ECON202 Exam 2 Study Guide Cheng
Chapter 5: Elasticity & its Application
● Calculating percentage change (X changing from X1 to X2) using the midpoint method:
○ Advantage of using the midpoint method vs. the conventional method: ■ When we compute price elasticity with the conventional method, we get a different answer depending on which ‘start point’ and ‘end point’ we choose. With the midpoint method, it avoids the problem of getting a different answer when we compute price elasticity between any two points on a demand curve, and it calculates by dividing the change in the variable by the midpoint value of the two points on the curve instead of the starting point on the curve.
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○ Example questions:
■ If X changes from 1 to 2, what is the % change using the midpoint method? (66.7%)
■ If X changes from 2 to 1, what is the % change using the midpoint method? (-66.7%)
● Suppose the relationship between x and y is negative and define R = �� × ��. ■ If |%��| > |%��|, then the change in R is driven by x.
● (e.g., %�� = 5% ������ %�� = −2%)
■ If |%��| < |%��|, then the change in R is driven by y.
● (e.g., %�� = 5% ������ %�� = −10%)
■ If |%��| = |%��|, R does not change.
● (e.g., %�� = 5% ������ %�� = −5%)
● Elasticity (η) - refers the degree to which individuals (buyers/sellers) change their demand/amount supplied in response to price or income changes
○ Graphically, it is a quantified relationship between variable X and variable Y ○ Mathematically, it measures the % change in Y due to the % change in X ○ Formula for elasticity:We also discuss several other topics like What is the societal marketing concept?
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■ Example questions
● If X goes up by 10% and Y goes up by 20% accordingly, what is the elasticity between X and Y? (η=2)
● If X goes up by 20% and Y goes down by 10% accordingly, what is the elasticity between X and Y? (η=.5)
○ Calculating economic elasticity with the midpoint method:
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○ So how do we interpret this?
■ The sign of elasticity (positive η/ negative η) tell you whether there is a positive or a negative relationship between X and Y.
■ The size of elasticity tells you whether the % change in Y is greater than, smaller than, or equal to the % change in X. When analyzing the ‘size of elasticity’ we will take the absolute value of η, meaning we’ll disregard any negative signs.
● Unit elastic: |η| = 1
○ % change in Y = % change in X
● Elastic: |η| > 1 (e.g., η = -1.5)
○ % change in Y > % change in X
○ Special case: perfectly elastic: |η | = ∞
● Inelastic: |η| < 1 (e.g., η = 0.5)
○ % change in Y < % change in X
○ Special case: perfectly inelastic: |η| = 0
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Example: Suppose the elasticity between X and Y is 1.5.
● There is a positive relationship (both X and Y increase) because 1.5 is positive.
● If X goes up by 10%, how should Y change? (Y should go UP by 15%,
because 1.5 = 15/10)
● If Y goes up by 10%, how should X change? (X should go UP by 6.67%
because 1.5 = 10/6.67)
Example: Suppose the elasticity between X and Y is -0.5. If you want to learn more check out Describe the composition of blood plasma.
● There is a negative relationship (X increases, so Y decreases, or vice versa) because -0.5 is negative.
● If X goes up by 10%, how should Y change? (Y should go DOWN by 15%) ● If Y goes up by 10%, how should X change? (X should go DOWN by
● Now, we can learn how to apply elasticity to the demand and supply curves. ○ Price Elasticity of Demand (PED; “point elasticity”) - relationship between P and Qd; term used to describe how responsive consumers are to a change in price
■ Ex. Assume that when gas prices increase by 50%, gas purchases fall by 25%. Using the formula above, we can calculate that the price elasticity of gasoline is: Price Elasticity = (-25%) / (50%) = -0.50
■ A change in demand in the long-run vs. the short-run:
● Demand in the long run is more elastic because people have more flexibility to discover other close substitutes
● In the short run, demand is more inelastic.
● Gas Price example: When gas prices go up, do you keep paying more and more for gas? Or do you decide to ride the bus/bike/walk/etc? Steeper (more inelastic) - short run; Flatter (more elastic) - long run
■ When comparing the elasticities of two different demand curves,
● The flatter demand curve is typically more elastic
● The steeper demand curve is typically more inelastic
● A horizontal demand curve is perfectly elastic
○ While quantity demanded changes, the % of change in price is zero, so elasticity is infinite
● A vertical demand curve is perfectly inelastic
○ While price changes, the % of change in quantity demanded is zero, so it is considered to be price-inconsistent
● Pizza vs. Electricity example:
○ If both the price of pizza and price of electricity increase both by 10%, for which good will quantity demanded decrease more?
■ Pizza has more substitutes, so you’ll have a larger quantity
response for pizza. Pizza gets more expensive, so you’ll find
other things to eat so you can get your electricity back on.
■ Demand for goods that have more close substitutes will be
more elastic! Electricity has basically no substitutes, so
people will pay for it regardless of the price, making it
● Engagement Ring example:
○ When buying an engagement ring you know you’re only going to need one, regardless of the price of it. There will be a vertical
demand curve because quantity is 1 at all prices, giving it a
perfectly inelastic, perfectly price-insensitive demand curve.
■ REVENUE and PRICE ELASTICITY OF DEMAND:
● On an elastic demand curve, a company would have to reduce their selling price to increase revenue; there is an inverse relationship between price and total revenue when demand is elastic.
○ EX. Good weather means that wheat production increases (supply goes up; supply curve shifts left, so price goes down while quantity goes up.) Does the price effect or quantity effect dominate? If
wheat demand is elastic, demand will go up; if it’s inelastic,
demand will go down. Wheat is inelastic because it has few
substitute goods, so consumers are not price-sensitive (price effect dominates, and revenue is driven down.)
● On an inelastic demand curve a company would likely have to increase their selling prices to increase revenue; there is a direct relationship between price and total revenue when demand is inelastic.
○ EX. Cops go out looking to track down and arrest all the drug dealers (supply of illegal drugs goes down; supply curve shifts left, giving a higher price and lower quantity). Which effect dominates? Is the demand for illegal drugs elastic or inelastic? It’s very
inelastic because addicts want SPECIFIC drugs, meaning the price effect will dominate because no matter the price, these addicts will keep buying it. Revenue for drug dealers will increase. Crime rates will probably increase also, but that’s a whole other story.
■ INCOME and PRICE ELASTICITY OF DEMAND:
● When determining how changes in income affect the quantity demanded, you must determine whether the good is an inferior, normal, or luxury good.
○ Inferior goods: negative relationship between income and
quantity (negative income elasticity); income rises & demand
falls; elasticity is less than 0 … (η < 0).
■ Example: For an inferior good with an elasticity of -0.7,
when income rises by 10%, quantity demanded will
decrease by 7%.
○ Normal goods: positive relationship between income and
quantity (positive income elasticity); income rises & demand
rises; elasticity is between 0 and positive 1 … (0<η<1)
■ Example: If income increases by 10% and the demand for
fresh fruit increases by 4% then the income elasticity is 0.4.
○ Luxury goods: elasticity is greater than positive 1 … (η>1) ■ Example: An 8% increase in income might lead to a 10% rise in the demand for new kitchens. The income elasticity of
demand in this example is +1.25.
■ Cross-Price elasticity of demand:
● Explains what happens to the demand of one good when the price of
another good changes
● Cross-Price Elasticity - percent change in quantity demanded of good 2 divided by the percent change in price of good 1.
● Positive elasticity means the 2 goods are substitutes
● Negative elasticity means they’re complements.
○ Example: Elasticity = 1.5 (substitutes), so when price 1 goes up by
10%, quantity demanded of good2 will go up by 15%
○ Example: Elasticity = -1.2 (complements), so when price 1 goes up
by 10%, quantity demanded of good2 will go up by 12%.
○ Price Elasticity of Supply (PES) - relationship between P and Qs; measures the responsiveness of the quantities supplied to a change in cost; the ability of sellers to change the amount of the good they produce; is always positive
● High price elasticity of supply -
○ Price of a good goes up, sellers will supply less of the good
○ Price of that good goes down, sellers will supply more
● Low price elasticity of supply - changes in price have little influence
■ The Price Elasticity of Supply using the midpoint method, shown in the example below:
Chapter 6: Supply, Demand, & Government Policies ● Price controls - policies created by the government to prevent market price from getting too high or too low
○ Binding vs. Non-binding policy constraints:
■ Binding constraints - when a policy affects market outcome
■ Non-binding constraints - when a policy has no effect on the market outcome
○ Price ceiling - (e.g. rent control)
● A legal maximum on the price at which a good can be sold
● Sets an upper boundary of the price range
● Designed to help low income consumers
● Only effective when it is below the market equilibrium price
● Can result in a shortage - a binding ceiling where the market can't clear
because the ceiling has been placed BELOW the market equilibrium.
○ If the price ceiling is above P* (price equilibrium), it is non-binding
■ No surplus or shortage exists
○ If the price ceiling is below P*, it is binding
■ Shortage exists
○ A binding price ceiling causes a shortage. In the long-run, will
the shortage increase or decrease?
■ Binding means we know it will be below P* (equilibrium), so
there’s a shortage. Will it become more severe, or will it
cure itself? We know that consumers in the long run will be
more elastic (flatter) because they can find more
substitutes. Makes an increase in the size of the shortage
because the wider X (long run graph) at the same price
ceiling has a bigger shortage than the taller X (short run
graph); more buyers, and fewer sellers causes this
○ Rent control: The equilibrium is $800 for rent at 300 apartments.
When the government sets a price ceiling at $500, there is a
shortage in the market, because landlords will only supply 250
apartments at $500, while people demand 400 apartments. 150
families can’t get an apartment. So even when the government
tries to help the poor by setting a rent control price ceiling, a
shortage/surplus may arise as a result, hurting the poor even
more than they were hurting in the first place.
○ Price floor - (e.g. minimum wage law)
● A legal minimum on the price of at which a good can be sold
● Sets a lower boundary of the price range
● Designed to help producers
● Only effective when it is above the market equilibrium price ● Can result in a surplus - a binding floor where the market can’t clear because the floor has been placed ABOVE the market equilibrium
○ If the price floor is above P*, it is binding
■ Surplus exists
○ If the price floor is below P*, it is non-binding
■ No shortage or surplus exists
○ Minimum wage law: In the labor market, the equilibrium is $6.00
when 500 laborers are employed. When the government sets a
binding price floor at $7.25, there is a surplus in the market of 150
because employers will provide only 400 job positions, while 550
laborers are looking for a job. (Laborers are on the supply curve
because they’re “selling” their labor.) This surplus of 150 means
that 150 laborers are unemployed.
■ Will skilled laborers (high wage) or unskilled laborers (low
wage) more likely be unemployed under this minimum
wage law? Law will be binding in the unskilled labor
market (and NOT in the skilled labor market) because taller
X (P* above 7.25) vs. wider X (P* below 7.25, so there’s a
■ If $15.00 was the new minimum wage law, there would be a
huge surplus in the labor market (unemployment). Attracts
people to market, so there are less jobs available, so more
● Negative Effects of Price Controls:
○ Black Markets - binding price controls cause shortage and surplus. As a result, a black market might emerge to eliminate the shortage and surplus.
■ Would we pay a higher or lower price in the black market?
● The legal market and black market have same the demand curve but
different supply curves - in the black market, the supply will be a vertical
line because only goods in the black market are shortage/surplus
goods of the legal market
○ Ex. Assume the binding price ceiling in the legal market is $8 and
suppliers produce 40 at that price. In the black market, at 40 units
supplied (vertical), there is a new equilibrium (market clearing
price) at $12. Black market price will be higher than the
binding price ceiling in the legal market.
● Tax policies - imposed by the government to influence market outcomes and to raise revenue for public purposes like the construction of roads, schools, and national defense ○ Definitions:
■ Unit Tax - the amount of tax imposed by the government per 1 unit
bought/sold; TaxB + TaxS
■ P* - market equilibrium price BEFORE tax policy
■ P*’ - market equilibrium price AFTER tax policy
■ PB- the price buyers pay after tax
● Market price + tax
■ PS- the price sellers receive after tax
● Market price - tax
■ TaxB - Effective tax (buyers) - taxes paid by buyers; NOT the same as the unit tax the government collects from buyers
● PB - P* (or) TaxB + (P*’ - P*)
■ TaxS- Effective tax (sellers) - taxes paid by sellers; NOT the same as the unit tax the government collects from sellers
● P* - PS(or) TaxS - (P*’ - P)
■ QT - quantity supplied/demanded after tax; AKA “post-tax market size” ■ Tax Incidence - the manner in which the burden of a tax is shared among buyers and sellers; this is when the government imposes taxes unevenly among buyers and sellers
○ How does the government tax buyers and sellers differently?
■ Although buyers are the ones to pay taxes, not sellers, we’ll determine how buyers and sellers are affected by taxes in similar ways.
● When there are NO taxes involved, buyers pay P* (equilibrium price) to sellers, who receive P*.
● When there ARE taxes imposed, buyers will pay PB(market price + tax) to the sellers, who receive price + tax. Then the government takes back a
nominal tax from buyers and a nominal tax from sellers.
○ What is the effect of taxing buyers and sellers differently? - most of the time, when the government splits up the unit tax among buyers and sellers differently, the tax incidence actually has NO effect on market outcomes.
■ Inelastic curves and tax burden:
● According to inelastic demand curves, buyers don't adjust their behavior, so the prices can change more significantly than the quantity. Inelastic
demand curves carry more of the tax burden on the buyers.
■ Elastic curves and tax burden:
● Elastic demand curves tell us buyers adjust their behavior according to price, so the sellers have to adjust greater than buyers. Elastic demand
curves carry more of the tax burden on the sellers.
■ So...in other words,
● Buyers will have a bigger tax burden when supply is more elastic than demand, because buyers are less willing and able to leave the market facing that tax.
● Sellers will have a bigger tax burden when demand is more elastic than supply, because they’re less willing and able to leave the market when facing that tax.
● Whichever group (sellers or buyers) is more price sensitive will have to pay less tax.
● Extreme cases:
○ Buyers pay ALL of effective tax:
■ Demand curve will be vertical (perfectly inelastic), and the
supply curve will be flatter.
■ Sellers pay nothing because P* = PS
○ Sellers pay ALL of effective tax:
■ Supply curve will be vertical (perfectly inelastic), and the
demand curve will be flatter.
■ Buyers pay nothing because P* = PB
○ Luxury taxes:
■ In 1990, Congress adopted a tax on luxury goods (yachts, fine jewelry, expensive cars, etc) with the goal of receiving a large amount of tax from wealthy buyers
■ Remember as we learned in the last chapter, luxury goods have an elastic demand (due to the existence of substitute goods) and an inelastic supply… this resulted in the burden of the tax falling largely on suppliers instead of buyers.
■ In 1993, this luxury tax was repealed because of its adverse effects.