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Department
Economics
Course
ECN 104
Professor
Angie Ray
Semester
Winter

Description
Micro Chapter 4: Elasticity Price Elasticity of Demand - When supply increases, the equilibrium price falls and the equilibrium quantity increases Does the price fall by a large amount and the quantity increase by a little? Does the price barely fall and the quantity increases by a large amount? This depends on the responsiveness of the quantity demanded to a change in price What do we mean by responsiveness and how can it be measured? - The measure of responsiveness is known as elasticity - The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same Calculating Price Elasticity of Demand p r nt n n qu nt ty m n Price elasticity of demand = p r nt n n pr - To calculate price elasticity of demand, we express the changes in price and quantity demanded as percentages of the average price and the average quantity - We calculate the elasticity at a point on the demand curve that is midway between the original point and the new point Example in textbook: The original price is $20.50 and new price is $19.50, therefore the average price is $20. The $1 price decrease is 5% of the average price, or the $1 decrease is 5% of $20 (which is the average price). That is, P (delta p or change in price) /p.avg = (change in price is $1/ avg. price is $20) x 100 = 5% The original quantity demanded is 9 pizzas and the new quantity demanded is 11 pizzas, therefore the average quantity demanded is 10 pizzas. The 2 pizza increase in the quantity demanded is 20% of the average quantity (the average quantity is 10 pizzas). That is, Q/Q.avg = (2/10) x 100 = 20% So the price elasticity of demand, which is the percentage change in the quantity demanded (20%) divided by the percentage change in price (5%) is 4. That is, Price elasticity =p r nt n n qu nt ty m n = = 4 p r nt n n pr Average Price and Quantity: - We use the average price and quantity because it gives the most precise measurement of elasticity which is at the midpoint between the original price and the new price - By using percentages of the average price and average quantity, we get the same value for elasticity regardless of whether the price falls from $20.50 to $19.50, or rises from $19.50 to $20.50 Percentages and Proportions: - Elasticity is the ratio of two percentage changes - Therefore, when we divide one percentage change by another, the 100s cancel - A percentage change is a proportionate change multiplied by 100 - So if we divide Q/Q.avg by P/p.avg we get the same answer as we get by using percentage changes A Units-Free Measure: - Elasticity is a units-free measure because the percentage change in each variable is independent of the units in which the variable is measured - Also, the ratio of the two percentages is a number without units Minus Sign and Elasticity: - When the price of a good rises, the quantity demanded decreases This is because, a positive change in price brings negative change in quantity demanded Therefore, the price elasticity of demand is a negative number However, it is the magnitude (absolute value) of the price elasticity (not the plus or minus sign), that tells us how responsive the quantity demanded is T r for , to omp r pr l st tys w us t magnitude, and ignore the minus sign Inelastic and Elastic Demand - There are t r m n urv s t t ov r t nt r r n of poss bl l st tys of demand - Perfectly inelastic demand if the quantity demanded remains constant even though the prices changes, price elasticity of demand is zero and the good is said to have a perfectly inelastic demand Example: Insulin it is so important to diabetics that even if the price rises or falls they do not change the quantity they buy - Unit elastic demand if the percentage change in the quantity demanded equals the percentage change in the price, then the price elasticity equals 1 and the good is said to have a unit elastic demand - Inelastic demand when the percentage change in the quantity demanded is more than the percentage change in the price, the price elasticity of demand is between 1 and infinity and the good is said to have an inelastic demand Example: Food and shelter - Perfectly elastic demand if the quantity demanded changes by a VERY large percentage, in response to only a tiny price change, the price elasticity of demand (the change in the quantity demanded of a good in response to a change in its price) is infinity and the food is said to have perfectly elastic demand Example: two vending machines side by side sell the same drink; one sells it for 10 cents cheaper. Even though the price difference is so small, no one will buy from the machine with the higher price, making the elasticity of the soft drink from the cheaper v n n m n p rf tly l st m n - Elastic demand the percentage change in quantity demanded is less than the percentage change in price, the price elasticity is between zero and 1 and the good is said to have an elastic demand Example: automobiles and furniture Elasticity along a Straight-Line Demand Curve - Elasticity and slope are related - A straight-line demand curve is a demand curve that has a constant slope Suppose that price falls from $25 to $15 a pizza, and the quantity demanded increases from 0 to 20 pizzas an hour. Average price is $20, and the average quantity is 10 pizzas an hour. P /p.avg = ($10/$20) x 100 = 50% Q/q.avg = (20/10) x 100 = 200% Price elastici=yp r nt n n qu nt ty m n = = = 4 p r nt n n pr Or Price elastici=y = = 4 That is, the price elasticity of demand at an average price of $20 a pizza is 4. Next, suppose that the price falls from $15 to $10 a pizza, and the quantity demanded increases from 20 to 30 pizzas an hour. The average price is now $12.50, and the average quantity is 25 pizzas an hour. Price elastici=y = = 1 - Through these examples, one can see that elasticity changes along a straight-line demand curve - At the midpoint of the curve, demand is unit elastic - Above the midpoint, demand is elastic - Below the midpoint, demand is inelastic - Therefore, on a straight-line demand curve, elasticity decreases as the price falls, and the quantity demanded increases Total Revenue and Elasticity - Total revenue equals the price of a good multiplied by the quantity sold - When a price changes, revenue also changes but a rise in price does not always increase total revenue - Change in total revenue depends on the elasticity of demand in the following way: If demand is elastic, a 1 % price cut increases the quantity sold by more than 1 % and total revenue increases (A tiny change in price 1% - increases the quantity sold by a large amount more than 1% - so revenue increases) If demand is inelastic, a 1 % price cut increases the quantity sold by less than 1 % and total revenue decreases (Because you r s t pr , but ont s ll s n f ntly lot mor , so you o not make enough profit and revenue decreases)] If demand is unit elastic, a 1% price cut increases the quantity sold by 1 percent and total revenue does not change (Because the change in price resulted in only enough increased sales to equal the same amount being made before, so revenue does not change) - Total revenue test a method of estimating the elasticity of demand by observing the change in total revenue that results from a change in the price, when all other influences on the quantity sold remain the same If a price cut increases total revenue, demand is elastic If a price cut decreases total revenue, demand is inelastic If a price cut does not change revenue, demand is unit elastic Your Expenditure and Your Elasticity - If you sp n mor on n t m w n ts pr f lls, your m n for t t t m s l st - If you spend the same amount, your demand is unit elastic - If you spend less, your demand is inelastic The Factors That Influence the Elasticity of Demand Closeness of Substitutes: - The closer the substitutes for a good or service, the more elastic is the demand for it - A necessity is a good that has poor substitutes, so generally, a necessity has an inelastic demand b us n n pr o snt r lly nflu n our m n of things we need, we buy them regardless of price - A luxury is a good that usually has many substitutes, so a luxury generally has an elastic demand we tend to buy more of luxury things that we WANT if price is cut because we can easier afford it Proportion of Income Spent on the Good: - The greater the proportion of income spent on the good, the more elastic is the demand for it
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