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Lecture 4

ECON 1B03 Lecture 4: Unit 4 modules

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Hannah Holmes

Unit 4.1 : price elasticity of demand Elasticity - measures how responsive Qd or Qs is to changes in P + other determinants - if P changes, will Qd change by little or by a lot ? - this knowledge is useful to firms + policymakers whose decisions may affect price + therefore affect Qd - firms wants to maximize profits - other things being equal, it will want to maximize total revenue - knowing price elasticity of demand tells firm whether it should raise or lower its price Total revenue - TR : price times the quantity traded - TR = PQ Price elasticity of Demand - measure of how much quantity demanded of good responds to change in price of that good - price elasticity of demand is computed as percentage change in quantity demanded divided by percentage change in price - price elasticity = Ep - number calculated is coefficient elasticity - size of coefficient, Ep, tell us how elastic the good is — how responsive demand is to change in price - larger the coefficient, the more responsive is demand to change in price of good - elasticity will vary because how people respond to price changes will vary so we can define different types of elasticity Types of price elasticity of demand Inelastic demand - change in P leads to proportionately smaller change in Qd - demand is not very responsive to price change - percentage change in P > percentage change in Qd - Ep < 1 - demand curve will be fairly steep - example : dentist visits Perfectly inelastic demand - change in P does not change Qd whatsoever - demand is not responsive to price change - percentage change in P = zero change in Qd - Ep = 0 - demand curve will be perfectly vertical - example : heart medicine Elastic demand - change in P leads to proportionately larger change in Qd - demand is very responsive to price change - % change in Qd > % change in P - Ep > 1 - demand curve will be fairly flat - example : manufactures Perfectly elastic demand - change in P leads to infinitely great change in Qd - demand is extremely responsive to price change - % change in Qd approaches infinity - Ep = infinity - demand curve will be horizontal - example : no real world example — or infinite number of substitutes Unit elastic - change in P leads to a proportionately equal change in Qd - % change in P = % change in Qd ) - Ep = 1 - demand curve will be non linear - will be rectangular hyperbola - non linear so that no matter where on the curve, TR will always be same, max value - example — wine in US Unit 4.2 : price elasticity of demand analysis Calculating elasticity - if given % changes in price + corresponding changes in Qd, use formula : - when given 2 prices + their corresponding Qd values, we have to calculate % changes in P and Qd - % change in Qd = (Qd — 2d ) 1 Qd 1 - % change in P = ( P 2P ) 1 P 1 point elasticity - measures impact of marginal change in price on Qd - formula for point elasticity is : Ep = dQ x P dP Q - dQ/ dP is slope of linear demand curve when demand is in form of Q = f (P) - in all 3 examples, elasticity coefficient has negative sign - law of demand — as P increases and Qd decreases , coefficient will always be negative number - when calculating price elasticity, we drop negative sign ( use absolute value) Some generalities about demand elasticity + their determinants 1) Goods that are necessities tend to have inelastic demand - examples - demand for insulin is perfectly inelastic - demand for textbooks is inelastic — if price went up, you would still buy book to pass course 2) goods that are luxuries tend to have elastic demand - example - demand for plasma TV - vacations abroad 3) goods that have close substitutes tend to have elastic demand - example - coke + pepsi - eggs don't have close substitute, thus inelastic 4) goods tend to have more elastic demand over longer time horizons - you can find substitutes in long run where you cant in short run 5) how you define market makes different - examples - food — inelastic - vegetables — more elastic - broccoli — even more elastic - the more narrowly defined the market, the more elastic demand for that good 6) how much of your budget you spend on good determines elasticity - if you spend large proportion of budget on good, demand for good will tend to be elastic - if you only spend small proportion of budget, demand will tend to be inelastic Some info - elasticity is not constant along linear demand curve - elasticity is not same as slope - slope measures rates of change - elasticity measures percentage changes - can illustrate different elasticities along demand curve : - why does elasticity change along curve the way it does? - our point elasticity formula for demand curve specified as Q = f (p) Ep = dQ x P dP Q - slope dQ / dP is constant for linear demand curve - but P + Q are different combo at different points on demand curve, so elasticity changes along demand curve - since dQ / dP is slope of demand curve thats why we can see elasticity by steepness (slope) of curve Price elasticity + total revenue Inelastic - with inelastic demand curve, an increase in price leads t
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