The Principles of Economics

Chapter 5: Elasticity and Its Application

5-1 The Elasticity of Demand

-elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants.

5-1a The Price Elasticity of Demand and Its Determinants

-Law of Demand: a drop in the price of a good leads to a rise in the quantities demand. 

-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 is often inelastic if the demand in quantity changes slightly in the price. 

-Demand is often elastic if the demand in quantity substantially changes in the price. 

-Goods with close substitutes are often more elastic in demand. 

-While necessities tend to include inelastic demands, luxury goods have quite elastic demands. 

-Labeling a good as luxury often depends on the buyer's preferences, not the good's properties. 

-The market's elasticity of demand relies on how the boundaries are drawn in said market. 

-Time horizons have less of an elastic demand than goods. 

Ex: When gasoline prices rise, the quantity of gasoline drops in the first few months.

5-1b Computing the Price Elasticity of Demand

-Price elasticity of demand = percentage change in quantity demanded / percentage change in price.

Ex. Price elasticity of demand = 20% / 10% = 2.

-The percentage change in price is positive, while the percentage change in the demanded quantity is negative. 

5-1c The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

-Price elasticity of demand = (Q2-Q1) / [(Q2+Q1)/2] / (P2-P1) / [(P2+P1)/2]

-The midpoint method helps to better calculate elasticities. 

-The numerator is the percentage change in quantity when using the midpoint method. 

-The denominator is the percentage change in price when using the midpoint method. 

5-1d The Variety of Demand Curves

-A unit elasticity is when the elasticity is exactly one and the percentage change in quantity is equal to the percentage change in price. 

5-1e Total Revenue and the Price Elasticity of Demand

-Total revenue is often used when studying the changes in supply or demand in markets.

-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. 

-The total revenue increases when the demand is inelastic, and vise versa.

-An inelastic demand means the price and total revenue are moving the same direction, and when the price increases, the total revenue will also increase. 

-An elastic demand means the price and total revenue are moving in opposite directions, and when the price increases, the total revenue will decrease. 

-A unit elastic demand means that the price elasticity is equal to one, and therefore the total revenue will remain constant when the price changes. 

5-1f Elasticity and Total Revenue along a Linear Demand Curve

-Slope = rise/run.

-Rise: ratio of the change in price; Run: change in quantity.

-Slope: ratio of changes in the two variables; Elasticity: ratio of percentage changes in the two variables. 

5-1g Other Demand Elasticities

-Income elasticity of demand = percentage change in quantity demanded / percentage change in income. 

-Cross-price elasticity of demand = percentage change in quantity demanded of good one / percentage change in the price of good two. 

-income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers' income, computed as the percentage change in quantity demanded divided by the percentage change in income. 

-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. 

-Engel's Law: as a family's income increases, the percentage of its income spent on food decreases. 

5-2 The Elasticity of Supply 

5-2a The Price Elasticity of Supply and Its Determinants

-price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. 

5-2b Computing the Price Elasticity of Supply

-Price elasticity of supply = percentage change in quantity supplied / percentage change in price. 

-Price elasticity of supply = 20% / 10% = 2.

5-2c The Variety of Supply Curves

-The price elasticity of supply tells us whether the supply curve is steep or flat. 

5-3 Three Applications of Supply, Demand, and Elasticity. 

5-3a Can Good News for Farming Be Bad News for Farmers?

-A decrease in price results in the fall of the total revenue.

-In 1950, 10 million people worked on farms in the U.S. and made up 17% of the workforce. 

5-3b Why Did OPEC Fail to Keep the Price of Oil High?

-OPEC successfully kept and maintained a high price of oil but only for a short period of time. 

5-3c Does Drug Interdiction Increase or Decrease Drug-Related Crime?

-Drug interdiction is aimed to decrease drug use, thus reducing drug-related crime. 

-Drug interdiction directly effects drug sellers rather than buyers.

-The demand for drugs is inelastic over short periods of time because higher prices don't have as harsh of an effect on drug use by established addicts. 

5-4 Conclusion 

-Educating yourself about supply and demand will allow you to analyze important events and policies in history and in the economy that'll help you become a better economist.