Macro

CH5: ELASTICITY AND IT’S APPLICATION

Summary:
• Elasticity measures the responsiveness of Qd or Qs to one of its Elasticity: a measure of the responsiveness of quantity demanded or
determinants. quantity supplied to a change in one of its determinants
• Price elasticity of demand equals percentage change in Qd divided price elasticity of demand: a measure of how much the quantity
by percentage change in P. When it’s less than one, demand is demanded of a good responds to a change in the price of that good,
“inelastic.” When greater than one, demand is “elastic.” computed as the percentage change in quantity demanded divided
• When demand is inelastic, total revenue rises when price rises. by the percentage change in price
When demand is elastic, total revenue falls when price rises. total revenue: the amount paid by buyers and received by sellers of
• Demand is less elastic in the short run, for necessities, for broadly a good, computed as the price of the good times the quantity sold
defined goods, and for goods with few close substitutes. Price x Quantity = TR
• Price elasticity of supply equals percentage change in Qs divided by income elasticity of demand: a measure of how much the quantity
percentage change in P. When it’s less than one, supply is “inelastic.” demanded of a good responds to a change in consumers’ income,
When greater than one, supply is “elastic.” computed as the percentage change in quantity demanded divided
• Price elasticity of supply is greater in the long run than in the short by the percentage change in income
run. cross-price elasticity of demand: a measure of how much the
• The income elasticity of demand measures how much quantity quantity demanded of one good responds to a change in the price of
demanded responds to changes in buyers’ incomes. another good, computed as the percentage change in quantity
• The cross-price elasticity of demand measures how much demand demanded of the first good divided by the percentage change in
for one good responds to changes in the price of another good. price of the second good
• The tools of supply and demand can be applied in many different price elasticity of supply: a measure of how much the quantity
kinds of markets. This chapter uses them to analyze the market for supplied of a good responds to a change in the price of that good,
wheat, the market for oil, and the market for illegal drugs. computed as the percentage change in quantity supplied divided by
the percentage change in price
 The price elasticity of demand measures how much the quantity
demanded responds to changes in the price. Demand tends to be 1. A life-saving medicine without any close substitutes will tend to
more elastic if close substitutes are available, if the good is a have
luxury rather than a necessity, if the market is narrowly defined, or a. a small elasticity of demand.
if buyers have substantial time to react to a price change. 2. The price of a good rises from $8 to $12, and the quantity
 The price elasticity of demand is calculated as the percentage demanded falls from 110 to 90 units. Calculated with the midpoint
change in quantity demanded divided by the percentage change in method, the price elasticity of demand is
price. If quantity demanded moves proportionately less than the b. 1/2.
price, then the elasticity is less than 1 and demand is said to be 12-8 / (12+8)/2x100=40
inelastic. If quantity demanded moves proportionately more than 90-100 / (90+100)/2x100=20
the price, then the elasticity is greater than 1 and demand is said 20/40 = 1/2 or 0.5
to be elastic.
 Total revenue, the total amount paid for a good, equals the price 3.A linear, downward-sloping demand curve is
of the good times the quantity sold. For inelastic demand curves, d. inelastic at some points, and elastic at others.
total revenue moves in the same direction as the price. For elastic 4. The ability of firms to enter and exit a market over time means
demand curves, total revenue moves in the opposite direction as that, in the long run
the price c. the supply curve is more elastic
 The income elasticity of demand measures how much the quantity 5. An increase in the supply of a good will decrease the total revenue
demanded responds to changes in consumers’ income. The cross- producers receive if
price elasticity of demand measures how much the quantity a. the demand curve is inelastic
demanded of one good responds to changes in the price of 6. Over time, technological advance increases consumers’ incomes
another good and reduces the price of smartphones. Each of these forces
 The price elasticity of supply measures how much the quantity increases the amount consumers spend on smartphones if the
supplied responds to changes in the price. This elasticity often income elasticity of demand is greater than ________ and if the
depends on the time horizon under consideration. In most price elasticity of demand is greater than ________.
markets, supply is more elastic in the long run than in the short b. zero, one
run
 The price elasticity of supply is calculated as the percentage Elastic: it means that people’s buying habits change a lot when the
change in quantity supplied divided by the percentage change in price changes. If the price goes up or down, the amount people buy
price. If quantity supplied moves proportionately less than the changes significantly.(many substitute, non-essential)
price, then the elasticity is less than 1 and supply is said to be Inelastic: it means that people’s buying habits do not change much
inelastic. If quantity supplied moves proportionately more than when the price changes. If the price goes up or down, the amount
the price, then the elasticity is greater than 1 and supply is said to people buy stays almost the same. (few substitute, essential)
be elastic
 The tools of supply and demand can be applied in many different
kinds of markets. This chapter uses them to analyze the market for
wheat, the market for oil, and the market for illegal drugs
 Elastic Supply: When the quantity supplied changes substantially in
response to changes in price.
Elastic > 1
Example: Goods like books, cars, and televisions have elastic supply
Inelastic < 1
because manufacturers can increase production significantly when
Unit Elasticity = exactly 1
prices rise by using existing factories more or by building new ones.
Inelastic Supply: When the quantity supplied changes only slightly in
Flatter Curve: Greater elasticity of demand. People adjust their
response to changes in price.
buying more when prices change.
Example: Beachfront land has inelastic supply because it's difficult to
Steeper Curve: Smaller elasticity of demand. People don't change
produce more of it regardless of price changes.
their buying much when prices change.
Flexibility of Producers: How easily producers can adjust their
production levels in response to price changes.
– Demand is perfectly inelastic
Short Run: Supply is inelastic because producers can't easily change
• Price elasticity of demand = 0
production capacities (like factory sizes).
• Demand curve is vertical
Long Run: Supply is more elastic because producers can build new
factories, expand existing ones, or enter/exit the market.
– Demand is perfectly elastic
• Price elasticity of demand = infinity
Perfectly Inelastic Supply: Quantity supplied does not change at all
• Demand curve is horizontal
with changes in price.
Supply Curve: Vertical line
• The flatter the demand curve Increasing Elasticity: Quantity supplied changes more with changes
–The greater the price elasticity of demand in price.
Supply Curve: Flatter slope
Inelastic Demand <1: Price ↑, Total Revenue ↑, price and total Perfectly Elastic Supply: Quantity supplied changes infinitely with
revenue move same direction changes in price.
Elastic Demand >1: Price ↑, Total Revenue ↓, price and total Supply Curve: Horizontal line
revenue move in opposite direction

Unit Elastic Demand: Price changes, but Total Revenue stays the
same; total revenue remain constant when price changes

 A life-saving medicine without any close substitutes will tend

to have:
 a. a small elasticity of demand.
o Explanation: Life-saving medicines are essential and typically have
few or no close substitutes. As a result, people will continue to buy
them even if the price rises, leading to inelastic demand (small
elasticity of demand).
 The price of a good rises from $8 to $12, and the quantity
demanded falls from 110 to 90 units. Calculated with the midpoint
Low Price, High Quantity: method, the price elasticity of demand is:
Demand is inelastic. For example, when the price of a basic food  b. 1/2.
item is low, people buy almost the same amount regardless of small o Explanation: Using the midpoint method:
price changes.
High Price, Low Quantity:
Demand is elastic. For example, luxury items like expensive cars see
big drops in sales when the price goes up because people can choose
cheaper alternatives.
o  A linear, downward-sloping demand curve is:
 d. inelastic at some points, and elastic at others.
o Explanation: Along a linear downward-sloping demand curve,
elasticity varies. It is elastic at higher prices (and lower quantities)
and inelastic at lower prices (and higher quantities).
 The ability of firms to enter and exit a market over time means
that, in the long run:
 c. the supply curve is more elastic.
o Explanation: Over time, firms can adjust their production capacities,
and new firms can enter the market while existing firms can exit,
making the supply more responsive to price changes (more elastic).
 An increase in the supply of a good will decrease the total
revenue producers receive if:
 a. the demand curve is inelastic.
o Explanation: When demand is inelastic, a lower price leads to a
proportionally smaller increase in quantity demanded. Therefore,
total revenue (price × quantity) decreases when supply increases
and prices fall.
Over time, technological advances increase consumers’ incomes and
reduce the price of smartphones. Each of these forces increases the
amount consumers spend on smartphones if the income elasticity of
demand is greater than ________ and if the price elasticity of
demand is greater than ________.
Answer:
 Income Elasticity of Demand: Zero
 Price Elasticity of Demand: One
Explanation:
1. Income Elasticity of Demand:
o Income elasticity of demand measures how the quantity demanded
of a good responds to a change in consumers' income.
o If the income elasticity of demand for smartphones is greater than
zero, it means that an increase in income leads to an increase in the
quantity demanded of smartphones. In other words, smartphones
are a normal good, and as people have more money, they will spend
more on smartphones.
2. Price Elasticity of Demand:
o Price elasticity of demand measures how the quantity demanded of
a good responds to a change in its price.
o If the price elasticity of demand for smartphones is greater than one,
it means that the quantity demanded responds more than
proportionately to a decrease in price. In other words, a reduction in
the price of smartphones leads to a more than proportionate
increase in the quantity demanded, increasing total spending on
smartphones.
Why Zero for Income Elasticity and One for Price Elasticity?
 Income Elasticity of Demand > Zero:
o When income elasticity of demand is greater than zero, it indicates
that as income increases, consumers will buy more smartphones.
This leads to an increase in the total amount spent on smartphones.
 Price Elasticity of Demand > One:
o When price elasticity of demand is greater than one, it indicates that
the demand for smartphones is elastic. In this case, a reduction in
the price of smartphones results in a larger percentage increase in
the quantity demanded. This means total revenue (price × quantity)
increases when the price decreases.
Thus, for both income increases and price decreases to lead to
higher total spending on smartphones, the income elasticity of
demand must be greater than zero, and the price elasticity of
demand must be greater than one.