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L7 - Elasticity of Demand - 09302013.pdf

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James Pesando

TECHNICAL NOTE For the special cases of perfectly inelastic demand and perfectly elastic demand, the "law of downward sloping demand" does NOT apply For a perfectly inelastic demand curve, for example, an increase in price does NOT reduce quantity demanded (Price) ​Elasticity of Demand Percent change in quantity demanded/ percent change in price Measures responsiveness of quantity demanded to a change in price (as move along DD curve) Price Elasticity of Demand and Total Revenue Total Revenue = Price * Quantity In response to an increase in price, total revenue: - increases if demand is inelastic - is unchanged if demand is unit elastic -decreases if demand is elastic Inelastic Demand Curve ( TR ^ if P ^) TR0 = P0 * Q0 (Revenue at old price) TR1 = P1 * Q1 (Revenue at higher price) Revenue increase: (P1 - P0) * Q1 Revenue decrease: P0 * (Q0 - Q1) In this case, revenue increase exceeds revenue decrease, so total revenue rises as price increases Intuition Revenue increases because customers who continue pay a higher price (P1 - P0) * Q1 Revenue decreases because some customers will not pay a higher price (P0 * (Q0 - Q1) If demand is inelastic, most customers continue to pay higher price If demand is elastic, most customers choose not to pay higher price Practical Application 1. You own the Toronto Transit Commission (TTC) 2. You own 1 of 5 toll bridges across a river If you want to increase your total revenue, should you raise the price ( i.e., the TTC fare or the toll)? TTC Few close substitutes, so DD is inelastic Total revenue increases if you raise price (fare) One of Five Toll Bridges (Four) close substitutes, so DD is elastic Total revenue falls if you raise price (toll) (Your total revenues would fall to zero if everyone uses one of the other bridges) Is the Royal Ontario Museum (ROM) being nice to its visitors? INSIGHT ROM has discovered, at the current price of admission, the demand curve is elastic TECHNICAL NOTE (STUDENT EXERCISE) Elasticity at each point (P,Q) on a linear, downward-sloping demand curve: Elasticity = P / Q * (1 / slope) NOTE: key to prob
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