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# Elasticity of Markets Part 1 ECON 201

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This 8 page Class Notes was uploaded by Chip Brothers on Thursday September 29, 2016. The Class Notes belongs to ECON 201 at University of Tennessee - Knoxville taught by Dr. Ken Baker in Fall 2016. Since its upload, it has received 11 views. For similar materials see Intro to Economics in Economics at University of Tennessee - Knoxville.

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Date Created: 09/29/16

Markets IV: Elasticity and its Applications I. Elasticity of Demand Elasticity Elasticity is used to measure the strength of a relationship between any two variables Elasticity measures the… • responsiveness of one variable in response to changes in a related variable • sensitivity of one variable in response to changes in a related variable • Specifically, it measures the % of change in one variable when another variable changes by 1% Price Elasticity of Demand and Supply Price Elasticity of Demand • Measures the responsiveness of Q tD changes in P • We know that when price falls consumers tend to buy more, but how much more? Measures the % change (∆) in Q whenDP changes by 1% Price Elasticity of Supply • Measures the responsiveness of Q tS changes in P • We know that when price falls firms tend to produce less, but how much less? Measures the % change (∆) in Q whenSP changes by 1% E D % change in Q / % chaDge in P E = % change in Q / % change in P S S Possible Values for E aDd E S • 0 < E < 1: Inelastic (Unresponsive) • Q Dor Q S is not responsive/sensitive to changes in price • E = 1: Unit Elastic • Q Dor Q S change by the same percentage as price • 1 < E: Elastic (Responsive) • Q Dor Q )Sis responsive/sensitive to changes in price Interpreting Elasticity: Elastic/Inelastic/Unit Elastic Demand If Ed > 1, then we say “demand for good X is elastic” • For Ed > 1, it must mean that %∆Q <D%∆P • QUANTITY DEMANDED CHANGES BY MORE THAN PRICE • E Df 2 means that Q wDll change by twice as much as P • If P rises by 8%, QDwill fall by 16% If Ed < 1, then we say “demand for good X is inelastic” • For Ed < 1, it must mean that %∆Q =D%∆P • QUANTITY DEMANDED CHANGES BY THE SAME AS PRICE • Ed of 0.25 means that Q wDll change by a fourth as much as P • If P rises by 8%, QDwill fall by 8% If Ed = 1, then we say “demand for good X is unit elastic” • For Ed = 1, it must mean that • QUANTITY DEMANDED CHANGES BY • Ed = 1 means that Q wDll change by the same % as P • If P rises by 8%, QDwill Basic idea: Price Elasticity of Demand Elasticity Factors Elastic: you change the amount you buy a lot when the price changes Inelastic: you change the amount you buy only a little when the price changes Why are some goods elastic and others inelastic? • Why is it that for some goods, people change their spending habits a lot when the price changes, while for other goods people don’t change their spending habits much at all? Elasticity Factors: Necessities vs. Luxuries Necessities Examples? • Bread, milk, medicine, physician services What happens when the price of these change? • Necessities TEND to be inelastic • Ed (physician services): 0.06 Luxuries Examples? • Restaurant meals, jewelry, vacation airline travel What happens when the price of these change? • Luxuries TEND to be elastic • Ed (foreign travel): 4.0 Elasticity Factors: Availability of Substitutes Goods with no close substitutes Examples? • coffee, gasoline, cigarettes What happens when the price of these change? • These TEND to be inelastic • Ed (coffee) = 0.03 • Ed (soda) = 0.9 Goods with many close substitutes Examples? • Flavored coffee, lucky jeans What happens when the price of these change? • These TEND to be elastic • Ed (French vanilla coffee) = 4.0 • Ed (Coke) = 3.8 Elasticity Factors: Portions of your Budget Inexpensive Goods Examples? • mints, gum, toothpicks What happens when the price of these change? • These TEND to be inelastic • E Dtoothpicks): 0.1 Expensive Goods Examples? • cars, washers/dryers What happens when the price of these change? • These TEND to be elastic • E Dcars): 3.6 Elasticity Factors: Short Run vs. Long Run Short Run In the short run, buyers don’t have time to change their habits/wants or find suitable substitutes What happens when the price of these change? • These TEND to be inelastic • E DGasoline, SR): 0.2 • E DAirline Travel, SR): 0.1 Long Run In the long run, buyers have more time to adjust to changes in price and find substitutes What happens when the price of these change? • These TEND to be elastic • E DGasoline, LR): 0.7 • E DAirline Travel, LR): 0.4 Calculating Elasticity Point Method: measures the elasticity at a certain point on the demand curve Arc Method: measures the elasticity between 2 points on the demand curve; measures the elasticity over a range of the demand curve The Midpoint Formula Application of Elasticity of Demand Predicting changes in total revenue, given E and Dhe change in P Suppose… • You work at Starbucks • Price for a small (tall) cup of coffee is $2.50 • Management is considering raising the price to $3.00 • From past data, we estimate E D 1.5 What will happen to Q ? D • Q Dill fall, but by how much? • What are we solving for? o % change in Q D Finding %ΔQ D Since we know Ed and %ΔP, we can find %ΔQd %ΔQ =DE *%DP • Ed = 1.5 (This was given in the problem) • What is %∆P? • The 50 cent increase in price from $2.50 is a 20% increase %∆P = 5/2.5 X 100 = 20% Since we know E Dnd %ΔP, we can now find %ΔQ D %∆Q =DE x D∆P %∆Q =D0.20 %∆Q = 0.30 D Or 30% Therefore, we estimate that a 20% increase in price will cause us to 30% fewer cups of coffee Predicting Changes in Total Revenue Total Revenue (TR) = Price (P) * Quantity (Q) What happens to TR when we raise the price of coffee? • We are charging a higher price, so that tends to raise TR • But, we are selling fewer cups, so that tends to lower TR • What is the final effect on TR?? • Will TR rise or fall? Assume: Old price was $2.50 and we sold 200 cups of coffee/hour TR = P * Q (old) TR = 2.5 x 200 (old) TR = 500/hr • Before the price change, total revenue was $500/hour • What is the new TR? We need to plug in new P and Q Do find the new TR • We know the new P = $3 What is the new Q ? D • We know the old Q wDs 200 (cups/hour) • We determined that the new Q wDll be around 30% less, so what is 30% of 200? 200 X .30 = 60 Therefore, we expect to sell • New expected Q isD140 cups/hour (200-60) • New TR = $3 X 140 = $420/hour • We can expect TR to fall if we increase price

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