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Lecture

Chapter 4-ECON.docx

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Department
Economics
Course Code
ECON 101
Professor
Flora Ng

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Chapter 4: Elasticity Basic idea: Elasticity measures how much one variable responds to changes in another variable. Price Elasticity of Demand Price elasticity of demand is a measure of the extent to which the quantity demanded of a good changes when the price of the good changes. The price elasticity of demand is calculated by using the formula: Percentage change in quantity demanded Percentage change in price Midpoint method To calculate the price elasticity of demand: Price Elasticity of Demand The measure is units free because it is a ratio of two percentage changes and the percentages cancel out. Changing the units of measurement of price or quantity leave the elasticity value the same. Price and quantity always change in opposite directions. So to compare the percentage change in the price and the percentage change in the quantity demanded, we ignore the minus sign and use the absolute values. Demand is elastic if the percentage change in the quantity demanded exceeds the percentage change in price. Demand is unit elastic if the percentage change in the quantity demanded equals the percentage change in price. Demand is inelastic if the percentage change in the quantity demanded is less than the percentage change in price. Demand is perfectly elastic if the quantity demanded changes by a very large percentage in response to an almost zero percentage change in price. Demand is perfectly inelastic if the quantity demanded remains constant as the price changes. Figure 4.3(a) illustrates the case of a good that has a perfectly inelastic demand. The demand curve is vertical. Figure 4.3(b) illustrates this case—a demand curve with ever declining slope. the percentage change in the quantity demanded is infinitely large when the price barely changes, Figure 4.3(c) illustrates the case of perfectly elastic demand—a horizontal demand curve. Elasticity Along a Straight-Line Demand Curve Figure 4.4 shows how demand becomes less elastic as the price falls along a linear demand curve. Total Revenue and Elasticity The total revenue from the sale of good or service equals the price of the good multiplied by the quantity sold. When the price changes, total revenue also changes. But a rise in price doesn’t always increase total revenue. The change in total revenue due to a change in price depends on the elasticity of demand:  If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increases.  If demand is inelastic, a 1 percent price cut decreases the quantity sold by more than 1 percent, and total revenues decreases.  If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged. Total revenue test Total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all other influences on the quantity sold remain the same).  If price and total revenue change in the opposite directions, demand is elastic. P falls ->TR increases  If price and total revenue change in the same direction, demand is inelastic. Pfalls->TR falls  If a price cut leaves total revenue unchanged, demand is unit elastic. Price Elasticity of Demand Your Expenditure and Your Elasticity  If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases.  If your demand is inelastic, a 1 percent price cut increases the quantity you buy by less than 1 percent and your expenditure on the item decreases.  If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 1 percent and your expenditure on the item does not change. The Factors That Influence the Elasticity of Demand The elasticity of demand for a good depends on:  The availability/closeness of substitutes
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