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ECON 200 Week 4 Notes

by: Drew Herring

ECON 200 Week 4 Notes ECON200

Drew Herring

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These notes cover chapters 4 and 5. They include mostly definitions, formulas, and examples.
Principles of Micro-Economics
Hossein Abbasi Alikamar
Class Notes
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This 6 page Class Notes was uploaded by Drew Herring on Friday September 23, 2016. The Class Notes belongs to ECON200 at University of Maryland taught by Hossein Abbasi Alikamar in Fall 2016. Since its upload, it has received 40 views. For similar materials see Principles of Micro-Economics in Microeconomics at University of Maryland.


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Date Created: 09/23/16
Chapter 4 Notes  Elasticity    4.0    ​ Introduction ­­ Elasticity  Elasticity​ is a measure of how much consumers and producers w​ ill r ​ eact to changes in  the market, or how​ ​ ensitive they are to market changes. Elasticity explains and measures how  buyers and sellers react to changes in production costs, changes in product cost, and changes in  income. There are two commonly used measures of elasticity, and they have to do with changes  in price of a product. They are:  1. Price elasticity of demand, and  2. Price elasticity of supply    Price elasticity of demand​ is a measurement of how much quantity demanded will  change in response to a change in price of a product. When prices go up or down, the quantity  demande​d will go a​ gainst the price trend. Higher prices = lower quantity demanded, and vice  versa. If changes in price severely impact quantity demanded, the demand curve of that product  is said to h​ ave ​high elasticity. If quantity demanded doesn’t change that much when prices  change, that product’s demand curv ​ e has​ ow elasticity.    4.1   F inding Price Elasticity of Demand   Price elasticity is the ​percentage change​ in the quantity of a good in response to a ​given  percentage change in price. Formulaically, it looks like:    (Equation 4.1  P rice elasti​city of Demand (ε)  =  % change in Quantity demanded    % change in price   How do you calculate percentage change in quantity demanded? All you need is an initial  quantity (Q1) and a final quantity (Q2). Once you have those values, you can plug them into this  equation:    (Q2−Q1) %​  change ​  in quantity = [ Q1 ]×100    Likewise, percentage change in price is represented by:    ​ % change in price = [ (P2−P1) ] × 100    P1   You can remember these formulas by saying “​new​ minus ​old​ over ​old​.”  Price elasticity of demand will always be a negative number. This is because out of  percentage change in quantity and percentage change in price, one of the two must be negative,  because one of the two is decreasing. Think about it, they both go in opposite directions. The  book might not always put the negative sign there, but just remember that it really is representing  a negative number.  Equation 4.1 doesn’t always give us accurate answers, though. A slightly more accurate  formula, called the ​mid­point method​, measures percent change relative to a point ​midway  between two points on a curve. The equation for price elasticity of demand using the mid­point  method is represented here:    ​ (Equation 4.3)            ε    =  (Q 2− Q 1)/[(Q 1+ Q 2)/2]   (P 2− P 1)/[(P 1+ P 2)/2]   Equation 4.3 gives us the same answer whether you move from a low price to a high  price, or a high price to a low price. Therefore, equation 4.3 is a more consistent equation.    4.2  Determinants of Price Elasticity of Demand  Some products have demands that are more elastic than other products. Imagine if for the  months of September through December, Pumpkin Spice Lattes dropped in price from $3 to $1.  Also, pretend that socks fell from $9 down to $3. Obviously, one of the price reductions would  cause a much higher demand, and it isn’t the socks. When it comes to price elasticity of demand,  there are 5 factors that determine how great the change in elasticity will be.  1. Availability of Substitutes ~ If a product with close substitutes experiences an increase in  price, then buyers will just purchase the substitute instead. Substitutes cause greater  elasticity.  2. Degree of Necessity ~ These are goods that people need, and will therefore pay for  whatever the market price is. Examples include air­conditioning, cars, or jackets. People  need these products, so an increase in prices won’t really change the elasticity. Vice  versa, if the prices drop people won’t rush to buy any more of what they already have,  therefore not really changing the elasticity there either.  3. Cost Relative to Income ~ This one is exactly what it sounds like. The book uses a good  example. If consumers spend a very small share of their income on a good, their demand  for the good will be less elastic than otherwise. For example, most people can buy a  year’s supply of salt for about $5. If the price doubled to $10, most people wouldn’t care  that much. Now imagine that a 3­week beach vacation could be had for only $2,500. If  the cost were suddenly doubled to $5,000 a lot less people would go on beach vacations.  Basically, if the cost of a good takes up a large portion of a person’s income, it will be  more elastic.  4. Adjustment time ~ This factor says that the effects of elasticity usually have more  consequences over the long term than the short term.  5. Scope of the Market ~ This factor has to do with categories of goods. A banana might  have high price elasticity of demand, while the category of fruit overall can have low  elasticity of demand.    When demand is ​perfectly elastic​, the demand curve is horizontal, or flat going left to  right. When demand is perfectly elastic, that means that demand is extremely sensitive to price.  Sometimes, demand is ​perfectly inelastic​, and has a vertical demand curve, this means it is a  straight line, going up and down. In this case, quantity demanded doesn’t change no matter the  price.   When demand has an absolute value of elasticity greater than one, the associated demand  is said to be ​elastic​. (Example: Price decreases by 40%....quantity demanded increases by 60%)  When the absolute value of price elasticity of demand is less than one, we say that the  demand is ​inelastic​. (Example: Price decreases by 40%.....quantity demanded increases by 20%)  If the absolute value of elasticity equals 1 exactly, it is called ​unit­elastic​. A unit­elastic  demand curve is a reverse mirror image of price change. If price decreases by 40% for a  unit­elastic good, then quantity demanded increases by exactly 40%.    If you know the elasticity of a product, you can determine whether a price change will  cause total revenue to rise or fall. ​Total Revenue​ is the amount that a firm receives from the sale  of goods and services, calculated as the ​quantity sold​ multiplied by the ​price paid​ for each unit.  For most goods, elasticity varies along the demand curve. Demand tends to be more  elastic when the price is high and more inelastic when price is low. It is unit­elastic precisely in  the middle of a linear demand curve.    4.3    Calculating Price Elasticity of Supply  Price Elasticity of Supply​ is the size of the change in the quantity supplied of a product  ​ when its price changes. It measures ​producers’ responses to a change in price. It tells us how  much quantity supplied changes as we move along the supply curve. It is measured the exact  same way as price elasticity of demand, as shown in this equation:    ​ (Equation 4.4) ​  ​Price Elasticity of Supply =          And with the mid­point method:    ​ (Equation 4.5)    Price Elasticity of Supply =    The elasticity of supply is always going to be positive. This is because it is always found  by dividing a positive by a positive or a negative by a negative.    4.4    Determinants of Price Elasticity of Supply  Three factors affect a supplier’s ability to change the quantity produced in response to  price changes. They are:  1. Availability of Inputs  a. If chocolate suddenly became expensive, chocolate chip cookies would rise in  price.  2. Flexibility of the Production Process  a. Whether or not a producer can efficiently transition from making one product to a  different one. Example: farming.  3. Adjustment Time  a. Gives producers time to produce alternative products.    4.5    Cross­Price Elasticity of Demand  Substitutes for goods seriously impact price elasticity. ​Cross­price Elasticity​ ​of  Demand​ is a measure of how the quantity demanded of a good changes when the price of a  different good changes. An example would be the change in the price of an Apple phone versus  that of an Android, and the resulting change in quantity demanded. Cross­price elasticity of  demand is represented by this equation:  (Equation 4.6)  Cross­Price Elasticity of Demand b/t A & B ​​=  % change in quantity of A demanded For substituted goods, cross­price elasticity of demand is positive.  For complementary goods, cross­price elasticity of demand is negative.    4.6     ​Income Elasticity of Demand  ​ ​ ​   Market equilibrium​ maximizes total possible surplus of all buyers and sellers in the  market. Prices above the market equilibrium reduces total market surplus. Prices below market  equilibrium also reduces total surplus.  The buyers/sellers that are lost when prices deviate from market equilibrium is called  deadweight loss​. In other words, they are the transactions that no longer take place, due to  non­equilibrium prices. 


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