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Chapter 5

Chapter 5 - Elasticity.docx

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McMaster University
Hannah Holmes

Chapter 5: Elasticity Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. Types of Price Elasticity - Factors that affect how people respond to different changes in price of a good. o Large number of substitutes? o Is it a luxury or a necessity? o How narrowly defined is the market o What about the time? Inelastic Demand - Quantity demand (Qd) does not respond strongly to price changes - Steep demand curve - % change in Qd < % change in P - Ep < 1 - Example: textbooks. Elastic Demand - Quantity demanded (Qd) responds strongly to price changes. - Flat demand curve - % change in Qd > % change in P - Ep > 1 Perfectly Inelastic Demand - Qd does not respond to price changes at all. - Demand curve is vertical - Ep = 0 - Example: prescription heart medication. Perfectly Elastic Demand - Qd changes infinitely with an change in price - Ep = infinity - Demand curve is horizontal - Example: supplier raises price of wheat; you go get it somewhere else Unit Elastic - Qd changes by same percentage as price - Ep = 1 - Demand curve is non-linear - Example: none really exist. Ep Demand Curve Example Inelastic <1 Steep Textbooks Elastic >1 Flat Most products Perfectly Inelastic = 0 Vertical Heart medication Perfectly Elastic = infinity Horizontal Wheat prices Unit Elastic = 1 Non-linear None exist Calculating Elasticity Ep = Midpoint Formula (preferable): Ep = ((Q2 – Q1) / ([Q2+Q1]/2)) / ((P2 – P1) / ([P2 + P1]/2)) Generalities about Elasticities and Their Determinants 1. Necessities tend to have inelastic demand a. Ex. Insulin and dentist office visits 2. Luxuries tend to have elastic demand a. Plasma TVs, vacations 3. Goods that have close substitutes have elastic demand a. Coke and Pepsi 4. Goods tend to have more elastic demand over longer time horizons a. You can find substitutes in the long run where you can’t in the short run. 5. How you define the market makes a difference a. Food is inelastic, vegetables are more elastic, broccoli is even more elastic b. The more narrowly defined the market is, the more elastic the demand is 6. How much of your budget you spend on a good determines elasticity. a. Large proportion of budget on a good  Elastic demand (ex. Car) b. Small proportion of budget on a good  Inelastic (ex. Coffee) Elasticity is not constant along a linear demand curve. It is not equivalent to slope. Slope measures rates of change, while elasticity measures percentage changes. Price Elasticity and Total Revenue Total revenue (TR) = P*Q Inelastic If you raise price, TR increases when customers will stay price increases Elastic If you lower prices, TR increases when new customers will price decreases come Unit Elastic Changes in price will TR will be maximum not affect revenue when Ep = 1 (TR area is square) Econ 1B03 Income Elasticity of Demand 19/01/11 Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is denoted Ei. If given percent changes in income and corresponding changes in quantity demanded (Qd): Ei = If given 2 levels of income and their corresponding Qd’s: [
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