ECO101H1 Lecture Notes - Lecture 10: Royal Ontario Museum, Inferior Good, Ss 1
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Chapter 5 – Elasticity and Its Application
You sell sparkling water, which you obtain from your own spring at no cost.
You are selling the water for $2 per bottle.
Since your costs are zero, your profit equals your total revenue (number of bottles
sold times price per bottle).
Question to increase your total revenue, should you increase the price above $2?
If you raise the price:
1. Customers who continue to buy your water would pay more (thus,
increasing total revenues) but;
2. You would have fewer customers due to the “Law of downward sloping
demand” (this, reducing revenues)
-We need more information about the demand curve in order to answer the
-Key concept elasticity of demand
(PRICE) ELASTICITY OF DEMAND
oA measure of the responsiveness of quantity demanded or quantity
supplied to one of its determinants.
oTo measure how much consumers respond to changes in these
o% QD divided by % P
oIgnore minus sign
The Price Elasticity of Demand and Its Determinants
-Law of demand states that a fall in the price of a good raises the quantity
-Price Elasticity of Demand
oA measure of how much the quantity demanded of a good responds to
a change in the price of that good
oComputed as the percentage change in quantity demanded divided by
the percentage change in price.
oDemand for a good is said to be elastic if the quantity demanded
responds substantially to changes in the price.
Elastic quantity doesn’t change much when price rises/falls
oDemand is said to be inelastic if the quantity demanded responds only
slightly to changes in the price.
Inelastic quantity changes substantially when price rises/falls
oAvailability of Close Substitutes
Goods with close substitutes tend to have more elastic demand
because it is easier for consumers to switch from that good to
Eg. Butter and Margarine
oNecessities versus Luxuries
Necessities tend to have inelastic demands, whereas luxuries
have elastic demands.
oDefinition of the Market
Elasticity of demand in any market depends on how we draw
the boundaries of the market.
Narrowly defined markets tend to have more elastic demand
than broadly defined markets because it is easier to find close
substitutes for narrowly defined goods.
Eg. Broad Category Food (inelastic demand)
Narrow Category Ice Cream (elastic demand)
Goods tend to have more elastic demand over longer time
Eg. Price of fuel rises, the quantity of fuel demanded falls only
slightly in the first few months but within several years, the
quantity of fuel demanded falls substantially.
Computing the Price Elasticity of Demand
-Price Elasticity of Demand = Percentage Change in Quantity Demanded
Percentage Change in Price
The Midpoint Method: A Better Way to Calculate Percentage Changes and
-Price Elasticity of Demand = (Q2 – Q1) / [(Q2 + Q1) / 2] = % Change in
(P2 – P1) / [(P2 + P1) / 2] % Change in
Situation Price Quantity Demanded
A 0.90 1100
B 1.10 900
% Quantity demanded = [200 /[(1100 + 900)/2] ] * 100 = 20%
% Price = (0.2 / ((0.90 + 1.00)/2) * 100 = 20 %
Elasticity = 20% / 20% = 1.0
-Same result if you go up demand curve from A to B or down demand curve
from B to A