ECON 200 Week 3 Notes
ECON 200 Week 3 Notes ECON 200
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This 7 page Class Notes was uploaded by Rachel Pollard on Friday January 22, 2016. The Class Notes belongs to ECON 200 at University of Washington taught by Haideh Salehi-Esfahani in Winter2015. Since its upload, it has received 18 views.
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Date Created: 01/22/16
Session 5 Tuesday, January 19, 2016 10:22 AM The degree of sensitivity of price changes • What matters to the law of demand: o The relative price of a good • Example: Year Price of all consumer goods Price of gasoline Relative price of gasoline (CPI) (*100) 1983 100 $1.20 1.20 2004 187 $1.79 0.95 2005 195 $2.50 1.28 2013 233.5 $3.29 1.41 2015 238.6 $2.60 1.09 o Base year: 1983 --> that is 100 (CPI) o From 1983 to 2004, the price of gasoline increased by 87 percent o CPI: indicative of changes in price o Relative price: Price divided by the CPI, multiplied by 100. o The relative price is called the real price. o In 2004, the dollar price of gasoline was higher than in 1983. o Would you say that in 2004 people bought less, the same, or more gasoline than in 1983? • They relatively buy more gasoline because the relative price fell. Price Elasticity of Demand • It measures how sensitive is the quantity demanded of the price • Applications of Demand: Introduction to the concept of elasticity and the price elasticity of demand • The Relative Elasticity of demand between two goods: Take the demand of 2 goods: beef and chicken. Suppose the seller of each good faces the demand curves drawn in figure below: the market demand for chicken and the market demand for beef: o Consider a price of $3 per lb. At this price the quantities of beef and chicken sold are equivalent. If the price for each good now drops by $1, which good will exhibit a larger change in its quantity demanded? We call this good to be “relatively elastic” compared to the other good. We will next measure the price elasticity of demand. A good with a relatively elastic demand will have a higher price elasticity measure than another good with a lower price elasticity of demand. In our graph above, for a given price, the relatively elastic demand will have a higher price elasticity measure. o Beef is more relatively elastic o The one that has a bigger quantity change, is more elastic. o Elastic means expansion: beef is expanding more • Example: o Consider a T-Shirt producer who faces the following market demand for her product: o If this person charges $100 for t-shirts she will sell 0. o If she charges $90, she will sell 10. o If she charges $20 per tshirt, she will sell 80 per day. o At Q=10, P=$90, Total Revenue = $900 (P*Q) The sellers call it total revenue, the buyers call it total expenditure o Suppose she increases her output by 1 unit, price falls by one unit (one dollar). This is due to the slope of 1. o Q=11, P=$89, TR=$979 o She gets $79 dollars more per day by dropping the price o A: At Q=80, P=$20, TR=$1600 o B: As the quantity goes up to 81, Q=81, P=$19, TR=$1539 • In A, As the price drops, the total revenue rises • In B, as the price drops, the total revenue drops too o From 90 to 89, this is a small change percentage wise, 1.1% drop in price • 10 to 11, is a 10% change o It's the percentage change that matters • 20 to 19, 5% drop • 80 to 81 is about a 1% change o The price elasticity of demand is the "percentage" change in quantity demanded as Price changes (in percentage chang e) • Price elasticity of demanε: § Ε= percent change in Q demand/percent change in price • = ΔQ/Q / ΔP/P Ε § Δ q = Q2-Q1 § Δ p= P2-P1 • E= dQ/Q / dP/P ---> E= Dq/Dp * P/Q • Using 2 (not shown above) • P=90 Q=10 (A) o P1=$90 o P2=$89 o Q1=10 o Q2=11 o 11-10/10/89-90/90 ---> -9 o A 1% drop in the price will raise the quantity demanded by 9%. • Using 4 • E=dQ/dP * P/Q o dQ/dP=-1 o P/Q = -90/10 = -9 o -1*-9=9 o If you change the price by 1%, you change the quantity by 9% change in the other direction by the consumers. This makes the demand ela stic • E=dQ/dP * P/Q o Quantity=0 it is infinite, infinitely elastic • At Another point, C o E=-1*50/50= -1 (unitary elasticity) This is at the midpoint of the demand curve • At Another point, B o P=$20 Q=80 o E=-1 *20/80 = -.25 • A 1$ drop will lead to .25% increase in quantity • This is inelastic • The quantity changes less than the price change o At another point, H • Q=100, P=0 • E=0 • This is called perfectly inelastic • There is no change in the quantity o In order to interpret the measure of price elasticity of demand easily, we consider the "absolute value" of E. • At point G, when Q=0 and P=100 we say |E| = infinite • At point A, |E|= 9 • At C|E|=1 • At B |E|=.25 • At H |E| = 0 • It starts with very large elasticity • The price of elasticity c hanges along the demand curve o When |E|>1, it is elastic • This is at points G and A and C o When |E|< 1, it is inelastic • This is at points B and H o It changes at point C because at C |E|=1 • Where demand is inelastic, if the seller raises the price of his produc t, what happens to his total revenue? o It will rise, because the quantity is a smaller percentage than the percentage in the price o Total Revenue goes up • Where the demand is elastic, if the seller raises the price of his product, what happens to his total revenue? o The total revenues fall • At unitary elasticity, there is no change. • Example: A seller increases the price of its product by 10% and the quantity sold falls by 20%. What is the price elasticity of demand for this product? o It's larger than 1. o E=-20%/+10% = -2 o |E|=2 o The quantity is very sensitive • Clicker Question: When demand is inelastic, a small increase in the price of the good results in a smaller percentage decrease in quantity, leading to increased revenues of the seller Example • Here look for the midpoint of each line. • The midpoint shows where |E|=1 • An elastic demand" Q changes are very responsive to P changes. • As P falls by one percentage, Q increase y a larger percentage so the total revenue of the seller rises. • As P rises by one percent, Q falls by a larger percentage so that total revenue of the seller will fall. • An inelastic demand, Q changes are not so responsive to P changes. • As P falls by one percent, Q increases by a smaller percentage so that total revenue of the seller will fall. • As the P rises by one percentage, Q falls by a smaller percentage so the total revenue of the seller will rise. Applications 1. When the OPEC countries meet for decision on their (joint) production, what is their objective? • They want to increase revenue Should they cut or increase their output? If demand for oil is inelastic, then in order to increase revenues they should --------- production of oil. • Cut. If you decrease by a little bit, the price change shoots up. If demand for oil is elastic, in order to increase revenues, they should --------- production of oil. • Increase. 2. Drug interdictions causes the price of drugs to --rise----- (rise/fall) Since demand for drugs is ----inelastic---------- (elastic/inelastic) total expenditures by addicts --increase-------- (increases/decreases) Therefore the number of crimes committed is likely to -----go up ----------- (go up/go down) Law enforcement expenditures will also have to rise. Legalizing drugs will force the price ---go down----- and with it expenditures will -----go down----- --------(go down/go up) and so will the number of crimes committed --fall---- (rise/fall) Session 6 Thursday, January 21, 2016 10:27 AM Example: Why do some retailers give discounts to students? • Higher price sensitivity: Students • Students have a higher price elasticity of demand compared to professionals. • By lowering the price a little bit for students, the quantity will dramatically increase. • This is a revenue increasing policy. Dimensions of the concept of elasticity • A coffee table has a higher price elastic ity of demand than furniture because it has substitutes. • Brand names tend to have a high price elasticity of demand Elasticity changes over time: Is the price elasticity of demand for gasoline higher in the short run or the long run? • Answer: over the long run • There's time to adjust to the changes. Limiting Cases E=dQ/dP * P/Q On Graph A: the Quantity is fixed ---> Perfectly Inelastic Graph B: The Price is fixed ---> Perfectly Elastic • Point of view: In a highly competitive market where there's lots of buy ers and lots of sellers perfectly elastic demand Empirical Evidence of price elasticity of demand for selected goods: Example of the price elasticity of demand: • The price elasticity of demand for coffee is estimated to be -.16. If the quantity demanded was 4 billion lbs. per year when the price of coffee is $3.60 per lb., how much coffee would be demanded at $2.4 per lb.? o Q2=? o Elasticity=-0.16 o Q1= 4 billion lbs o P1= $3.6 per lb o P2= $2.4 per lb E= qz-q1/q1/p2-p1/p1 -.16=-0.16 qq2-4/4/2.4-3.6/3.6 Q2-4/4//-.333=-.16 Qz-4/4=-.16 (-.333)=.053 Qz-4=4(.053) Q2= 4+4(.053)=4.213 Shipping Out the Good Apples • Why are the good watermelons shipped out? • The high quality goods are exported because of the law of demand There has been a significant drop in th e number of smokers in the US in the last few decades. How does the law of demand help explain this phenomenon? • Smoking becomes more costly as life expectancy increases • The price of smoking includes both the market price of cigarettes and the cost of foreg one years of life. Using the law of demand, how do we explain the increase in the obesity rates in the US? • The production of sugary things: lots of substitutes, it's become cheaper • Quantity of calories consumed versus price per calorie