🛒principles of microeconomics review
5.1 Price Elasticity of Demand and Price Elasticity of Supply
Last Updated on June 24, 2024
Price elasticity measures how quantity changes when price changes. It's crucial for understanding market dynamics. For demand, it shows how consumers react to price shifts. For supply, it reveals how producers adjust output as prices fluctuate.
Elasticity values range from perfectly inelastic to perfectly elastic. Factors like time, substitutes, and income affect elasticity. Understanding these concepts helps predict market behavior and guides pricing strategies for businesses and policymakers.
Price Elasticity of Demand and Supply
Price elasticity calculation method
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- Measures responsiveness of quantity demanded to price changes
- Percentage change in quantity demanded divided by percentage change in price
- Midpoint method avoids arbitrary designation of original and new price or quantity
- Uses average of initial and final values for price and quantity
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- and are initial and final quantities demanded (units sold)
- and are initial and final prices (dollars per unit)
Interpreting supply elasticity values
- Measures responsiveness of quantity supplied to price changes
- Percentage change in quantity supplied divided by percentage change in price
- PES > 1: Elastic supply, quantity supplied highly responsive to price changes (oil production)
- PES = 1: Unit elastic supply, quantity supplied changes proportionally with price changes (mass-produced goods)
- 0 < PES < 1: Inelastic supply, quantity supplied less responsive to price changes (housing market)
- PES = 0: Perfectly inelastic supply, quantity supplied does not change with price changes (land)
- PES = ∞: Perfectly elastic supply, quantity supplied changes infinitely with any price change (digital products)
Elastic vs inelastic curves
- Elastic demand:
- PED > 1, demand highly responsive to price changes (luxury goods)
- Relatively flat demand curve
- Small price change leads to large change in quantity demanded
- Inelastic demand:
- PED < 1, demand less responsive to price changes (necessities)
- Relatively steep demand curve
- Large price change leads to small change in quantity demanded
- Elastic supply:
- PES > 1, supply highly responsive to price changes (mass-produced goods)
- Relatively flat supply curve
- Small price change leads to large change in quantity supplied
- Inelastic supply:
- PES < 1, supply less responsive to price changes (limited natural resources)
- Relatively steep supply curve
- Large price change leads to small change in quantity supplied
Determinants of elasticity
- Time horizon: Elasticity often increases over longer periods as consumers and producers have more time to adjust
- Availability of substitutes: More substitutes generally lead to higher elasticity of demand
- Market structure: Competitive markets tend to have more elastic supply than monopolistic markets
- Production capacity: Industries with excess capacity can more easily increase supply, leading to higher elasticity
- Price-to-income ratio: Goods that represent a larger portion of consumers' income tend to have more elastic demand
Key Terms to Review (28)
Law of Demand: The law of demand is an economic principle that states that as the price of a good or service increases, the quantity demanded of that good or service decreases, and vice versa. This inverse relationship between price and quantity demanded is a fundamental concept in microeconomics.
Law of Supply: The law of supply states that, all else equal, as the price of a good or service rises, the quantity supplied of that good or service will increase, and as the price falls, the quantity supplied will decrease. This relationship between price and quantity supplied is the foundation for understanding how markets function.
Price Elasticity of Demand: Price elasticity of demand measures the responsiveness of the quantity demanded of a good or service to changes in its price. It quantifies how much the quantity demanded changes when the price changes, providing insights into consumer behavior and the dynamics of supply and demand in a market.
Substitutes: Substitutes are goods or services that can be used in place of one another to satisfy a similar need or desire. They are products that consumers view as interchangeable or comparable, and can be substituted for each other in consumption.
Price Elasticity of Supply: Price elasticity of supply measures the responsiveness of the quantity supplied of a good or service to a change in its price. It quantifies the degree to which suppliers adjust the amount they are willing to sell in response to price changes in the market.
Complements: Complements are goods or services that are used together, where the demand for one increases as the demand for the other increases. They are closely related and interdependent, such that a change in the price or availability of one affects the demand for the other.
Luxury: Luxury refers to goods and services that are not necessary for basic survival but are considered highly desirable, often associated with a high level of comfort, quality, and exclusivity. The concept of luxury is particularly relevant in the context of price elasticity of demand and pricing strategies.
Elastic: Elastic refers to the responsiveness or sensitivity of one economic variable, such as quantity demanded or quantity supplied, to changes in another economic variable, such as price. It is a measure of how much one variable changes in response to changes in another variable.
Unit Elastic: Unit elastic refers to a situation where the price elasticity of demand or supply is equal to 1, indicating that a 1% change in price leads to a 1% change in quantity demanded or supplied. This concept is crucial in understanding the relationship between price changes and their impact on consumer and producer behavior.
Necessity: Necessity refers to an essential or indispensable item or service that is required for an individual or society to function and meet basic needs. It is a fundamental concept in the context of price elasticity of demand and pricing strategies.
Price-Elasticity Ratio: The price-elasticity ratio is a measure that quantifies the responsiveness of the quantity demanded or supplied of a good or service to changes in its price. It is a crucial concept in the study of microeconomics, particularly in the analysis of 5.1 Price Elasticity of Demand and Price Elasticity of Supply.
Price-Sensitive: Price-sensitive refers to the degree to which the quantity demanded or supplied of a good or service is affected by changes in its price. It is a central concept in the analysis of price elasticity of demand and supply.
Income Elasticity: Income elasticity is a measure of the responsiveness of the quantity demanded of a good or service to a change in the consumer's income. It quantifies the degree to which demand for a product changes when the consumer's income changes, while holding all other factors constant.
Inelastic: Inelastic refers to a situation where the quantity demanded or supplied of a good or service is not highly responsive to changes in its price. This means that a change in price will result in a relatively smaller change in the quantity demanded or supplied.
Alfred Marshall: Alfred Marshall was a renowned British economist who is considered one of the most influential figures in the development of modern economic theory. His contributions were particularly significant in the areas of price elasticity of demand, price elasticity of supply, and the concept of elasticity in general.
Elasticity of Substitution: The elasticity of substitution measures the responsiveness of the quantity demanded of one good to a change in the price of a related good, holding the consumer's income and the prices of all other goods constant. It quantifies how easily consumers can substitute one good for another in their consumption when relative prices change.
Perfectly Inelastic: Perfectly inelastic refers to a situation where the quantity demanded or supplied of a good is completely unresponsive to changes in its price. In other words, the quantity does not change at all regardless of the price level.
Perfectly Elastic: Perfectly elastic refers to a situation where the quantity demanded or supplied of a good changes infinitely in response to even the smallest change in price. This means that consumers or producers are extremely sensitive to price changes, resulting in a perfectly horizontal demand or supply curve.
Quantity-Sensitive: Quantity-sensitive refers to a situation where the quantity demanded or supplied of a good or service is highly responsive to changes in its price. This concept is central to the understanding of price elasticity of demand and supply.
Elasticity Coefficient: The elasticity coefficient is a measure of the responsiveness of one economic variable, such as quantity demanded or quantity supplied, to changes in another variable, such as price. It is a crucial concept in understanding the dynamics of supply and demand in a market.
Midpoint Formula: The midpoint formula is a mathematical equation used to calculate the midpoint between two points on a coordinate plane. It is a crucial concept in the context of price elasticity of demand, price elasticity of supply, and pricing strategies.
Determinants of Elasticity: Determinants of elasticity refer to the various factors that influence the price elasticity of demand and the price elasticity of supply for a particular good or service. These determinants play a crucial role in understanding how responsive consumers and producers are to changes in price.
Cross-Price Elasticity: Cross-price elasticity is a measure of how the quantity demanded of one good changes in response to a change in the price of another good. It reflects the degree of substitutability or complementarity between two products, and is an important concept in understanding consumer behavior and market dynamics.
Price-to-Income Ratio: The price-to-income ratio is a metric that compares the median home price in an area to the median household income. It provides a measure of housing affordability by indicating how many years of median income would be required to purchase a median-priced home.
Availability of Substitutes: The availability of substitutes refers to the number and similarity of alternative products or services that can be used in place of a particular good or service. It is a key factor that influences the price elasticity of demand and supply for a product.
Production Capacity: Production capacity refers to the maximum level of output or production that a business or industry can achieve with its available resources, such as labor, equipment, and facilities. It is a crucial concept in understanding the dynamics of price elasticity of demand and price elasticity of supply.
Market Structure: Market structure refers to the organizational and competitive characteristics of a market, which determine how firms in that market interact and the outcomes they can achieve. It is a key concept in economics that helps understand how the degree of competition in a market affects the pricing, output, and other decisions made by firms.
Time Horizon: The time horizon refers to the length of time considered in economic analysis. It is a crucial concept that influences the price elasticity of demand and supply, as the responsiveness of consumers and producers to price changes can vary significantly depending on the time frame under consideration.