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Chapter 4

Chapter 4- Elasticity

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Department
Economics
Course
ECON 101
Professor
Emanuel Carvalho
Semester
Winter

Description
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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