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Chapter 4

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Economics

ECON 101

Emanuel Carvalho

Winter

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Chapter 4: Elasticity
Price Elasticity of Demand
You know that when supply increases, the equilibrium price falls and the equilibrium quantity
increases But does the price fall by a large amount and the quantity increase by a little? Or
does the price barely fall and the quantity increase by a large amount?
Answer depends on the responsiveness of the quantity demanded to a change in price
Price elasticity of demand: 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
Price Elasticity of demand = Percentage change in quantity demanded
Percentage change in price
To calculate the price elasticity of demand, we express the changes in price and quantity
demanded as percentages of the average price and average quantity
Example:
The original price is $20,50 and the new price is $19.50, so the average price is $20. The
$1 price decrease is 5 percent of the average price. That is,
o =($1/$20)X100=5%
The original quantity demanded is 9 pizzas and the new quantity demanded is 11 pizzas,
so the average quantity demanded is 10 pizzas. The 2 pizza increase in the quantity
demanded is 20 percent of the average quantity. That is,
o =(2/10)X100=20%
Price elasticity of demand = 20%/5%=4
Average Price and Quantity
Average quantities give the most precise measurement of elasticity
Get the same value for the elasticity regardless
Percentages and Proportions
Elasticity is the ratio of two percentage
A percentage change is a proportionate change multiplied by 100
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
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
Because a positive change in price brings a negative change in the quantity demanded, the price
elasticity demand is a negative number
But it is the magnitude, or absolute value, of the price elasticity that tells us how responsive the
quantity demanded is So to compare price elasticity of demand, we use the magnitude of the elasticity and ignore the
minus sign
Inelastic and Elastic Demand
Perfectly inelastic demand: Demand with a price elasticity of zero; the quantity demanded
remains constant when the price changes
One good that has a very low price elasticity of demand (perhaps zero over some price
range)is insulin
Insulin is of such importance to some diabetics that if the price rises or falls, they do not
change the quantity they buy
Unit elastic demand: Demand with a price elasticity of 1; the percentage change in the quantity
demanded equals the percentage change in price
Inelastic demand: A demand with a price elasticity between 0 and 1; the percentage change in
the quantity demanded is less than the percentage change in price
E.g. Food & Shelter
Perfectly elastic demand: Demand with an infinite price elasticity; the quantity demanded
changes by an infinitely large percentage in response to a tiny price change
Demand for a good that has perfect substitutes (e.g. two soft drinks)
Elastic demand: Demand with a price elasticity greater than 1; other things remaining the same,
the percentage change in the quantity demanded exceeds the percentage change in price
E.g. Automobiles and furniture
Elasticity Along a Straight-Line Demand Curve
At the mid-point of the curve, demand is unit elastic
Above the midpoint, demand is elastic
Below the midpoint, demand is inelastic
Total Revenue and Elasticity
Total revenue: The value of a firm’s sales. It is calculated as the price of the good multiplied by
the quantity sold
A rise in price does not always increase total revenue
The change in total revenue depends on the elasticity of demand in the following way:
If the demand is elastic, a 1$ price cut increases the quantity sold by more than 1% and
total revenue increases
If the demand is inelastic, a 1% price cut increases the quantity sold by less than 1% and
total revenue decreases
If demand is unit elastic, a 1% price cut increases the quantity sold by 1 % and total
revenue does not change
Total revenue test: a method of estimating the price 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
See pg.90 Your Expenditure and Your Elasticity
When a price changes, the change in your expenditure on the good depends on your elasticity of
demand
If your demand is elastic, a 1% price cut increases the quantity you buy by more than 1%
and your expenditure on the item increases
If your demand is inelastic, a 1% price cut increases the quantity you buy by less than 1%
and your expenditure on the item decreases
If your demand is unit elastic, a 1% price cut increases the quantity you buy by 1% and
your expenditure on the item does not change
If you spend more on an item when its price falls, your demand for that item is elastic; if you
spend the same amount, your demand is unit elastic; and if you spend less, you demand is
inelastic
The Factors That Influence the Elasticity of Demand
The elasticity of demand depends on:
1. The closeness of substitutes
2. The proportion of income spent on the good
3. The time elapsed since a price change
Closeness of Substitutes
The closer the substitutes for a good or service, the more elastic is the demand for it
E.g. Oil not very much substitutes Inelastic
E.g. Plastics = close substitutes for metals Elastic
The degree of substitutability between two goods also depends on how narrowly (or broadly)
we define them (E.g. computer = no substitute, but Dell = substitute for HP)
Generally, a necessity has an inelastic demand and a luxury has an elastic demand
Proportion of Income Spent on the Good
Other things remaining the same, the greater the proportion of income spent on the good, the
more elastic is the demand for it
E.g. If the price of gum raised, you may still buy it, but if the price of an apartment
raises, you would want to share; gum = inelastic
Time Elapsed Since Price Change
The longer the time that has elapsed since a price change, the more elastic is demand
E.g. When the price of a PC first dropped, people bought more. But as people got more
informed about the variety of ways of using a PC, the quantity pof PCs bought has
increased sharply
More Elasticities of Demand
Cross Elasticity of Demand
We measure the influence of a change in the price of a substitute or complement by using the
concept of the cross elasticity of demand
Cross elasticity of demand: The responsiveness of the demand for a good to a change in the
price of a substitute or complement, other things remaining the same. It is calculated as the
percentage change in the quantity demanded of the good divided by the percentage change in
the price of the substitute or complement Cross elasticity of demand =

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