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# Week 5 Lecture notes EC 110

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This 12 page Class Notes was uploaded by Matt Owens on Friday February 13, 2015. The Class Notes belongs to EC 110 at University of Alabama - Tuscaloosa taught by Kent O. Zirlott in Spring2015. Since its upload, it has received 128 views.

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Date Created: 02/13/15

Matt Owens Principles of Microeconomics February 10 2015 Chapter 5 Notes In this chapter look for the answers to these questions 0 What is elasticity What kinds of issues can elasticity help us understand 0 What is the price elasticity of demand How is it related to the demand curve How is it related to revenue and expenditure 0 What is the price elasticity of supply How is it related to the supply curve 0 What are the income and crossprice elasticities of demand A Scenario You design websites for local businesses You charge 200 per website and currently sell 12 websites per month Your costs are rising including the opportunity cost of your time so you consider raising the price to 250 The law of demand says that you won t sell as many websites if you raise your price How many fewer How much will your revenue fall or might it increase Elasticity Basic idea 0 Elasticity measure how much one variable responds to changes in another variable I One type of elasticity measures how much demand for your websites will fall if your raise your price Definition 0 Elasticity A numerical measure of the responsiveness of Qd or Q8 to one of its determinants Price Elasticity of Demand Percentage change in Qd Price elasticit of demand y Percentage change in P Price Elasticity of Demand Measures how much Qd responds to a change in P Loosely speaking it measure the pricesensitivity of buyers demand 15 is a pure number It is not a percentage or unit 15 should actually be negative du to quantity falling by 1 5 but we take the absolute m Price elasticity of demand Percentage change in Qd Percentage change in P Example 0 Price elasticity of P demand equals 15 1 5 10 39 o AlongaD curve P and Q move in opposite directions which would make price elasticity negative 0 We will drop the minus sign and report all price elasticities as positive numbers 39 quot3r a isfji i9p 5 W362 iv39 7 MI nr swww rmwwbmubii Calculating Percentage Changes Demand for Your Websites 250 200 Standard method of computing f the percentage change End value start value X 100 start value Going from A to B the percentage change in P equals 250 l 200200 25 5 Problem The standard method 8 12 gives different answers depending on where you start From A to B P rises 25 Q falls 33 elasticity 3325 133 From B to A P falls 20 Q rises 50 elasticity 5020 250 So we instead use the Midpoint Method End value start value X 100 midpoint average The midpoint is the number halfway between the start and end values the average of those values It doesn t matter which value you use as the start and which was the quotendquot you get the same either way Calculating Percentage Changes Using the midpoint method the percentage change in P equals 250 200 i x100222 225 12 8 The percentage change in Q equals 0 X 100 400 The price elasticity of demand equals 40 222 18 Use the following info to calculate the price elasticity of demand for theme park tickets 0 IfP 70 Qd 5000 o IfP 300 Qd 9000 39 change in Qd 500030004000 50 39 change in P 907080 25 I 5025 20 The Variety of Demand Curves The price elasticity of demand is closely related to the slope of the demand curve but it is not equal to the slope of the demand curve The reason for this is because slope is a ration of two changes and elasticity is a ratio of two percentage changes Rule of thumb o The atter the curve the bigger the elasticity The steeper the curve the smaller the elasticity Five different classifications of D curves Elastic Demandquot Price elasticity of demand change in Q gt10 change in P 10 D curve relatively at 0 NOT PERFECTLY FLAT Consumers price sensitivity relatively high Elasticity gt1 rises more than 10 Inelastic Demandquot changeinQ lt10 change inP 10 Price elasticity of demand D curve relatively steep Consumers price sensitivity relatively low Elasticity lt 1 Percentage change in Q is less than percentage change in price Q rises less than 10 Unit Elastic Demandquot changeinQ 10 1 changeinP 10 Price elasticity of demand Elasticity 1 Percentage change in Q equals the percentage change in price Q rises by 10 Perfectly Inelastic Demand one extreme case changeinQ 0 changeinP 10 Price elasticity of demand p D D curve perfectly vertical Consumers price sensitivity none W Elasticity 0 Example Prescription Medicines Q 01 Q 39 c39h39anges v by 0 Perfectly Elastic Demand the other extreme h 39 an 0 Pr1ce elast1c1ty of demand Z ange 1n Q y 0 1nf1n1ty 0 change 1n P 10 P D curve perfectly horizontal o Consumers pr1ce sen51t1V1ty P2 P1 3 D extreme 5 Elasticity infinity If prices changes just a little bit 2 quantity goes to 0 Q Example Seafood Q1 Q2 Q changes by any What Determines Price Elasticity To learn the determinants of price elasticity we look at a series of examples Each compares two common goods In each example 0 Suppose the prices ofboth goods rise by 20 o The good for which Qd falls the most in percent has the highest price elasticity of demand Which good is it Why 0 What lesson does the example teach us about the determinants of the price elasticity of demand Example 1 Breakfast Cereal vs Sunscreen The prices ofboth of these goods rise by 20 For which good does Qd drop the most Why 0 Breakfast cereal has close substitutes eg pancakes Eggo waf es oatmeal grits so buyers can easily switch if the price rises o Sunscreen has no close substitutes so consumers would probably not buy much less if its price rises 0 Lesson Price elasticity is higher when close substitutes are available Example 2 Lucky Brand Jeans vs Clothing The prices ofboth goods rise by 20 For which good does Qd drop the most Why 0 For a narrowly defined good such as Lucky Brand jeans there are many substitutes khakis shorts other denim brands 0 There are fewer substitutes available for broadly defined goods There aren t too many substitutes for clothing other than living in a nudist colony 0 Lesson Price elasticity is higher for narrowly defined goods than broadly defined ones Example 3 Insulin vs Caribbean Cruises The prices ofboth of these goods rise by 20 For which good does Qd drop the most Why 0 To millions of diabetics insulin is a necessity A rise in its price would cause no decrease in Qd o A cruise is a luxury If the price rises some people will forego it Lesson Price elasticity is higher for luxuries than for necessities Example 4 Gasoline in the Short Run vs Gasoline in the Long Run The price of gasoline rises 20 Does Qd drop more in the short run or the long run Why 0 There s not much people can do in the short run other than ride the bus or carpool In the long run people can buy smaller cars or live closer to where they work Lesson Price elasticity is higher in the long run than the short run 0 The Determinants of Price Elasticity A Summary The price elasticity of demand depends on The extent to which close substitutes are available Whether the good is a necessity or a luxury How broadly or narrowly the good is defined The time horizon elasticity is higher in the long run than the short run 0000 Price Elasticity and Total Revenue Continuing our scenario if you raise your price from 200 to 250 would your revue rise or fall Revenue P x Q A price increase has two effects on revenue 0 Higher P means more revenue on each unit you sell Price Effect 0 But you sell fewer units lower Q due to Law of Demand If you raise your price revenue will fall Quantity Effect Which of these two effects is bigger IT depends on the price elasticity of demand Percentage Change in Q Price elasticity of demand Percentage Change 1n P Revenue P x Q If demand is elastic then price elasticity of demand gt than 1 o change in Q gt change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P so revenue falls igire f flagg for P site Sost to higher revenue dueto lower Q Elastic demand elasticity 18 IfP 200 Q 12 and revenue 250 3 2400 o IfP 250 Q 8 and revenue 2000 200 When D is elastic a price increase T 8 12 Q causes revenue fall If demand is inelastic then price elasticity of demand is lt 1 o change in Q lt change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P so revenue rises In our example suppose that Q only falls to 10 instead of 8 when you raise your price to 250 iquot 3rei9 iial iland for P reV BU W sit s t Now demand is inelastic elasticity 082 to hlgher P gimme IfP 200 Q 12 and revenue 2400 due to If P 250 Q 10 and revenue 2 2500 250 Egg lower Q When D is inelastic a price increase causes revenue to rise 200 j 2 Q 39 Elasticity and Expenditure Revenue With elasticity equal to 1 the tickets elasticity of demand is quotunitquot elastic This means there will be no change in total revenue stays the same since price and quantity demanded are changing by the same percentages P increases 25 QD falls 25 TR remains the same Pharmacies raise the price of insulin by 10 Does total revenue on insulin rise or fall Since demand is perfectly inelastic Q will not fall so revenue rises As a result of a fare war the price of a luxury cruise falls 20 Does luxury cruise companies total revenue rise or fall Revenue P x Q Will not have to calculate on exam but you will need to know what it is the concept and why we use it The fall in P reduced revenue but Q increases which increases revenue Which effect is bigger Since demand is elastic Q will increase more than 20 so revenue rises Price Elasticity of Supply Percentage Change in Q5 Price elasticit of su l y pp y Percentage Change in P Price elasticity of supply measures how much QS responds to a change in P Loosely speaking it measures sellers pricesensitivity Again use the midpoint method to compute the percentage changes 16 8 Example Price elasticity of supply equals 20 You never have to take the absolute value of the elasticity of supply because it will always be positive The Variety of Supply Curves The slope of the supply curve is closely related to price elasticity of supply Rule of thumb The atter the curve the bigger the elasticity The steeper the curve the smaller the elasticity Five different classifications Inelastic ChangeinQ lt10 lt Price elasticity of supply 100 0 Change in P S curve relatively steep Sellers price sensitivity relatively low Elasticity lt 1 Q1 02 Q rises less than 10 Unit Elasticquot changeinQ 10 0 Price elasticity of Supply 2 00 Change in P 10 Elasticity 1 P1 39 39 39 Q1 02 Q rises by 10 Elastic changeinQ gt10 Fri 1 i i f l gt 1 C6 e 351 C ty 0 supp y change in P 10 P2 5 curve relatively at P 1 Sellers price sensitivity relatively high 1 Elasticity gt 1 5 Q1 02 Q rises more than 10 Perfectly Elasticquot change inQ any Pr1ce elast1c1t 0f su l 1nf1n1t y pp y change in P 0 y P 5 curve horizontal Sellers price sensitivity extreme Elasticity infinity Q1 02 0 Changes by anv Perfectly Inelastic changeinQ 0 Pr1ce elast1c1ty of supply W m 3 S curve vertical Sellers price sensitivity none Elasticity 0 621 Q 0 changes by 0 The Determinants of Supply Elasticity The more easily sellers can change the quantity they produce the greater the price elasticity of supply 0 Example Supply of beachfront property is harder to vary and thus less elastic than supply of new cars For many goods price elasticity of supply is greater in th e long run than in the short run because firms can build new factories or new firms may be able to enter the market How the Price Elasticity of Supply Can Vary 5 Supply often becomes less elastic as Q rises dueto capacity limits elasticity 15 I l l l A nunA 12 elasticity gt 1 4 c a A E Other Elasticities Income Elasticity of Demand Measures the response of Qd to a change in consumer income Percent change in Qd Income elasticity of demand Percent change 1n Income Recall from Chapter 4 An increase in income causes an increase in demand for an normal good Hence for normal goods income elasticity gt 0 For inferior goods income elasticity lt 0 CrossPrice Elasticity of Demand measures the response of demand for one good to changes in the price of another good change in Qd for good 1 rossPrice Elasticit of Demand C y change in price of good 2 For substitutes crossprice elasticity gt O eg an increase in price of beef causes an increase in demand for chicken For complements crossprice elasticity lt O eg an increase in price of computers causes decrease in demand for software

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