Chapter 5 How markets work 5 1 The Elasticity of Demand Elasticity how much consumers respond to changes in variables Price elasticity of demand measures how much the quantity demanded responds to a change in price o Demand is elastic is the quantity demanded changes to changes in price o Demand is inelastic if the quantity demanded does not change much to price change o Price elasticity of demand shows how willing consumers are to buy less of the good when price rises some influences are Availability of close substitutes goods with close substitutes have more elastic demand because it is easier for a consumer to switch from that good to another Ex butter and margarine increase in price in either of those would lead to a drop in quantity demanded and a switch to the other product vs eggs inelastic Necessities vs luxuries Definition of the market Necessities inelastic luxuries elastic Narrowly defined markets have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods o Ex food is inelastic because there are no substitutes o Ice cream narrow category elastic demand because it is easy to substitute o Vanilla ice cream is an even narrower category Time horizon goods have more elastic demand over longer periods of time Ex looking at the effects of gradually rising prices of gas during this time people buy more fuel efficient cars quantity of gas demanded keeps falling Price elasticity of demand change in quantity demanded change in price o Quantity of good demanded is negatively related to price so take the absolute value o A larger price elasticity shows a greater responsiveness of quantity demanded to changes in price Midpoint method to calculate price elasticity is better elasticity from A to B may be different from B to A Demand is elastic when elasticity 1 demand is inelastic when elasticity 1 demand is unit elastic when or ending value beginning value midpoint of Q that of P o elasticity 1 o The flatter the curve the more elastic the steeper the curve more inelastic Total revenue amount paid by buyers and received by sellers of a good o Total revenue P x Q price times quantity of good sold o Elasticity of demand directly influences revenues when the price of a good changes o If demand is inelastic increase in price increase in total revenue fall in quantity is proportionately smaller than rise in price o If demand is elastic increase in price causes a decrease in total revenue Even if slope is constant it does not mean the elasticity stays the same Income elasticity of demand measures how quantity demanded changes as consumer income changes o Income elasticity of demand change in quantity demanded change in income Normal goods higher income higher quantity demanded income elasticity Inferior goods higher income lower quantity demanded income elasticity o Income elasticities also vary in size 5 2 Elasticity of Supply Ex clothing and food have small income elasticities because consumers still buy despite income change Luxuries have large income elasticities because consumers can do without them 1 Cross price elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good o Cross price elasticity of demand change in quantity demanded of good 1 change in price of good 2 o Substitutes have cross price elasticity of demand Ex increase in price of hot dogs increase in demand of hamburgers both changes are happening in the same direction o Complements have cross price elasticity of demand Ex increase in price of computers decreased demand for software Price elasticity of supply measures how much quantity supplied responds to changes in price o Supply is elastic if quantity supplied responds to changes in price o Supply is inelastic if quantity supplied does not change much to changes in price o Price elasticity of supply depends on flexibility of sellers to change amount of good they produce Ex beach houses have inelastic supply because it is impossible to make more of it Books cars have elastic supplies o Key determinant of price elasticity of supply is time period considered o The easier sellers can change the quantity produced the greater the price elasticity Supply is more elastic long term than short term In short periods of time firms cannot quickly change quantity supplied and so over short time quantity does not change much with change in price Over long periods firms can close factories quantity supplied can respond to price changes producers can expand capacity If increased production is expensive supply curve is inelastic if production is not too expensive supply curve is elastic o Supply is elastic when industry can be expanded without causing a big increase in demand and price supply is inelastic when industry expansion causes a significant increase in demand price o Wider the scope of the market less elastic supply narrower scope of market more elastic Price elasticity of supply change in quantity supplied change in price Elasticity rises curve gets flatter o Sometimes elasticity can change in a graph it can be large in one area and small in another Ex for low levels of quantity supplied elasticity of supply is high with price changes firms can use their idle equipment once capacity is fully used increasing production requires the construction of new plants and prices must rise so supply becomes less elastic 5 3 Three Applications of Supply Demand and Elasticity A new hybrid of wheat lower total revenue for farmers o Cheaper to produce this lower prices increase quantity supplied o Supply curve shifts to right demand curve inelastic stays the same so equilibrium price changes In the short run supply and demand for oil are inelastic because not much can be done immediately with supply and buying habits do not respond immediately to changes in price o It is easier to raise prices in the short run than the long run Drug interdiction has direct impact on sellers not buyers because it reduces the supply of drugs