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Chapter 4

Chapter 4- Elasticity

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Department
Economics
Course
Economics 1021A/B
Professor
Michael Parkin
Semester
Fall

Description
Microeconomics Chapter 4 Price Elasticity of Demand • different outcomes arise from differing degrees of responsiveness of the quantity demanded to a change in price • the slope of a demand curve depends on the units in which we measure the price and quantity • units of measurement are unrelated, can’t compare demands for different goods • 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 use this formula, need to know the quantities demanded at different prices express the changes in price and quantity demanded as percentages of the average price and the • average quantity AVERAGE PRICEAND QUANTITY • use average price and average quantity because it gives the most precise measurement of elasticity- at the midpoint between the original price and the new price • get the same value for the elasticity regardless of whether the price falls or rises PERCENTAGES AND PROPORTIONS • elasticity is the ratio of two percentage changes • when we divide one percentage change by another, the 100s cancel • a percentage change is a proportionate change multiplied by 100 • the proportionate change in price is change in price/average price and the proportionate change in quantity demanded is change in quantity/average quantity AUNITS-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 measure MINUS SIGN AND ELASTICITY • positive change in price brings a negative change in the quantity demanded, the price elasticity of demand is a negative number • the magnitude, or absolute value, of the price elasticity of demand that tells us how responsive the quantity demanded is, ignore the minus sign Inelastic and Elastic Demand • if the quantity demanded remains constant when the price changes, then the price elasticity of demand is zero and the good is said to have a perfectly inelastic demand i.e. insulin • if the percentage change in the quantity demanded equals the percentage change in the price, then the price elasticity is 1 and the good is said to have a unit elastic demand the percentage change in the quantity demanded is more than the percentage change in the • price, price elasticity of demand is between 1 and infinity and the good is said to have an elastic demand • if the quantity demanded changes by an infinitely large percentage is response to a tiny price change, then the price elasticity of demand is infinity and the good is said to have a perfectly elastic demand i.e. soft drink from two machines located side by side • the demand for a good that has a perfect substitute is perfectly elastic • the percentage change in the quantity demanded is less than the percentage change in the price, price elasticity of demand is between zero and 1 and the good is said to have an inelastic demand i.e. automobiles Elasticity Along a Straight-Line Demand Curve • elasticity along a straight-line demand curve- a demand curve that has a constant slope • elasticity changes along a straight-line demand curve • at the midpoint 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 from the sale of a good equals the price of the good multiplied by the quantity sold • when a price changes, total revenue also changes • a rise in price does not always increase total revenue if demand is elastic, a 1% price cut increases the quantity sold by more than 1% and total • revenue increases • 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 • 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 price, when all other influences on the quantity sold remain the same • if a price cut increases total revenue, demand is elastic • if a price cut decreases total revenue, demand is inelastic • if a price cut leaves total revenue unchanged, demand is unit elastic • at unit elasticity, total revenue is at a maximum Your Expenditure and Your Elasticity 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 The Factors that Influence the Elasticity of Demand • elasticity of demand for a good depends on the closeness of substitutes, proportion of income spent on the good and time elapsed since a price change CLOSENESS OF SUBSTITUTES • the closer the substitutes for a good, the more elastic is the demand for it i.e. gasoline has substitutes but none that are very close, demand is inelastic • degree of substitutability between two goods also depends on how narrowly or broadly we define them • i.e. personal computer has no close substitutes, but a Dell PC is a close substitute for a Hewlett-Packard PC, elasticity of demand for personal computers is lower than the elasticity of demand for a Dell or HP • a necessity is a good that has poor substitutes and that is crucial for our well-being, generally has an inelastic demand • a luxury is a good that usually has many substitutes, one of which is not buy it, generally has an elastic demand 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 i.e. gum and housing prices, you don’t like either price increases, but you hardly notice the • higher price of gum, while the higher rent puts your budget under severe strain TIME ELAPSED SINCE PRICE CHANGE • the longer the time that has elapses since a price change, the more elastic is demand • demand for oil has become more elastic as more time has elapses since huge price hike More Elasticities of Demand CROSS ELASTICITY OF DEMAND • 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 is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, ot
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