This is “Review and Practice”, section 5.4 from the book Economics Principles (v. 1.0). For details on it (including licensing), click here.
For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. To download a .zip file containing this book to use offline, simply click here.
This chapter introduced a new tool: the concept of elasticity. Elasticity is a measure of the degree to which a dependent variable responds to a change in an independent variable. It is the percentage change in the dependent variable divided by the percentage change in the independent variable, all other things unchanged.
The most widely used elasticity measure is the price elasticity of demand, which reflects the responsiveness of quantity demanded to changes in price. Demand is said to be price elastic if the absolute value of the price elasticity of demand is greater than 1, unit price elastic if it is equal to 1, and price inelastic if it is less than 1. The price elasticity of demand is useful in forecasting the response of quantity demanded to price changes; it is also useful for predicting the impact a price change will have on total revenue. Total revenue moves in the direction of the quantity change if demand is price elastic, it moves in the direction of the price change if demand is price inelastic, and it does not change if demand is unit price elastic. The most important determinants of the price elasticity of demand are the availability of substitutes, the importance of the item in household budgets, and time.
Two other elasticity measures commonly used in conjunction with demand are income elasticity and cross price elasticity. The signs of these elasticity measures play important roles. A positive income elasticity tells us that a good is normal; a negative income elasticity tells us the good is inferior. A positive cross price elasticity tells us that two goods are substitutes; a negative cross price elasticity tells us they are complements.
Elasticity of supply measures the responsiveness of quantity supplied to changes in price. The value of price elasticity of supply is generally positive. Supply is classified as being price elastic, unit price elastic, or price inelastic if price elasticity is greater than 1, equal to 1, or less than 1, respectively. The length of time over which supply is being considered is an important determinant of the price elasticity of supply.
Refer to Figure 5.2 "Price Elasticities of Demand for a Linear Demand Curve" and
Consider the following quote from The Wall Street Journal: “A bumper crop of oranges in Florida last year drove down orange prices. As juice marketers’ costs fell, they cut prices by as much as 15%. That was enough to tempt some value-oriented customers: unit volume of frozen juices actually rose about 6% during the quarter.”
Suppose you are the manager of a restaurant that serves an average of 400 meals per day at an average price per meal of $20. On the basis of a survey, you have determined that reducing the price of an average meal to $18 would increase the quantity demanded to 450 per day.
The text notes that, for any linear demand curve, demand is price elastic in the upper half and price inelastic in the lower half. Consider the following demand curves:
Figure 5.13
The table gives the prices and quantities corresponding to each of the points shown on the two demand curves.
Demand curve D_{1} [Panel (a)] | Demand curve D_{2} [Panel (b)] | ||||
---|---|---|---|---|---|
Price | Quantity | Price | Quantity | ||
A | 80 | 2 | E | 8 | 20 |
B | 70 | 3 | F | 7 | 30 |
C | 30 | 7 | G | 3 | 70 |
D | 20 | 8 | H | 2 | 80 |
Suppose Janice buys the following amounts of various food items depending on her weekly income:
Weekly Income | Hamburgers | Pizza | Ice Cream Sundaes |
---|---|---|---|
$500 | 3 | 3 | 2 |
$750 | 4 | 2 | 2 |
Suppose the following table describes Jocelyn’s weekly snack purchases, which vary depending on the price of a bag of chips:
Price of bag of chips | Bags of chips | Containers of salsa | Bags of pretzels | Cans of soda |
---|---|---|---|---|
$1.00 | 2 | 3 | 1 | 4 |
$1.50 | 1 | 2 | 2 | 4 |
The table below describes the supply curve for light bulbs:
Price per light bulb | Quantity supplied per day |
---|---|
$1.00 | 500 |
1.50 | 3,000 |
2.00 | 4,000 |
2.50 | 4,500 |
3.00 | 4,500 |
Compute the price elasticity of supply and determine whether supply is price elastic, price inelastic, perfectly elastic, perfectly inelastic, or unit elastic: