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Chapter 4

Chapter 4.docx

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Department
Economics
Course
ECON 1000
Professor
All Professors
Semester
Winter

Description
1 Chapter 4 – Elasticity Price Elasticity of Demand 2 The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in the 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 the formula: Percentagechange Price elasticity of Demand = ¿quantity demanded Percentagechange∈price To calculate price elasticity of demand, we express the change in price as a percentage of the average price and the change in the quantity demanded as a percentage of average quantity. By using the average price and average quantity, we calculate the elasticity at a point on the demand curve midway between the original point and the new point. Average Price and Quantity. We use average price and average quantity because it gives the most precise measurement of elasticity – ad the midpoint between the original price and the new price. Percentages and Proportions. Elasticity is the ratio of two percentage changes and is a proportionate change multiplied by 100. The proportionate change in price is ∆ P/Pave and 3 the proportionate change in quantity demanded isQ/Qave . So if we divide∆Q/Qave ∆ P/Pave by , we get the same answer as we get by using percentage changes. 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 measured. The ratio of two units is a number without units. 4 Minus Sign and Elasticity. When the price of a good rises, the quantity demanded decreases. Because a positive change in price brings a negative change in the quantity demanded, the price elasticity of demand is a negative number. But it is the magnitude, or the absolute value, of the price elasticity of demand that tells us how responsive the quantity demanded is. So to compare price elasticities of demand, we use the magnitude of the elasticity and ignore the minus sign. Inelastic and Elastic Demand If the quantity demanded remains constant when the price changes, the price elasticity of demand is zero and the good is said to have perfectly inelastic demand. One good that has a very low price elasticity of demand is insulin. If the percentage change in the quantity demanded equals the percentage change in the price, then the price elasticity equals 1 and the good is said to have a unit elastic demand. Between the cases is the general case in which the percentage change in the quantity demanded is less than the percentage change in price. In this case, the price elasticity of demand is between zero and one and the good is said to have an inelastic demand. Food and shelter are examples of goods with inelastic demand. 5 If the quantity demanded changes by an infinitely large percentage in response to tiny price change, then the price elasticity of demand is infinity and the good is said to have a perfectly elastic demand. Between the cases is the general case in which the percentage change in the quantity demanded exceeds the percentage change in price. In this case price elasticity of demand is greater than one and the good is said to have an elastic demand. Examples are cars and furniture. Elasticity along a Linear Curve Elasticity and slope are not the same.Alinear demand curve has a constant slope but a varying elasticity. 6 Total Revenue and Elasticity The 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. The change in total revenue depends on the elasticity of demand in the following ways: • If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. • If demand is inelastic a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases. • If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change 7 The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from the change in the price, when all other influencesbon the quantity sold remain the same. • If the price cut increases total revenue, demand is elastic • If a price cut decreases total revenue, demand is inelastic. • If the price cut leaves total revenue unchanged, demand is unit elastic Your Expenditure and Your Elasticity When a price changes, the change in your expenditure on the good depends on your elasticity of demand. 8 • If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases. • If your demand is unit inelastic, a 1 percent price cut increases the quantity you buy by less than 1 percent and your expenditure on the item decreases. • If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 1 percent and your expenditure on the item does not change. The Factors That Influence the Elasticity of Demand • The closeness of substitutes. The closer the substitute for a good or service, the more elastic is the demand for it. The degree of substitutability depends on how narrowly (or broadly) we define a good. Necessity generally has an inelastic d
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