Chapter 6 Elasticity

6
Elasticity
Revised by Solina Lindahl

WHAT YOU WILL LEARN IN THIS CHAPTER
• Why is elasticity used to measure the response to changes in prices or income?
• What are the different elasticity measures and what do they mean?
• What factors influence the size of these various elasticities?
• Why is it vitally important to determine the size of the relevant elasticity before setting prices or government fees?

PRICE ELASTICITY OF DEMAND PART 1
• Even for ambulance rides: We know there is an inverse relationship between price and quantity demanded.
• But how much does quantity demanded change when price changes?

PRICE ELASTICITY OF DEMAND PART 2
• A demand curve is elastic when an increase in price reduces the quantity demanded a lot (and vice versa).
• When the same increase in price reduces quantity demanded just a little, then the demand curve is inelastic.

PRICE ELASTICITY OF DEMAND
• The more responsive quantity demanded (QD) is to a change in price, the more elastic is the demand curve.

ELASTICITY RULE
• Elasticity ≠ slope BUT:
– If two linear demand (or supply) curves run through a common point, then at any given quantity, the curve that is FLATTER is MORE ELASTIC.

DEFINING AND MEASURING ELASTICITY PART 1
• Price elasticity of demand = the percentage change in quantity demanded divided by the percentage change in price.
Price elasticity of demand  %change in quanity demand %change in price

DEFINING AND MEASURING ELASTICITY PART 2
• Example:
– If the price of oil increases by 10% and the quantity demanded falls by 5%, then the price elasticity of demand for oil is:
 5%  0.5 10%
– Note: since we know that price and quantity demanded will always move in opposite directions (law of demand) we usually drop the minus sign (for price elasticity of demand ONLY).

USING THE MIDPOINT FORMULA
• There is a problem: Our percent change calculation depends on our choice of starting point.
• To solve this problem, we calculate the price elasticity of demand using the midpoint formula for percentage changes.

THE MIDPOINT METHOD
• Instead of dividing by the initial quantity or price, we’ll use the average quantity or price.
% change in X  Change in X 100 AverageValue of X
Average value of X  Starting Value of X  Final Value of X 2