ELA - Elasticity Overview

Elasticity Overview

Introduction

The previous module discussed the basic factors which impact demand and supply and how changes affect the market. In this module, we will investigate the factors which influence the sensitivity of demand and supply to the variables that act upon them. Specific attention will be given to the impact elasticity has on total welfare in the face of government actions in the market.

Essential Questions

1. What is elasticity?
2. How are price elasticity of demand and supply calculated?
3. What factors determine E_d and E_s?
4. How is the total revenue test used to determine the price elasticity of demand?
5. What does income elasticity reveal about the nature of a good? How is it calculated?
6. What does cross-price elasticity reveal about the nature of goods? How is it calculated?
7. How is elasticity related to the creation of deadweight loss?
8. How does elasticity determine tax burden?

Key Terms

Click here to download the key terms document for this module. Links to an external site.

Elasticity – a measure of the sensitivity, or responsiveness, of a choice to a change in an external factor

Price Elasticity of Demand (E_d) – measures the sensitivity of consumers’ quantity demanded for a good when the price of that good changes

Elastic – in terms of price elasticity, a good is considered elastic when a change in price produces a relatively greater percentage change in quantity.

Unit Elastic – in terms of price elasticity, a good is considered unit elastic when a change in price produces a proportional percentage change in quantity

Inelastic - in terms of price elasticity, a good is considered inelastic when a change in price produces a relatively smaller percentage change in quantity

Perfectly Elastic – in terms of price elasticity of demand, the E_d = infinity (∞); meaning a price change causes an immediate and infinite response in quantity

Perfectly Inelastic - in terms of price elasticity of demand, the E_d = 0; meaning a change in price produces no change in quantity

Income Elasticity (E_I) – is a measure of how sensitive consumption of a good is to a change in consumers’ income.

Luxury Good – a good for which the proportional increase in consumption exceeds the proportional increase in income.

Normal Good – a good for which income and demand are positively related

Inferior Good – a good for which income and demand are negatively related

Cross Price Elasticity of Demand (E_cp) – a measure of how sensitive the consumption of Good X is to a change in the price of Good Y.

Substitutes – Two similar goods that essentially provide the same utility to a consumer are considered substitutes.

Complements – two goods that provide more utility when consumed together than when consumed separately are considered complements

Price Elasticity of Supply (E_s) – a measure of the sensitivity of producers’ quantity supplied for a good when the price of that good changes.

Total Revenue – the price of a good multiplied by the quantity sold

Total Revenue Test – a method of determining price elasticity of demand by considering how price and total revenue are related.

Excise Tax – a per unit tax on a specific good or service.

Subsidy -a government transfer, either to consumers or producers, on the consumption or production of a good.

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