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EC120 (343)
Chapter 5

EC 120 Chapter 5

6 Pages
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School
Wilfrid Laurier University
Department
Economics
Course
EC120
Professor
Ken Jackson
Semester
Fall

Description
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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