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Elasticity Review for AP Economics (page 3)

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

Income Elasticity of Demand

In the case of the income elasticity, it is a measure of how sensitive consumption of good X is to a change in a consumer's income.

    EI = (% Δ Qd good X)/(% Δ Income)

Example:

Jason's income rises 5 percent and we see his consumption of fast food meals rise 10 percent.

    EI = 10%/5% = 2

So what do we make of this? First, because EI is greater than zero, we can determine that fast food meals are a normal good for Jason. Second, at least in this example, the consumption of fast food meals is quite income elastic. A relatively small percentage increase in income causes a large, in fact twofold, percentage increase in fast food meals. Some refer to these goods as luxuries.

Example:

Jen's income rises 5 percent and we observe her consumption of bread rise 1 percent.

    EI = 1%/5% = .2

Once again, this measure would indicate that bread is a normal good as more income prompts more bread consumption. However, the relatively small increase in consumption compared to the increase in income tells us that bread is relatively income inelastic. This makes sense, after all, how much more bread does one really wish to consume as their income rises? If Jen's income doubled, would she double, or more than double, her consumption of bread? These goods are often referred to as necessities.

Example:

Consumer income increases by 5 percent and we observe consumption of packaged bologna decrease by 2 percent.

    EI = –2%/5%= –.4

Again, there are two important observations that can be made here. First, because consumption of bologna decreased with an increase in income, we can conclude that bologna, in this example, is an inferior good. Second, there is a relatively inelastic response in bologna consumption to a change in income.

Cross-Price Elasticity of Demand

Consumers also change their consumption of good X when the price of a related good, good Y changes. The sensitivity of consumption of good X to a change in the price of good Y is called the cross-price elasticity of demand.

    Ex,y = (% Δ Qd good X )/(% Δ Price good Y )

Example:

The price of eggs increases by 1 percent and the consumption of bacon falls 2 percent. The fact that bacon consumption fell when eggs became more expensive tells us that these goods are complementary goods.

    Ex,y = (% Δ Qd bacon)/(% Δ Price eggs) = –2%/1% = –2

Example:

The price of Honda cars increases 2 percent and consumption of Ford cars increases 4 percent. Because Ford cars saw increased consumption when Honda cars got more expensive, the two goods are substitutes.

    Ex,y = (% Δ Qd Ford)/(% Δ Price Honda) = 2%/1% = +2

Price Elasticity of Supply

Now that we have addressed the sensitivity of consumer consumption of good X, let us discuss elasticity from the supplier's perspective. When the price of good X changes, we expect quantity supplied to change. The Law of Supply predicts that as the price of good X increases, so too does quantity supplied. But what we do not know is, "by how much?" The price elasticity of supply helps to measure this response.

Price Elasticity of Supply Formula

    Es = (% Δ in quantity supplied of good X)/(% Δ in the price of good X)

Note: The Law of Supply insures that Es is positive. The greater this ratio, the more sensitive, or responsive, suppliers are to a change in the price of good X.

The Element of Time

Perhaps the most important determinant of how price elastic suppliers are in a particular industry is the time that it takes suppliers to change the quantity supplied once the price of the good itself has changed. This flexibility of course is different for different types of producers.

Example:

A local attorney produces hours of legal service in a small midwestern town from her small office. At the current market price for an hour of legal advice, she works a 40-hour workweek with the help of one clerical employee. If the price of an hour of legal assistance rises by 10 percent in the local market, initially our attorney responds by working a few additional hours each weekday evening and on Saturday, but the constraints of the calendar allow for only an increase of 5 percent in the hours that she supplies.

    Short term Es = 5%/10% = .5

If this higher price is maintained for a month or two, the attorney might ask her employee to work additional hours, thus allowing the small office to increase the quantity of hours supplied by 10 percent. And, if the price continues to stay at the higher rate, she might expand the office and employ a junior associate and thus increase the hours supplied by 20 percent.

    Long term Es = 20%/10% = 2

Because suppliers, once the price of the good has changed, usually cannot quickly change the quantity supplied, economists predict that the price elasticity of supply increases as time passes. Figure 7.6 illustrates the short-term (SSR) and long-term (SLR) supply curves for our attorney. In general, the less steep the supply curve, the more elastic suppliers are in response to a change in the price.

Elasticity

Review questions for this study guide can be found at:

Elasticity, Microeconomic Policy, and Consumer Theory Review Questions for AP Economics

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