chapter 5 part 1 elasticity. elasticity of demand elasticity – a measure of the responsiveness of...
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Elasticity of DemandElasticity of DemandElasticity Elasticity – a measure of the – a measure of the
responsiveness of Qd or Qs to changes in responsiveness of Qd or Qs to changes in market conditionsmarket conditions
Price Elasticity of DemandPrice Elasticity of Demand – measure of – measure of how much the Qd responds to a change in how much the Qd responds to a change in the Pthe P
Computed as: Computed as: % change in Qd% change in Qd
% change % change in Pin P
Elastic v. Inelastic DemandElastic v. Inelastic Demand
D for a good is D for a good is elasticelastic if the Qd responds if the Qd responds substantially to a change in P substantially to a change in P
Examples: McDonald’s hamburgersExamples: McDonald’s hamburgers
D for a good is D for a good is inelasticinelastic if the Qd if the Qd responds only slightly to a change in Presponds only slightly to a change in P
Examples: InsulinExamples: Insulin
Determinants of Price Elasticity of DDeterminants of Price Elasticity of DAvailability of Close Substitutes - goods Availability of Close Substitutes - goods
w/ close substitutes tend to be more w/ close substitutes tend to be more elastic; goods w/o close substitutes tend to elastic; goods w/o close substitutes tend to be more inelastic Ex: butterbe more inelastic Ex: butter
Necessities vs. Luxuries – necessities Necessities vs. Luxuries – necessities tend to have inelastic demands; luxuries tend to have inelastic demands; luxuries tend to have elastic demands Ex: gas tend to have elastic demands Ex: gas vs. sailboatvs. sailboat
Cont’dCont’dDefinition of the Market – broad categories Definition of the Market – broad categories
have fairly inelastic demands, narrowly have fairly inelastic demands, narrowly defined markets usually are more elastic defined markets usually are more elastic Ex: food vs. Green appleEx: food vs. Green apple
Time Horizon – goods tend to have more Time Horizon – goods tend to have more elastic demands over long time periods. elastic demands over long time periods. Ex: P of gas rises, Qd barely falls for a Ex: P of gas rises, Qd barely falls for a while, but in the long run D falls while, but in the long run D falls substantiallysubstantially
Rank the following items from most Rank the following items from most to least elastic…to least elastic…
BeefBeefSaltSaltEuropean vacationEuropean vacationSteakSteakHonda AccordHonda AccordDijon MustardDijon Mustard
Results…?Results…?
European VacationEuropean VacationHonda AccordHonda AccordSteakSteakDijon MustardDijon MustardBeefBeefsaltsalt
Computing the Price Elasticity of Demand
The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed
P ercen tag e ch an g e in p rice
Computing the Price Elasticity of Demand
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:
( )
( . . ).
1 0 81 0
1 0 0
2 2 0 2 0 02 0 0
1 0 0
2 0 %
1 0 %2
P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed
P ercen tag e ch an g e in p rice
Along a D curve, P and Q move in opposite directions, which would make price elasticity negative.
We will drop the minus sign and report all price elasticities as positive numbers (or just take the absolute value)
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.
The midpoint is the number halfway between the start & end values, the average of those values.
MIDPOINT FORMULA:
2 1 2 1
2 1 2 1
( ) /[( ) / 2]Price elasticity of demand =
( ) /[( ) / 2]
Q Q Q Q
P P P P
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:
(10 8)22%(10 8) / 2
2.32(2.20 2.00) 9.5%
(2.00 2.20) / 2
Types of Elasticities
When the price elasticity of demand is >1, demand is elastic
When the price elasticity of demand is <1, the demand is inelastic.
When the price elasticity of demand is = 1, the demand has unit elasticity.
Another way to think about it…
If the ΔQd(%) > ΔP(%) then it’s ELASTIC If the ΔQd(%) < ΔP(%) then it’s INELASTIC
The Variety of Demand Curves Perfectly Inelastic
Quantity demanded does not respond to price changes.
Perfectly Elastic Quantity demanded changes infinitely with any
change in price. Unit Elastic
Quantity demanded changes by the same percentage as the price.
Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.
But it is not the same thing as the slope!
Perfectly Inelastic Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Quantity
Demand
1000
1. Anincreasein price . . .
2. . . . leaves the quantity demanded unchanged.
Price
Inelastic Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity0
$5
90
Demand1. A 22%increasein price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100
Unit Elastic Demand
2. . . . leads to a 22% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
4
1000
Price
$5
80
1. A 22%increasein price . . .
Demand
Elastic Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Demand
Quantity
4
1000
Price
$5
50
1. A 22%increasein price . . .
2. . . . leads to a 67% decrease in quantity demanded.
Perfectly Elastic Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity0
Price
$4 Demand
2. At exactly $4,consumers willbuy any quantity.
1. At any priceabove $4, quantitydemanded is zero.
3. At a price below $4,quantity demanded is infinite.
Total Revenue and Price Elasticity of Demand
Total revenue is the amount paid by buyers and received by sellers of a good.
Computed as the price of the good times the quantity sold.
TR = P x Q TR is also called Total Expenditure or TE!!
Total Revenue
Demand
Quantity
Q
P
0
Price
P × Q = $400(revenue)
$4
100
When the price is $4, consumers will demand 100 units, and spend $400 on this good.
TR TEST If D is inelastic: P rises, Qd falls > TR rises
P falls, Qd rises > TR falls If D is elastic: P rises, Qd falls > TR falls
P falls, Qd rises > TR rises
If D is unit elastic: P rises, Qd falls > TR –
P falls, Qd rises > TR –
How Total Revenue Changes When Price Changes: Inelastic Demand
Demand
Quantity0
Price
Revenue = $100
Quantity0
Price
Revenue = $240
Demand$1
100
$3
80
An Increase in price from $1 to $3 …
… leads to an Increase in total revenue from $100 to $240
How Total Revenue Changes When Price Changes: Elastic Demand
Demand
Quantity0
Price
Revenue = $200
$4
50
Demand
Quantity0
Price
Revenue = $100
$5
20
An Increase in price from $4 to $5 …
… leads to an decrease in total revenue from $200 to $100
Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies!
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