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Lecture 7

Lecture 7-Price Elasticity of Demand and Total Revenue

5 Pages
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Department
Economics
Course Code
ECO101H1
Professor
Jack Carr

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Tuesday, October 6th, 2009.
Price Elasticity of Demand and Total Revenue
Total Revenue = Price x Quantity
In response to an increase in price, total revenue:
- increases if demand is inelastic
- is unchanged if demand is unit elastic
- decrease if demand is elastic
Inelastic Demand Curve (TR 9 if P 9)
TR0 = P0 x Q0 (Revenue at old price)
TR1 = P1 x Q1 (Revenue at higher price)
Revenue increase: (P1 ± P0) x Q1
Revenue decreases: P0 x (Q0 ± Q1)
Toronto Transit Commission
Price (fare) 9 Æ TR 9, because
DD is inelastic (few close substitutes)
One of Five Toll Bridges Across River
Price (toll) 9 Æ 75; because
DD is elastic (several close substitutes)
Q1
Q0
P0
P1
Q
P
xxx
xxx
xx
xx
xx
xx
Revenue Increase
Revenue Decrease
www.notesolution.com
Income Elasticity of Demand:
Percent change in quantity demanded
Percent change in income
Normal good: income elasticity > 0
Inferior good: income elasticity < 0
Insight: Most goods are normal goods
Few goods are inferior goods
(Example: bus travel)
Income Increases
Normal good: DD shifts to right
DQ³LQFUHDVHLQGHPDQG´
Inferior Good: DD shifts to left
D³GHFUHDVHLQGHPDQG´
Q1
SS
P
Q
P
DD1 (income increases)
DD
Q
P1
Q1
SS
P1
Q
P
DD1 (income increases)
DD
Q
P
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Description
Tuesday, October 6th, 2009. Price Elasticity of Demand and Total Revenue Total Revenue = Price x Quantity In response to an increase in price, total revenue: - increases if demand is inelastic - is unchanged if demand is unit elastic - decrease if demand is elastic Inelastic Demand Curve (TR 9 if P 9) TR0 = P0 x Q0 (Revenue at old price) TR1 = P1 x Q1 (Revenue at higher price) Revenue increase: (P1 ± P0) x Q1 Revenue decreases: P0 x (Q0 ± Q1) Toronto Transit Commission Price (fare) 9 Æ TR 9, because DD is inelastic (few close substitutes) One of Five Toll Bridges Across River Price (toll) 9 Æ 75; because DD is elastic (several close substitutes) Q1 Q0 P0 P1 Q P Revenue Increase Revenue Decrease www.notesolution.com Income Elasticity of Demand: Percent change in quantity demanded Percent change in income Normal good: income elasticity > 0 Inferior good: income elasticity < 0 Insight: Most goods are normal goods Few goods are inferior goods (Example: bus travel) Income Increases Normal good: DD shifts to right DQ³LQFUHDVHLQGHPDQG´ Inferior Good: DD shifts to left D³GHFUHDVHLQGHPDQG´ Q1 SS P Q P DD1 (income increases) DD Q P1 Q1 SS P1 Q P DD1 (income increases) DD Q P www.notesolution.com (Price) Elasticity of Supply: Percent change in quantity supplies Percent change in price 1. Terminology Perfectly inelastic: elasticity = 0 Inelastic: 0 < elasticity < 1 Elastic: 1 < elasticity <  Perfectly elastic: HODVWLFLW\  2. Differences in elasticity reflect - time elapsed since price change* - factor substitution possibilities Elasticity of Supply: Special Cases P DD Q0 Q Perfectly Inelastic Firms supply quantity Q0 regardless of price P SS P0 Q Perfectly Elastic Firms supply unlimited quantity at P0. (and zero if price beneath P0) www.notesolution.com Example Perfectly Inelastic SS: (1) Quantity of cell phone frequencies (2) No. of lakefront lots (200 feet) on Lake of Bays Perfectly Elastic SS: Any good for which firms can produce unlimited quantity at unchanged cost Short -Run and Long-Run Supply Curves If price rises above $2, increase in supply will be grater in long run than in short run. Short-run elasticity of supply: (60 ± 50) /55 = 0.45 (3 ± 2) /2.5 Long-run elasticity of supply: (80 ± 50) /65 = 1.15 (3 ± 2) /2.5 SS (short run) Q P SS (long run) $3 80 60 50 $2 www.notesolution.com Example If police succeed in reducing the flow of heroin into Vancouver, will the amount of heroin-related crime decline? Demand is inelastic (few substitutes) Æ 1) reduction in quantity demanded is small relative to the increase in price 2) total expenditure* on heroin increases (P1 * Q1 > P0 * Q0) 3) heroin ± related crime increases (since expenditures on heroin will increase) *total expenditure by buyers = total revenue received by sellers Q1 Q0 P0 P1 Q P SS DD SS1 SS1 = new supply curve (reduced supply) www.notesolution.comTuesday, October 6 , 2009. Price Elasticity of Demand and Total Revenue Total Revenue = Price x Quantity In response to an increase in price, total revenue: - increases if demand is inelastic - is unchanged if demand is unit elastic - decrease if demand is elastic Inelastic Demand Curve (TR if P ) P P 1 xxx Revenue Increase P xxx xx Revenue Decrease xx xx Q 1 0 Q xx TR =0P x 0 0 (Revenue at old price) TR =1P x 1 1 (Revenue at higher price) Revenue increase : (P1 P 0 x Q 1 Revenue decreases: P x (Q0 Q )0 1 Toronto Transit Commission Price (fare) TR , because DD is inelastic (few close substitutes) One of Five Toll Bridges Across River Price (toll) %#; because DD is elastic (several close substitutes) www.notesolution.com
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