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Chapter 5 Elasticity. You are responsible for reading Chapter 4!!!. What have we done?. Chapter 3 gave us downward sloping demand curves Law of demand Now want to see how Q d changes when price changes. Elasticity. Response of one variable to a change in another variable

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Chapter 5 elasticity l.jpg
Chapter 5Elasticity

You are responsible for reading Chapter 4!!!


What have we done l.jpg
What have we done?

  • Chapter 3 gave us downward sloping demand curves

    • Law of demand

  • Now want to see how Qd changes when price changes


Elasticity l.jpg
Elasticity

  • Response of one variable to a change in another variable

  • Price elasticity of demand

    • Measure of the responsiveness of Qd of a product to a change in the price of that product



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So…

  • What if Ed = 3?

    • If price was increased from the prevailing point the % change in Qd would be 3 times the change in price

  • Shouldn’t it be negative?

    • So price increases and Qd decreases?

  • Yes!!

    • For ease we look at the absolute value, but know that the law of demand holds


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Point elasticity

  • Measures the change between two observed points.


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example

  • P1 = 10

  • P2 = 12

  • Q1 = 100

  • Q2 = 50

  • Elasticity??

  • Which is Point A???

  • Big Problem!!!


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Problem

  • Answers vary depending on where you start

  • Becomes more important the larger the change


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Arc Elasticity

  • To avoid the endpoint problem take elasticity at the midpoint (average) of the two points


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Differences

  • With arc elasticity it is clear which points are used

  • P1 is the first price

  • P2 is the second price

  • Qd1 and Qd2 are the first and second quantity demanded respectively


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Price elasticity of demand can yield 5 basic results

  • Numerator > Denominator

  • Numerator < Denominator

  • Numerator = Denominator

  • Numerator = 0

  • Denominator = 0

  • Each has a specific name and result


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Elastic Demand

  • Ed > 1

  • % change in quantity demanded > % change in price

  • FLATTER CURVE

  • What are some examples of an elastic good???


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Inelastic Demand

  • Ed<1

  • % change in the price > percent change in quantity demanded

  • STEEPER CURVE

  • What are some examples of an inelastic good?



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Unit Elastic Demand

  • Ed=1

  • % change in price = % change in quantity demanded

  • Change in price brings a proportionate change in quantity demanded

  • CURVE



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Perfectly Elastic Demand

  • Ed = (denominator = 0)

  • % change in quantity demanded is A LOT in response to a change in price

  • Price increases and quantity demanded goes to 0

  • Totally flat --- horizontal

  • Extreme

  • Examples???


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Perfectly inelastic demand

  • Ed = 0

  • % change in quantity demanded DOESN’T CHANGE in response to a change in price

  • Totally steep --- vertical

  • Extreme

  • Examples???



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Aren’t demand curve downward sloping?

  • Because the extremes (perfectly inelastic and perfectly elastic) are not.

  • Use as points of reference only


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How does a change in price affect Total Revenue of a Firm?

  • Revenue depends on elasticity

  • Michael Jordan and Nike shoes

    • No substitutes -- inelastic demand

      • What happens to Qd if price increases?

    • Substitutes – elastic demand

      • What happens to Qd if price increases?


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What is total revenue??

  • Total revenue = price*quantity

  • Firm uses to decide if to produce more or less


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examples

  • Elastic demand

    • Price increase

    • Price decrease

  • Inelastic demand

    • Price increase

    • Price decrease

  • Unit elastic demand

    • Price increase

    • Price decrease



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Important to look at because…

  • Elasticity of the demand determines if with a price increase…

    • Total revenue increases

    • Total revenue decreases

    • Total revenue remains the same


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Price elasticity of demand and a straight line

  • Demand is downward sloping

  • Along the line elasticity varies from highly elastic to highly inelastic

  • But…remember SLOPE is constant


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P

A

B

C

D

E

F

G

Q

Find Total Revenue and Elasticity of Demand



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Summary

  • Upper end of Demand Curve

    • Qd is low and price is high

    • Freak out more when price is high

  • Lower end of Demand Curve

    • Qd is high and price is low

    • Freak out less when price is low


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So…

  • As move down the demand curve from higher prices to lower the price elasticity of demand goes from elastic to inelastic


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Determinates of price elasticity of demand

  • Number of substitutes available

    • Increase substitutes increases elasticity

    • More narrowly defined goods have more substitutes (compared to broadly defined)

      • Example: Fords vs all cars


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More determinates

  • Percentage of one’s budget that is spent on the good

    • More expensive??? More elastic

    • More affected by price (even small changes)


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Final determinate

  • Amount of time that passed since price change

    • Increase time passed gives more opportunity to change behavior or react to price change

    • Overtime can look for substitutes

    • Increase time increases elasticity

    • More elastic in long term than short


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Cross Elasticity of Demand

  • Measures the responsiveness of quantity demanded to a change in price of ANOTHER good


When would you use cross price elasticity l.jpg
When would you use Cross Price Elasticity?

  • To determine if goods are substitutes or compliments

  • Ec>0 – substitutes

    • % change in quantity demanded and price move in same direction

  • Ec<0 – compliments

    • % change in quantity demanded and price move in opposite directions

  • Ec=0 – goods unrelated


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Income elasticity of demand

  • Measures the responsiveness of quantity demanded to the change in income


Why use income elasticity of demand l.jpg
Why use income elasticity of demand?

  • Use to determine if a good is normal or inferior

  • Ey>0 – normal good

    • As income increases Qd increases

  • Ey<0 – inferior good

    • As income increases Qd decreases


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Can also say…

  • If |Ey| > 1

    • % change in Qd > % change in Y

    • Income elastic

  • If |Ey| < 1

    • % change in Qd < % change in Y

    • Income inelastic

  • If |Ey| = 1

    • % change in Qd = % change in Y

    • Income unit elastic


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Can we use income elasticity in the real world??

  • If invest in the stock market do you want to invest in a normal or inferior good?

  • Normal

  • Why

  • Increase income would increase quantity bought and increase stock prices


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Price Elasticity of Supply

  • Measures the responsiveness of quantity supplied of a good to the change in the price of that good


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Classification is like demand

  • Es > 1

    • Elastic

  • Es < 1

    • Inelastic

  • Es = 1

    • Unit elastic

  • Each of these will result in a “normal” upward sloped supply curve


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Any extreme elasticities???

  • Yes!!

  • Es =

    • Perfectly elastic or horizontal

  • Es = 0

    • Perfectly inelastic or vertical





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Does time play a role in elasticity of supply?

  • Yes!!

  • Overtime producers are able to adjust their behavior and production patterns

  • Supply becomes more elastic as time passes


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Elasticity and taxes

  • If government levies a tax on a product who pays the tax??

  • Producers?? Consumers?? Share??

  • Depends on the elasticity of demand and supply


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How find??

  • Find equilibrium price

  • Supply shifts left in the amount of the tax

  • Find new equilibrium

  • Find point of second equilibrium on ORGINAL supply curve

    • Shows the actual price realized by firm or equilibrium price – tax = point in question

  • Difference between points determines how much of tax you pay



Who pays more of the tax l.jpg
Who pays more of the tax??

  • Perfectly inelastic demand

  • Perfectly elastic demand

  • Demand more elastic than supply

  • Supply more elastic than demand




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Summary

  • Ed > Es producer bears most of the tax burden

  • Ed < Es consumer bears most of the tax burden

  • Ed = Es equally share the tax burden


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Homework

Numbers 5, 6, and 8Working with Graphs and Numbers1, 2, and 4


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Do we understand Chapter 5??


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