Summary
Income Effects, Substitution Effects, and Elasticity
- 1. Changes in the price of a good affect the quantity consumed as a result of the substitution effect, and in some cases the income effect. Most goods absorb only a small share of a consumer’s spending; for these goods, only the substitution effect—buying less of the good that has become relatively more expensive and more of the good that has become relatively cheaper—is significant. The income effect becomes substantial when there is a change in the price of a good that absorbs a large share of a consumer’s spending, thereby significantly changing the purchasing power of the consumer’s income.
- 2. Many economic questions depend on the size of consumer or producer responses to changes in prices or other variables. Elasticity is a general measure of responsiveness that can be used to answer such questions.
- 3. The price elasticity of demand—the percent change in the quantity demanded divided by the percent change in the price (dropping the minus sign)—is a measure of the responsiveness of the quantity demanded to changes in the price. In practical calculations, it is usually best to use the midpoint method, which calculates percent changes in prices and quantities based on the average of the initial and final values.
Interpreting Price Elasticity of Demand
- 4. Demand can fall anywhere in the range from perfectly inelastic, meaning the quantity demanded is unaffected by the price, to perfectly elastic, meaning there is a unique price at which consumers will buy as much or as little as they are offered. When demand is perfectly inelastic, the demand curve is a vertical line; when it is perfectly elastic, the demand curve is a horizontal line.
- 5. The price elasticity of demand is classified according to whether it is more or less than 1. If it is greater than 1, demand is elastic; if it is less than 1, demand is inelastic; if it is exactly 1, demand is unit-elastic. This classification determines how total revenue, the total value of sales, changes when the price changes. If demand is elastic, quantity demanded is relatively more responsive to changes in price, total revenue falls when the price increases and rises when the price decreases. If demand is inelastic, quantity demanded is relatively less responsive to changes in price, total revenue rises when the price increases and falls when the price decreases.
- 6. The price elasticity of demand depends on whether there are close substitutes for the good in question, whether the good is a necessity or a luxury, the share of income spent on the good, and the length of time that has elapsed since the price change.
Other Elasticities
- 7. The cross-price elasticity of demand measures the effect of a change in one good’s price on the quantity of another good demanded. The cross-price elasticity of demand can be positive, in which case the goods are substitutes, or negative, in which case they are complements.
- 8. The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in income. The income elasticity of demand indicates how intensely the demand for a good responds to changes in income. It can be negative; in that case the good is an inferior good. Goods with positive income elasticities of demand are normal goods. If the income elasticity is greater than 1, a good is income-elastic; if it is positive and less than 1, the good is income-inelastic.
- 9. The price elasticity of supply is the percent change in the quantity of a good supplied divided by the percent change in the price. If the quantity supplied does not change at all, we have an instance of perfectly inelastic supply; the supply curve is a vertical line. If the quantity supplied is zero below some price but infinite above that price, we have an instance of perfectly elastic supply; the supply curve is a horizontal line.
- 10. The price elasticity of supply depends on the availability of resources to expand production and on time. It is higher when inputs are available at relatively low cost and when more time has elapsed since the price change.