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Ch. 4: Elasticity.

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Define, calculate, and explain the factors that influence

- the own price elasticity of demand
- the cross price elasticity of demand
- the income elasticity of demand
- the elasticity of supply

- Price elasticity of demand
- units-free measure of the responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus.

%DQ = DQ/Qavg

= 2/10

= .2

%DP = DP/Pavg

= -$1/$20

= -.05

e = .2/.05 =4

- By using the average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls.
- Measuring as % changes leaves the elasticity value the same (“units free”).
- Although the formula yields a negative value for elasticity because price and quantity move in opposite directions, we report the absolute value.

- Inelastic and Elastic Demand
- if e>1: elastic
- if e=1: unit elastic
- if e<1: inelastic
- Shape of
- Perfectly inelastic demand curve (e=0)
- Perfectly elastic demand curve (e= infinite)

At prices above the mid-point of the demand curve, demand is elastic.

At prices below the mid-point of the demand curve, demand is inelastic.

- Total Revenue and Elasticity
- TR=P*QD
- When P changes, TR could rise or fall because QD moves in opposite direction.

- %D TR = % D P + % D Q
= % D P - % D P(e)

= % D P(1-e)

- If demand is elastic (e>1),
P increase TR decreases

P decrease TR increases

- If demand is inelastic (e<1),
P increase TR increases

P decrease TR decreases

- If demand is unitary elastic,
P increase or decrease TR unchanged.

- As P falls from $25 to $12.50, D is elastic, and TR rises.
- At $12.50, D is unit elastic and TR stops increasing.
- As P falls from $12.50 to 0, D is inelastic, and TR decreases.

- The elasticity of demand for a good depends on:
- The number & closeness of substitutes
- The proportion of income spent on the good
- The time elapsed since a price change

- Cross Elasticity of Demand
- measures responsiveness of demand for a good to a change in the price of another good.
exy= %D quantity demanded for x

%D change in price of y

- exy> 0 substitutes
- exy<0 complements

- measures responsiveness of demand for a good to a change in the price of another good.

- Income Elasticity of Demand
- measures how the quantity demanded of a good responds to a change in income, ceteris paribus.eI = %D in quantity demanded
% D in income

- eI >0 normal good
- eI >1 luxury good
- eI <0 inferior good

- measures how the quantity demanded of a good responds to a change in income, ceteris paribus.eI = %D in quantity demanded

A change in demand causes

- A larger change in equilibrium price if supply is supply is steeper,
- A smaller change in equilibrium quantity if supply is steeper.

Elasticity of supply

- measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same.

- Factors That Influence the Elasticity of Supply
- Elasticity of supply for inputs
- The time frame for supply decisions
- Storage costs