Price elasticity of demand measures how much people buy when prices change. It's calculated using the midpoint method to avoid bias. The formula compares percentage changes in quantity and price, giving insights into consumer behavior and market dynamics.

Elasticity concepts extend beyond demand. Supply elasticity shows how production responds to price shifts. Cross-price and income elasticities reveal relationships between goods and consumer income. These tools help businesses and policymakers make informed decisions about pricing and market strategies.

Price Elasticity of Demand

Calculate price elasticity of demand using the midpoint method

• Measures the responsiveness of quantity demanded to a change in price
• Uses midpoint method to calculate PED to avoid arbitrary base values
• Midpoint method formula: $PED = \frac{(Q_2 - Q_1)}{(Q_2 + Q_1)/2} \div \frac{(P_2 - P_1)}{(P_2 + P_1)/2}$
  • $Q_1$ and $Q_2$ represent the initial and final quantities demanded
  • $P_1$ and $P_2$ represent the initial and final prices
• Example calculation: Price increases from $10 to $12 and quantity demanded decreases from 100 to 80, then $PED = \frac{(80 - 100)}{(80 + 100)/2} \div \frac{(12 - 10)}{(12 + 10)/2} = -1.11$
• Negative PED value indicates an inverse relationship between price and quantity demanded
• PED can be used to analyze changes in total revenue for producers

Interpretation of supply elasticity

• Measures the responsiveness of quantity supplied to a change in price
• Calculated using the midpoint method: $PES = \frac{(Q_2 - Q_1)}{(Q_2 + Q_1)/2} \div \frac{(P_2 - P_1)}{(P_2 + P_1)/2}$
• Interpretation of PES values:
  • PES > 1: Elastic supply, quantity supplied highly responsive to price changes (oil)
  • PES = 1: Unitary elastic supply, quantity supplied changes proportionally with price
  • 0 < PES < 1: Inelastic supply, quantity supplied less responsive to price changes (housing)
  • PES = 0: Perfectly inelastic supply, quantity supplied does not change with price (land)
  • PES = ∞: Perfectly elastic supply, quantity supplied changes infinitely with any price change
• Higher PES values indicate greater responsiveness of supply to price changes

Elastic and Inelastic Demand/Supply

Elastic vs inelastic scenarios

• Elastic demand (|PED| > 1):
  • Quantity demanded highly responsive to price changes
  • Small change in price leads to large change in quantity demanded
  • Examples: luxury goods (designer clothing), goods with many substitutes (fast food)
  • Implication: Producers have less power to increase prices without losing significant sales
• Inelastic demand (|PED| < 1):
  • Quantity demanded less responsive to price changes
  • Large change in price leads to small change in quantity demanded
  • Examples: necessities (insulin), goods with few substitutes (gasoline)
  • Implication: Producers can increase prices without losing significant sales
• Elastic supply (PES > 1):
  • Quantity supplied highly responsive to price changes
  • Small change in price leads to large change in quantity supplied
  • Examples: goods with readily available inputs and production capacity (mass-produced electronics)
  • Implication: Market equilibrium quickly restored after a demand shock
• Inelastic supply (0 < PES < 1):
  • Quantity supplied less responsive to price changes
  • Large change in price leads to small change in quantity supplied
  • Examples: goods with limited production capacity or scarce inputs (rare earth metals)
  • Implication: Market equilibrium takes longer to restore after a demand shock

Related Elasticity Concepts

Cross-price and income elasticity

• Cross-price elasticity measures how the demand for one good changes in response to a price change in another good
• Income elasticity of demand measures how the demand for a good changes in response to changes in consumer income
• These elasticities help understand the relationships between different goods and consumer behavior

Applications of elasticity

• Total revenue analysis: Elasticity determines how price changes affect a firm's total revenue
• Price discrimination: Firms can use elasticity information to charge different prices to different consumer groups
• Tax incidence: Elasticity affects how the burden of a tax is shared between consumers and producers