Chapter 5 Elasticity and Its Application The Elasticity of Demand Price Elasticity of Demand and its Determinants elasticity measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants price elasticity of demand measure of how much the quantity demanded of a good responds to change in the price of that good computed as the percentage change in quantity demanded divided by the percentage change in price availability of close substitutes o goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others necessities vs luxuries o necessities tend to have inelastic demands ex Doctors visits o o depends on buyer preferences luxuries have elastic demands ex Sailboats definition of the market o elasticity of demand in any market depends on how we draw the boundaries of the market o narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods time horizon o goods tend to have more elastic demand over longer time horizons Computing the Price Elasticity of Demand price elasticity of demand change in quant demand change in price change in quantity will always have opposite sign as change in price drop the minus sign and report all price elasticities of demand as positive numbers The Midpoint Method midpoint method computes a percentage change by dividing the change by the midpoint average of the initial and final levels o Ex 5 is the midpt of 4 and 6 Change from 4 to 6 is a 40 rise 6 4 5x100 40 midpoint method is often used when calculating the price elasticity of demand between 2 points Q1 P1 Q2 P2 price elasticity of demand Q2 Q1 Q2 Q1 2 P2 P1 P2 P1 2 The Variety of Demand Curves demand is elastic when elasticity is greater than 1 demand is inelastic when elasticity is less than 1 if elasticity is 1 quantity moves the same amount proportionally as the price demand has unit elasticity flatter demand curve greater price elasticity of demand steeper demand curve smaller price elasticity of demand vertical demand curve zero elasticity perfectly inelastic demand stays the same horizontal demand curve small changes in price lead to huge changes in demand perfectly elastic Total Revenue Price Elasticity of Demand total revenue amount paid by buyer and received by sellers of a good computed as the price of the good times the quantity sold P x Q if demand is inelastic then an increase in the price causes an increase in total revenue if demand is elastic an increase in price causes a decrease in total revenue o when demand is inelastic price elasticity less than 1 price total revenues move in same o when demand is elastic price elasticity greater than 1 price total revenue move in o opposite directions if demand is unit elastic price elasticity is 1 total revenue remains constant when the price changes general rules direction Elasticity and Total Revenue Along a Linear Demand Curve slope is the ratio of change in price rise to change in quantity run even though the slope of a linear demand curve is constant the elasticity is not the slope of is the ratio of changes in the 2 variables whereas the elasticity is the ratio of percentage changes in 2 variables Other Demand Elasticities Income Elasticity of Demand o Income elasticity of demand how much the quantity demanded of a good responds to a change in income computed as a percentage change in quantity demanded divided by the percentage change in income o Income elasticity of demand change in demand change in income o Most goods are normal goods higher income raises demand positive income elasticities o Some goods are inferior goods bus rides higher income lowers demand negative income o Necessities tend to have small income elasticities because consumers buy these regardless elasticities of income o Luxuries tend to have large income elasticities because consumers feel that they can do without these goods if income is low Cross Price Elasticity of Demand o Cross price elasticity of demand how much the quantity demanded of one good responds to change in the price of another good o Cross price elasticity of demand change in demand of good 1 change in price of good 2 demand is positive o Substitutes are goods that typically used in place of another cross price elasticity of o Complements are goods that are typically used together cross price elasticity is negative Elasticity of Supply Price Elasticity of Supply its Determinants price elasticity of supply how much quantity supplied of a good responds to change in the price of a good computed as change in supply change in price supply is elastic if quantity supplied responds substantially to price supply is inelastic if quantity supplies responds only slightly to price price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce land is inelastic hard to produce manufactured goods are elastic key determinant of the price elasticity of supply is the time being considered in short run quantity supplied is not very responsive to price in long run quantity supplied can respond a lot to price changes o o o Computing the Price Elasticity of Supply price elasticity of supply change in supply change in price change in price diff in price midpt price change in supply diff in supply midpt supply quantity Variety of Supply Curves in the extreme case of zero elasticity supply is perfectly inelastic and the supply curve is vertical quantity supply is the same regardless of price at the opposite extreme supply is perfectly elastic as supply curve becomes horizontal in some markets the elasticity of supply is not constant but varies over the supply curve
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