🛒Principles of Microeconomics Unit 5 Review

Price elasticity measures how sensitive quantity demanded or supplied is to a change in price. It's one of the most practical tools in microeconomics because it helps predict how consumers and producers respond to price shifts, which in turn affects revenue, tax policy, and market outcomes.

Price Elasticity of Demand and Supply

Price elasticity calculation method, Elasticity – Introduction to Microeconomics

Price Elasticity of Demand: Calculation

Price elasticity of demand (PED) measures how responsive consumers are to a price change. The formula is:

$PED = \frac{\%\Delta Q_d}{\%\Delta P}$

PED is technically negative (price and quantity demanded move in opposite directions), but we typically use the absolute value when classifying elasticity.

The midpoint method is the standard approach for calculating PED. The regular percentage-change formula gives you different answers depending on which price-quantity pair you call "original" vs. "new." The midpoint method fixes this by using the average of both values as the base:

$PED = \frac{(Q_2 - Q_1) / [(Q_2 + Q_1) / 2]}{(P_2 - P_1) / [(P_2 + P_1) / 2]}$

$Q_1$ and $Q_2$ are the initial and final quantities demanded
$P_1$ and $P_2$ are the initial and final prices

Example: Suppose the price of a coffee drink rises from $4 to $6, and quantity demanded falls from 100 to 60 units.

Change in quantity: $60 - 100 = -40$ . Average quantity: $(60 + 100)/2 = 80$ . Percentage change in $Q$ : $-40/80 = -0.50$
Change in price: $6 - 4 = 2$ . Average price: $(6 + 4)/2 = 5$ . Percentage change in $P$ : $2/5 = 0.40$
$PED = -0.50 / 0.40 = -1.25$ . The absolute value is 1.25, so demand is elastic.

Price elasticity calculation method, Price Elasticity of Supply | Boundless Economics

Price Elasticity of Supply: Calculation and Interpretation

Price elasticity of supply (PES) measures how responsive producers are to a price change:

$PES = \frac{\%\Delta Q_s}{\%\Delta P}$

PES is positive because price and quantity supplied move in the same direction. Here's how to interpret the values:

PES Value	Classification	Meaning	Example
$PES = 0$	Perfectly inelastic	Quantity supplied doesn't change at all	Fixed land supply
$0 < PES < 1$	Inelastic	Quantity supplied changes less than proportionally to price	Housing (slow to build)
$PES = 1$	Unit elastic	Quantity supplied changes proportionally to price	Some manufactured goods
$PES > 1$	Elastic	Quantity supplied changes more than proportionally to price	Factory-produced goods with spare capacity
$PES = \infty$	Perfectly elastic	Any price decrease causes quantity supplied to drop to zero	Theoretical extreme

Elastic vs. Inelastic Curves

The slope of a demand or supply curve on a graph gives you a visual clue about elasticity, though slope and elasticity aren't the same thing.

Demand curves:

Elastic demand ( $PED > 1$ ): The curve is relatively flat. A small price increase causes a large drop in quantity demanded. Think luxury goods or items with many substitutes, like a specific brand of cereal.
Inelastic demand ( $PED < 1$ ): The curve is relatively steep. Even a big price increase barely changes quantity demanded. Think necessities like insulin or gasoline.
Unit elastic demand ( $PED = 1$ ): The percentage change in quantity exactly matches the percentage change in price. Total revenue stays constant when price changes.

Supply curves:

Elastic supply ( $PES > 1$ ): The curve is relatively flat. Producers can ramp up output quickly when price rises. This is common in industries with excess capacity or easy-to-source inputs.
Inelastic supply ( $PES < 1$ ): The curve is relatively steep. Producers can't easily increase output. This applies to goods with limited natural resources or long production timelines, like housing or fine wine.

Determinants of Elasticity

Several factors determine whether demand or supply will be elastic or inelastic:

Availability of substitutes: This is the single biggest factor for demand elasticity. More close substitutes means more elastic demand. Pepsi has elastic demand because Coke exists. Insulin has inelastic demand because there's no real substitute.
Necessity vs. luxury: Necessities (food, medicine) tend to have inelastic demand. Luxuries (vacations, designer clothes) tend to have elastic demand because consumers can simply go without.
Proportion of income: Goods that take up a larger share of your budget tend to have more elastic demand. You'll barely notice a 10% increase in the price of salt, but you'll definitely notice a 10% increase in rent.
Time horizon: Elasticity tends to increase over time for both demand and supply. In the short run, consumers are stuck with their habits and producers are stuck with their current capacity. Over months or years, consumers find substitutes and producers build new facilities.
Production capacity: Firms with spare capacity or easy access to inputs can increase output quickly, making supply more elastic. Industries that require specialized equipment or scarce resources have more inelastic supply.

🛒Principles of Microeconomics Unit 5 Review