• ### Unit 3: Elasticity and its Applications

In this unit, we delve into the concept of elasticity and its practical applications for how firms make pricing decisions and how governments analyze and make policy decisions. Put simply, elasticity measures responsiveness. It helps us understand why Netflix increases their prices for their Standard and Premium tiers more frequently, compared to their entry-level Basic plan. Government analysts also rely on elasticity to determine the extent of tax increases.

We can apply elasticity to demand and supply analysis. Elasticity measures how quantity responds to changes in the price of the product, the price of related goods, income, advertising, and more. Once you grasp the concept and its basic calculations, applications of elasticity in economic analysis are nearly limitless.

Completing this unit should take you approximately 4 hours.

• ### 3.1: The Concept of Elasticity

According to the Cambridge Dictionary, The word elastic means "an elastic material is able to stretch and be returned to its original shape or size." Think of a rubber band. In the context of economics, elasticity measures how much a variable will "stretch" in response to a change in a related variable.

In this section, we introduce the concept of elasticity as it is studied in microeconomics. While this concept can be challenging due to its various types and the necessity to make calculations and interpret the results, you will discover it is not only highly useful but also quite intuitive and easy to grasp.

• ### 3.2: Elasticities of Demand

Now that you are familiar with the concept of elasticity as a measure of responsiveness, you are ready to apply it to the concepts you learned in Unit 2. We begin by analyzing how demand (quantity demanded) responds to changes in specific variables that affect it.

As you know, the quantity demanded of a good or service reacts to changes in its price, and the price elasticity of demand tells us by how much. Additionally, the demand for a good or service also responds to changes in consumers' income, measured by the income elasticity of demand, and the prices of related items, indicated by the cross-price elasticity of demand.
• ### 3.3: Elasticity of Supply and Its Applications

Now that you have fully grasped the concept of elasticity, let's apply it to supply. Recall from Unit 2 that supply illustrates the quantity a firm is willing to provide at each market price. Before you proceed, take a moment to assess whether you can define and calculate the price elasticity of supply.
• ### 3.4: Elasticity, Revenues, and Pricing Decisions

Throughout this unit, we have emphasized that elasticities of supply and demand are essential tools for the decision-making process of both firms and policymakers. In this section, we further explore the relationship between revenues and elasticity.

Before we begin, take a moment to review the concept of revenue to make sure everything is clear with income. Our course resources define income as "a flow of money received, often measured on a monthly or an annual basis," and revenue as "income from selling a firm's product, defined as price times quantity sold."

• ### 3.5: Elasticity and Its Applications

Elasticity is a concept that often prompts the thought, "Why did I not consider this earlier?" It serves as a fundamental analytical tool. For example, organizations like the FAO (Food and Agriculture Organization of the united Nations) use income and price elasticities of demand, among other variables, to assess food security (see https://www.fao.org/3/Y2876E/y2876e08.htm). Researchers apply these elasticities to study the distribution of essential pharmaceutical products in developing countries (see https://www.fao.org/3/Y2876E/y2876e08.htm). Policymakers, as we have mentioned, heavily depend on these measures when implementing new taxes or modifying existing ones.

We usually associate revenues with companies or firms. However, governments also generate revenues, primarily through taxes. As we explore later in the course, governments aim to maximize their tax revenue to fund the provision of public goods and services.

Before you studied this unit, you may have assumed, "All the government has to do is increase taxes to boost revenue for financing their expenditure." It is not that simple!

Consider this scenario: if the government imposes a high tax on red meat, consumers may simply switch to alternative products (substitutes) and significantly reduce their demand for red meat. As you may have already noticed, this logic closely resembles that of pricing and revenues for a firm. Both firms and governments must carefully assess elasticities.