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This 3 page Class Notes was uploaded by Samantha jose on Saturday February 6, 2016. The Class Notes belongs to 101 at Washington State University taught by Dr. Love in Fall. Since its upload, it has received 65 views. For similar materials see Microeconomics in Economcs at Washington State University.
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Date Created: 02/06/16
Elasticity Price Elasticity of Demand • We know there is an inverse relationship between price and quantity demanded • BUT how much does quantity demanded change when price changes? • A demand curve is elastic when an increase in price reduces the quantity demanded a lot (and vice versa). • When the same increase in price reduces quantity demanded just a little, then the demand curve is inelastic. Elasticity Rule • Elasticity DOES NOT EQUAL slope o If two linear demand (or supply) curves run through a common point, then at any given quantity, the curve that is FLATTER is MORE ELASTIC Defining and Measuring Elasticity • Price elasticity of demand = the percentage change in quantity demanded divided by the percentage change in price Price elasticity of demand = % change in quantity demanded / % change in price • Example: o If the price of oil increases 10% and the quantity demanded falls by 5%, then the price elasticity of demand for oil is: § -5%/10%= -0.5 Using the Midpoint Formula for Elasticity • There is a problem: Our percent change calculation depends on our choice of starting point • To solve this problem, we calculate the price elasticity of demand using the midpoint formula for percentage changes Midpoint Method • Instead of dividing by the initial quantity or price, we’ll use the average quantity or price % change in X = Change in X / Average Value of X * 100 Where Average value of X = (Starting value of X + Final Value of X)/2 Mathematics of Demanded Elasticity • Example: at the initial price of $10, the quantity demanded is 100. When the price rises to $20, the quantity demanded is 90. • % change in quant demanded = (90-100/100+90)/2*100=-10.5% • % change in price = (20-10/10+20)/2*100%=66.6% • Price Elasticity demand= -10.5%/66.6%=-0.15 Estimating Elasticities • Economists (and many others) are interested in price elasticity of demand. Estimating elasticity is crucial to understanding and predicting market outcomes. Interpreting the Price Elasticity of Demand • Classification of price elasticity of demand: o A good can have a price elasticity as low as zero or as high as infinity § If the |Ed| < 1, demand curve is inelastic § If the |Ed| > 1, demand curve is elastic § If the |Ed| = 1, demand curve is unit-elastic o Perfectly inelastic demand: price elasticity of demand is 0: § It is a vertical straight line o Perfect elastic demand: § A Horizontal line o Unit-elastic demand: § Price elasticity of demand = 1 Elasticity & Total Revenue Total Revenue: price times quantity demanded (TR = Price * Quantity) • When demanded is inelastic, the price effect dominates the quantity effect o So an increase in price will cause only a slight reduction in the quantity demanded. o In this instance, total revenue will rise when the price rises (vice versa) • When demand is elastic, the quantity effect dominates the price effect o So an increase in price will cause significant reduction in the quantity demanded o In this instance, total revenue will fall when the price rises (vice versa) • When demand is unit-elastic, the quantity effect equals the price effect o So an increase in price exactly balances the reduction in the quantity demand o In this instance, total revenue doesn’t change. Price Elasticity of Demand • 1. The availability of close substitutes is very important o fewer substitutes makes it harder to consumers to adjust Q when P changes, so demand is inelastic o many substitutes? Switching brans when prices change is EASY, so demand is elastic • 2. Whether the good is a necessity or a luxury also effects the elasticity of demand o For necessities, we do not change Q much when P changes o For luxuries, we are more sensitive to P changes • 3. The share of income spent on the good matters o We are less sensitive to price changes when the good feels cheap o We are more sensitive to price changes when the good feels expensive • 4. The length of time elapsed since the price change matters o less time to adjust means lower elasticity o Over time consumers can adjust their behavior by finding substitutes (making demand more elastic) Other Demand Elasticities • The cross-price elasticity of demand measures how sensitive the quantity demanded of good A is to the price of good B Cross-price elasticity of demand = % change in quantity A demanded % change in price B Cross-Price Elasticity of Demand • For Substitutes, cross-price elasticity of demand is positive o An increase in the price of one brance of cookies will increase the demand for other brands • For Complements, cross-price elasticity of demand is negative o An increase in the price of milk causes a decrease in demand for Oreos Income Elasticity of Demand • The income elasticity of demand measures how sensitive the quantity demanded of a good is to changes in income Income elasticity of demand = % change in quantity demanded % change in income • The income elasticity of demand can be used to distinguish normal from inferior goods. o For normal goods, income elasticity is positive o For inferior goods, income elasticity is negative • Normal goods can be income-elastic or not o For income-elastic goods, income elasticity is greater than 1 o For income-inelastic goods, income elasticity is positive but less than one Price Elasticity of Supply Usually sellers offer more when prices are higher but how strong is that relationship? Measuring Price Elasticity of Supply • Similar to price elasticity demand: Price elasticity of supply= % change in quantity supplied % change in price Elasticity of Supply • A supply is elastic if a rise in price increase the quantity supplied a lot (vice versa) • Its inelastic if sellers change quantity a lot What Factors Determine the Price Elasticity of Supply • 1. Availability of inputs o if increase production is very expensive, then the supply curve will be inelastic o if production can be increased cheaply, then the supply curve will be elastic • 2. Time o price elasticity of supply increases as producers have more time to respond to price changes long-run price elasticity of supply is usually higher than the short-run elasticity
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