UMD ECON 200 - Chapter 5: Elasticity and Its Application

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Chapter 5 Elasticity and Its Application The Elasticity of Demand Elasticity a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of 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 by the percentage change in price quantity demanded of a good is negatively related to its price o A good is considered elastic if the quantity demanded changes substantially when the price changes said to be inelastic if it only changes slightly o If the good has a close substitute it has a more elastic demand butter margarine the price of butter goes up it is easy to switch to margarine so butter demand falls greatly o Necessities inelastic demand willing to buy when prices are high while luxuries are elastic demand o Narrow markets have a more elastic demand than broad markets icecream narrow can be replaced by another desert while food broad is hard to be replaced by something else o Long periods of time more elastic demand Midpoint method for calculating elasticities with 2 points o Q1 P1 Q2 P2 o Q2 Q1 Q2 Q1 2 divided by P2 P1 P2 P1 2 Economist classify demand curves according to their elasticity o Demand is considered elastic if the elasticity is greater than 1 quantity demanded moves more than the price o Demand is considered inelastic is the elasticity is less than 1 quantity demanded moves less than the price o Demand is considered to have unit elasticity if the elasticity is exactly 1 quantity demanded and price move the same o Flatter the demand curve greater price elasticity o Horizontal line perfectly elastic o Steeper the demand curve smaller price elasticity o Vertical line perfectly inelastic o Total revenue the amount paid by buyers and received by sellers of a good computed as the price of the good times the quantity sold Total revenue changes as one moves along the demand curve based on the price elasticity of demand Inelastic demand increase in total revenue price total revenue move in same direction Elastic demand decrease in total revenue price total revenue move in opposite directions Unit elastic demand total revenue remains constant even when price changes o A linear demand curve can be elastic inelastic at different points Income elasticity of demand a measure of how much the quantity demanded of a good responds to a change in the consumers income computed as the percentage change in quantity demanded divided by the percentage change in income o Normal goods higher income raises quantity demanded positive income elasticities Necessities small income elasticities Luxuries large income elasticities o Inferior goods higher income lowers quantity demanded 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 computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good o Substitutes hotdogs hamburgers cross price elasticity pos o Complements cream cheese bagels negative The Elasticity of Supply 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 computed as the percentage change in quantity supplied divided by the percentage change in price o Over time things are more elastic o Flatter the supply curve greater price elasticity o Horizontal line perfectly elastic o Steeper the supply curve smaller price elasticity o Vertical line perfectly inelastic Three Applications of Supply Demand and Elasticity Use the 3 questions does the supply demand curve shift direction of the shift how the shift affects equilibrium price quantity Can good news for farming be bad news for farmers yes o A new hybrid of wheat allows farmers to supply more wheat at any given price supply curve shifts to the right but the demand curve remains the same o Even though the farmers can produce more wheat each bushel of wheat sells for less total revenue depends on the elasticity of demand usually basic food like wheat is inelastic b c it is inexpensive have few good substitutes Why did OPEC fail to keep the price of oil high o OPEC decided to raise oil prices to increase their income by supplying less oil o Short run supply demand for oil inelastic o Long run supply demand for oil elastic o Therefore OPEC made a profit in the short run only Does drug interdiction increase or decrease drug related crime o Gov increases agents on the war on drugs gov stops arrests smugglers which reduces the quantity of drugs raises the cost of drugs demand for drugs remains the same o Supply curve shifts to the left equilibrium price of drugs rises equilibrium quantity falls o Drugs are inelastic drug users won t stop their addiction just b c the price went up therefore the increase in price stated above raises total revenues in the drug market drug users have to pay more for drugs now and therefore might need to steal rob more to support themselves increasing crime o Drug education is seen as more effective b c it can reduce both drug use and drug related crime

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# UMD ECON 200 - Chapter 5: Elasticity and Its Application

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