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Chapter 5Elasticity

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 Qd changes when price changes

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

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

Point elasticity

- Measures the change between two observed points.

example

- P1 = 10
- P2 = 12
- Q1 = 100
- Q2 = 50
- Elasticity??
- Which is Point A???
- Big Problem!!!

Problem

- Answers vary depending on where you start
- Becomes more important the larger the change

Arc Elasticity

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

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

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

Elastic Demand

- Ed > 1
- % change in quantity demanded > % change in price
- FLATTER CURVE
- What are some examples of an elastic good???

Inelastic Demand

- Ed<1
- % change in the price > percent change in quantity demanded
- STEEPER CURVE
- What are some examples of an inelastic good?

Unit Elastic Demand

- Ed=1
- % change in price = % change in quantity demanded
- Change in price brings a proportionate change in quantity demanded
- CURVE

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???

Perfectly inelastic demand

- Ed = 0
- % change in quantity demanded DOESN’T CHANGE in response to a change in price
- Totally steep --- vertical
- Extreme
- Examples???

Aren’t demand curve downward sloping?

- Because the extremes (perfectly inelastic and perfectly elastic) are not.
- Use as points of reference only

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?

What is total revenue??

- Total revenue = price*quantity
- Firm uses to decide if to produce more or less

examples

- Elastic demand
- Price increase
- Price decrease
- Inelastic demand
- Price increase
- Price decrease
- Unit elastic demand
- Price increase
- Price decrease

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

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

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

So…

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

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

More determinates

- Percentage of one’s budget that is spent on the good
- More expensive??? More elastic
- More affected by price (even small changes)

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

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?

- 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

Income elasticity of demand

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

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

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

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

Price Elasticity of Supply

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

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

Any extreme elasticities???

- Yes!!
- Es =
- Perfectly elastic or horizontal
- Es = 0
- Perfectly inelastic or vertical

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

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

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??

- Perfectly inelastic demand
- Perfectly elastic demand
- Demand more elastic than supply
- Supply more elastic than demand

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

Homework

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

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