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Chapter 4

ECON 101 - chapter #4 notes.doc

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Department
Economics
Course
ECON 101
Professor
Corey Van De Waal
Semester
Winter

Description
ECON 101 – Chapter #4 Notes Elasticity in economics is the measurement of how changing one economic variable (such as: supply, demand, income) affects other. In my words, it is the responsiveness of a good or service to a change in price. Price Elasticity of Demand We know that when supply increases the equilibrium price falls and the equilibrium quantity increases. BUT does the price fall by a lot and the QD increase only a little? OR does the price barely fall and the QD increase a lot? The answer to this is: It depends on the responsiveness of the quantity demanded to a change in price. For example, if the quantity demanded is greatly affected by a small change in price, this means that the QD is elastic. In the textbook we get two different scenarios that give rise to 2 different outcomes The different outcomes arise from the differing degrees of responsiveness of QD to a change in price, otherwise known as the price elasticity of demand. In this case, ONLY because we are using the same units we can compare the responsiveness of the QD to a change in price of both scenarios. So we can compare the price elasticity of demand of each product in the 2 scenarios, and we can do this by using SLOPE. The slope of demand curve D A is steeper than the slope of demand curve D B. Remember: We can ONLY compare in this case because they are using the SAME UNITS! (pizzas). Usually, we cannot make this kind of comparisons using slopes since we generally don’t compare products measured is the same units. So since they aren’t measure in the same units they CANNOT BE COMPARED USING SLOPES. As a matter of fact, elasticity is measured using NO units of measurement, it is simply a number: 0, greater than 0 but less than 1, simply 1, or greater than 1. The price elasticity of demand is 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 We calculate the price elasticity of demand by using: Δ % in Quantity Demanded Price elasticity of demand = Δ % in Price SO, in order to calculate price elasticity of demand, we express the changes in price and QD as percentages of the average price and the average quantity. The only way to explain this is using an example: Let’s say that initially the price of a HUGE pizza you want to buy because you’re smashed is $20.50 per pizza and the pizza joint sells about 9 pizzas an hour. Suddenly a giant Lion appears out of nowhere and just eats half the pizza. Now, having been licked by a lion the owner decides to lower the price of the pizza to $19.50 (Your drunk beyond recognition so, you’ll take it either way) and therefore the QD of pizzas increases to 11 an hour. SO, the original price was $20.50, the new price is $19.50, and the AVERAGE price is $20. So we calculate: ΔP / ΔPAvg= (1/20) = 5% SIMILARLY, the original quantity demanded was 9 pizzas and the new quantity demanded is 11 pizzas, so the AVERAGE quantity is 10 pizzas. So we calculate: ΔQ / ΔQ Avg= (2/10) = 20% SO, Price elasticity of demand = 20%/5% = 4 Sometimes, the price of a good rises, in these cases we know that this causes a negative change on QD. This would make the price elasticity of demand a negative number. But it’s the absolute value or the magnitude of the price elasticity of demand that tells us how responsive the QD is; therefore we use the absolute value of elasticity. Inelastic and Elastic Demand There are 5 types of elasticity: 1. Perfectly Inelastic demand – if the QD remains constant when the price changes, then the price elasticity = 0, and it is said to be perfectly inelastic. Example – Insulin has perhaps an elasticity of 0. This is because its of such importance to diabetics that if price rises or falls they do not change the quantity they buy. 2. Unit Elastic demand – If the percentage change in the quantity demanded equals the percentage change in the price, then elasticity = 1, and the good is said to have unit elastic demand. 3. Perfectly Elastic demand – if the QD changes by an infinitely large percentage in response to a tiny price change, then the price elasticity of demand = ∞, and the good is said to have perfectly elastic demand. 4. Inelastic demand – When the percentage change in the QD is greater than the percentage change in price. In this case, the price elasticity of demand is between 1 and infinity, the good is said to have inelastic demand. 5. Elastic demand – When the percentage change in QD is less than the percentage change in price. In this case, the price elasticity of demand is between 0 and 1. The good is said to have elastic demand. Total Revenue and Elasticity When a price changes, total revenue also changes. But a rise in price does not always increase total revenue. The change in total revenue depends on the elasticity of demand: • If demand is elastic, a 1% price cut increases the quantity sold by more than 1% and total revenue increases.  elastic remember means responsive to a change in price. • If 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. These very same rules apply to expenditures; • If your demand is elastic then 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, then 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, then a 1% price cut increase the quantity you buy by 1% and expenditure on the item does not change. The Factors that influence the Elasticity of demand The elasticity of demand depends on: 1. The closeness of substitutes – The closer the substitute for a good or service, the more elastic is the demand for it. For example – oil from which gasoline is made has substitutes but NONE that are close. SO the demand for oil is inelastic. Plastics are close substitutes for metals, so the demand for metals is elastic. 2. The proportion of income spent on the good – The greater the proportion of income spent on the good, the more elastic is the demand for it. For example – Think of chocolate and Hummers. If the price of chocolate doubles, you’ll consume almost as much chocolate as before. So your demand for chocolate is inelastic. If hummer prices double, you FREAK OUT and sell that shit away (or just don’t buy it). SO basically your demand for hummers is not as inelastic as your demand
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