CHAPTER 5 – ELASTICITY AND ITS APPLICATIONSElasticity: the measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinantsSensitivity to price changes: demandDifferent products can have very different price sensitivitiesElasticity is one measure of sensitivity of demand to priceDemand is inelastic if the quantity demanded responds only slightly to changes in the priceOriginal methodPrice 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 demandAvailability of close substitutesGoods with close substitutes- more elastic demand easier for consumers to switch from that good to othersNecessities vs. luxuriesNecessities- inelastic demandsLuxuries- elastic demandsDefinition of the marketNarrowly defined markets- more elastic demand (easier to find substitutes)Broadly defined markets- less elastic demandTime horizonLonger time horizon- more elastic demandGas prices cause an inelastic demand, but could eventually become elastic over time when people buy more fuel-efficient cars or drive lessMidpoint method (initial value method in class – Paul Samuelson)Gives same answer regardless of direction of changeThe variety of demand curvesDemand is elastic when elasticity > 1, relatively flat curveDemand is inelastic when elasticity < 1, curve is relatively steepDemand is perfectly inelastic when elasticity = 0, demand curve is verticalRare- same quantity demanded when price changesInelastic curves look like the letter IDemand is perfectly elastic when price elasticity of demand approaches infinity, the demand curve is horizontalIf 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 demand***The flatter the demand curve, the greater the price elasticity of demandGraphs:Total revenue and the price elasticity of demandTotal revenue: the amount paid by buyers & received by sellers of a goodR = (price of the good)*(quantity sold) = P*QWhen 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 risesWhen demand is elastic, price & total revenue move in opposite directions the increase in price will result in a large decrease in quantity so revenue fallsIf demand is unit elastic, total revenue remains constant when the price changes the two effects offset one another so revenue is constantSlope of a demand curveLinear elasticity is not constant even though slope isPoints with low price & high quantity curve is inelasticPoints with high price & low quantity curve is elasticOther demand elasticitiesIncome elasticity of demand: a measure of how much the quantity demanded of a god responds to a change in consumers’ incomeNormal goods have positive income elasticitiesInferior goods have negative income elasticitiesCross-price elasticity of demand: a measure of how much the quantity demanded of one good responds to a change in the price of another goodSubstitutes have positive cross-price elasticitiesComplements have negative cross-price elasticitiesThe price elasticity of supply and its determinantsPrice elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that goodSupply is elastic if the quantity supplied responds substantially to changes in the priceSupply is inelastic if the quantity supplied responds only slightly to changes in the priceDepends on the flexibility of sellers to change the amount they produce (manufactured goods are easier to produce more of)Key determinant time period consideredSupply is usually more elastic in longer time periodsNew factories, close old factories, new firms enter, old firms close, etc. over long periods of timeComputing the price elasticity of supplyCan use the midpoint method to determine both percentagesThe variety of supply curvesSupply is perfectly inelastic when elasticity = 0, curve is verticalQuantity supplied is the same regardless of priceSupply is perfectly elastic when elasticity approaches infinity, curve is horizontalVery small changes in price lead to very large changes in the quantity suppliedGraphs:Price elasticity of supply can varyFirms often have a maximum capacity for productionElasticity may be very high at low levels of quantity supplied or very low at high levels of quantity suppliedExample- can good news for farming be bad news for farmers?A farmer may devote all land/time to wheatResearchers find a new hybrid to produce more wheat using the same amount of resourcesSupply curve shifts right – demand curve stays the sameRevenue = P*Q Q rises, P fallsWhether revenue rises or falls depends on the elasticity of demandWheat is usually inelastic because it is cheap & has very few good substitutesWhen demand curve is inelastic, decrease in price causes revenue to fallCHAPTER 6 – SUPPLY, DEMAND, AND GOVERNMENT POLICIESGovernment policiesDissatisfaction with the results of law of supply & demand is a motivation for gov. actionEx. Rents on apartments increase, unacceptable, then there is pressure on gov. to regulate apartment marketAn obvious way to try to circumvent law of supply & demand is to legislate a restriction on the price of a good/serviceControls on pricesPrice ceiling: a legal maximum on the price of a good/servicePrice floor: a legal minimum on the price of a good/servicePrice 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 equilibriumPrice ceiling below equilibrium ceiling is a binding constraint (stops prices at lower price) everyone has to lower their pricesShortage occursSellers must ration the scarce goods among the large number of potential buyersHow price ceilings affect market outcomes: rent exampleRent control: local gov. imposes a maximum legal price market for apartmentsRationing mechanisms occurs when there is a binding constraintLong waiting listPreferences given to certain types of tenants (ex. not allow children in building- he can afford to exclude buyers)Discrimination, biases towards friends, etc.Apartments go to buyers willing to pay bribesRent
View Full Document
Unlocking...