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Chapter 5 Elasticity and its Application

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## Chapter 5 Elasticity and its Application

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**What is Elasticity?**• Measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants**Price Elasticity of Demand**• Measure of how much quantity demanded responds to a change in price • Can be computed as % change in quantity demanded divided by % change in price**Determinants of Price Elasticity of Demand**• Availability of Close Substitutes: More substitutes available, more elastic demand is • Necessities vs. Luxuries: Necessities are less elastic • Definition of the market: Narrowly defined are more elastic than broadly defined ones • Time Horizon: Goods tend to be more elastic over longer time periods**Let’s practice:**• Put the following into its likely order from most elastic to least elastic: Beef Salt European Vacation Steak New Honda Accord Dijon mustard**Answers**• European Vacation • New Honda Accord • Steak • Dijon Mustard • Beef • Salt**Computing Price Elasticity of Demand**• Formula is: Price Elasticity of Demand = % Change in Quantity Demanded % Change in Price So… if the price of of ice cream rises by 10% and quantity demanded falls by 20% Price elasticity of demand = 2**Of the following, what will have the greatest elastic effect**on demand? • Good A, which has few if any substitutes • Good A, which has many substitutes • Good A, which is seen as a necessity • Good A, which is defined very broadly (like market for soap) • None of the above**A 5 percent decrease in the price of good X leads to a 20**percent increase in the quantity demanded of Good X. The elasticity coefficient of demand is: • 24 • 4 • .25 • 2.25 • 1**Put the following in order from most elastic to least**elastic: • Eggs • Rice • Beef • Mountain Dew • Healthcare • Housing • Restaurant Meals**Midpoint Method**• The elasticity is calculated by going from one point to another on demand curve, which will be different at different parts on curve • So, you get around it using midpoint method • Price Elasticity of Demand = (Q2 – Q1)/{(Q1+Q2)/2} (P2 – P1)/{(P1+P2)/2} Rarely, need to use this – big idea is that you use it to counteract differences in elasticities**Midpoint Method**• Example: Calculate Price Elasticity of Demand if the price rises from $4 to $6 and the resulting quantity demanded falls from 120 to 80 Answer = 1**Variety of Demand Curves**• Demand is elastic if elasticity is greater than 1 • Demand is inelastic if elasticity is less than 1 • Demand is unit elastic if elasticity is exactly 1**Rule of Thumb for Elasticity**• Flatter the demand curve, the greater the price elasticity of demand • The steeper the curve, the smaller the price elasticity of demand**Special Cases**• Perfectly Elastic Perfectly Inelastic**Of the following, which is not a factor that will determine**elasticity of a good? • Percent of income spent on a good • How the market is defined • Time in which the market is viewed • Number of substitutes available • Change in income**If any change in price leads to no change in quantity**demanded, then demand for this good: • Is relatively elastic • Is perfectly inelastic • Is relatively inelastic • Is perfectly elastic • The answer cannot be determined based on the information given**A good that may be perfectly inelastic is:**• Toothpaste • Bottled Water • Pencils • Insulin • Granny Smith apples**Total Revenue**• Total Revenue = Amount paid by buyers and received by sellers of the good (P x Q) • Rules about TR as it relates to Elasticity • When demand is inelastic, price & total revenue move in the same direction • When demand is elastic, price & total revenue move in opposite directions • If demand is unit elastic, total revenue remains constant as price changes**Linear Demand Curves**• Slope is constant, but elasticity isn’t**Income Elasticity of Demand**Income Elasticity Demand = % Change in Quantity Demanded % Change in Income Normal = positive income elasticity Inferior = negative income elasticity Necessities = small income elasticity Luxuries = large income elasticity**Cross-Price Elasticity of Demand**Shows if goods are substitutes or complements % Change in Quantity Demanded of Good 1 % Change in Price of Good 2 Substitutes = Positive Cross-Price Elasticity Complements = Negative Cross-Price**Price Elasticity of Supply**% Change in Quantity Supplied % Change in Price Depends on flexibility of sellers to change the amount of the good they produce Time period is key determinant (more elastic in long run)**Variety of Supply Curves**• Flat supply curves show more elasticity; more vertical supply curve is more inelastic • Perfectly Inelastic = Vertical; Perfectly Elastic = Horizontal