chapter 5

• Elasticity


  A measure of how much buyers and sellers respond to changes in market conditions
• Elasticity is useful in many applications
• Price elasticity of demand


  A measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price
• Demand


  • More elastic if the good has close substitutes
  • More inelastic if the good is a necessity
  • More elastic in narrowly defined markets
  • More elastic over longer time horizons
• Computing the price elasticity of demand


  Percentage change in quantity demanded / Percentage change in price
• Midpoint method


  A way to calculate percentage changes and elasticities that gives the same answer regardless of the direction of change
• Types of demand curves based on elasticity

  • Elastic (elasticity > 1)
  • Inelastic (elasticity < 1)
  • Unit elasticity (elasticity = 1)
• Relationship between demand curve slope and elasticity

  • Flatter demand curve = greater price elasticity
  • Steeper demand curve = smaller price elasticity
• Real world price elasticities of demand

  • Gasoline: -0.25 in short run, -0.6 in long run
  • Cigarettes: -0.4
  • Luxury goods: -1.5 to -2.1
  • Necessities: -0.1 to -0.3
• Horizontal demand curve


  Reflects the fact that very small changes in the price lead to huge changes in the quantity demanded
• Inelastic curves look like the letter I
• This is not a deep insight, but it might help on your next exam
• Price elasticities of demand for various goods

  • Eggs: 0.1
  • Healthcare: 0.2
  • Cigarettes: 0.4
  • Rice: 0.5
  • Housing: 0.7
  • Beef: 1.6
  • Peanut Butter: 1.7
  • Restaurant Meals: 2.3
  • Mountain Dew: 4.4
• These kinds of numbers are fun to think about, and they can be useful when comparing markets
• One reason to take these estimates with a grain of salt is that the statistical techniques used to obtain them require some assumptions about the world, and these assumptions might not be true in practice
• Another reason is that the price elasticity of demand need not be the same at all points on a demand curve
• For both reasons, you should not be surprised if different studies report different price elasticities of demand for the same good
• Total revenue


  The amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold
• When demand is inelastic


  Price and total revenue move in the same direction: If the price increases, total revenue also increases
• When demand is elastic


  Price and total revenue move in opposite directions: If the price increases, total revenue decreases
• If demand is unit elastic

  Total revenue remains constant when the price changes
• Slope of a linear demand curve

  Constant, but elasticity is not
• At points with a low price and high quantity, the demand curve is inelastic
• At points with a high price and low quantity, the demand curve is elastic
• A constant elasticity is possible, but it is not always the case
• Income elasticity of demand

  Measures how the quantity demanded changes as consumer income changes
• Normal goods


  Have positive income elasticities
• Inferior goods


  Have negative income elasticities
• Necessities


  Tend to have small income elasticities
• Luxuries


  Tend to have large income elasticities
• Cross-price elasticity of demand


  Measures how the quantity demanded of one good responds to a change in the price of another good
• Substitutes


  Have positive cross-price elasticities
• Complements


  Have negative cross-price elasticities
• Cross-price elasticity of demand


  A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good
• Whether the cross-price elasticity is positive or negative depends on whether the two goods are substitutes or complements
• Substitutes


  Goods that are typically used in place of one another
• An increase in the price of hot dogs


  Induces people to grill hamburgers instead
• Cross-price elasticity for substitutes

  Is positive
• Complements


  Goods that are typically used together
• An increase in the price of computers

  Reduces the quantity of software demanded