ECO 204
Chapter 5
DEMAND ELASTICITIES

Price elasticity of demand measures responsiveness of quantity demanded to price. Average price and quantity are used to calculate the percentage change in quantity demanded divided by the percentage change in price. Price elasticity of demand usually varies from one segment of the demand curve to another. For linear demand curves, elasticity becomes progressively smaller as one moves down the curve. If demand is elastic, an increase in price causes total revenue to decrease; if it is inelastic, a price increase causes total revenue to increase; and if demand is unit elastic, total revenue is unaffected by price. Price elasticity tends to be lower when a good is considered a necessity, has few good substitutes, or accounts for only a small part of the total budget or when buyers have little time to adjust to price changes.
Income elasticity of demand measures the percentage change in quantity demanded divided by the percentage change in income. Income elasticity of demand is positive for normal goods and negative for inferior goods. The cross elasticity of demand measures, in percentage terms, how the quantity demanded of one good responds to price changes for another good. For substitutes, the cross elasticity is positive, for complements it is negative, and for independent goods, it is zero.
 

Outline

I.      Price Elasticity of Demand

        A.      Price elasticity of demand equals percentage change in quantity demanded, divided by percentage change in price.
        B.      Percentage change in quantity demanded equals the price elasticity of demand times percentage change in price.

II.     The Formula

        A.      Ed = %change in quantity demanded/%change in price

III.    Categorizing Elasticity

        A.      Demand is elastic when price elasticity of demand is greater than 1
        B.      Demand is inelastic when price elasticity of demand is less than 1
        C.      Demand is unit elastic when price elasticity of demand is equal to 1
        D.      Perfectly inelastic demand, represented by a vertical demand curve, exists when demand is totally unresponsive to price
        E.      Perfectly elastic demand, represented by a horizontal demand curve, exists when demand is infinitely responsive to price

IV.     Elasticity and Total Revenue

        A.      Total revenue is equal to the price of a good times the quantity sold.
        B.      Given a downward-sloping demand curve, an increase in price means that each 
                unit sold contributes more to total revenue--however, fewer units will be sold at a higher price.

V.      What Determines Ed?

        A.      Availability of Substitutes
                1.      Consumers are more sensitive to price changes when acceptable substitutes are available.
                2.      When substitution possibilities are limited, Ed tends to be low.
        B.      Degree of Necessity
                1.      Goods viewed as necessities tend to have a low price elasticity of demand 
                2.      Goods that have a low degree of necessity typically have a high Ed
        C.      Share of Budget Spent on the Good
                1.      Typically, the less of a consumer's budget devoted to a good, the less 
                        elastic is demand
                2.      "Big ticket" items tend to have relatively high elasticity of demand
        D.      Time Period
                1.      A longer time period allows for greater responsiveness by consumers-and leads to a greater elasticity of demand.
                2.      In the short run, elasticity tends to be lower.

VI.     Other Elasticities of Demand

        A.      The Income Elasticity of Demand
                1.      As income rises, the demand for normal goods also rises
                2.      As income rises, the demand for inferior goods falls
                3.      Income elasticity for luxury goods is greater than 1
                4.      Income elasticity for necessities is greater than 0 but less than 1
                5.      Income elasticity is equal to percentage change in quantity demanded, divided by percentage change in income.

        B.      The Cross Elasticity of Demand
                1.      Cross elasticity of demand relates the percentage change in quantity 
                        demanded of one good to the percentage change in price of another good
                2.      The cross elasticity relationship varies according to the nature of the goods involved
                        a.      For substitute goods--goods that may be used interchangeably-cross elasticity will be positive
                        b.      Complementary goods--goods that are used together--typically have a negative cross elasticity
                        c.      Independent, or unrelated goods, have a cross elasticity of zero.
VII.    Elasticity of Supply

        A.      Elasticity of supply equals the percentage change in quantity supplied, divided by the percentage change in price.
        B.      A vertical supply curve is perfectly inelastic, a horizontal supply curve perfectly elastic.
        C.      The longer the time period, the more elastic is supply.

VIII. Tax Incidence

        A.      Tax incidence deals with the issue of how the tax burden is actually distributed
        B.      Tax incidence depends on the price elasticity of supply and demand
        C.      The Role of Elasticity
                1.      Given supply, the more elastic demand is, the less of a tax is 
                        passed on to consumers
                2.      Given demand, the more elastic supply is, the more of a tax is 
                        shouldered by consumers.                 

ECO 204