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Chapter 5

# EC 120 Chapter 5

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Wilfrid Laurier University

Economics

EC120

Ken Jackson

Fall

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Principles of Microeconomics Chapter 5
Chapter 5:Elasticity and its Application
The Elasticity of Demand
Elasticity is a measure of the responsiveness of quantity demanded or quantity
supplied to one of its determinants
The price Elasticity of Demand and Its Determinants
The law of demand states that a fall in the price of a good raises the quantity
demanded
The price elasticity of demand is a measure of how much the quantity demanded
of a good responds to a change in the price of that good, computed as the
percentage change in quantity demanded divided by the percentage change in
price
Demand for a good is said to be elastic if the quantity demanded responds
substantially to changes in the price
Demand is said to be inelastic if the quantity demanded responds only slightly to
changes in the price
The price elasticity of demand for any good measures how willing consumers are
to move away from the good as its price rises
The following are rules about what determines the price elasticity of demand
o Availability of close substitutes
Goods with close substitutes tend to have more elastic demand
because it is easier for consumers to switch from that good to
others
o Necessities versus Luxuries
Necessities tend to have inelastic demands, whereas luxuries have
elastic demands
Whether the good is a necessity of a luxury depends on the person
o Definition of the Market
The elasticity of demand in any market depends on how we draw
the boundaries of the market
Narrowly defined markets tend to have a more elastic demand than
broadly defined markets because it is easier to find close
substitutes for narrowly defined goods.
o Time Horizon
Goods tend to have more elastic demand over longer time horizons
Within years the quantity of a good demanded may fall
substantially
Computing the Price Elasticity of Demand
Economists compute the price elasticity of demand as the percentage change in
the quantity demanded divided by the percentage change in the price
Price elasticity of demand = percentage change in quantity demanded
Percentage change in price EX. Suppose that a 10% increase in the price of an ice-cream cone causes the
amount of ice cream you buy to fall by 20%. We calculate your elasticity of
demand as:
Price elasticity of demand = 20 percent = 2
10 percent
In this example, the elasticity is 2, reflecting that the change in the quantity
demanded is proportionately twice as large as the change in the price. Because the
quantity demanded of a good is negatively related to its price, the percentage
change in quantity will always have the opposite sign as the percentage change in
price. In this example, the percentage change in price is a positive 10% (reflecting
an increase), and the percentage change in quantity demanded is negative 20%
(reflecting a decrease). Because of this price elasticities of demand are sometimes
reported as negative number. In the book, we drop the minus sign and report all
price elasticities as positive numbers known in math as absolute value. Due to this
a larger price elasticity implies a greater responsiveness of quantity demanded to
price.
The midpoint method: a better way to calculate percentage changes and Elasticities
If you try calculating the price elasticity of demand between two points on a
demand curve, you will quickly notice an annoying problem: the elasticity from
point A to point B seems different from the elasticity from point B to point A.
EX. Point A Price = $4 Quantity = 120
Point B Price = $6 Quantity = 80
Going from point A to point B, the price rises by 50% and the quantity falls by
33%, indicating that the price elasticity of demand is 33/50, or 0.66. by contrast,
going from point B to point A, the price falls by 33 percent, and the quantity rises
by 50 percent, indicating that the price elasticity of demand is 50/33 or 1.5.
One way to avoid this problem is by using midpoint method. The standard way to
compute a percentage change is to divide the change by the initial level
The midpoint method computes a percentage change by dividing the change by
the midpoint (or average) of the initial and final levels.
We express the midpoint method with the following formula:
Price elasticity of demand = (Q2-Q1)/ [9Q2+Q1)/2]
(P2-P1)/ [9P2+P1)/2]
The numerator is the percentage change in quantity computed using the midpoint
method, and the denominator is the percentage change in price computed using
the midpoint method
The variety of demand curves
o Demand is when the elasticity is greater than 1, so that quantity moves
proportionately more than the price
o If the elasticity is exactly 1, so that quantity moves the same amount
proportionately as price, demand is said to have unit elasticity
o Because the price elasticity of demand measures how much quantity
demanded responds to changes in the price, it is closely related to the
slope of the demand curve o The flatter the demand curve that passes through a given point, the greater
the price elasticity of demand. The steeper the demand curve that passes
through a given point, the smaller the price elasticity of demand.
o Perfectly inelastic demand curve is vertical, the quantity demanded stays
the same. As elasticity rises, the demand curve gets flatter and flatter
o Demand is perfectly elastic when the price elasticity of demand
approaches infinity and the deman curve becomes horizontal, reflecting
small changes in the price which lead to huge changes in the quantity
demanded
o Inelastic curves look like the letter I. Elastic curves look like the letter E.
Total revenue and the Price Elasticity of Demand
o Total revenue (in a market) is the amount paid by buyers and received by
sellers of a good, computed as the price of the good times the quantity sold
(P X Q).
o If the demand is inelastic than an increase in the price causes and increase
in total revenue
o If the demand is elastic then there is an increase in the rpice which causes
a decrease in the total revenue
o General rule
When demand is inelastic (a price elasticity less than 1), price and
total revenue move in the same direction
When demand is elastic (a price elasticity greater than 1), price and
total revenue move in opposite direction
If demand is unit elastic (a price elasticity exactly equal to 1), total
revenue remains constant when the pr

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