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ECON1: Lecture 6 (10/11/16)

by: Viola You

ECON1: Lecture 6 (10/11/16) ECON 1

Viola You

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Chapter 5, first half.
Principles of Economics
R. Rojas
Class Notes
Economics, Microeconomics
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This 11 page Class Notes was uploaded by Viola You on Tuesday October 11, 2016. The Class Notes belongs to ECON 1 at University of California - Los Angeles taught by R. Rojas in Fall 2016. Since its upload, it has received 3 views. For similar materials see Principles of Economics in Economics at University of California - Los Angeles.


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Date Created: 10/11/16
*Midterm: Chapters 1­5 Chapter 5 Example Scenario: ● Business designing websites. $200 per website, 12 per month. ● Your costs are rising (including opportunity cost of time), you consider raising  price to $250 ● Law of demand says you won’t sell as many websites if you raise your price. ○ Some are loyal customers and stay, some leave because price is  too high ● Q: How many fewer websites? How much will your revenue fall, or might it  increase? Define Elasticity ­ A numerical measure of the responsiveness of  QD  or  S   to one of its  determinants.  ● Elasticity measures how much one variable responds to changes in another  variable. ● Example: One type of elasticity measures how much demand for your websites  will fall if you raise your price.  Elasticity of Demand ● We know there is an inverse relationship between price and quantity demanded. ○ But how much does quantity demanded change when price  changes? ● Define Elastic ­ A demand curve is elastic when an increase in price reduces the  quantity demanded a lot (and vice versa). ● Define Inelastic ­ A demand curve is inelastic when the same increase in price  reduces quantity demanded just a little. Example: Laptop price is up at 10% vs pencil price is up at 10% ● Greater change in how much is demanded for laptop, not much change for  pencils ● Laptop is elastic ● Pencils are inelastic Elasticity Rule ELASTICITY =/= SLOPE But: If two linear demand (or supply) curves run through a common point, then at any given  quantity the curve that is Flatter is More Elastic.  Determinants of the Elasticity of Demand 1. Availability of Substitutes 2. Time Horizon 3. Category of product (specific or broad) 4. Necessities vs Luxuries 5. Purchase Size ○ In terms of the item you’re purchasing and level of income 1. Availability of Substitutes ● VERY IMPORTANT ● Works for both when prices go up or down ● Fewer substitutes makes it harder for consumers to adjust Q when P changes…  so demand is inelastic ● Many substitutes = switching brands when prices change is easy, so demand is  elastic Example 1: When patent expires on brand-name drug and 5 generic drugs come on market, what happens to elasticity of demand? → IT RISES ● More substitutes, more to choose from Example 2: Breakfast cereal vs sunscreen ● Price of both goods rise 20%. Which good does Q  droD most? Why? ● Breakfast cereal has close substitutes (pancakes, waffles, leftovers), so buyers  can easily switch if the price rises ○ Basically, we can choose to eat anything else for breakfast ● Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises ○ Hats, umbrellas, etc. don’t quite substitute what sunscreen can do  directly to your skin Lesson: Price elasticity is higher (greater quantity change = flatter slope) when close  substitutes are available 2. Time Horizon ● Time horizon matters ● Less time to adjust means lower elasticity → STEEPER ● Over time consumers can adjust their behavior by finding substitutes (making more elastic) → FLATTER Example 3: Gasoline in the short run vs long run ● Prices of gas rises 20%. Does Q  dDop more in the short run or long run? Why? ○ There’s not much people can do in the short run, other than ride  bus or carpool ○ In the long run, people can save and buy smaller cars or live  closer to where they work ● Lesson: Price elasticity is higher in the long run than the short run 3. Category of Product (Narrow vs Broad) ● The classification of the good matters ○ The less specific the classification, the fewer substitutes there  are (making demand inelastic)  ○ And vise versa ○ Ex: The elasticity of demand is higher for “lettuce” (very specific)  than for “food” (broad) Example 4: Blue jeans vs clothing ● Prices of both goods rise by 20%. For which good does Q  droD the most? Why? ○ Jeans would drop most. ○ You buy clothes, but you don’t necessarily need jeans. ○ For a narrowly defined good such as blue jeans, there are many  substitutes (khakis, shorts) ○ Fewer substitutes available for broadly defined goods (there aren’t too many substitutes for clothes) Lesson: Price elasticity is higher for narrowly defined goods than for broadly defined ones.  4. Necessities vs Luxuries ● The nature of the good to the consumer can also affect the elasticity of demand. ○ For necessities, we do not change Q much when P changes. ○ tend to have inelastic demands ● For luxuries, we are more sensitive to P changes. ○ tend to have elastic demands Example 5: Insulin vs. Caribbean Cruises ● The prices of both goods rise by 20%. For which good does Q  drDp the most?   Why? ○ To millions of diabetics, insulin is a necessity.  ○ A rise in its price would cause little or no decrease in demand. ○ A cruise is a luxury.  If the price rises, some people will forego it.  Lesson: Price elasticity is higher for luxuries than for necessities 5. Purchase Size ● The size of the purchase (relative to our budget) matters ○ We are less sensitive to price changes when the good feels  cheap. ○ We are more sensitive to price changes when the good feels  expensive. Price Elasticity of Demand Define Price Elasticity of Demand (E ) ­ Measures how much Q responds to a change in price  D D  (P) ● Loosely speaking, it measures the price­sensitivity of buyers’ demand Example: Price of oil increases 10% and over a few years, quantity demanded falls 5%. Long  run elasticity of demand for oil is: ● Negative slope Along a D curve, P and Q move in opposite directions, which would make price elasticity  negative.  ● If price goes down and quantity of demand increases, the slope stays the same, but the elasticity isn’t quite the same Elasticity of demand is always NEGATIVE, so we typically drop the negative sign and use  absolute value instead ● If the |ED| < 1, the demand curve is inelastic ● If the |ED| > 1, the demand curve is elastic ● If the |ED| = 1, the demand curve is unit elastic Variety of Demand Curves ● Price of elasticity of demand is closely related to slope of the demand curve Rule of thumb:  ● The flatter the curve, the bigger the elasticity. ● The steeper the curve, the smaller the elasticity.  Examples of Price Elasticities: ● Eggs = 0.1 ● Healthcare = 0.2 ● Housing = 0.7 ● Beef = 1.7 ● Restaurant meals = 2.3 ● Mountain Dew = 4.4 Needs are less elastic, and luxuries are more elastic. ● Less substitutes = less elastic Elasticity of a Linear Demand Curve The slope of a linear demand curve is  constant, but its elasticity is not Price of Elasticity Demand using Midpoint Formula To erase natural bias associated with choice of base point, calculate elasticity using Midpoint  Formula: Example: Initial price is $10, quantity demanded is 100. Price rises to $20, quantity demanded is 90.  Elasticity of Demand and Total Revenue A firm’s revenues are equal to [price per unit] x [quantity sold] Revenue (R) = Price (P) x Quantity (Q) Elasticity of demand directly influences revenue when price of good changes. Using very first example about designing websites: ● If you raise your price from $200 to $250, would your revenue rise or fall? ○ Revenue = P x Q ● Price increase has two effects on revenue:  1. Higher P → more revenue on each unit you sell 2. BUT you sell fewer units (lower Q) due to law of demand ● ^ which of these two have a bigger effect on revenue? ○ Depends on elasticity of demand [TO BE CONTINUED]


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