# Chapters These notes cover all of chapter 4 and five in detail. Key terms, and concepts incorporated in an easy to follow format. Recommended for studying a midterm.

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16 Oct 2011

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Econ Mid Term Review Chapter 4 and 5

Chapter 4 – Elasticity

Chapter 5 – Efficiency and Equity

Chapter 4 Review

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

buyers’ plans remain the same.

Calculating Elasticity: The price elasticity of demand is calculated by using the

formula:

Percentage change in quantity demanded

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Percentage change in price

To calculate the price elasticity of demand:

We express the change in price as a percentage of the average price—the average of

the initial and new price, and we express the change in the quantity demanded as a

percentage of the average quantity demanded—the average of the initial and new

quantity.

By using the average price and average quantity, we get the same elasticity value

regardless of whether the price rises or falls. The ratio of two proportionate

changes is the same as the ratio of two percentage changes. The measure is units

free because it is a ratio of two percentage changes and the percentages cancel out.

Changing the units of measurement of price or quantity leave the elasticity value the

same.

The formula yields a negative value, because price and quantity move in opposite

directions. But it is the magnitude, or absolute value, of the measure that reveals

how responsive the quantity change has been to a price change.

Inelastic and Elastic Demand

Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity.

If the quantity demanded doesn’t change when the price changes, the price elasticity

of demand is zero and the good as a perfectly inelastic demand.

If the percentage change in the quantity demanded equals the percentage change in

price, the price elasticity of demand equals 1 and the good has unit elastic demand.

Elasticity values that have a percentage change in the quantity demanded that is

smaller than the percentage change in price so that the price elasticity of demand is

less than 1 and the good has what is called inelastic demand. IF the percentage

change in the quantity demanded is infinitely large when the price barely changes,

the price elasticity of demand is infinite and the good has perfectly elastic demand. If

the percentage change in quantity demanded is greater than the percentage change

in price, the price elasticity of demand is greater than 1 and the good has elastic

demand.

Total Revenue and Elasticity

The total revenue from the sale of good or service equals the price of the good

multiplied by the quantity sold. When the price changes, total revenue also changes

but a rise in price doesn’t always increase total revenue.

The change in total revenue due to a change in price depends on the elasticity of

demand: If demand is elastic, a 1 percent price cut increases the quantity sold by

more than 1 percent, and total revenues decreases. If demand is unit elastic, a 1

percent price cut increases the quantity sold by 1 percent, and total revenue

remains unchanged.

The total revenue test is a method of estimating the price elasticity of demand by

observing the change in total revenue that results from a price change (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 leaves total revenue unchanged, demand is unit elastic.

Expenditure and Elasticity

If your demand is elastic, a 1 percent price cut increases the quantity you buy

by more than 1 percent and your expenditure on the item increases.

If your demand is inelastic, a 1 percent price cut increases the quantity you

buy by less than 1 percent and your expenditure on the item decreases.

If your demand is unit elastic, a 1 percent price cut increases the quantity you

buy by 1 percent and your expenditure on the item does not change.

The Factors That Influence the Elasticity of Demand

The elasticity of demand for a good depends on:

The closeness of substitutes

The proportion of income spent on the good

The time elapsed since a price change

Closeness of substitutes

The closer the substitutes for a good or service, the more elastic are the demand for

it. Necessities, such as food or housing, generally having inelastic demand.

Luxuries, such as exotic vacations, generally have elastic demand.

Proportion of income spent on the good

The greater the proportion of income consumer’s spent on a good, the larger is its

elasticity of demand.

Time Elapsed Since Price Change

The more time consumers have to adjust to a price change, or the longer that a good

can be stored without losing its value, the more elastic is the demand for that good.

Cross Elasticity of Demand

The cross elasticity of demand is a measure of the responsiveness of a demand for a

good to a change in the price of a substitute or a compliment, other things remaining

the same.

The formula for calculating the cross elasticity is:

Percentage change in quantity demanded

Percentage change in price of substitute or compliment

The cross elasticity of demand for a substitute is positive.

The cross elasticity of demand for a complement is negative.

Income Elasticity of Demand

The income elasticity of demand measures how the quantity demanded of a good

responds to a change in income, other things equal. The formula for calculating the

income elasticity of demand is:

Percentage change in quantity demanded

Percentage change in income