Chapter 6 - Elasticity: The Responsiveness of Demand and Supply

Question 1

Elasticity

Answer 1

A measure of how much one economic variable responds to changes in another economic variable

Question 2

Price elasticity of demand

Answer 2

The responsiveness of the quantity demanded to a change in price.

Question 3

Price elasticity of demand formula

Answer 3

Price elasticity of demand = percentage change in quantity demanded/ percentage change in price

Question 4

Why is price elasticity of demand always negative?

Answer 4

It’s always negative because percentage change in quantity demanded and percentage change in price are always opposite. If one increases, the other decreases.

P.s. Price elasticity of demand is not the same as the slope of the curve

Question 5

What’s the difference between elasticity and inelasticity?

Answer 5

A product is considered to be elastic if the quantity demand of the product changes drastically when its price increases or decreases. This means it’s more sensitive. On a graph, it is not as vertical (smaller slope) and the price elasticity of demand is > 1.

Ex. Food is elastic because there are many substitutes so if the price increases, demand will decrease a fair bit.

Conversely, a product is considered to be inelastic if the quantity demand of the product changes very little when its price fluctuates. This means it’s less sensitive. On a graph, it is close to being vertical (larger slope) and the price elasticity of demand is < 1.

Ex. When gasoline is inelastic because when its prices go up a fair bit, the demand will decrease just a little bit because there are no substitutes. Eventually, you will have to buy it.

Question 6

The Midpoint Formula

Answer 6

We can use the midpoint formula to ensure that we have only one value of the price elasticity of demand between the same two points on a demand curve.

It uses the average of the initial and final quantities and the initial and final prices.

Price elasticity of demand = (1/2) / (3/4)

1: (Q2 - Q1)
2: ({Q1 + Q2)/2) Average of quantity
3: (P2 - P1)
4: ((P1 + P2)/2) Average of price

Question 7

Perfectly inelastic demand

Answer 7

The case where the quantity demanded is completely unresponsive to price, and the price elasticity of demand equals zero.

Ed = 0 and the demand curve is a vertical line

Question 8

Inelastic demand

Answer 8

Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value.

Ed < 1 and the demand curve is between perfectly inelastic and unit-elastic

Question 9

Unit-elastic demand

Answer 9

Demand is unit elastic when the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value.

Ed = 1 and the demand curve is 45 degrees

Question 10

Elastic demand

Answer 10

Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value.

Ed > 1 and the demand curve is between unit-elastic and perfectly elastic

Question 11

Perfectly elastic demand

Answer 11

The case where the quantity demanded is infinitely responsive to price, and the price elasticity of demand equals infinity.

Ed = infinity and the demand curve is a horizontal line

Question 12

What are the key determinants of the price elasticity of demand?

Answer 12

1) Availability of close substitutes
2) Passage of time
3) Luxuries versus necessities
4) Definition of the market
5) Share of the good in the consumer’s budget

Question 13

How is “availability of close substitutes” a key determinant of price elasticity of demand?

Answer 13

It’s the most important determinant of price elasticity of demand because how consumers react to a change in the price of a product depends on what alternatives they have.

Ex. For gasoline (inelastic), a change in price won’t affect demand all that much because there aren’t many substitutes. But if pizza (elastic) becomes too expensive, there are a lot of substitutes.

Question 14

How is “passage of time” a key determinant of price elasticity of demand?

Answer 14

It usually takes consumers some time to adjust their buying habits when prices change. The more time that passes, the more elastic the demand for a product becomes.

Ex. If the price of chicken falls, it will take time to change consumption habits.

Question 15

How is “luxuries versus necessities” a key determinant of price elasticity of demand?

Answer 15

Luxuries usually have more elastic demand curves than goods that are necessities.

Ex. If an expensive watch (elastic) increases in cost, demand will decrease but with bread (inelastic), it won’t be the case because it’s a necessity.

Question 16

How is “definition of the market” a key determinant of price elasticity of demand?

Answer 16

In a narrowly defined market, consumers have more substitutes available. The more narrowly we define a market, the more elastic demand will be.

Ex. Demand for gasoline at a particular gas station is elastic because if the price increases, you can go to other gas stations. But gasoline as a whole is inelastic because if the price increases, people still need it.

Question 17

How is “share of the good in the consumer’s budget” a key determinant of price elasticity of demand?

Answer 17

Goods that take only a small fraction of a consumer’s budget tend to have less elastic demand than goods that take a large fraction.

Ex. If the price of both table salt and cars increases by 50%, the demand for cars will go down more because salt doesn’t cost as much.

Question 18

Total revenue

Answer 18

The total amount of funds received by a seller of a good or service.

TR = price * quantity sold

Question 19

What is the relationship between price elasticity of demand and total revenue?

Answer 19

When Ed > 1 (elastic demand), as price decreases, total revenue increases. So firms should decrease the price to increase TR.

When Ed = 1 (unit-elastic demand), as price decreases, total revenue stays the same.

When Ed < 1 (inelastic demand), as price decreases, total revenue decreases. So firms should increase the price to increase TR.

Question 20

If the demand is ____ … then an ____ in price does what to the revenue and why?

1) elastic, increase
2) elastic, decrease
3) inelastic, increase
4) inelastic, decrease
5) unit-elastic, increase
6) unit-elastic, decrease

Answer 20

1) reduces revenue because the decrease in quantity demanded is proportionally greater than the increase in price.
2) increases revenue because the increase in quantity demanded is proportionally greater than the decrease in price.
3) increases revenue because the decrease in quantity demanded is proportionally smaller than the increase in price.
4) reduces revenue because the increase in quantity demanded is proportionally smaller than the decrease in price.
5) does not affect revenue because the decrease in quantity demanded is proportionally the same as the increase in price.
6) does not affect revenue because the increase in quantity demanded is proportionally the same as the decrease in price.

Question 21

How do firms estimate and calculate the price elasticity of demand?

Answer 21

To estimate the price elasticity of demand, a firm needs to know the demand curve for its product. For a well-established product, economists can use historical data to statistically estimate the demand curve.

To calculate the price elasticity of demand for a new product, firms often rely on market experiments. With market experiments, firms try different prices and observe the change in quantity demanded that results.

Question 22

Cross-price elasticity of demand

Answer 22

The percentage change in quantity demanded of one good divided by the percentage change in the price of another good.

a = b/c

a: Cross-price elasticity of demand
b: Percentage change in quantity demanded of one good
c: Percentage change in price of another good

Question 23

What’s the difference in getting a positive, negative or zero number from the cross-price elasticity of demand formula?

Answer 23

If the number that you get is positive, it means that the two goods are substitutes.

Ex. Two brands of tablet computers

If the number that you get is negative, it means that the two goods are complements.

Ex. Tablet computers and applications downloaded from online stores

If the number you get is zero, it means that the two goods are unrelated.

Ex. Tablet computers and peanut butter

Question 24

Income elasticity of demand

Answer 24

A measure of the responsiveness of quantity demanded to changes in income, measured by the percentage change in quantity demanded divided by the percentage change in income.

a = b/c

a: Income elasticity of demand
b: Percentage change in the quantity demanded
c: Percentage change in income

Question 25

What’s the difference in getting a ____ from the income elasticity of demand formula?

1) positive but less than 1
2) positive but greater than 1
3) negative

Answer 25

1) If the income elasticity of demand is positive but less than 1, then it is a normal good and a necessity. An example could be bread.
2) If the income elasticity of demand is positive but greater than 1, then it is a normal good and a luxury. An example could be caviar.
3) If the income elasticity of demand is negative, then the good is inferior. This means when the price goes up, demand goes down, or vice versa. Examples could be high-fat meat, used clothes or used cars.

Question 26

Price elasticity of supply

Answer 26

The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price.

a = b/c

a: Price elasticity of supply
b: Percentage change in quantity supplied
c: Percentage change in price

Question 27

Determinants of the Price Elasticity of Supply

Answer 27

Whether supply is elastic or inelastic depends on the ability and willingness of firms to alter the quantity they produce as price increases.

Often, firms have difficulty increasing the quantity of the product they supply during any short period of time.

Question 28

How different are the graphs for elastic, inelastic, unit-elastic, perfectly elastic and perfectly inelastic in demand curve and supply curve?

Answer 28

The idea is still the same. Elastic is still Ed > 1. Inelastic is Ed < 1. But the main difference is the fact that supply curves and demand curves are different.