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ECON 200 Chapter 4

by: Lucy Notetaker

ECON 200 Chapter 4 ECON 200

Lucy Notetaker

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These notes cover Chapter 4: Elasticity
Principles of Economics: Microeconomics
Dr. Robert Schwab
Class Notes
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This 5 page Class Notes was uploaded by Lucy Notetaker on Sunday September 11, 2016. The Class Notes belongs to ECON 200 at University of Maryland taught by Dr. Robert Schwab in Fall 2016. Since its upload, it has received 137 views. For similar materials see Principles of Economics: Microeconomics in Economics at University of Maryland.


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Date Created: 09/11/16
ECON 200 Chapter 4: Elasticity Is anyone an avid coffee drinker? Is anyone a consistent Starbucks customer? Well I don’t know about you guys, but the price of Starbucks has gone through the roof over the years. I recently bought a macchiato and the price with tax was over 5 dollars. So when will the price of a cup of coffee be too much for a previous Starbucks enthusiast? That’s this chapter…I present to you- Elasticity! What is Elasticity? Elasticity: a measure of how much consumers and producers will respond to a change in market conditions - It’s no secret that if the price of a latte rose to ten dollars for a tall, you would buy less lattes. But, would you buy one less a week or go off of them completely. That’s elasticity (quantity demanded solves “if you would”, but elasticity solves “by how much?”) - The Four common measure of elasticity 1. Price Elasticity of Demand 2. Price Elasticity of Supply 3. Cross Price Elasticity of Demand 4. Income Elasticity of Demand - I promise I will define these all below Price Elasticity of Demand Price Elasticity in Demand: the size of the change in the quantity demanded of a good or a service when it’s price change - How sensitive are people to price change? If an increase in a dollar makes them boycott a product then the product is more elastic, whereas if a five dollar increase only makes a marginal difference in demand then it’s less elastic How to Calculate - Start by drawing the demand curve, and then locate two different points on the line. - Observe the quantity and price for both points - Then we use this formula to calculate price elasticity - PE=%change in quantity demanded/% change in P *Percent change is found by subtracting Q1 from Q2 then dividing by Q1 and multiplying by 100, in that order (replace Q with P for price) - Price Elasticity will always be a negative number - Price and demand move in opposite directions, so even if you don’t see a negative sign, it’s there…use your imagination The Midpoint Method - I personally like the first method, but if you hated that then here’s another option - But, here’s a fatal error, the price elasticity is different depending on which way you go. Example: if I change the cost of a shirt from 2 dollars to 10 dollars my price elasticity of demand will be different than if I put a $10 shirt on sale for $2) Mid-Point Method: method that measures percentage change in demand (or supply) relative to a point midway between two points on a curve - PE of demand=[(Q2-Q1)/((Q1+Q2)/2)]/[(P2-P1)/((P2+P1)/2)] - Okay that’s the scariest formula ever on Word, but let me explain it to make sense of it. - First assign point 1 and point 2 to keep things consistent - The top is quantity, so follow the subtraction with regards to respected points - The second part of the numerator is just the midpoint formula - Then divide by the bottom, which is the exact same thing, just with price instead of quantity - This formula gives you the same number for price increase and decrease Determinants of Price Elasticity of Demand - It’s not just price that affects sensitivity to price changes. Here are the non price factors 1. Availability of Substitutes: If there are substitutes, the product will be more elastic because customers have an alternative. An example would be a cheeseburger. If McDonald’s hikes up the price, there is always Five Guys. 2. Degree of Necessity: Necessities are less elastic, because people need them so price won’t really change that. If I hike up the price of your water bill, I can almost guarantee you aren’t going to cut off water to your house. 3. Cost Relative to Income: If a customer only spends a small percentage of their income on a good, it will be less elastic. Are you ever surprised when you run out of baking soda? It’s because you rarely buy it…it lasts a long time. This product would not be very elastic. 4. Adjustment Time: Elasticity increases as time increases. An example would be the price of rice. If you go to the grocery store in a pinch and see that rice is double the price, you might still buy it because you need a quick dinner and that’s you’re specialty. Overtime though, if the price stays high, you may start experimenting with quinoa and couscous then rice won’t be necessary. 5. Scope of the Market: Lots of people define certain items to have different elasticity depending on the market of that item. For example, a Ferrari probably has a high elasticity, but a car has a relatively low elasticity because many people rely on a car for daily transportation. Using Price Elasticity of Demand Perfectly Elastic: Demand curve is horizontal, so demand can be any quantity at a given price, but will drop to zero if price increases Perfectly Inelastic: Demand Curve is vertical; quantity demanded is always the same, no matter what the price - Economics are very rarely perfect, so let’s get back to reality - There are three scenarios 1. Elastic: Demand that has an absolute value of elasticity greater than one (40% change in price leads to 50% change in quantity demanded). These are sensitive goods like ruby bracelets 2. Inelastic: When the absolute value of elasticity is less than 1 (50% change in price leads to a 40% change in quantity demanded). A good like electricity would be an example of this 3. Unit Elastic: Demand that has an absolute value of elasticity exactly equal to 1 (40% change in price leads to a 40% change in quantity demanded). Total Revenue: the amount a firm receives from the sale of goods and services, calculated as the quantity sold multiplied by the price paid for each unit. - That’s wordy, so let’s say I sell massage chairs for 500 dollars and sell 5 of them. Multiply 500 x 5, that’s total revenue - Price increases affect revenue in two ways 1. Quantity Effect: decrease in revenue because you sell fewer units 2. Price Effect: Increase in revenue because you get a higher price for each unit sold - It’s a matter of which one “beats out” the other one - Back to Elasticity: An elastic item will cause revenue to drop, and an inelastic item will cause revenue to go up - *note elasticity is for two specific points on the curve. If we raise the price from 3 dollars to 3.50 it will not be the same as 4 dollars to 4.50 - Demand tends to be more elastic when price is high than when it is low (takes us back to “Cost Relative of Income”) - Slope is not elasticity, a steeper slope does not mean something is more elastic - Same slope can easily have a different elasticity between two points - Revenue is a curve rather than a line, you want to hit the peak of the “hill” where prices increase leads to an increase in revenue, but don’t overdo it or else quantity demanded starts to plummet - I hate to say memorize, but try and memorize these “rule” bullets. It will help you in the long run. Price Elasticity of Supply Price Elasticity of Supply: the size of the change in the quantity supplied of a good or service when it’s prices change - This measures the producers responsiveness to change rather than the consumer - Back to Chapter 3: When price rises, quantity supplied rises and vice versa when prices fall - Remember all those formulas from quantity demanded, well good news…you get to use them again. - Find two points on the SUPPLY curve and use either the first formula or the midpoint formula (your choice, but remember the midpoint formula carried more accuracy when moving different directions. - Here’s that midpoint formula so you don’t have to scroll up… - PE of supply=[(Q2-Q1)/((Q1+Q2)/2)]/[(P2-P1)/((P2+P1)/2)] - *Note, the Price elasticity of supply will always be positive because supply and price move the same way - All that elasticity jazz (elastic, inelastic, perfectly elastic) it all holds true for supply too (perks of using the absolute value) Determinants of Price Elasticity of Supply - Price Elasticity of Supply is going to come from whether or not the supplier is able to change the quantity produced in response to the price 1. Availability of Inputs: If the producer has a good that is hard to obtain (say, diamonds) then the price will need to be very high for him/her to mine more. 2. Flexibility of the Production Process: If the solution to a price increase is just plant more then it will be very elastic, but say the production is very difficult like drilling holes in diamonds. It takes a specialized drill, so the product would be inelastic. 3. Adjustment Time: Supply is more elastic over long periods of time, than short periods of time. Think of a class that fills up easily. In the short run, you can’t do much. Sorry the seats are full, but in the long run, sections can be added or a bigger lecture hall can be used. Other Elasticity Cross Price Elasticity of Demand: a measure of how the quantity demanded of one good changes when the price of a different good changes - Let’s say that you have two choices for shaving. You can use shaving cream of shaving gel. Shaving gel prices go down, while shaving cream is still high. You enjoy using both. Comparing how this price change affects the other product on the market is the cross price elasticity of demand. - Formula (first assign one product A and the other B) - CPED between A and B=(% change in quantity demanded for A)/ (% change in price B) - If they are substitutes, it should be positive, but if they are complements it should be negative - From there you can tell strength. A strong substitute that is almost identical to first problem, you’ll get a high positive number, but a strong complement whereas you need one to operate another will be a very low negative Income Elasticity of Demand: a measure of how much the quantity demanded changes in response to a change in consumer’s income - Formula is IED=(%change in quantity demanded/%change in income) - Normal-Luxury goods will be more elastic than just normal goods (Frappuccino vs. coffee) - Income elasticity is negative for inferior goods and the larger the negative, the more inferior the good - If you happen to crack open the chapter, page 94 has a great table that sums everything up. That was 4 dense pages, so go take a stretching break. You’ll still be working on your elasticity. Have a great night!


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