Chapter 5
Chapter 5: Elasticity and Its
Application
Elasticity is the responsiveness of quantity demanded or supplied to changes in market factors like
price, income, and the prices of related goods. Understanding elasticity helps businesses and
policymakers predict and react to changes in market conditions.
I. The Price Elasticity of Demand
1. Definition and Formula
The price elasticity of demand measures how much the quantity demanded changes when the price
of a good changes.
Formula:
\text{Price Elasticity of Demand} = \frac{\%\text{Change in Quantity Demanded}}{\%\text{Change in
Price}}
If the price of coffee rises by 10% and the quantity demanded falls by 20%, the elasticity is:
\frac{-20\%}{10\%} = -2
2. Determinants of Price Elasticity of Demand
Availability of Substitutes:
Goods with more substitutes (e.g., brands of cereal) have higher elasticity.
Goods with fewer substitutes (e.g., insulin) are inelastic.
Necessities vs. Luxuries:
Necessities (e.g., water) have inelastic demand because they are essential.
Luxuries (e.g., vacations) are elastic as they are not essential.
, Definition of the Market:
Narrowly defined markets (e.g., mangoes) are elastic due to close substitutes.
Broadly defined markets (e.g., fruit) are inelastic.
Time Horizon:
Short-term demand is less elastic as consumers need time to adjust.
Long-term demand becomes more elastic as consumers find alternatives.
3. Elastic, Inelastic, and Unit Elastic
Elastic Demand (Elasticity > 1):
Quantity demanded changes significantly with price.
Example: Luxury cars.
Inelastic Demand (Elasticity < 1):
Quantity demanded changes minimally with price.
Example: Gasoline.
Unit Elastic (Elasticity = 1):
Percentage changes in price and quantity demanded are equal.
4. Total Revenue and Price Elasticity
Total Revenue (TR) = Price × Quantity.
When demand is elastic, increasing price decreases TR because consumers reduce purchases
significantly.
When demand is inelastic, increasing price increases TR because consumers continue purchasing
despite higher prices.
Example:
A movie theater raises ticket prices by 20%.
If attendance drops by 5%, demand is inelastic, and TR increases.
Chapter 5: Elasticity and Its
Application
Elasticity is the responsiveness of quantity demanded or supplied to changes in market factors like
price, income, and the prices of related goods. Understanding elasticity helps businesses and
policymakers predict and react to changes in market conditions.
I. The Price Elasticity of Demand
1. Definition and Formula
The price elasticity of demand measures how much the quantity demanded changes when the price
of a good changes.
Formula:
\text{Price Elasticity of Demand} = \frac{\%\text{Change in Quantity Demanded}}{\%\text{Change in
Price}}
If the price of coffee rises by 10% and the quantity demanded falls by 20%, the elasticity is:
\frac{-20\%}{10\%} = -2
2. Determinants of Price Elasticity of Demand
Availability of Substitutes:
Goods with more substitutes (e.g., brands of cereal) have higher elasticity.
Goods with fewer substitutes (e.g., insulin) are inelastic.
Necessities vs. Luxuries:
Necessities (e.g., water) have inelastic demand because they are essential.
Luxuries (e.g., vacations) are elastic as they are not essential.
, Definition of the Market:
Narrowly defined markets (e.g., mangoes) are elastic due to close substitutes.
Broadly defined markets (e.g., fruit) are inelastic.
Time Horizon:
Short-term demand is less elastic as consumers need time to adjust.
Long-term demand becomes more elastic as consumers find alternatives.
3. Elastic, Inelastic, and Unit Elastic
Elastic Demand (Elasticity > 1):
Quantity demanded changes significantly with price.
Example: Luxury cars.
Inelastic Demand (Elasticity < 1):
Quantity demanded changes minimally with price.
Example: Gasoline.
Unit Elastic (Elasticity = 1):
Percentage changes in price and quantity demanded are equal.
4. Total Revenue and Price Elasticity
Total Revenue (TR) = Price × Quantity.
When demand is elastic, increasing price decreases TR because consumers reduce purchases
significantly.
When demand is inelastic, increasing price increases TR because consumers continue purchasing
despite higher prices.
Example:
A movie theater raises ticket prices by 20%.
If attendance drops by 5%, demand is inelastic, and TR increases.
