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L6 - Elasticity of Demand - 09252013.pdf

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James Pesando

You sell sparkling water, which you obtain from your own spring at no cost. You are selling the water for $2 per bottle. Since your costs are zero, your profit equals your total revenue ($ of bottles sold * price per bottle). Q: 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" (thus, reducing revenues) Insight: We need MORE information about the demand curve in order to answer the question Key concept: Elasticity of Demand (Price) Elasticity of Demand Defination: Percent change in quantity demanded / Percent change in price Measures responsiveness of quantity demanded to a change in price Mid-point Convention Mid-Point Convention Situation Price Quantity Demanded A .9 1,100 B 1.10 900 200 / [(1100+900)/2] * 100 = (200 / 1000) * 100 = 20 % 0.2 / [(0.9+1.1)/2] * 100 = 20 % Elasticity = 20% / 20% = 1.0 Insight: same result if go up demand curve from A to B or down demand curve from B to A Example 1. Elasticity = 20 / 10 = 2 QD is very responsive to a change in price Example 2. Elasticity = 2 / 10 = 0.2 QD is not very responsive to a change in price Why do Elasticities Differ: Availability of Substitutes More/Better substitutes --> higher elasticity Margarine is close substitute for butter --> butter has high price elasticity Tobacco has few close substitutes --> cigarette has low price elasticity Application: Example 1 Which will have a higher (price) elasticity of demand: Toothpaste or INDIVIDUAL brand of toothpaste Answer: DD for individual brand, since there are more substitutes (other brands) Insight: If the price of toothpaste (all brands) increased by 25%, there would be a small reduction
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