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Intermediate Microeconomics
Jordan Marcusse
1 What is elasticity?
Elasticity is an important concept in economics (micro- and macro-), and one
that the textbook gives short shrift. Elasticity is a way of measuring the re-
sponsiveness of an endogenous variable to a change in parameters. Elasticity is
a useful measure because its values can be understood without needing to know
what units we are measuring in.
In lecture 6, we will work with 3 definitions of elasticity:
dxi m
Income elasticity of demand :xi ,m = (1)
dm xi
dxi pi
(Own) Price elasticity of demand :xi ,pi = (2)
dpi xi
dxi pi
Cross price elasticity of demand :xi ,pi = (3)
dpi xi
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income, so well use m + m = $101. In this case, m = 0.01 m. We should
observe a small change in demand. Say, from x = 10 to x + x = 10.2. Then,
x = 0.02x. The percentage change in x, x x is twice as large as the percentage
change in m, m
m . We call this ratio the arc income elasticity of demand, which
we denote with Ex,m .
x m
Ex,m = / = 0.02/0.01 = 2
x m
Say we look at a smaller percentage change in m, say m = 0.001 m, and find
that x = 0.0027 x. Then we get a new measure of arc elasticity.
The exact value of arc elasticity depends on our choice of m, and requires
computing the quantity demanded every time we consider arc elasticity at a
different set of p1 , p2 , m. This is somewhat arbitrary, and a bit of a hassle to do
repeatedly. It is more useful to use calculus, which will give us a function into
which we can plug in values p1 , p2 , m, and spares us the consideration of what
is a sufficiently small value for m.
To see how this is done, rearrange terms in the formula for arc elasticity:
x m
Ex,m =
m x
Make m arbitrarily small.
x(m) m
x,m = limm0
m x
x(m + m) x(m) m
= limm0
m x
dx m
=
dm x
dx
This is less work. Say dm = 0.3 for our example above, then x,m = 0.3 100
10 = 3.
So, in the neighborhood of m = $100, the optimal value of x grows three times as
fast as income, as m increases. This implies that as m increases, the proportion
of income that is spent on x increases, at least for values of m near $100.
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3 (Own) Price elasticity of demand
We may also want to look at comparative statics in terms of prices. What
happens to demand for a good as its price increases? Just like with income, we
could take the derivative dx dxi
dpi . Not surprisingly, dpi < 0, for virtually every good.
i
This last step takes our formula for own price elasticity of demand, and substi-
tutes it in. Expenditure on good i increases in response to pi if xi ,pi > 1.
sign of this effect, so this first derivative will suffice. However, if we wanted to
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make comparisons of the magnitude of these effects across goods, we will need
to use cross price elasticity:
dx1 p2
x1 ,p2 =
dp2 x1
4.1 Complements/Substitutes
Two goods are substitutes if their cross price elasticity of demand, xi ,pi is
positive.
Two goods are complements if their cross price elasticity of demand, xi ,pi
is negative.
Suppose p2 increases. If your response is to spend more on good 2, and less
on good 1, you are trying to keep a balance between the two goods, as if they
go together. Thats why theyre called complements. If, instead, your response
is to buy less of good 2, and more of good 1, good 1 is substituting for good 2.