Elasticity Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: Price Elasticity of Demand, Determinants of Elasticity, Total Revenue, Income Elasticity, Cross-Price Elasticity of Demand, Elasticity of Supply
Studying the economic concept of elasticity is much like a corporate executive workshop, the topic of which is "Sensitivity Training." When we observe a consumer's purchase decision, say for good X, change in response to a change in some external variable (the price of good X or her income), elasticity helps us measure the sensitivity of her consumption to that external change. We also examine the sensitivity of suppliers of good X to a change in the price of good X. We use basic mathematical relationships to measure elasticity, but it is useful to remember that all elasticity formulas measure sensitivity to a change.
Price Elasticity of Demand
The Law of Demand tells us that: "all else equal, when the price of a particular good falls, the quantity demanded for that good rises." But what it fails to answer for us is: "by how much"? Will it be a relatively large increase in quantity demanded or will it be almost negligible? In other words, we would like to measure how sensitive consumers are to a change in the price of this good.
Price Elasticity of Demand Formula
- Ed = (%Δ in quantity demanded of good X)/(%Δ in the price of good X)
Note: The Law of Demand insures that Ed is negative, but, for ease of interpretation, economists usually ignore the fact that price elasticity of demand is negative and simply use the absolute value. The greater this ratio, the more sensitive, or responsive, consumers are to a change in the price of good X.
Range of Price Elasticity
Economists like to classify things. It's a sickness, but it is usually done for a reason. (You do need to know these for the exam.) For example, we classify elasticities based upon how sizeable the reaction of consumers is to a change in the price. Rather than describing consumers as "really responsive" or "really, really responsive" or "super duper responsive," we classify consumer responses as elastic or inelastic. The examples below should clarify things.
The price of a laptop computer increases by 10 percent and we observe a 20 percent decrease in quantity demanded. Using the above formula:
Ed = (–20%)/(+10%) = –2 or simply Ed = 2
- If Ed > 1, demand is said to be "price elastic" for good X. The responsiveness of the consumer exceeded, in percentage terms, the initial change in the price.
The price of a package of chewing gum increases by 10 percent and we observe a 5 percent decrease in quantity demanded. Using the above formula:
Ed = (5%)/(10%) = ½
- If Ed < 1, demand is said to be "price inelastic" for good X. The initial change in the price exceeded, in percentage terms, the responsiveness of the consumer.
The price of oranges increases by 5 percent and the quantity demanded decreases by 5 percent. Using our elasticity formula:
Ed = (5%)/(5%) = 1
- If Ed = 1, demand is said to be "unit elastic" for good X. The initial change in the price is exactly equal to, in percentage terms, the responsiveness of the consumer.
Elasticity on the Demand Curve
Take a very simple demand curve for cheeseburgers: P = 6 – Qd, and plot this demand curve below (Figure 7.1).
Table 7.1 summarizes changes in price, quantity demanded and price elasticity at each point on the demand curve.1
As you can see, in Figure 7.1, the price elasticity of demand is not constant at points A through G on the demand curve. Specifically, as the price rises, Ed rises, telling us that consumers are more price sensitive at higher prices than they are at lower prices. This makes good intuitive sense. When the price is relatively low (e.g., point B) a 50 percent increase in price might be almost negligible to consumers. But if the original price is quite high (point F) then a 50 percent increase in the price is pretty drastic. In fact, if we divide the demand curve in half, you can see that above the midpoint (point D), demand is price elastic and below the midpoint, demand is price inelastic. At the midpoint, demand is unit elastic.