Ec 10A, Chapter 5 Notes
Ec 10A, Chapter 5 Notes Econ 10A
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This 4 page Class Notes was uploaded by Devon Black on Saturday September 17, 2016. The Class Notes belongs to Econ 10A at Harvard University taught by N. Gregory Mankiw in Fall 2016. Since its upload, it has received 6 views. For similar materials see Principles of Economics in Economics at Harvard University.
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Date Created: 09/17/16
Principles of Economics, 7 thed. Chapter 5: Elasticity and Its Application I) The Elasticity of Demand A) The Price Elasticity of Demand and Its Determinants 1) A fall in the price of a good raises the quantity demanded (a) Elasticity reflects how much the quantity demanded is raised (1) Elastic – responds significantly to change (2) Inelastic – doesn’t respond much 2) Availability of Close Substitutes (a) Makes items more elastic because it’s easy to switch from one to the other (b) Ex: butter and margarine 3) Necessities versus Luxuries (a) Necessities are inelastic because you need them (1) Ex: doctor’s visit (b) Whether a good is a necessity or a luxury depends on the preference of the buyer 4) Definition of the Market (a) Narrowly defined markets are more elastic than broadly defined markets (b) Ex: food is a broadly defined market, lots of things can be food (1) Ice cream is more narrowly defined, and you can substitute various desserts for ice cream (i) Vanilla ice cream is even more narrowly defined because you can substitute almost any other flavor for vanilla and the only thing that will be different is the taste and there are other flavors very similar to vanilla 5) Time Horizon (a) The more time that passes, the more elastic a good becomes (b) Ex: gas prices rise (1) People still need to buy gas so at first it’s inelastic (2) Over time, people buy more fuel efficient cars, switch to public transportation, and move closer to where they work (i) A couple of years later, the quantity demanded of gas has fallen significantly B) Computing the Price Elasticity of Demand 1) Price elasticity of demand = % change in quantity demanded/% change in price 2) Price elasticities are technically negative numbers, but we’ll use the absolute value C) The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities 1) Really long formula – look in section notes 2) Gives the same answer, regardless of direction D) The Variety of Demand Curves 1) Elastic > 1 2) Inelastic < 1 (a) The quantity moves proportionally less than the price 3) Unit elasticity = 1 (a) % change in quantity equals the % change in price 4) Elasticity is closely related to the slope of the demand curve (a) The flatter the curve, the more elastic it is 5) 0 elasticity (vertical line) = perfectly inelastic (a) No matter what the price is, the quantity demanded stays the same 6) Infinite elasticity (horizontal line) = perfectly elastic (a) There is only quantity demanded at an exact price and even a slight deviation from this price will drastically change the quantity demanded from infinite to zero E) Total Revenue and the Price Elasticity of Demand 1) If demand is inelastic, then an increase in price will cause an increase in total revenue 2) If demand is elastic, then an increase in price will cause a decrease in total revenue 3) If demand is unit elastic, then total revenue will stay constant when price changes F) Elasticity and Total Revenue along a Linear Demand Curve 1) In a linear demand curve, the slope is constant 2) Elasticity does not stay constant (a) Slope is the ratio of changes in two variables whereas elasticity is the ratio of percentage changes in two variables (b) Low price, high quantity = inelastic (c) High price, low quantity = elastic G) Other Demand Elastics 1) The Income Elasticity of Demand (a) How demand changes as consumer income changes (b) Most goods are normal goods, so as income increases so does quantity demanded (1) Vice versa for inferior goods (c) For any good, even among normal goods, income elasticities are very varied in size (1) Necessities have small income elasticities while luxury items have large income elasticities 2) The Cross-Price Elasticity of Demand (a) Percentage change in Qd for good 1/percentage change in price for good 2 (b) Positivity or negativity of the final number depends whether the goods are complements or substitutes (1) Complements are negative (2) Substitutes are positive II) The Elasticity of Supply A) The Price Elasticity of Supply and its Determinants 1) Higher prices increases the quantity supplied – we want to figure out by how much 2) Elasticity depends on the flexibility of sellers to change how much of a good to produce (a) Beachfront land is inelastic because all of it is bought up already so you can’t produce more (b) Manufactured goods are elastic 3) Key determinant in the price of elasticity is the time period being run (a) Long time = more elastic B) Computing the Price Elasticity of Supply 1) ES= % change in QS/% change in price C) The Variety of Supply Curves 1) Vertical line = perfectly inelastic, zero elasticity 2) As elasticity rises, the supply lines becomes flatter 3) Horizontal = perfectly elastic, infinite elasticity (a) Very small changes in price greatly affect the supply curve 4) For an actual curve, the elasticity varies at different points on the curve III) Three Applications of Supply, Demand, and Elasticity A) Can Good News for Farming Be Bad News for Farmers? 1) We have a wheat farmer who tries to be very productive with his land 2) A university discovers a type of wheat that can increase the amount of wheat you can produce from each acre by 20% (a) Use the supply and demand diagram to figure out whether or not this is good news 3) Supply curve shifts to the right because farmers are able to sell more wheat at any given price (a) Price of wheat falls: Q rises, P falls (b) For an individual farmer, it makes sense to use the new type of wheat but when all the farmers use it, the supply increases substantially and the prices fall 4) Whether or not the total revenue rises or falls depends on the elasticity of demand (a) Inelastic demand causes revenue to fall 5) Some programs subsidize farmers to not plant anything on their land (a) Reduces the supply of farm products raises the prices of farm goods 6) What is good for society is necessarily good for farmers and vice versa B) Why Did OPEC Fail to Keep the Price of Oil High? 1) 1970s: OPEC decides to raise the world price of oil in order to increase the incomes of member countries (a) Price of oil increases by more than 50% in a year (b) Does the same thing again a few years later – total of 150% increase (c) Shifts supply curve to the left because in order to raise the prices, OPEC members produced less oil 2) Oil prices steadily declined about 10%/year (a) Member countries get angry OPEC breaks down oil prices DROP 45% in mid-1990s 3) Short-term: oil’s supply and demand are inelastic because the quantity of oil reserves and oil extraction rates can’t be changed quickly 4) Long-term: oil companies increase their production while consumers buy new efficient cars and start taking public transportation C) Does Drug Interdiction Increase or Decrease Drug-Related Crime? 1) Government arrests more drug sellers and smugglers cost of selling drugs is raised and the quantity supplied is reduced at any price 2) Drug demand is inelastic since they’re addictive, then the increase in prices leads to an increase in total revenue (a) Addicts need to get more money, may resort to stealing increase in drug-related crime 3) Drug education reduces the demand for drugs (shifts to the left), which reduces the price and reduces the quantity sold (a) Reduces both drug-related crime (people aren’t stealing to buy drugs they’re not using) and drug use (b) Lower prices over time, since the longer the time period the more elastic the demand curve is, might lead to an increase in drugs since higher prices might discourage experimentation but in the long term these higher prices would result in fewer drug addicts and less drug- related crime D) Conclusion Vocabulary Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants Price Elasticity of Demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price Total Revenue: the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity of the good sold (P x Q) Income Elasticity of Demand: a measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by percentage change in income Cross-Price Elasticity of Demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good Price Elasticity of Supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price
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