Foundations of Economic Analysis: Elasticities Flashcards Preview

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1

What is Elasticity?

Elasticity is a measure of responsiveness. It measures how much the quantity demanded or supplied varies with changes in other variables.

2

In economics and elasticity, what are we interested in?

However, in economics we are also interested in the position on the line where the measurement is to take place.
  
The (own-) price elasticity of demand is defined as:
 
η = % Change in Qd / % Change in P
 
This measures the responsiveness of the quantity demanded to the (own-) price. η is the conventional symbol for elasticity.

3

What is the formula that we use for elasticities?

The formula we use is η = ΔQ/Q ΔP/P
 
ΔQ = 8-4 = 4
Q = 4
Therefore the % change in Q is 100*(4/4) = 100%
 
ΔP = 3-5= -2
P = 5
Therefore the % change in price is 100*(-2/5) = -40%

4

What are the five elasticity possibilities?

i) Perfectly inelastic, i.e. η = 0. In this case demand is unresponsive to price changes.
 
ii) Inelastic, i.e. 0 > η > -1. In this case quantity demanded changes by a smaller percentage than price.
 
iii) Unit elasticity, i.e. η = -1. In this case quantity demanded and price change by the same percentage amounts each time. 

iv) Elastic, i.e. -1< η < -. In this case quantity demanded changes by a larger percentage than price.

v) Perfectly elastic, i.e. η = -. In this case quantity demanded is as much as the buyer can demand at one price and nothing at a higher price.

5

What formula do we use to work out elasticity?

η = ΔQ/Q ΔP/P
 
(η = % Change in Qd / % Change in P)

Elasticity is not the same as the slope of the demand curve.

6

Explain why elasticity is not the same as the slope of the demand curve?

Elasticity varies along the curve even though the slope is constant.
 
This is because of the way elasticity is calculated:
 
η = ΔQ/ΔP P/Q
 
As Q heads towards 0 then the ratio P/Q increases towards infinity, which means that the elasticity becomes infinite.

As P heads towards zero then the ratio P/Q decreases towards zero which means that the elasticity tends to 0.

7

Give three characteristics of constant-elasticity curves?

Elasticity is zero: there is no change in the quantity demanded as price changes.

Elasticity is infinite - small reductions in price leads to infinite increases in demand.

Unit elasticity: the curve has elasticity 1 throughout its whole length.

8

What is meant by cross price elasticities of demand?

We are focusing on (own-) price elasticities of demand in this course
However, cross-price elasticities can also be useful:

XED = (Δ% in Qd for good X)/(Δ% in Price for good Y)

If XED>0, then X and Y are substitutes (e.g. Coke and Pepsi)

If XED<0, then X and Y are complements (e.g. cars and petrol)

If XED=0, then X and Y are independent of each other

9

What is meant by elasticity of supply?

Much of what has been said about the elasticity of demand can be used to describe the price elasticity of supply:
 
η = % Change in Qs of good X / % Change in P of good X
 
i.e. exactly the same as for demand except that we are looking at the responsiveness of the quantity supplied to a change in price.

10

What is meant by the term "extreme elasticities"?

The "extreme" elasticities of supply are similar to those for demand.

A perfectly elastic supply curve is horizontal, while a perfectly inelastic supply curve is vertical.

One change is in unit elasticity, which is in fact a straight line graph through the origin:

11

What is meant by income elasticity?

This measures the impact of changes in income on the quantity demanded of a good.
 
The income elasticity of demand is measured in a similar way to the other elasticities:
 
η = % Change in Quantity Demanded / % Change in Income
 
Income elasticity can be either positive or negative depending on the effect of income on the quantity demanded. 

12

In general though:

If the income elasticity is positive then the good is a normal good.

If the income elasticity is above unity, then the good is a luxury good (e.g. BMW).

If the income elasticity is negative then the good is an inferior good (e.g. Black & White TV, inter-city bus service)

The good can then be inelastic or elastic as with all other elasticities.