Skip to main content

Microeconomics: Elasticity

In economics, the term elasticity is used to refer to the ratio of the change of an economic variable to the change in another. In our context, elasticity will mainly be used to describe the relationship between a change in quantity to the change in price.
  • If the change in quantity is equal to the change in price, then this change can be described as unit elastic. Another way to think about this concept is that the change in price will create a proportional change in quantity.
  • If the quantity change is larger than the change in price then the change is elastic.
  • If the quantity change is smaller than the price change then the change is inelastic.
Price elasticity of demand: it describes the relative change of quantity demanded to a change in price.  Price elasticity is calculated by simply dividing the rate of change in quantity by the rate of change in price.
An alternative method that is equivalent is:
where M is the slope of a linear demand curve.

Price elasticity of supply: the relative response of quantity supplied to a change in price. Its price elasticity is calculated the same way as the price elasticity of demand.
Since P and Q have an inverse relationship, the price elasticity coefficient of the demand curve will always be negative. However, by convention, only report the absolute value.
  • If Ed,Es<1, then the curve is inelastic.
  • If Ed,Es=1, then the curve is unit elastic.
  • If Ed,Es>1, then curve is elastic.
Factors that determine the price elasticity of demand:
  • if the good or service is a necessity, then the demand curve tends to be inelastic. People have to buy this product in order to survive, therefore the price has little effect on the quantity demanded. On the other hand, a luxury good is not essential, its price has a strong impact on the quantity demanded. Therefore its demand curve is relatively elastic.
  • If there are no close substitute, then the demand tends to be inelastic. It is inelastic because the consumers have no other options if they need this particular service/good. If there other close substitutes than the curve becomes more elastic.
  • If consumers need a good or service immediately, the demand will be inelastic. For example, if the price of gasoline increases, in the short run, people will not change their consumption patterns. Consumers are locked in this pattern because they own vehicles that consume gas. However, in the long run, consumers start to adopt new consumption patterns that involves less gasoline. Under this condition, the demand becomes more elastic over time.
  • A good or service whose price absorbs a significant portion of a consumer's income tends to have an elastic demand. If a good has a relative small price compared to the average consumer's income, then its demand curve is relatively inelastic. 
Factors that determine the price elasticity of supply:
  • The longer it takes a product to be made, then the price elasticity of supply is more inelastic. A change in price causes a smaller change in the quantity produced by the producers.
  • In the long run, if the barriers of entry in the market are low, then the production can be expended more cheaply if there is an increase in the demand for a particular good. This will cause the supply curve to become more elastic over time.
Income elasticity of demand: it measures how much the quantity demanded will change due to a change in income. This determines whether a good is classified as normal or inferior.
  • If Ei>0, then the good is normal.
  • If Ei<0, then the good is inferior.
Cross price elasticity of demand: it determines whether goods are complements or substitutes. Mathematically, it represents the change in quantity of one good relative to the change in price of another good.

  • If Exy>0, then the good (or service) is a substitute.
  • If Exy<0, then the good is a complement.
Here is a paper discussing the importance of price elasticities when conducting public health research. Near the bottom of the article, you can find list of products with their respective price elasticity.

Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 67-70.

Labels:

Comments

Post a Comment

Popular posts from this blog

Macroeconomics: multiplier and crowding out effects

Multiplier effect: whenever   any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures. The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy. The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS. The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP. The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate. This increase in interest ...
Post a Comment
Read more

Exercise: inflation and GDP deflator

You have the following table containing information about country Y's GDP deflator, nominal, and real GDP. If the base year is 2015, fill in the blanks and then find the annual inflation rate for each year. Year  Nominal GDP  GDP Deflator  Real GDP 2015 $23,457 100 $23,457 2016 $25,752 ... $23,943 2017 $25,982 108.1 ... 2018 $26,016 ... $25,431.1 2019 $26,323 105.5 ... Solution: Year  Nominal GDP  GDP Deflator  Real GDP   Inflation rate 2015 $23,457 100 $23,457 n.a 2016 $25,752 107.6 $23,943 7.6% 2017 $25,982 108.1 $24,035.2 0.45% 2018 $26,016 102.3 $25,431.1 -5.37% 2019 $26,323 105.5 $24,950.6 3.13%  GDP deflator for the year 2018: Real GDP for the year 2017: General formula to find real GDP by re-arranging the GDP deflator formula: Notice that the sub-index i is for the year. The (annual) inflation rate is simply the growth rate of prices from a year to its previous year: Inflation rate of the year 2018: Notice that in 2018 country Y experienced...
Post a Comment
Read more

Exercise: Payoff matrix -Oligopoly market-

You are given a payoff matrix for two firms in an oligopoly market. Find the dominant strategy (if any) for each firm. What profit would they each earn if they form a cartel (if possible)? Can the cartel hold in the long run? If not, what is the long run equilibrium? Payoff Matrix:  Firm A: high prices  Firm A: low prices Firm B: high prices A: $1000 B: $1000 A: $1200 B: $800 Firm B: low prices A: $600 B: $1200 A: $700 B: $700 The dominant strategy for firm A is to charge a low price for its product. You can see that no matter what firm B chooses, firm A is always better off by choosing the low price option (i.e its profit is always bigger than if it had charged a high price). The strategy for firm B depends on the choices firm A makes. If firm A charges a high (low) price then firm B should charge a low (high) price. In order to find the point at which the firms would collude (i.e act as one monopolistic firm), find the point(s) where the sum of economic profits is the greate...
Post a Comment
Read more