UMD ECON 200 - Chapter 5: Elasticity and Its Application

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Chapter 5: Elasticity and Its ApplicationI. The Elasticity of Demand- Elasticity: A measure of the responsiveness of quantity demanded or quantity supplied to a change inone of its determinantsa. The Price Elasticity of Demand and Its Determinants- Price elasticity of demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided bythe percentage change in price- Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price- Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the pricei. Availability of Close Substitutes1. Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others.a. Butter & Margarine: A small increase in the price of butter causes the quantity of butter sold to fall by a large amountb. Eggs: Do not have a close substitute so the demand for eggs is less elastic than the demand for butterii. Necessities versus Luxuries1. Necessities have inelastic demandsa. The doctor’s visit rises, people will not dramatically reduce the number oftimes they go to the doctor because it is viewed as a necessity2. Luxuries have elastic demandsa. If a sailboat’s price rises, the quantity of sailboats demanded falls substantially because it is viewed as a luxuryiii. Definition of the Market1. Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goodsa. Food, a broad category, has a fairly inelastic demand because there are nogood substitutesb. Ice cream, a narrower category, has a more elastic demand because it is easy to substitute other desserts for ice cream.iv. Time Horizon1. Goods tend to have more elastic demand over longer time horizonsa. The price of gasoline rises, so the quantity of gasoline demanded falls only slightly in the first few monthsb. Over time, with this price increasing, people will take long term actions by buying fuel-efficient cars, switch to public transportation, and move closer to where they workb. Computing the Price Elasticity of Demandi. Economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price. 1. EXAMPLEa. Suppose that a 10 percent increase in the price of an ice-cream cone causes the amount of ice cream you buy to fall by 20 percent. Calculate elasticity of demand as:Price of elasticity of demand = 20 percent/ 10 percent = 2 i. The elasticity is 2, reflecting that the change in the quantity demanded is proportionately twice as large as the change in priceb. Because the quantity demanded of a good is negatively related to its price, the percentage change in quantity will always have the opposite sign as the percentage change in price.i. In this book, drop the minus sign and report all price elasticities of demand as positive numbers.c. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticitiesi. Use midpoint method to calculate elasticities when A  B and B  A are different.1. For instance, $5 is the midpoint between $4 and $6. Therefore, a change from $4 to $6 is considered a 40% rice because (6 – 4) / 5 x 100 = 40.Midpoint: Price = $5, Quantity = 100The following formula expresses the midpoint method for calculating the price elasticity of demand between two points, denoted (Q1, P1) and (Q2, P2): d. The Variety of Demand Curves i. Demand is considered elastic when the elasticity is greater than 1, which means the quantity moves proportionately more than the price.ii. Demand is considered inelastic when the elasticity is less than 1, which means the quantity moves proportionately less than the price.iii. If the elasticity is exactly 1, the quantity moves the same amount proportionately as the price, and demand is said to have unit elasticity.1. These are related to the slope of the demand curve because the price elasticity ofdemand measures how much quantity demanded response to the change in price. e. Total Revenue and the Price Elasticity of Demand- Total revenue: the amount paid by buyers and received by sellers of a good, computed as the price ofthe good times the quantity sold. i. In any market, total revenue is P x Q, the price of the good times the quantity of the good sold. We can show total revenue graphically, as in Figure 2.ii. The examples in Figure 3 illustrate some general rules:1. When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction.2. When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directions.3. If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes.f. Elasticity of Total Revenue along a Linear Demand Curvei. Slope is defined as “rise over run,” which here is the ratio of the change in price (“rise”) to the change in quantity (“run”).ii. Even though the slope of a linear demand curve is constant, the elasticity is not1. Because the slope is the ratio of changes in the two variables2. And the elasticity is the ratio of percentage changes in the two variables.iii. The linear demand curve illustrates that the price elasticity of demand need not be the same as all points on a demand curve. A constant elasticity is possible, but it is not always the caseg. Other Demand Elasticitiesi. The Income Elasticity of Demand- Income elasticity of demand: a measure of how much the quantity demanded of a good response to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income1. Normal goods: higher income raises the quantity demanded. Because quantity demanded and income move in the same direction, normal goods have positive income elasticities.2. Inferior goods: Higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, inferior goods have negativeincome elasticities.3. Income elasticities vary substantially in sizea. Necessities (food, clothing) tend to have small income elasticities becauseconsumers choose to buy some of these goods even when their incomes are lowb. Luxuries (caviar, diamonds) tend to have large income elasticities


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UMD ECON 200 - Chapter 5: Elasticity and Its Application

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