UMD ECON 200 - Elasticity and It’s Application

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Elasticity is a measure of how much buyers and sellers respond to changes in market conditions/a measure of the responsiveness or quantity supplied to change in one of its determinantsPrice elasticity of demand is 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 quantityThe demand for a good is said to be elastic if the quantity demanded responds substantially to in changes in the priceDemand is said to be inelastic if the quantity demanded responds only slightly to changes in the priceThe price elasticity of demand for any good measures how willing customers are to buy less of the good as its price rises*Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to othersexample: a small increase in the price of butter causes the quantity of butter sold to fall by a large amount*Necessities tend to have inelastic demands, whereas luxuries have elastic demands, whereas luxuries have elastic demandsexample: when the price of a doctors visit rises, people will not dramatically reduce the number of times they go to the doctor, although they might go somewhat less often*The elasticity of demand in any market depends on how we draw the boundaries of the marketNarrowly defined markets tend to have more elastic demand than broadly define markets because it is easier to find close substitutes for narrowly defined goodsExample: “food” has inelastic demand because it is broadExample: “ice cream” has elastic demand since it is easier to substitute*Goods tend to have more elastic demand over longer time horizonsComputing the Price Elasticity of Demand=(percentage change in quantity demanded)/(percentage change in price)The Midpoint Method: A better way to Calculate Percentage Changes and Elasticity’sElasticity from point a to point b is different than elasticity from point b to point a=(Q2-Q1)/[(Q2+Q1)/2]/(P2-P1)/[(P2+P1)/2]Numerator is the percentage change in quantity computed using the midpoint method and the denominator is the percentage change in price computed using the midpoint methodThe Variety of Demand CurvesDemand is considered elastic when the elasticity is greater than 1, meaning that the quantity moves proportionately more than the priceDemand is considered inelastic when the elasticity is less than 1, meaning that the quantity moves proportionately less than the priceIf the elasticity is exactly 1, the quantity moves the same amount proportionately as the price, demand is said to have unit elasticityIf the resources have an elasticity of 0, the demand is perfectly inelasticRule of thumb: the flatter the demand curve that passes through a given point, the greater the price elasticity of demandThe steeper the demand curve that passes through a given point, the smaller the price elasticity of demandTotal Revenue and the Price Elasticity of DemandTotal revenue: the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity soldP x QPrice of a good times quantity of a goodWhen demand is inelastic (a price elasticity less than 1), price and total revenue move in the same directionWhen demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directionsIf demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changesElasticity and Total Revenue along a Linear Demand CurveEven though the slope of a linear demand curve is constant, the elasticity is notThe slope is the ratio of changes in the two variablesThe elasticity is the ratio of percentage changes in the two variablesOther Demand Elasticity’sThe Income Elasticity of Demand: measures how the quantity demanded changes as consumer income changesIncome elasticity of demand= (percentage change in quantity demanded)/(percentage change in income)Normal goods: Higher income raises the quantity demandedInferior goods: Higher income lowers the quantity demandedThe Cross-Price Elasticity of Demand: measures how the quantity demanded of one good responds to a change in the price of another goodCross price elasticity of demand= (percentage change in quantity demanded of good 1)/(percentage change in the price of good 2)The Price Elasticity of Supply and It’s DeterminantsPrice 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 the quantity supplied divided by the percentage change in priceComputing the Price Elasticity of Supply=(percentage change in quantity supplied)/(percentage change in price)The Variety of Supply CurvesZero elasticity means something is perfectly inelastic and the supply curve is verticalPerfectly elastic is a horizontal graph and the supply slowly approaches infinity, meaning that very small changes in the price lead to very large changes in the quantity suppliedSummary:Price elasticity of demand measures how much the quantity demanded responds to changes in price. Demand is more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial times to react to a price change.Total revenue, the total amount paid for a good equals the price of the good times the quantity sold. For inelastic demand curves, total revenue moves in the same direction as the price. For elastic demand curves, total revenue moves in the opposite direction as the price.The income elasticity if demand measures how much the quantity demanded responds to changes in customer’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to changes in the price of another goodThe price elasticity of supply measures how much the quantity supplied responds to changes in the price This elasticity often depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run.The tools of supply and demand can be applied in many different kinds of markets.Controls On PricesPrice Ceiling: the legal maximum on the price at which a good can be soldPrice Floor: the legal minimum on the price at which a god can be soldNot binding: the price ceiling is non binding when the price that balances supply and demand is below the ceilingBinding: The price ceiling

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# UMD ECON 200 - Elasticity and It’s Application

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