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Principles of Macroeconomics
Table of Contents
Unit 5 Overview: Elasticity
5.1 Price Elasticity of Demand and Price Elasticity of Supply
5.2 Polar Cases of Elasticity and Constant Elasticity
5.3 Elasticity and Pricing
5.4 Elasticity in Areas Other Than Price

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5.2 Polar Cases of Elasticity and Constant Elasticity

Citation:

Elasticity measures how sensitive quantity is to price changes in economics. It ranges from infinite (extremely responsive) to zero (unresponsive). Understanding these extremes helps grasp real-world scenarios between them.

Constant elasticity occurs when the percentage change in quantity remains consistent for a given percentage change in price. This concept applies to both supply and demand, with factors like substitutes and time horizons affecting elasticity levels.

Polar Cases of Elasticity

Infinite and zero elasticity concepts

  • Infinite elasticity
    • Occurs when any change in price results in an infinite change in quantity demanded (water) or supplied (digital goods)
    • Represented by a perfectly horizontal line on a supply or demand curve
    • For demand curves, consumers are extremely sensitive to price changes and will drastically alter their purchasing behavior in response to even small price fluctuations
    • For supply curves, producers can supply an infinite amount at a given price without incurring additional costs (software)
  • Zero elasticity
    • Occurs when any change in price results in no change in quantity demanded (insulin) or supplied (land)
    • Represented by a perfectly vertical line on a supply or demand curve
    • For demand curves, consumers are completely insensitive to price changes and will purchase the same quantity regardless of price fluctuations
    • For supply curves, producers cannot change the quantity supplied regardless of price changes due to fixed resources or production constraints

Identifying elasticity in graphs

  • Constant unitary elasticity
    • Represented by a demand curve with a constant slope of -1, forming a rectangular hyperbola
    • A 1% change in price results in a 1% change in quantity demanded in the opposite direction, maintaining a constant total revenue (housing)
    • Total revenue remains constant as price changes because the percentage change in quantity demanded perfectly offsets the percentage change in price
  • Identifying infinite elasticity on a graph
    • Appears as a perfectly horizontal line on a supply (ebooks) or demand curve (generic brand rice)
    • Any change in price, no matter how small, results in an infinite change in quantity, as consumers or producers are extremely responsive to price fluctuations
  • Identifying zero elasticity on a graph
    • Appears as a perfectly vertical line on a supply (original artwork) or demand curve (life-saving medication)
    • Any change in price, no matter how large, results in no change in quantity, as consumers or producers are completely unresponsive to price changes

Constant Elasticity

Elasticity in supply vs demand

  • Elasticity of demand
    • Measures the responsiveness of quantity demanded to changes in price, calculated as $E_d = \frac{%\Delta Q_d}{%\Delta P}$
    • Elastic demand: $|E_d| > 1$, quantity demanded (luxury cars) changes by a larger percentage than price
    • Inelastic demand: $|E_d| < 1$, quantity demanded (tobacco) changes by a smaller percentage than price
    • Unit elastic demand: $|E_d| = 1$, quantity demanded (milk) changes by the same percentage as price
    • Price elasticity of demand can be calculated using the midpoint formula to avoid inconsistencies between price increases and decreases
  • Elasticity of supply
    • Measures the responsiveness of quantity supplied to changes in price, calculated as $E_s = \frac{%\Delta Q_s}{%\Delta P}$
    • Elastic supply: $E_s > 1$, quantity supplied (mass-produced goods) changes by a larger percentage than price
    • Inelastic supply: $E_s < 1$, quantity supplied (oil) changes by a smaller percentage than price
    • Unit elastic supply: $E_s = 1$, quantity supplied (agricultural products) changes by the same percentage as price
  • Factors affecting elasticity
    • For demand: availability of substitutes (Pepsi vs Coke), proportion of income spent (housing vs gum), necessity vs luxury (food vs jewelry), and time horizon (gasoline in the short run vs long run)
    • For supply: time horizon (crops in the short run vs long run), production capacity (factories), inventory (retail stores), and ease of changing production inputs (service industries vs manufacturing)

Other types of elasticity

  • Cross-price elasticity: Measures how the quantity demanded of one good changes in response to a change in the price of another good, useful for identifying substitutes and complements
  • Income elasticity: Measures how the quantity demanded of a good changes in response to a change in consumer income, helping classify goods as normal or inferior
  • Price discrimination: A pricing strategy where firms charge different prices to different consumer groups based on their willingness to pay, made possible by differences in price elasticity of demand among these groups

Key Terms to Review (20)

Price Elasticity: Price elasticity is a measure of the responsiveness of the quantity demanded or supplied of a good or service to changes in its price. It quantifies the degree to which consumers and producers react to price changes in the market.
Elastic Demand: Elastic demand refers to a situation where the quantity demanded of a good or service is highly responsive to changes in its price. When demand is elastic, a small change in price leads to a relatively large change in the quantity demanded, indicating that consumers are sensitive to price fluctuations for that particular product or service.
Total Revenue: Total revenue is the total amount of money a business earns from the sale of its goods or services. It is the product of the price per unit and the quantity sold, and is a crucial metric in understanding a firm's financial performance and pricing strategies.
Infinite Elasticity: Infinite elasticity refers to a situation where the quantity demanded or supplied of a good is completely responsive to even the smallest change in price. In this case, the elasticity value approaches infinity, indicating that consumers or producers are willing to buy or sell any quantity at the prevailing market price.
Income Elasticity: Income elasticity is a measure of the responsiveness of the quantity demanded of a good or service to changes in the consumer's income. It quantifies the degree to which the demand for a product changes as the consumer's income level changes.
Inelastic Demand: Inelastic demand refers to a situation where the quantity demanded of a good or service changes relatively little in response to changes in its price. In other words, consumers' demand for the product is not very sensitive to price fluctuations. This concept is central to understanding the efficiency of the market system, the relationship between price elasticity and pricing strategies, and the broader applications of elasticity beyond just price.
Price Discrimination: Price discrimination is the practice of selling the same product or service at different prices to different customers, based on their willingness or ability to pay. It allows sellers to capture more consumer surplus by charging each customer the maximum price they are willing to pay.
Elasticity of Supply: Elasticity of supply refers to the responsiveness of the quantity supplied of a good or service to changes in its price. It measures the degree to which the supply of a product changes in relation to a change in its price.
Unit Elastic Supply: Unit elastic supply refers to a situation where the quantity supplied of a good or service responds proportionately to changes in its price. In other words, a 1% change in price leads to a 1% change in quantity supplied, resulting in a price elasticity of supply equal to 1.
Cross-Price Elasticity: Cross-price elasticity is a measure of the responsiveness of the demand for one good to a change in the price of another good. It quantifies the relationship between the demand for two related, but distinct, products.
Perfectly Horizontal Line: A perfectly horizontal line is a line that runs parallel to the x-axis, with a constant y-coordinate value. It represents a scenario where a variable is completely unresponsive to changes in another variable, exhibiting the most extreme form of inelasticity.
Constant Unitary Elasticity: Constant unitary elasticity refers to a situation where the elasticity of demand or supply for a good remains constant at a value of 1, regardless of the price level. This means that a 1% change in price will result in an equal 1% change in the quantity demanded or supplied, maintaining a unit elastic relationship between price and quantity.
Rectangular Hyperbola: A rectangular hyperbola is a type of hyperbolic function where the product of the coordinates of any point on the curve is a constant. This geometric shape has important applications in the study of elasticity and consumer behavior within the field of microeconomics.
Inelastic Supply: Inelastic supply refers to a situation where the quantity supplied of a good or service is relatively unresponsive to changes in its price. Producers are unable or unwilling to significantly adjust the amount they are willing to sell, even if the price rises or falls.
Zero Elasticity: Zero elasticity, also known as perfectly inelastic demand, refers to a situation where the quantity demanded of a good or service does not change at all in response to changes in its price. In this scenario, the demand curve is perfectly vertical, indicating that consumers will purchase the same amount regardless of the price.
Midpoint Formula: The midpoint formula is a mathematical technique used to calculate the midpoint between two points on a coordinate plane. It is particularly relevant in the context of understanding the concepts of elasticity, specifically the polar cases of elasticity and constant elasticity.
Elastic Supply: Elastic supply refers to a situation where the quantity supplied of a good or service is highly responsive to changes in its price. In other words, suppliers are able and willing to adjust the amount they offer for sale in the market based on fluctuations in the prevailing price.
Perfectly Vertical Line: A perfectly vertical line is a line that is perpendicular to the horizontal axis, indicating that the variable on the vertical axis does not change regardless of the value of the variable on the horizontal axis. This concept is particularly relevant in the context of the polar cases of elasticity and constant elasticity.
Elasticity of Demand: Elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to changes in its price. It quantifies how much the quantity demanded changes in relation to a change in price.
Unit Elastic Demand: Unit elastic demand refers to a situation where the percentage change in quantity demanded is equal to the percentage change in price. In other words, a 1% change in price leads to a 1% change in quantity demanded in the opposite direction, resulting in a unitary elasticity of demand.