Interpreting Price Elasticity of Demand and other Elasticities

Clarifying Price Elasticities

• Perfectly inelastic▫ When quantity demanded

does not respond at all to changes in price Demand curve is a

vertical line Price elasticity equals 0

• Perfectly elastic▫ When any price increase

will cause the quantity demanded to drop to zero. Demand curve is

horizontal This implies an infinite

price elasticity of demand

•Elastic▫Price elasticity of demand is greater than 1

•Inelastic▫Price elasticity of demand is less than 1

•Unit elastic▫Price elasticity of demand is exactly 1

Why does it matter whether demand is elastic, inelastic or unit elastic?

•It helps predict how changes in price will affect total revenue, earned by producers from the sale of that good.▫Total Revenue = P X Q

•Also two countervailing effects are present▫A price effect

After a price increase, each unit sold sells at a higher price, which tends to raise revenue

▫A quantity effect After a price increase, fewer units are sold,

which tends to lower revenue

What factors determine Price Elasticity of Demand?

•Whether close substitutes are available▫Price elasticity of demand tends to be high

if there are other goods that consumers regard as similar and would be willing to consume instead

▫Price elasticity of demand tends to be low if there are no close substitutes

•Whether a good is a necessity or a luxury?▫Price elasticity tends to be low if it is

something you must have▫Price elasticity tends to be high if the good

is a luxury

•Share of income spent on the good▫Price elasticity of demand tends to be low

when spending on a good accounts for a small share of a consumer’s income A significant change in price has little

impact on how much a consumer spends▫When the good accounts for a significant

share of consumer spending, consumer is less likely to be responsive to a change in price thus price elasticity of demand is high

•Time▫Price elasticity of demand tends to increase

as consumers have more time to adjust to a price change

Long-run price elasticity of demand is higher than short-run elasticity.

Other Elasticities

Cross-Price Elasticity of Demand•Demand for a good is often affected by

the prices on other goods (substitutes and complements)

•A change in the price of related good shifts the demand curve of the original good, reflecting a change in the quantity demanded at any given price.

•This can be measured by the cross-price elasticity of demand▫It is a ratio of the percent change in the

quantity demanded of one good to the percent change in the price of another.

•If two goods are substitutes (i.e. hot dogs/ hamburgers) cross-price elasticity of demand is positive▫If they are close substitutes cross-price

elasticity will be positive and large▫If not cross-price elasticity will be positive

and small

•When two goods are complements (i.e. hot dogs/ hot dog buns) cross-price elasticity is negative▫If the cross-price elasticity is slightly below

zero, they are weak complements, if it is very negative, they are strong complements

In the case of cross price elasticity the plus or minus sign is very important: it indicates whether the goods are substitutes or complements

Income Elasticity of Demand

•Measures how changes in income affect the demand for a good

•Income elasticity of demand can be both positive and negative▫When the income elasticity of demand is

positive, the good is a normal good- the quantity demanded at any given price increases as income increases

▫When it is negative, the good is an inferior good- quantity demanded at any given price decreases as income increases

•Economist use income-elasticity of demand to predict which industries will grow most rapidly as incomes of consumers grow over time.

•This helps make a useful distinctions among normal goods

•Income elastic▫The income elasticity of demand for that

good is greater than 1 When income rises, the demand for income-

elastic goods rise faster than income Example: second homes and international travel

•Income inelastic▫The income elasticity of demand for that

good is positive but less than 1 When income rises, demand for income-

inelastic goods rises, but more slowly than income Example: food and clothing

Price Elasticity of Supply

•Definition: A measure of the responsiveness of the quantity of a good supplied to the price of that good. It is the ratio of the percent change in quantity supplied to the percent change in the price as we move along the supply curve.

•Formula

•Extreme Values▫Perfectly Inelastic Supply = 0

Graphed Vertically▫Perfectly elastic Supply = infinite

Graphed horizontally

Factors that determine Price Elasticity of Supply•Availability of Inputs

▫Price elasticity of supply tends to be large when inputs are readily available and can be shifted into and out of production at a relatively low cost

▫Price elasticity of supply tends to be small when inputs are available only in a more-or-less fixed quantity or can be shifted into and out of production only at a relatively high cost

•Time▫Price elasticity of supply tends to grow

larger as producers have more time to respond to a price change Long-run price elasticity of supply is often

higher than short run elasticity

•Short run = a few weeks or months•Long run = several years