Chapter 4 – Notes

Elasticity: an economic measure of how sensitive one economic factor is to changes in

another – Elasticity is based on the ability to find alternatives – an economic concept used to
measure the change in the aggregate quantity demanded of a good or service in relation to
price movements of that good or service.
Elastic: responds a lot to a change in price
Inelastic: rigid, does not respond a lot to a change in price
Price Elasticity of Demand: how much quantity demanded responds to a change in price

Factors Affecting Price Elasticity of Demand:

1- Is the Good a Necessity or a Luxury
- Demand is price elastic if the good is a luxury – will be affected by the price
- Demand is price inelastic if the good is a necessity – will not be affected by price
change (an addiction is considered a necessity for a person)

2- Availability of Substitutes
- A good that has no substitutes – demand is price inelastic
- A good that has a lot of substitutes – demand is price elastic – will respond to a
change in price

3- Definition of the Market

- Food (general term): demand is price inelastic
- Dessert (more specific): demand is more elastic than “food”
- Ice-cream (narrower): demand is price elastic
- Cookie Dough Ice Cream: demand is price elastic even more
 As a good is more specific – the more elastic it becomes because there are
more options to substitute it with
 Exception: a good that is very specific due to a Snob Appeal so it becomes
inelastic

4- Short Run VS Long Run

- In the Short Run  demand is price inelastic
- In the Long Run  demand is price elastic
 Because we have time to think of alternatives and respond
- Example: Organization of Petroleum Arab Countries (OPAC)
- Example: During an argument with someone, in the short run (during the moment)
I do not have time to react, then in the long run, I think of better arguments
because I have more time to react

5- Proportion of Income – Relative to the Person and their Income

 - Some goods are small proportion of our income (example: gum)  demand is
price inelastic
- Some goods are big proportion of our income (example: car)  demand is price
elastic

6- Price of the Good Itself

- Goods with a really low price (example: gum, salt)  demand is price inelastic
- Goods with high price  demand is price elastic

Calculations:
% Change ∈Quantity Demand
- Price Elasticity of Demand =
% Change ∈Price
- Total Revenue = Price X Quantity

Scenarios of Change in Quantity Demanded Vs Change in Price:

a) Elastic: proportional change of Quantity Demanded > than proportional change in
Price
- Price Elasticity of Demand > 1
 Price Increases by a low proportion, Qd Falls A lot = Total Revenue
Decreases
 Price Decreases by a low proportion, Qd Increases A lot = Total
Revenue Increases

b) Inelastic: proportional change in Price > proportional change in Quantity Demanded

- Price Elasticity of Demand < 1
 Price Increases A lot, Qd Decreases by less proportion = Total
Revenue Increase
 Price Decreases A lot, Qd Increases by less proportion = Total
Revenue Decreases

c) Unit Elastic: proportional change in Price = proportional change in Quantity

Demanded
- Price Elasticity of Demand = 1
 Price Increases, Qd Falls by same Proportion = Total Revenue stays
the same
 Price Falls, Qd Increases by same Proportion = Total Revenue stays
the same

d) Perfectly Inelastic (whatever happens to the price, Quantity Demanded doesn’t

change): proportional change in Quantity Demanded = 0
- Price Elasticity of Demand = 0

e) Perfectly Elastic: proportional change in Quantity Demanded = infinity

 - Price Elasticity of Demand = infinity

Price Discrimination: charging different prices for the same product depending on elasticity
- Example: Airplane Tickets are higher in price when you book the day before you
travel because they know you are stuck and you need to travel tomorrow, but
booking 2 months in advance is cheaper
- Example: Foreigners pay more than Egyptians for the same products
- Taxi Cabs standing in front of the Airport charge a higher price because the
demand is price inelastic because I do not have another choice

Factors Affecting Price Elasticity of Supply:

1- Availability of raw materials inputs
2- Degree of ease of production process
3- Short Run Vs Long Run
4- Access to Storage
- Preservatives help in access to storage
- Once something reaches expiry date, it no longer has access to storage
Paradox of the Bumper Harvest: When price of food crops increases, the demand does not
increase proportionally – hence the revenue earned by farmers fall.
Wheat example:
- Technology improvement causes supply of wheat to increase
- The price of wheat decreases as a result
- Demand for wheat is price inelastic – good which is a necessity, not a lot of
substitutes
- Price falls a lot, Quantity demanded increases but less than proportion
- As a result, total revenue decreases – making this scenario a Paradox
- How to fix this situation, the government could apply a Crop Restriction

Crop Restriction: limiting the amount the farmers can produce

- Supply will decrease cause the farmer can only use part of his land
- Price will go up
- Demand for wheat is price inelastic
- So, quantity demanded will fall less than proportionally
Production Quotas/ Restrictions
Impact of a Tax:
- Tax on certain products: for every product sold, a certain amount of money goes
to the government.
- The tax becomes equivalent to an increase in cost of product, so the seller
increases the price per pack
- The burden of the tax goes on both the consumer and the seller
Example: Cigarettes Pack = $1
- The government requires a tax of $1 per pack
- So, if the producer increases the price to $1.8
- The consumer bears the burden of $0.8 extra
- The producer bears the burden of losing $0.2
- Consumer bears 80% of the tax, the producer bears 20%
- The side of the market that is more inelastic is the side that bears the larger burden
of the tax, in this case, it is the consumer bearing the larger burden

In the example of a perfectly inelastic demand

- The consumer will bear the entire tax burden

Income Elasticity of Demand: percentage change in demand relative to the percentage

change in income
- Income goes up, demand for normal goods increases  Income elasticity =
positive
- Income goes up, demand for inferior goods decreases  Income elasticity =
negative
Positive income elasticity:
- Normal goods  income elasticity is positively low
- Luxury goods  income elasticity is positively high
During Recessions:
- Inferior good producers: economy is failing, incomes are falling, demand for
inferior good will increase
- Normal good producers: low income elasticity, people cannot stop consuming
food for example, so demand will decrease a bit but not a lot
- Luxury/ superior good producers: need government help because they get
affected the most with the decreasing incomes. Since they have very highly
positive income elasticities
Cross Elasticity of Demand: percentage change in the demand for X divided by the
percentage change in the price of Y
- If Cross elasticity of demand is zero = independent goods
- If cross elasticity of demand is negative = complementary goods
- Example: Price of sugar goes up, demand for coffee decreases
- If cross elasticity of demand is positive = substitutes