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Lecture 2

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Department
Economics (Arts)
Course
ECON 208
Professor
Irakli Japaridze
Semester
Summer

Description
Econ 208 Lecture #2 May 2, 2013 Chapter 4: Elasticity Price Elasticity of Demand ▯ Elasticity of demand: how demand adjusts a variable when another variable changes o Demand is elastic when quantity demanded is very responsive to a change in the product’s own price and inelastic when the demand is unresponsive ▯ Related to demand curve but not the same ▯ Why do we need it? o Change a little locally to cause great change elsewhere o Change to minimize effects ▯ Important for policy makers ▯ Ex: policy makers determine that cigarettes are bad so they increase taxes which increases the cost thus causing demand to decrease however policy makers must ensure they do not raise the cost too much or it will lead to a dire loss in revenue ▯ Demand is elastic when there are substitutes for a product o Ex: Coca Cola and Pepsi are almost always the same price since the two are very similar and if one brand were to raise their price than people would simply buy the other brand o Ex: if a company raises the price of beef, people will buy pork thus the demand for these products are elastic ▯ If you lived in a neighborhood where people could not eat pork due to religious constraints then you could raise the price of beef and people will still buy it because there is no substitute therefore the demand is inelastic ▯ Firms dream of an inelastic market – one where no matter how much a price is raised, buyers won’t leave the market o Otherwise if you raise the price, demand will go down therefore you make more profit per unit but you do not sell as many units Elastic Demand Inelastic Demand 120 120 100 100 80 80 E E E Price 60 E D Price 60 D 40 S 40 S 20 S 20 S 0 0 0 100 200 0 100 200 Quantity Quantity ▯ Slope of demand curve only one component of elasticity Econ 208 Lecture #2 May 2, 2013 o Ex: increase of five units would cause an impact if you were only selling 60 units originally but would not cause an impact on elasticity if you were originally selling 1000 units ▯ Elasticity of demand (η) = percentage change of demand /percentage change of price 6 12 η = ∞  5 10 4 8 D (η=0) Price 6 Unit Price3 Elasticit D (η=∞) 4 y D 2 D (η=1) 1 2 0 0 0 5 10 15 0 2 4 6 Quantity Demanded Quantity Demanded o η = 0 means that no matter the change in price, demand will not change o η = ∞ is perfect elasticity meaning that there is only demand at that specific price o η = 1 is the unit elastic price o η > 1 (elastic) o η < 1 (inelastic) ▯ Monopolists want to work in this section because above the unit elasticity (5 in this case) if you increase price by 1%, more than 1% of buyers will leave the market o η will be negative if there is a price increase (typically when elasticity is positive, it is dealing with supply elasticity instead of demand elasticity ▯ η = (ΔQ /Q ) (Δp/p) = ((Q –Q )/(Q +Q )/2) /((p –p )/(p +p )/2) Product Original New Price Average Original New Average Price Price Quantity Quantity Quantity 6-pack of $9.00 $8.00 $8.50 2000 3000 2500 Corona Beer ▯ η = ((3000–2000)/(3000+2000)/2) /((8–9)/(8+9)/2) = (1000/2500) /(1/8.5) = 0.4/0.1176 = 34% ▯ What determines elasticity of demand? o Elasticity is high when there are close substitutes ▯ Ex: Coca Cola and Pepsi can easily be substituted for another ▯ Goods may not actually be a good substitute Econ 208 Lecture #2 May 2, 2013 ▯ Ex: someone might say that the Samsung Galaxy is not a good substitute for an Iphone if they both cost $500 but if the Iphone increases its price to $5000, that same person might think that the Galaxy is a suitable substitute ▯ Availability of substitutes determined by: ▯ Length of time interval considered o Ex: when the Ipod came out there was no substitute thus there was a fair amount of time before substitutes surfaced on the market therefore the demand was inelastic until substitutes were developed o Patents help keep demand inelastic by delaying the time competitors can enter the market ▯ Without a patent, research/development will lessen because there is no sense in spending money if there won’t be profit ▯ No patent means anyone can copy your idea therefore saturating the market with competitors and cutting into your revenue ▯ Profit is incentive to research and profit is protected by a patent ▯ Whether a good is a necessity or a luxury ▯ How specifically a product is defined o Demand is inelastic when a commodity is a necessity ▯ Ex: there is no substitute for insulin (other than not doing anything which will lead to death) therefore if someone had a monopoly on insulin they could charge any price without considering the consequences ▯ Regulated by government to prevent this from occurring ▯ Demand can vary over time o Demand 120 can be inelastic in the 100 short term as there are few competitors in a 80 market Price 60 o In the D (LongRun) 40 long run, as competitors D (ShortRun) flood the market, 20
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