ECON 208 Chapter Notes - Chapter 4: Diet Pepsi, Excise, Inferior Good

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Published on 16 Apr 2013
School
McGill University
Department
Economics (Arts)
Course
ECON 208
Page:
of 5
Chapter 4 Elasticity
4.1 Price Elasticity of Demand
Demand elastic when quantity demanded is quite responsive to changes in price
When quantity demanded is relatively unresponsive to changes in price, demand is inelastic
The more responsive the quantity demanded is to changes in price, the less the change in
equilibrium price and the > the change in equilibrium quantity resulting from any given shift in
the supply curve
The Measurement of Price Elasticity
Able to compare two demand curves b/c
o both drawn on same scale and initial equilibrium prices (Slope of demand curve tells us
the amount by which price must change to cause a unit change in quantity demanded)
o quantities were the same in both parts (if initial prices and quantities the same in both
cases, the larger absolute change is also the larger %age change)
Price elasticity of demand (Ƞ): a measure of the responsiveness of quantity demanded to a

= %age change in quantity demanded
%age change in price
The Use of Avg Price and Quantity in Computing Elasticity
Demand elasticities computed using changes in price and quantity measured in terms of avg
values of each to avoid the ambiguity caused by the fact that when a price or quantity changes,
the change is a different %age of the original value than it is of the new value
Using avg values for price+demand = measured elasticity of demand on demand curve between
A and B is independent of whether the movement is from A B or B-A
   (no units)
Interpreting Numerical Elasticities
Negative slope of demand curve = ^price = decrease in quantity demanded
Since %age changes in price+quantity have opposite signs, demand elasticity ve
More responsive quantity demanded to a change in price = greater elasticity, larger
Demand curve vertical when elasticity 0, change in price = no change in quantity demanded,

Demand curve horizontal when elasticity infinite, even a very small change in price leads to an
enormous change in quantity demanded
Inelastic demand: following a given %age change in price, there is a smaller %age change in
quantity demanded; elasticity<1
Elastic demand: following a given %age change in price, there is a greater %age change in
quantity demanded; elasticity>1
Demand is unit elastic when%age change in quantity demanded is = to %age change in price,
elasticity = 1
Moving down a linear demand curve, price elasticity falls continuously, even tho the slope is
constant; the same absolute changes in price+quantity occur over the intervals CD and EF, but
elasticity differs b/c these absolute changes represent diff %ages
Elasticity approaches infinite as we get closer to where the demand curve intersects the vertical
axis; elasticity approaches 0 as we get closer to where the demand curve intersects the
horizontal axis

Linear demand curve has constant elasticity only when it is vertical or horizontal; non-linear
demand curve w/ constant elasticity when unit elasticity (=1) hyperbola for which price times
quantity demanded is constant
What Determines Elasticity of Demand?
Availability of Substitutes
A change in the price of products, with the price of the substitutes remaining constant, can be
expected to cause much substitution
Product defined more broadly, such as all foods or all clothing, have many fewer satisfactory
substitutes than do products defined much more narrowly. Rise in prices of broadly defined
products expected to cause a smaller fall in quantities demanded than if close substitutes availa
Demand elasticity higher for diet pepsi than beverages overall
Products with close substitutes tend to have elastic demands; products with no close substitutes
tend to have inelastic demands. Narrowly defined products have more elastic demands than do
more broadly defined products
Short Run and Long Run
Takes time to develop satisfactory substitutes demand that is inelastic in the short run may
prove to be elastic in the long run
The response to a price change, and thus the measured price elasticity of demand, will tend to
be greater the longer the time span
Cornflakes and sweaters full response to price change happens fast little reason to make
distinction between short and long run effects; change in price of electricity may not have its
major effect til the stock of appliances that use the products has been adjusted
Short-run demand curve shows immediate response of quantity demanded to a change in price
given the current stock of durable goods
o Supply increase leads to movement down the relatively inelastic curve causes large fall
in price but only small ^ in quantity
Long-run demand curve shows the response of quantity demanded to a change in price after
enough time has passed to change the stock of durable goods
o Supply increase, Demand is more elastic long-run equilibrium has price and quantity
above those that prevailed in short-run equilibrium
The long-run demand for a product is more elastic than the short-run demand
Elasticity and Total Expenditure
Total expenditure depends on the price elasticity of demand
At any point on the demand curve: Total Expenditure = Price x Quantity
Change in TE depends on the relative changes in the price and quantity
o Price decline of 10%
o Elastic demand: Quantity demanded changes by >10% - Q change dominates and TE ^
o Inelastic Demand: Q demanded changes by <10% - P change dominates and TE falls
o Unit Elastic Demand: Q demanded increases by 10%, then Q and P %age changes offset
each other and TE remains unchanged
TE maximum when price elasticity is =1
4.2 Price Elasticity of Suppy
Price elasticity of supply (Ƞs): a measure of the responsiveness of quantity supplied to a change

s = %age change in quantity supplied
%age change in price
+ve slope: ^price causes ^ quantity supplied: +ve elasticity since both change in same direction
s  
Supply curve may have constant slope but the elasticity may be different at diff places on the
curve: when s>1, elastic supply; when s<1, inelastic supply
Vertical supply curve  then elasticity of
supply is 0; horizontal supply curve has an infinite elasticity of supply: there is 1 critical price at
which output is supplied but where a small drop in price will reduce the quantity that producers
are willing to supply from an indefinitely large amount to zero
Linear supply curve that begins at origin elasticity of supply along such a curve is always 1
Determinants of Supply Elasticity
Substitution and Production Costs
^price of product profitability depends partly on how easy it is for producers to shift from the
production of other products to the one whose price has risen (more elastic product)
Supply elasticity also depends on how costs behave as output is varied
o Costs of production ^ fast as output ^, then the stimulus to expand production in
response to a ^in price will be choked off by ^costs = supply inelastic
o Costs of production ^ slowly as production ^, ^price that ^profits will elicit a large ^ in
quantity supplied before the ^in costs stops expansion in output = supply elastic
Short Run and Long Run
Hard to change quantity supplied in response to a price increase in short time but easier in long
Short-run supply curve shows the immediate response of quantity supplied to a change in price
d
o Demand increase sharp increase in price and only modest increase in Q
Long-run supply curve shows the response of quantity supplied to a change in price after
enough time has passed to allow producers to adjust their productive capacity
o Demand increase firms able to ^capacity, ^ quantity, less effect on price
The long-run supply for a product is more elastic than the short-run supply.
4.3 An Important Example Where Elasticity Matters
Elasticity crucial to determining whether consumers/producers/both end up paying excise taxes
Excise tax: a tax on the sale of a particular commodity
Tax incidence: the location of the burden of a tax that is, the identity of the ultimate bearer of
the tax

Document Summary

Demand elastic when quantity demanded is quite responsive to changes in price. When quantity demanded is relatively unresponsive to changes in price, demand is inelastic. The more responsive the quantity demanded is to changes in price, the less the change in equilibrium price and the > the change in equilibrium quantity resulting from any given shift in the supply curve. Price elasticity of demand ( ): a measure of the responsiveness of quantity demanded to a change in the commodity"s own price. = %age change in quantity demanded. The use of avg price and quantity in computing elasticity. Using avg values for price+demand = measured elasticity of demand on demand curve between. A and b is independent of whether the movement is from a b or b-a. Negative slope of demand curve = ^price = decrease in quantity demanded. Since %age changes in price+quantity have opposite signs, demand elasticity ve.