater the tax revenue for government. For maximum revenue, governments try to tax products and services with inelastic demands and supplies.
The more inelastic demand and supply are, the greater the tax revenue for government. For maximum revenue, governments try to tax products and services with inelastic demands and supplies.
