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ECON 101 (211)
Chapter 4

# Chapter 4 Lecture Notes.doc

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School
University of Waterloo
Department
Economics
Course
ECON 101
Professor
Corey Van De Waal
Semester
Winter

Description
CHAPTER 4: Elasticity Chapter Overview: A. To predict the quantitative effects of changes in demand and supply on prices  and quantities, we need to know how responsive demand and supply are to price  and other influences on buying plans and selling plans. B. This chapter explains how we measure the responsive demand and supply to  price and other influences on buying plans and selling plans using the concept  of elasticity. It explains how we calculate, interpret, and use elasticity. • Defining & calculating the price elasticity of demand • Perfectly elastic, Perfectly inelastic, Elastic, Inelastic &Unit elastic demand • Elasticity along a straight line demand curve • Total revenue & elasticity • The Factors That Influence the Elasticity of Demand • Cross elasticity of demand • Income elasticity of demand • Define, calculate and explain the factors that influence the price elasticity of supply • Cannot use just the demand curve because it is a unit dependent measure • We therefore have to use elasticity because it is a unit free measure 1 • What is different in the two diagrams below? Figure 4.1 • slope of the demand curve is very steep 2 • slope of the demand curve is flat Price Elasticity of Demand The contrast between the two outcomes in Figure 4.1 highlights the need for  A measure of the responsiveness of the quantity demanded to a price change. 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 buyers’ plans remain the same. Calculating Elasticity The price elasticity of demand is calculated by using the formula: Ɛ d Percentage change in quantity demanded / Percentage change in price = [(Difference in Q demanded /average quantity) x 100] [(difference in P / average price) x 100] = delta Q delta P 3 • elasticity is a unit free measure • also known as the mid point formula To calculate the price elasticity of demand:  We express the change in price as a percentage of the average price—the average of the initial and new price,  and we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity The percentage change in quantity demanded, %DQ, is calculated as DQ/Qave, which is 2/10 = 1/5. The percentage change in price, %DP, is calculated as DP/Pave, which is \$1/\$20 = 1/20 The price elasticity of demand is %DQ/ %DP = (1/5)/(1/20) = 20/5 = 4.  By using the average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls. 4  The ratio of two proportionate changes is the same as the ratio of two percentage changes.  The measure is units free because it is a ratio of two percentage changes and the percentages cancel out.  Changing the units of measurement of price or quantity leave the elasticity value the same. • The formula yields a negative value, because price and quantity move in opposite directions. • But it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. Demand can be perfectly elastic, inelastic, unit elastic, or elastic, and can range from zero to infinity. (1) Perfectly elastic - a small change in price masks a huge change in quantity - Horizontal line on the plane - Price is constant (2) Perfectly Inelastic demand - If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and the good as a perfectly inelastic demand. A vertical line on the plane. Quantity if constant 5 Flatter demand curve – is more elastic Stepper demand curve - in more inelastic Ed > 1, % delta Q > % delta P Ed<1, % delta Q < % delta P (3) If the percentage change in the quantity demanded equals the percentage change in price, …the price elasticity of demand equals 1 and the good has unit elastic demand. Figure 4.3(b) illustrates this case—a demand curve with ever declining slope. delta Q = delta P Total revenue = P x Q (3) If the percentage change in the quantity demanded is infinitely large when the price barely changes, … the price elasticity of demand is infinite and the good has a perfectly elastic demand. Figure 4.3(c) illustrates the case of perfectly elastic demand—a horizontal demand curve. 6 (4) If the percentage change in the quantity demanded is smaller than the percentage change in price,  the price elasticity of demand is less than 1 and the good has inelastic demand. (5) If the percentage change in the quantity demanded is greater than the percentage change in price,  the price elasticity of demand is greater than 1 and the good has elastic demand Elasticity Along a Straight-Line Demand Curve Figure 4.4 shows how demand becomes less elastic as the price falls along a linear demand curve. 7 • For example, if the price falls from \$25 to \$15, the quantity demanded increases from 0 to 20 pizzas an hour. • The average price is \$20 and the average quantity is 10 pizzas. • The price elasticity of demand is (20/10)/(10/20), which equals 4. *********************************************** • If the price falls from \$10 to \$0, the quantity demanded increases from 30 to 50 pizzas an hour. • The average price is \$5 and the average quantity is 40 pizzas. • The price elasticity is (20/40)/(10/5), which equals 1/4. ************************************************ • If the price falls from \$15 to \$10, the quantity demanded increases from 20 to 30 pizzas an hour. • The average price is \$12.50 and the average quantity is 25 pizzas. • The price elasticity is (10/25)/(5/12.5), which equals 1. Exercise 1: When the price of bubble gum is \$0.50, the quantity demanded is 400 packs per day. When the price falls to \$0.40, the quantity demanded increases to 8 600. Given this information and using the midpoint method, what
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