Lecture 5 elasticity
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Lecture 5 Elasticity. Required Text: Frank and Bernanke – Chapter 4. Market Demand Curve. For every single consumer there is a separate demand curve. If we have two consumers in the market, then we will have two individual demand curves, D1 and D2. P. P 1. P 2. D2. D1. Q 1. Q 2. Q.

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Lecture 5 Elasticity

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Lecture 5 elasticity

Lecture 5Elasticity

Required Text:

Frank and Bernanke – Chapter 4


Market demand curve

Market Demand Curve

  • For every single consumer there is a separate demand curve.

  • If we have two consumers in the market, then we will have two individual demand curves, D1 and D2.

P

P1

P2

D2

D1

Q1

Q2

Q


Market demand

Market Demand

  • Given the two demand curves D1 and D2

    • Note that , at price=$2,

      Consumer 1 buys 10 units

      Consumer 2 buys 20 units

      Thus the market demand at P=$2 is 30 units

    • At price=$1,

      Consumer 1 buys 22 units

      Consumer 2 buys 30 units.

      Thus the market demand is 52 units.

  • Thus, the aggregate or market demand is obtained by the horizontal summation of all individual consumer’s demand curves.

P

Market Demand

$2

$1

D2

D1

10

22

20

30

Q

52


Market demand1

Market Demand

  • Market Demand - a schedule showing the amounts of a good consumers are willing and able to purchase in the market at different price levels during a specified period of time.

  • Change in its own price results in a movement along the demand curve.

P

P1

P2

Market Demand

Q1

Q2

Q


Factors that shift the market demand curve

Factors that Shift the Market Demand Curve

  • Population

  • Tastes

  • Income

    • Normal good

    • Inferior good

  • Price of Related Goods

    • Substitutes - increase in the price of a substitute, the demand curve for the related good shifts outward (& vice versa)

    • Complements - increase in the price of a complement, the demand curve for the related good shifts inward (& vice versa)

  • Expectations

    • Expectations about future prices, product availability, and income can affect demand.

P

D1

D

D2

Q


Responsiveness of the quantity demanded to a price change

Responsiveness of the Quantity Demanded to a Price Change

  • Earlier, we indicated that, ceteris paribus, the quantity of a product demanded will vary inversely to the price of that product. That is, the direction of change in quantity demanded following a price change is clear.

  • What is not known is the extent by which quantity demanded will respond to a price change.

    • To measure the responsiveness of the quantity demanded to change in price, we use a measure called PRICE ELASTICITY OF DEMAND.


Price elasticity of demand e d

Price Elasticity of Demand (ED)

  • Price Elasticity of demand for a good is defined as the percentage change in the quantity demanded relative to a percentage change in the good’s own price.

    Algebraically:


Classifications of own price elasticity of demand

Classifications of Own-Price Elasticity of Demand

  • Classifications:

    • Inelastic demand ( |Ed| < 1 ): a change in price brings about a relatively smaller change in quantity demanded (ex. gasoline).

      • Total Revenue = P×Q rises as a result of a price increase

    • Unitary elastic demand ( |Ed| = 1 ): a change in price brings about an equivalent change in quantity demanded.

      • TR= P×Q remains the same as a result of a price increase

    • Elastic demand ( |Ed| > 1 ): a change in price brings about a relatively larger change in quantity demanded (ex. expensive wine).

      • TR = P×Q falls as a result of a price increase


Using price elasticity of demand

Using Price Elasticity of Demand

  • Elasticity is a pure ratio independent of units.

  • Since price and quantity demanded generally move in opposite direction, the sign of the elasticity coefficient is generally negative.

  • Interpretation: If Ed = - 2.72: A one percent increase in price results in a 2.72% decrease in quantity demanded


Price elasticity along linear demand curves

Price Elasticity along Linear Demand Curves

P

  • Linear Demand Curve:

    Q = a – bP

  • Price elasticity of this demand

    Ed = (∂Q/ ∂P)(P/Q) = − b(P/Q)

  • Any downward sloping demand curve has a corresponding inverse demand curve.

  • Inverse linear Demand Curve: P = a/b – (1/b)Q

a/b

M

a/2b

Q

0

a/2

a

  • At P= a/b, Ed = − ∞;atP = 0, Ed = 0; at P= a/2b, Ed = −1

  • In the region of the demand curve to the left of the mid-point M, demand is elastic, that is − ∞ ≤ Ed < – 1

  • In the region to the right of the mid-point M, demand is inelastic, – 1 < Ed ≤ 0


Cross price elasticity of demand

Cross Price Elasticity of Demand

  • Shows the percentage change in the quantity demanded of good Y in response to a change in the price of good X.

  • Edyx = % Change in Qdy / % change in Px

  • Algebraically:

    Read as the cross-price elasticity of demand for commodity

    Y with respect to commodity X.

    Units of Y demandedPrice of XEdyx

    60 $10

    40 $12(-20/2)x(10/60) = - 1.66


Classification of cross price elasticity of demand

Classification of Cross-price elasticity of Demand

  • Interpretation:

    • If Edyx= - 0.36: A one percent increase in price of chips results in a 0.36% decrease in quantity demanded of beer

  • Classification:

    • If (Edyx > 0): implies that as the price of good X increases, the quantity demanded of Good Y also increases. Thus, Y and X are substitutes in consumption (ex. chicken and pork).

    • If (Edyx < 0): implies that as the price of good X increases, the quantity demanded of Good Y decreases. Thus Y & X are complements in consumption (ex. bear and chips).

    • If (Edyx = 0): implies that the price of good X has no effect on quantity demanded of Good Y. Thus, Y & X are Independent in consumption (ex. bread and coke)


Income elasticity of demand e i

Income Elasticity of Demand (EI)

  • Shows the percentage change in the quantity demanded of good Y in response to a percentage change in Income.

  • EI = % Change in QY / % change in I

  • Algebraically:

    Units of Y demanded IncomeEI

    100 $1200

    150 $1600(50/400)x(1200/100) = 1.5


Income elasticity of demand e i1

Income Elasticity of Demand (EI)

  • Interpretation:

    • If EI= 2.27: A one percent increase income results in a 2.27% increase in quantity demanded of beer

  • Classification:

    • If EI> 0, then the good is considered a normal good (ex. beef).

    • If EI< 0, then the good is considered an inferior good (ex. ramen noodles)

    • High income elasticity of demand for luxury goods

    • Low income elasticity of demand for necessary goods


Price elasticity of supply e d

Price Elasticity of Supply (ED)

  • Price Elasticity of supply of a good is defined as the percentage change in the quantity supplied relative to a percentage change in the good’s own price.

    Algebraically:

    • Perfectly inelastic supple – A vertical supply curve

    • Perfectly elastic supply – a horizontal supply curve.


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