Chapter 5: Elasticity and Its ApplicationThe Elasticity Of DemandThe 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 : measures how much the quantity demanded responds to a change in price. 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 doesn’t (inelastic.)- Time Horizon: goods tend to have more elastic demand over longer time 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 priceThe 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 infinityTotal Revenue and the Price Elasticity of Demand- Total Revenue : the amount paid by buyers and received by sellers of a good, computer as the price of the good times and the quality sold. 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 directiono 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 directionso 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 : measures how the quantity demanded changes as consumer income 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: measures how the quantity demanded of one good responds to a change in the price of another good. o Percentage change in quantity demanded of good 1/percentage change in quantity demanded of good 2.o Substitutes: positive- an increase in hotdog prices, increase in hamburgers sold (same direction)o Complements: negative- an increase in computer prices, decrease in software (opposite directions)The Elasticity of SupplyThe Price Elasticity of Supply and Its Determinants- Price of Elasticity of Supply : measures how much the quantity supplied responds to changes in the price. o Elastic: quantity supplied responds substantially to changes in price. Manufactured goodso Inelastic: quantity supplied responds only slightly to changes in price. Beachfront property, can’t supply more of ito 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 PoliciesControls on Prices- Price Ceiling : a legal maximum on the price at which a good can be sold.- Price Floor : 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. 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. - Case Studies: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. Thisresulted 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
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