Chapter 6 — Key Takeaways
What elasticity is
Price elasticity of demand = % change in quantity demanded ÷ % change in price.
Use the midpoint formula to compute the percent changes (so the answer is the same in either direction). Take the absolute value.
- Elastic (elasticity > 1): a small price change produces a large quantity response
- Unit elastic (= 1): proportional response
- Inelastic (< 1): a price change produces a small quantity response
- Perfectly elastic / inelastic are the theoretical extremes
Four determinants of demand elasticity
- Availability of substitutes — more substitutes → more elastic. Coke (specific brand) is elastic; cola (broad category) is less so.
- Necessity vs. luxury — necessities are inelastic, luxuries are elastic. Insulin is inelastic; vacations are elastic.
- Time horizon — the long run is more elastic than the short run. Gasoline demand is inelastic in months, much more elastic in years.
- Share of budget — large-share goods are more elastic than small-share goods. Toothpicks are inelastic; housing is more elastic.
Other elasticities
Income elasticity = % change in quantity demanded ÷ % change in income. - Positive → normal good (above 1 = luxury, between 0 and 1 = necessity) - Negative → inferior good
Cross-price elasticity of A with respect to B = % change in quantity of A ÷ % change in price of B. - Positive → substitutes (Coke and Pepsi) - Negative → complements (cars and gas)
Price elasticity of supply = % change in quantity supplied ÷ % change in price. - Determined mainly by time horizon (long run more elastic), input availability, factor mobility, and spare capacity.
Tax incidence
The more inelastic side of the market bears more of the burden of a tax.
- Cigarettes: inelastic demand → smokers pay most of the cigarette tax
- Luxury yachts: elastic demand, inelastic supply → builders pay most of the luxury tax (history: the 1991 U.S. luxury tax mostly hit yacht builders, not buyers)
The principle is that whichever side has fewer alternatives is forced to absorb more of the tax. We will return to this in much more depth in Chapter 7.
Elasticity and total revenue
- Elastic demand: a price increase reduces total revenue (quantity falls more than price rises)
- Inelastic demand: a price increase raises total revenue (quantity falls less than price rises)
- Unit elastic: total revenue is unchanged
The minimum wage application
The size of any minimum-wage employment effect depends on the elasticity of low-wage labor demand. Empirical estimates from Card-Krueger (1994), Neumark-Wascher, Dube, and the CBO suggest the elasticity is in the range of −0.1 to −0.4 — smaller than a naive supply-and-demand model would predict. Reasons: monopsony power, productivity adjustments, price pass-through, and search frictions in labor markets. The debate is empirical and ongoing.
Themes this chapter touched
- Tradeoffs — every elasticity is a tradeoff between price and quantity
- Incentives — buyers and sellers respond to prices, but the size of the response varies
- Data tells stories — elasticities are empirical numbers, and different estimates can support different stories
- Disagreement — the labor demand elasticity for minimum wage debates is genuinely contested
One sentence summary
Elasticity is the size of the response — the bridge from "things move in this direction" to "things move by this much" — and it determines who pays for government policies, how much revenue businesses make, and how big the response will be to any market shock.
Where this leads
- Chapter 7 — Government Intervention. Elasticity becomes essential for predicting the effects of price ceilings, price floors, taxes, and subsidies.
- Chapter 8 — Surplus. Elasticity determines how much welfare is lost when markets are distorted.
- Chapter 21 — Labor Markets. The full treatment of the minimum wage debate.