Chapter 5 Elasticity and Its Application The Elasticity Of Demand The Price Elasticity of Demand and Its Determinants Elasticity a measure of the responsiveness of quantity demanded or quantity supplied to one if its determinants Price Elasticity of Demand to a change in price measures how much the quantity demanded responds o Elastic if the quantity demanded responds substantially to change in price o Inelastic if the quantity demanded responds only slightly to changes in price Goods with close substitutes have more elastic demand because it is easier for consumers to switch from that good to another o Butter vs margarine raise in price for butter will cause raise in quantity demand for margarine Eggs are unrelated so in this case they re less elastic because they don t have a substitute Necessities versus luxuries necessities are inelastic because no matter what people are going to demand them such as going to the doctor but luxuries are elastic since a raise in price will cause a fall in demand people can live without them Narrowly defined markets have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods o Ice cream vs food ice cream has many substitutes elastic but food Time Horizon goods tend to have more elastic demand over longer time doesn t inelastic horizons o Gasoline if the price rises demand barely falls Over time people will buy more fuel efficient cars or use closer transportation so demand falls more substantially Computing the Price Elasticity of Demand Price Elasticity of demand Percentage change in quantity demanded percentage change in price The Midpoint Method A better Way to Calculate Percentage Changes and Elasticities Price Elasticity of Demand Q2 Q1 Q2 Q1 2 P2 P1 P2 P1 2 o Numerator percentage change in quantity o Denominator percentage change in price The Variety of Demand Curves Elastic when elasticity is greater than 1 Inelastic when elasticity is less than 1 Unit elastic when elasticity equals 1 Perfectly inelastic when elasticity equals 0 Perfectly elastic when elasticity equals infinity Total Revenue and the Price Elasticity of Demand Total Revenue computer as the price of the good times and the quality sold the amount paid by buyers and received by sellers of a good o PXQ price of good x quantity of goods sold o If demand is inelastic elasticity is less than 1 then an increase in price causes increase in total revenue Price and total revenue move in same direction o If demand is elastic elasticity is greater than 1 then an increase in price causes a decrease in total revenue Price and total revenue move in opposite directions o If demand is unit elastic price elasticity is 1 then total revenue is constant when price changes Elasticity and Total Revenue Along a Linear Demand Curve Price elasticity of demand need not be the same at all points on the demand curve Constant elasticity is possible but not always the case Other Demand Elasticities The Income Elasticity of Demand as consumer income changes measures how the quantity demanded changes o Percentage change in quantity demanded percentage change in income o Normal goods Higher income higher demand cars o Inferior goods Higher income lower demand bus tickets o Necessitates food clothes small income elasticities because people buy some of these goods regardless of income o Luxuries diamonds large income elasticities because people don t NEED them The Cross Price Elasticity of Demand one good responds to a change in the price of another good measures how the quantity demanded of o Percentage change in quantity demanded of good 1 percentage change in o Substitutes positive an increase in hotdog prices increase in hamburgers o Complements negative an increase in computer prices decrease in quantity demanded of good 2 sold same direction software opposite directions The Elasticity of Supply The Price Elasticity of Supply and Its Determinants Price of Elasticity of Supply to changes in the price measures how much the quantity supplied responds o Elastic quantity supplied responds substantially to changes in price Manufactured goods o Inelastic quantity supplied responds only slightly to changes in price Beachfront property can t supply more of it o Supply is more elastic in the long run In the short run quantity supplied is not very responsive to price Computing the Price Elasticity of Supply Percentage change in quantity supplied percentage change in price The Variety of Supply Curves Zero elasticity vertical curve Infinite elasticity horizontal curve The tools of supply and demand can be applied in many different kinds of markets Such as wheat oil and drugs see pages 103 108 Chapter 6 Supply Demand and Government Policies Controls on Prices Price Ceiling Price Floor a legal maximum on the price at which a good can be sold a legal minimum on the price at which a good can be sold How Price Ceilings Affect Market Outcomes Not binding price balances supply and demand below price ceiling Binding market price equals the price ceiling Case Studies o Forces of supply and demand tend to move the price toward the equilibrium price but when the market price hits the ceiling it can by law rise no further o Causes a shortage at that price quantity demanded exceeds quantity supplied When the government imposes a binding price ceiling on a competitive market a shortage of the good arises and sellers must ration the scares goods among the large number of potential consumers o Gas Prices In 1973 oil prices increased and gas price was below the price ceiling Once the price of crude oil rose the production cost increased so supply decreased Usually this would raise equilibrium price but the price ceiling prevented the price from hitting this level This resulted in severe shortage o Rent Control Most cities have price ceilings on rent regulated by the government The goal is to make poor people have an easier time finding somewhere to live In the short run landlords have a fixed number of apartments that they can rent to people this number cannot be adjusted as the market changes The number of people searching for housing in a city may not be responsive to rents in the short run people take time to adjust to their housing In the short run supply and demand for housing is inelastic Rent control causes shortages In the long run tenants don t maintain their properties or expand Low rent rates causes an influx of people moving to major cities which makes
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