Unit 3: Elasticity and its Applications

3a. Explain the concept of elasticity as it applies to microeconomics

  • Why is elasticity a fundamental concept in economics?
  • On which variables can we apply an elasticity analysis?
  • Why is elasticity calculated in terms of percentage changes?

Elasticity is a core concept in microeconomics. Thus far, we have focused on understanding the direction (increase or decrease) of changes in the basic microeconomic variables: demand, supply, quantity demanded, quantity supplied, and price. With elasticity, we assess how much (in percentage terms) a variable changes in response to a given percentage change in a related variable. All we need to do is divide the percentage change in the dependent variable by the percentage change in the independent variable. Economists use elasticity to analyze how demand and/or supply react to specific changes in price, income, price of related goods, advertising, taxes, etc.

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3b. Discuss price elasticity of demand and understand how to measure it

  • What is the price elasticity of demand?
  • What is the formula used to calculate the price elasticity of demand?
  • Why do we take absolute value to calculate the price elasticity of demand?
  • What is the interpretation of an elasticity result that is, for example, lower than one?
  • Do all consumers have the same price elasticity of demand?
  • What goods and services would you expect to have a lower price elasticity of demand, necessities, or luxuries? 

Let's apply the concept of elasticity to the quantitative analysis of the relationship between various microeconomic variables. One of the most widely used elasticities is the price elasticity of demand (PED), which measures the percentage change in the quantity demanded of a good in response to a given percentage change in its price.

Mathematically:

PED = | (ΔQ/Q) / (ΔP/P) | = | % change in Qd / % change in P |

The interpretation of the result is as important as the calculation itself. You do not need to memorize the possible results and their meaning. Make sure you understand what the numbers mean. For example, if the elasticity is positive or greater than one, the upper part of the fraction is higher than the bottom part. Therefore, the quantity demanded reacts more than the change in price itself. If the elasticity is negative, the upper part of the fraction is lower than the bottom part. Therefore, the quantity demanded reacts less than the change in price itself. This rationale allows you to interpret the results.

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3c. Give examples of income elasticity of demand and cross price elasticity of demand and understand their results

  • What is the income elasticity of demand?
  • What is the cross price elasticity of demand?
  • Do we take absolute value to calculate income elasticity of demand?
  • How do you interpret negative cross price elasticity results?
  • How do we use income elasticity of demand to classify goods as normal or inferior?

Let's expand on the analysis of demand elasticities by incorporating the income elasticity of demand (IED) and the cross-price elasticity of demand.

Income elasticity of demand quantifies the percentage change in quantity demanded relative to a given percentage change in income. We refrain from calculating absolute values to differentiate betweeninferior goods (negative results) and normal goods (positive results). As we did for the PED, we use the values one and minus one to assess whether demand is income elastic or inelastic.

Mathematically:

IED = (ΔQ/Q) / (ΔIncome/Income)

IED = % change in Qd / % change in Income

Cross price elasticity of demand (XED) measures how much the quantity demanded of a good or service changes (in percentage) relative to a given percentage change in the price of another good or service. As with price elasticity of demand, we refrain from calculating absolute values because we need to interpret both positive and negative values. 

XED = % change in Qy / % change in Px

For example, if we analyze the cross-price elasticity between olive oil and sunflower oil, a positive value implies that consumers tend to substitute olive oil with sunflower oil when the price of olive oil rises. This indicates that olive oil and sunflower oil are substitutes. 

Again, rather than rely on rote memorization, focus on understanding the interpretation and analysis of the results. This approach will significantly enhance your understanding of microeconomics. Can you create your own example and interpretation of a negative value for the cross price elasticity of demand?

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3d. Explain price elasticity of supply and its applications

  • What is the price elasticity of supply?
  • How do we interpret the results of the price elasticity of supply?
  • What factors affect the price elasticity of supply?
  • Do we need to take absolute value to calculate the price elasticity of supply? 

The price elasticity of supply shows how producers adjust their output in response to price changes.

Mathematically:

PES = % change in Qs / % change in P

A result higher than one (change in quantity supplied is higher than the change in price) suggests that producers can readily increase or decrease production in response to price changes. You can apply a similar reasoning to understand the implications of results lower than one, including zero.

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3e. Predict how elasticity affects revenue and pricing decisions

  • What is the relationship between total revenues and the price elasticity of demand?
  • What is the relationship between total revenues and price elasticity of supply?
  • Facing a demand that is price elastic, should a firm increase the price to optimize total revenue?

You have probably gathered that businesses must understand elasticity! Pricing strategies significantly impact revenues and profits. Since we multiply price by the number of units sold to determine revenues, the responsiveness of sales to price changes directly influences revenue.

Rather than providing a comprehensive table of elasticity-revenue relationships, this unit empowers you to analyze any situation. Let's revisit the key steps:

  1. Interpret the elasticity result – determine whether the change in quantity is higher or lower than the price (or income) change;
  2. Remember the total revenue formula – revenue equals price multiplied by quantity and
  3. Analyze revenue's direction – identify whether revenue increases or decreases. Account for the inverse relationship between price and quantity demanded.

For example, the price elasticity of demand for oranges is approximately 0.6. This indicates that if the price of oranges increases by a specific percentage, ceteris paribus, the quantity demanded will decrease by a lower percentage. What would occur to total revenues? They would rise because the change in price exceeds the change in the quantity demanded.

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3f. Discuss how tax incidence relates to the model of demand and supply and to elasticity

  • What is tax incidence?
  • What is the tax burden?
  • What is the effect of a tax levied on a product with a demand that is perfectly price elastic?

Tax incidence determines who ultimately bears the cost of a tax, considering both the direct and indirect consequences of the tax. Tax incidence involves analyzing how the tax burden is distributed between buyers and sellers in the market. The tax burden, also known as the tax share, refers to the actual economic cost of the tax borne by an individual or entity. For example, firms pay the government a tax on their sales. However, firms can pass the entire or partial amount of tax along to the consumer. The amount the consumer supports of this tax burden and the amount the firm assumes depends on the relative price elasticity of demand and the price elasticity of supply. Understanding elasticity is essential for policymakers to assess the impact of tax policies.

The price elasticity of supply and demand also determine the amount of revenue the government receives from the tax. For example, a tax on a product with highly inelastic demand (such as alcoholic beverages or cigarettes) will generate more tax revenue than a tax on a product with relatively elastic demand (a product with many close substitutes). 

Be sure to review the two videos on the relationship between taxation and the two polar cases of price elasticity of demand. 

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Unit 3 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • cross price elasticity of demand (XED)
  • elasticity
  • income elasticity of demand
  • price elasticity of demand (PED)
  • price elasticity of supply
  • tax burden
  • tax incidence