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Chapter 5

Economics Chapter 5.pdf

8 Pages
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Department
Economics
Course Code
ECN 104
Professor
Tsogbadral Galaabaatar

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Economics Chapter 5 Basic idea: Elasticity measures how much one variable responds to changes in another variable. • One type of elasticity measures how much demand for your websites will fall if you raise your price. d s Elasticity is a numerical measure of the responsiveness of Q (quantity demand) or Q (quantity supply) to one of its determinants. d Price elasticity of demand measures how much Q responds to a change in P. Loosely speaking, it measures the price-sensitivity of buyers’ demand. Calculating Percentage changes Exercise 1 Use the following information to calculate the price elasticity of demand for hotel rooms: d if P = $70, Q = 5000 if P = $90, Q = 3000 What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. d In each example: Suppose the prices of both goods rise by 20%. The good for which Q falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? What lesson does the example teach us about the determinants of the price elasticity of demand? Example 1) Breakfast Cereal vs. Sunscreen The prices of both of these goods rise by 20%. For which good does Q drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: Price elasticity is higher when close substitutes are available. Example 2) Blue Jeans vs. Clothing The prices of both goods rise by 20%. For which good does Q drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). There are fewer substitutes available for broadly defined goods. Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. Example 3) Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does Q drop the most? Why? To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities. Example 4) Gasoline in the Short Run vs. Gasoline in the Long Run The price of gasoline rises 20%. Does Q drop more in the short run or the long run? Why? There’s not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: Price elasticity is higher in the long run than the short run. The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on:  The extent to which close substitutes are available  Whether the good is a necessity or a luxury  How broadly or narrowly the good is defined  The time horizon – elasticity is higher in the long run than the short run Total revenue (in a market): the amount paid by buyer & received by sellers of a good. Computed as the price of the good times the quantity sold The variety of demand curves The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves.… 1. Perfectly inelastic demand (one extreme case) 2. Inelastic Demand 3. Unit elastic demand 4. Elastic Demand 5. Perfectly Elastic Demand Price Elasticity and Total Revenue Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. If demand is elastic, then price elast. of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. If demand is inelastic, then price elasticity of demand < 1 % change in Q < % change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead
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