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# Princ Of Microecon ECN 001A

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This 4 page Class Notes was uploaded by Madie Schinner on Tuesday September 8, 2015. The Class Notes belongs to ECN 001A at University of California - Davis taught by Staff in Fall. Since its upload, it has received 44 views. For similar materials see /class/191881/ecn-001a-university-of-california-davis in Economcs at University of California - Davis.

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Date Created: 09/08/15

University of CaliforniaDavis TA Jason Lee Economics lAIntro to Micro Email jawleeucdavisedu Handout 5 I Elasticities A Price Elasticity of Demand As we learned in Chapter 3 of the book there is a clear relationship between the quantity demanded of a good and the price of the good The price elasticity of demand examines the magnitude of the negative relationship AQ Price Elasticity of Demand AP The price elasticity of demand measures the change in the quantity demanded of a good given a change in the price of the good If the price elasticity of demand 2 then this means that a 1 increase in the price will result in a 2 decrease in the quantity demanded By convention since the relationship between P and Q is always negative the price elasticity of demand is calculated as an absolute value Normally to calculate a change we use the following formula x100 new old Change f o For price elasticity of demand we will use a different change formula using the midpoint formula Q2 Q1 lQ1Qzl L 2 Price Elasticity of Demand P 2 P1 Pl P2 L 2 J Where Q1 original quantity 2 new quantity P1 original price P2 new price Here are some important definitions regarding price elasticity of demand If the absolute value of the price elasticity of demand is Greater than 1 then the good has elastic demand the quantity demand is very responsive to a change in price Equal to 1 then the good has unitelastic demand Less than 1 then the good has inelastic demand the quantity demand is insensitive to a change in price There are two special cases for price elasticity of demand 1 When the price elasticity of demand 0 the good is said to be perfectly inelastic The demand curve is a vertical line Any increase or decrease in price will not change the quantity demanded 2 When the price elasticity of demand co the good is said to be perfectly elastic The demand curve is a horizontal line Even the smallest increase in price will cause quantity demanded to fall to 0 Determinants of Price Elasticity of Demand 1 The availability of close substitutes If a good has a lot of substitutes then the quantity demanded would be very responsive to price since if the price goes up one can just switch to a substitute good Thus goods with a lot of close substitutes have elastic demand 2 Passage of time The longer the time since a price change the more likely people would adjust thus the good becomes more elastic as time passes 3 Luxuries vs necessitiesLuxury goods are more elastic since you can afford to live without it If the price of a Hummer triples you re not going to buy the Hummer However if the price of water triples you are still going to pay for water 4 De nition of a market The more narrow the definition of a market the more elastic the good We should expect that Captain Crunch cereal has a high price elasticity since there are many substitutes such as Cheerios Frosted Flakes etc If we use the broader category of breakfast cereal then the price elasticity is lower since there are fewer substitute breakfast foods 5 Share of the good in the Consumer s budget The larger the share of a consumer s budget the more elastic the good Relationship between Price Elastici of Demand and Total Revenue How much does a firm receive when they sell a good As you might expect it is just the quantity of good sold times the price of the good Total Revenue Price X Quantity Price elasticity is important because it can tell firms what would happen to total revenues if they increase or decrease the price they charge for a good If the good has an elastic demand an increase in price will result in lower revenue If the good has an inelastic demand an increase in price will result in higher revenue If the good has an unitelastic demand an increase in price will result in no change in revenue The opposite holds true for a decrease in price B CrossPrice Elasticity of Demand Another relationship we are interested in is the effect of a change of price on 1 good with a related good We quantify this relationship as the crossprice elasticity of demand AQ5 APy 39 It measures the effect of a percentage change in the price of good y on the percentage change in the quantity demanded of good x The sign of the crossprice elasticity of demand is important in determining the nature of the relationship between the two goods Cross Price Elasticity of Demand If the good has a positive crossprice elasticity of demand then the two goods are substitutes If the good has a negative crossprice elasticity of demand then the two goods are complements If the good has a crossprice elasticity of demand 0 then the goods are not related C Income Elasticity of Demand This elasticity shows the effect of a change in income on the quantity demanded of a good We quantify this relationship as the income elasticity of demand AQ Income Elasticity of Demand Ancome For the income elasticity of demand we are interested in both the magnitude and the sign of the elasticity If the income elasticity of demand is positive and greater than 1 then the good is a normal good and is a luxury If the income elasticity of demand is positive and between 0 and 1 then the good is a normal good and is a necessi If the income elasticity of demand is negative then the good is inferior D Price Elasticity of Supply This elasticity examines the positive relationship between the price of the good and the quantity supplied It is similar to the price elasticity of demand AQS Price Elasticity of Supply AP You can use the midpoint formula as well to calculate the change in quantity supplied and change in prices Since the relationship between quantity supplied and price is always positive the price elasticity of supply will always be positive However the magnitude of the elasticity is important If the price elasticity of supply is greater than 1 then the good has elastic supply If the price elasticity of supply is equal to 1 then the good has unitelastic supply If the price elasticity of supply is less than 1 then the good has inelastic supply As with the price elasticity of demand there are two special cases 1 If the price elasticity 0 then the supply curve is vertical and it is said to be perfectly inelastic 2 If the price elasticity 00 then the supply curve is horizontal and it is said to be perfectly elastic Practice Problems 1 Suppose the price of salt per pound rises from 15 cents to 17 cents The quantity demanded decreases from 525 pounds to 475 pounds while the quantity supplied increases from 525 pounds to 600 pounds a Calculate the elasticity of demand for salt b Is the demand for salt elastic unitelastic or inelastic c Calculate the elasticity of supply for salt d Is the supply for salt elastic unitelastic or inelastic 2 Suppose Stan is a usedcar salesman who cuts his car prices by 15 to generate some more sales He finds at the end of the month that his car sales have increased by 12 a What can you say about the price elasticity of demand for Stan s used cars b What will happen to Stan s total revenue 3 It is estimated that the income elasticity of demand for beer is 009 a What will happen to the quantity demanded of beer if your income increases by 10 b Is beer a normal good 4 The state of Delaware recently increased the toll charged on Interstate 95 from 2 to 3 Use the following information to answer the following questions M onth T all Vehicles per month September 2006 200 520000 October 2006 300 440000 a Calculate the price elasticity of demand for the Interstate 95 toll road b How much revenue did the state of Delaware collect from toll roads in September In October c How does your answer in part a relate to part b

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