Elasticity Types

Why This Matters

Elasticity is the concept that transforms basic supply and demand analysis into a powerful predictive tool. On the AP Microeconomics exam, you're being tested on your ability to understand how responsive buyers and sellers are to changes in price, income, and the prices of related goods—and why that responsiveness matters for business decisions, tax policy, and market outcomes. The exam loves to connect elasticity to total revenue, tax incidence, and consumer behavior, so mastering these relationships is essential.

Think of elasticity as the "sensitivity meter" of economics. It answers questions like: Will raising prices increase or decrease a firm's revenue? Who actually pays a tax—buyers or sellers? How do income changes affect demand for different types of goods? These aren't abstract concepts—they show up in FRQs asking you to analyze graphs, calculate values, and explain real-world market outcomes. Don't just memorize the formulas; know what each elasticity type reveals about market behavior and why it matters for decision-making.

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Measuring Consumer Responsiveness to Price

Price elasticity of demand captures how sensitive consumers are to price changes, measured as the ratio of percentage changes. This is the most frequently tested elasticity concept, and you need to understand both the calculation and its implications for total revenue.

Price Elasticity of Demand

• Calculated as percent change in quantity demanded divided by percent change in price—the formula is $E_d = \frac{\%\Delta Q_d}{\%\Delta P}$, and the midpoint method avoids directional bias
• Magnitude determines classification: $|E_d| > 1$ is elastic, $|E_d| < 1$ is inelastic, $|E_d| = 1$ is unit elastic—always interpret the absolute value
• Total revenue test connects directly to elasticity: if demand is elastic, price and total revenue move in opposite directions; if inelastic, they move together

Elastic Demand

• Quantity demanded changes by a larger percentage than price—consumers are highly responsive, often because substitutes are readily available
• Associated with luxuries, non-essentials, and narrowly defined markets—the more options consumers have, the more elastic their demand
• Lowering price increases total revenue because the gain in quantity sold more than offsets the lower price per unit

Inelastic Demand

• Quantity demanded changes by a smaller percentage than price—consumers keep buying even when prices rise significantly
• Common for necessities, addictive goods, and products with few substitutes—think medications, gasoline, or insulin
• Raising price increases total revenue because lost sales are minimal compared to the higher price per unit

Unit Elastic Demand

• Percentage change in quantity exactly equals percentage change in price—occurs at the midpoint of any linear demand curve
• Total revenue remains constant regardless of whether price rises or falls—the two effects perfectly offset
• Marks the revenue-maximizing point on a demand curve, making it critical for optimal pricing analysis

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Extreme Cases of Price Sensitivity

Perfectly elastic and perfectly inelastic demand represent theoretical extremes that help illustrate how elasticity works at its limits. These show up on graphs as horizontal and vertical demand curves, respectively.

Perfectly Elastic Demand

• Any price increase causes quantity demanded to drop to zero—represented by a horizontal demand curve at the market price
• Occurs in perfectly competitive markets where firms sell identical products and consumers can instantly switch to competitors
• Firms are price takers with no pricing power; they must accept the market equilibrium price or sell nothing

Perfectly Inelastic Demand

• Quantity demanded stays constant regardless of price changes—represented by a vertical demand curve
• Occurs for absolute necessities with no substitutes—life-saving medications or goods consumers must have at any cost
• Entire tax burden falls on consumers when demand is perfectly inelastic, since they cannot reduce purchases in response to higher prices

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Measuring Producer Responsiveness

Price elasticity of supply measures how quickly and easily producers can adjust output when prices change. Time horizon is the key determinant—the longer producers have to respond, the more elastic supply becomes.

Price Elasticity of Supply

• Calculated as percent change in quantity supplied divided by percent change in price—the formula is $E_s = \frac{\%\Delta Q_s}{\%\Delta P}$
• Determined by production flexibility and time—industries with spare capacity or easily scalable inputs have more elastic supply
• Affects tax incidence and deadweight loss: when supply is more inelastic, producers bear more of a tax burden and deadweight loss tends to be smaller

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Measuring Responsiveness to Income

Income elasticity of demand reveals how consumer purchasing patterns shift as their income changes. This elasticity helps classify goods and predict how economic growth or recession affects different markets.

Income Elasticity of Demand

• Calculated as percent change in quantity demanded divided by percent change in income—the formula is $E_I = \frac{\%\Delta Q_d}{\%\Delta I}$
• Sign determines good type: positive values indicate normal goods (demand rises with income), negative values indicate inferior goods (demand falls with income)
• Magnitude distinguishes necessities from luxuries: for normal goods, $E_I < 1$ means necessity, $E_I > 1$ means luxury—luxuries see demand grow faster than income

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Measuring Responsiveness to Related Goods

Cross-price elasticity of demand measures how the price of one good affects demand for another. This reveals market relationships between products and is essential for understanding substitutes and complements.

Cross-Price Elasticity of Demand

• Calculated as percent change in quantity demanded of Good A divided by percent change in price of Good B—the formula is $E_{AB} = \frac{\%\Delta Q_A}{\%\Delta P_B}$
• Sign reveals the relationship: positive values indicate substitutes (Coke and Pepsi), negative values indicate complements (printers and ink cartridges)
• Magnitude indicates relationship strength—a cross-price elasticity near zero suggests the goods are unrelated, while large values indicate strong market connections

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Quick Reference Table

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Self-Check Questions

1. If a firm raises its price and total revenue decreases, what does this tell you about the price elasticity of demand for its product? How would you classify this demand?

2. A good has an income elasticity of $-0.4$. Is this good normal or inferior? Would demand for this good likely rise or fall during an economic recession?

3. Compare and contrast substitutes and complements in terms of their cross-price elasticity signs. Give one example of each and explain why the sign makes intuitive sense.

4. On a graph showing a per-unit tax, how would you determine whether buyers or sellers bear more of the tax burden? What role does the relative elasticity of supply and demand play?

5. Why does elasticity vary along a linear demand curve even though the slope is constant? At what point on the curve is demand unit elastic, and why does this matter for a firm's pricing strategy?