Chapter 5 10 02 2012 CHAPTER 5 ELASTICITY AND ITS APPLICATIONS Elasticity the measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants Sensitivity to price changes demand Different products can have very different price sensitivities Elasticity is one measure of sensitivity of demand to price Demand is inelastic if the quantity demanded responds only slightly to changes in the price Original method Price elasticity of demand see below use absolute value change in quantity change in quantity average quantity 100 change in price change in price average price 100 Determinants elasticity of demand Availability of close substitutes o Goods with close substitutes more elastic demand easier for consumers to switch from that good to others Necessities vs luxuries o Necessities inelastic demands o Luxuries elastic demands Definition of the market o Narrowly defined markets more elastic demand easier to find substitutes o Broadly defined markets less elastic demand Time horizon o Longer time horizon more elastic demand o Gas prices cause an inelastic demand but could eventually become elastic over time when people buy more fuel efficient cars or drive less Midpoint method initial value method in class Paul Samuelson Gives same answer regardless of direction of change The variety of demand curves Demand is elastic when elasticity 1 relatively flat curve Demand is inelastic when elasticity 1 curve is relatively steep Demand is perfectly inelastic when elasticity 0 demand curve is vertical o Rare same quantity demanded when price changes o I nelastic curves look like the letter I Demand is perfectly elastic when price elasticity of demand approaches infinity the demand curve is horizontal If elasticity 1 demand is said to have unit elasticity quantity moves same amount proportionately as the price curve has an intermediate slope The steeper the demand curve the smaller the price elasticity of The flatter the demand curve the greater the price elasticity of demand demand Graphs Total revenue and the price elasticity of demand Total revenue the amount paid by buyers received by sellers of a good o R price of the good quantity sold P Q When demand is inelastic price total revenue move in the same direction the increase in price will result in a small decrease in quantity so revenue rises When demand is elastic price total revenue move in opposite directions the increase in price will result in a large decrease in quantity so revenue falls If demand is unit elastic total revenue remains constant when the price changes the two effects offset one another so revenue is constant Slope of a demand curve Linear elasticity is not constant even though slope is Points with low price high quantity curve is inelastic Points with high price low quantity curve is elastic Other demand elasticities Income elasticity of demand a measure of how much the quantity demanded of a god responds to a change in consumers income Normal goods have positive income elasticities Inferior goods have negative income elasticities Cross price elasticity of demand a measure of how much the quantity demanded of one good responds to a change in the price of another good Substitutes have positive cross price elasticities Complements have negative cross price elasticities The price elasticity of supply and its determinants Price elasticity of supply a measure of how much the quantity supplied of a good responds to a change in the price of that good Supply is elastic if the quantity supplied responds substantially to Supply is inelastic if the quantity supplied responds only slightly to changes in the price changes in the price Depends on the flexibility of sellers to change the amount they produce manufactured goods are easier to produce more of Key determinant time period considered Supply is usually more elastic in longer time periods o New factories close old factories new firms enter old firms close etc over long periods of time Computing the price elasticity of supply Can use the midpoint method to determine both percentages The variety of supply curves Supply is perfectly inelastic when elasticity 0 curve is vertical o Quantity supplied is the same regardless of price Supply is perfectly elastic when elasticity approaches infinity o Very small changes in price lead to very large changes in the curve is horizontal quantity supplied Graphs Price elasticity of supply can vary o Firms often have a maximum capacity for production o Elasticity may be very high at low levels of quantity supplied or very low at high levels of quantity supplied Example can good news for farming be bad news for farmers A farmer may devote all land time to wheat Researchers find a new hybrid to produce more wheat using the same amount of resources Supply curve shifts right demand curve stays the same Revenue P Q Q rises P falls Whether revenue rises or falls depends on the elasticity of demand Wheat is usually inelastic because it is cheap has very few good When demand curve is inelastic decrease in price causes revenue substitutes to fall Chapter 6 10 02 2012 CHAPTER 6 SUPPLY DEMAND AND GOVERNMENT POLICIES Government policies Dissatisfaction with the results of law of supply demand is a motivation for gov action Ex Rents on apartments increase unacceptable then there is pressure on gov to regulate apartment market An obvious way to try to circumvent law of supply demand is to legislate a restriction on the price of a good service Controls on prices Price ceiling a legal maximum on the price of a good service Price floor a legal minimum on the price of a good service Price ceiling above equilibrium price is not binding does not affect market outcome no one would raise prices if their prices are working market naturally moves towards equilibrium Price ceiling below equilibrium ceiling is a binding constraint stops prices at lower price everyone has to lower their prices o Shortage occurs o Sellers must ration the scarce goods among the large number of potential buyers How price ceilings affect market outcomes rent example Rent control local gov imposes a maximum legal price market for apartments Rationing mechanisms occurs when there is a binding constraint o Long waiting list o Preferences given to certain types of tenants ex not allow children in building he can afford to exclude buyers o Discrimination biases towards friends etc o Apartments go to buyers willing to pay bribes Rent control in short
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