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Chapter 5

•Questions

oWhat is elasticity? What kinds of issues can elastic help us understand?

oWhat is the price elasticity of demand? How is it related to the demand

curve? How is it related to revenue and expenditure?

oWhat

oWhat are the income and cross-price elasticities of demand?

•Elasticity

oBasic idea: elasticity measures how much one variable responds to

changes in another variable

One type of elasticity measures how much demand for your

websites will fail if you raise your price.

oDefinition: Elasticity is a numerical measure of the responsiveness of

Q(demand) and Q(supply) to one of its determinants

•Price Elasticity of Demand

oPrice elasticity of demand measures how much of Q(demand)

responds to change in P(price)

oPrice elasticity of demand = Percentage change in Q(demand) /

Percentage change in P(price)

oLoosely speaking, it measures the price-sensitivity of buyers’ demand

oAlong a D curve, P and Q move in opposite directions, which would

make price elasticity negative

We will drop the minus sign and report all price elasticities as

positive numbers

•Calculating Percentage changes

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oStandard method of computer percentage change: end value – start

value / start value * 100%

oMidpoint Method: is the number halfway between the start and end

values, the average of those values

oit doesn’t matter which value you use as the start and which as the

end, you get the same answer either way

oMidpoint Method = end value – start value / midpoint * 100%

•What determines price elasticity?

oExample 1:

Breakfast Cereal versus Sunscreen

Price of both goods rise by 20%, for which good does Qd drop

the most?

•Breakfast cereal has close substitutes (e.g., pancakes,

waffles, leftover pizza)

•Sunscreen has no close substitutes so consumers won’t

buy less if price rises

•Price elasticity is higher when close substitutes are

available

oExample 2

Blue Jeans vs Clothing

Price of both goods rise by 20%, for which good does Qd drop

the most?

•For a narrowly defined good such as blue jeans, there are

many substitutes (e.g., khakis, shorts, speedos)

•There are fewer substitutes for a broadly defined good

•Price elasticity is higher for narrowly defined goods than

broadly defined ones

oExample 3

Insulin vs Caribbean Cruises

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prices of both goods rise by 20%, for which good does Qd drop

the most?

•To millions of diabetics, insulin is a necessity. Rise in price

won’t affect demand so much

•Cruise is a luxury. If price increases, demand will

definitely decrease

•Price elasticity is higher for luxuries than for necessities

oExample 4

Gasoline in the short run vs Gasoline in the long run

Prices of both goods rise by 20%, does Qd drop more in the

short run or long run?

•Theres not much people can do in the short run, other

than ride the bus and carpool

•In the long run, people can buy smaller cars or live closer

to where they work

•Price elasticity is higher in the long run than short run

•Variety of Demand Curves

oPrice elasticity of demand is closely related to slope of the demand

curve

oRule of thumb

Flatter the curve, the bigger the elasticity

Steeper the curve, the smaller the elasticity

oFive different classifications of Demand Curves

Perfectly inelastic demand (one extreme case)

•% change in Q / % change in P = 0%/10% = 0

•Demand Curve: Vertical

•Consumers Price Sensitivity: None

•Elasticity: 0

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