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# Week 5: Chapter 6 Notes Econ 1011

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This 5 page Class Notes was uploaded by Alex on Thursday October 1, 2015. The Class Notes belongs to Econ 1011 at George Washington University taught by Henry Terrell in Spring 2015. Since its upload, it has received 51 views. For similar materials see Principles of Economics: Microeconomics in Economcs at George Washington University.

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Date Created: 10/01/15

Econ 1011 Elasticity 92815 Chapter 6 l Defining and Measuring Elasticity A For investors to know whether or not they are able to earn a significant profit in a specific business they need to know the price elasticity of demand ll Calculating the Price Elasticity of Demand A B C In terms of ambulance rides as the price for an ambulance ride increases the demand for them decreases In order to turn a quantity demanded curve into a measure of price responsiveness we must calculate the price elasticity of demand Price elasticity of demand ratio of the percent change in quantity demanded to the price change in price as we move along the demand curve The purpose of price changes is to find a measure that doesn t depend on the units in which a good is measured To calculate this we must first calculate the percent change in the quantity demanded and the corresponding percent change in the price as we move along the demand curve 1 o change in quantity demanded change in quantity demanded initial quantity demanded 100 2 o change in price change in price initial price 100 a When the price of ambulance rides increases from 200 to 210 the demand for rides decreases from 10 million to 9 million which yields a change in the quantity demanded of 01 million rides 1 o change in quantity demanded 01 million rides 10 million rides 100 1 b The initial price is 200 and the change in price is 10 yielding a percent change in price of 1 o change in price 10 200 100 5 To calculate the price elasticity of demand we find the ratio of the percent change in the quantity demanded to the percent change in the price 1 Price elasticity of demand o change in quantity demanded o change in price 2 Based on the ambulance ride example a Price elasticity of demand 1 5 02 3 The minus sign has been dropped because the law of demand states that the demand curves have downward slopes so the price and quantity demanded always move in opposite directions a A positive percent change in price leads to a negative percent change in the quantity demanded and vice versa b Price of elasticity is always a negative number When talking about the price elasticity of demand the minus sign is usually dropped and the absolute value is reported When the price elasticity of demand is large consumers change their quantity demanded by a large percentage compared to the percent change in price demand is highly elastic 1 02 represents the fact that the quantity demanded will fall by a relatively small amount when price rises 2 This is an inelastic demand lll An Alternative Way to Calculate Elasticities The Midpoint Method A Price elasticity of demand compares percent change in quantity demanded with the percent change in price Econ 1011 Elasticity 92815 Chapter 6 B Ex You are trying to estimate the price elasticity of demand for gas by comparing gas E F prices and consumption in different countries 1 Gas costs about three times more per gallon in Europe as it does in the US What is the price difference a Price of gas in Europe is 200 higher than the US price of gas in the US is 667 lower than in Europe To avoid calculating different elasticities for increasing and decreasing prices we use the midpoint method Midpoint method change in X change in X average value of X 100 1 X is defined as a Average value of X starting value of X final value of X 2 2 Both percent change in price and percent change in quantity demanded are found using this method Suppose we have data for two points on a demand curve 1 Price elasticity of demand Qg39 Q1 Q Qz2 P2 P1 P1 P22 When finding a price elasticity of demand calculated by the midpoint method drop the minus sign and use the absolute value How Elastic is Elastic A Consider the demand for a good when people pay no attention to the price 1 Snake antivenom 2 Consumers will buy 1000 doses year regardless of the price 3 There would be a vertical line at 1000 doses 4 Percent change in the quantity demanded is zero at any price the price elasticity of demand is zero Perfectly inelastic demand case of a zero price elasticity of demand The opposite extreme occurs when a tiny raise in price causes the quantity demanded to drop to zero or a tiny drop in price causes the quantity demanded to get extremely large Perfect elasticity when the price elasticity of demand is infinite Price elasticity is usually somewhere between the two extremes 1 Elastic price elasticity of demand is greater than 1 2 Inelastic price of elasticity of demand is less than 1 3 Unitelastic price elasticity of demand is 1 A toll bridge the higher the toll the fewer the drivers who use the bridge 1 When the toll is raised form 090 to 110 and the demand curve is unitelastic 20 price rise leads to a fall in the number of cars using the bridge from 1100 to 900 a 20 drop price elasticity of demand is 20 20 1 2 When the toll is is raised from 090 to 110 and the demand curve is inelastic 20 price rise leads to a fall in the number of cars using the bridge from 1050 to 950 a 10 drop price elasticity of demand is 10 20 05 3 When the toll is raised from 090 to 110 and the demand curve is elastic 20 price rise leads to a fall in the number of cars using the bridge from 1200 to 800 a 40 drop price elasticity of demand is 40 20 2 Total revenue the total value of sales of a product equal to the price multiplied by the quantity sold 1 Total revenue price quantity sold 2 1100 drivers use the bridge at a toll of 090 090 1100 990 Price effect after a price increase units sell at a higher price which raises revenue Econ 1011 Elasticity 92815 Chapter 6 J Quantity effect after a price increase fewer units are sold which lowers revenue The overall effect on revenue can go either way 1 If the price effect is the stronger of the two effects revenue goes up 2 If the quantity effect is the stronger of the two effects revenue goes down 3 If the two effects are equal the revenue is unchanged Price elasticity of demand tells what happens to total revenue when price changes 1 Unitelastic increase in price doesn t change total revenue 2 Inelastic increase in price leads to a higher total revenue 3 Elastic increase in price leads to a lower total revenue Price elasticity of demand also predicts the effect of a fall in price on total revenue 1 Price effect of a lower price per unit usually lowers revenue 2 Quantity effect of more units usually raises revenue Which effect dominates depends on the price elasticity 1 Unitelastic the two effects exactly balance 2 Inelastic the quantity effect is dominated by the price effect 3 Elastic the price effect is dominated by the quantity effect V Price Elasticity Along the Demand Curve A B C D E VI Wh A When an economist says that the price elasticity of demand for a product is the mean at the current price the elasticity is For majority of demand curves the price elasticity of demand at one point is different from the price elasticity of demand at other points on the same curve Using a bar graph the height of a bar at each quantity demanded measures the total revenue created at each price When the price is low demand is inelastic When the price is high demand is elastic at Factors Determine the Price Elasticity of Demand There are four main factors that determine elasticity 1 Whether the Good Is a Necessity or a Luxury a The price of elasticity of demand is usually high if the good is a luxury b The price of elasticity of demand for a luxury good is much higher than a necessity because the consumer knows they can live without it The Availability of Close Substitutes a The price elasticity of demand is usually low if there are no close substitutes b The price elasticity of demand is usually high if there are other easily obtainable goods that are similar to the original one Share of Income Spent on the Good a When the good absorbs a significant amount of the consumer s income they usually find a way to reduce their demand when the price increases b People who consumer the good less frequently have a lower amount of their income spent on the good and therefore a lower elasticity of demand Time Elapsed Since Price Change a Price elasticity of demand usually increases as consumers have time to adjust b The longrun price elasticity of demand is usually higher than the shortrun price elasticity of demand 2 4 VII The CrossPrice Elasticity of Demand A B Demand for a good is usually affected by substitutes and complements Change in price of related goods shifts the demand curve of the original good Econ 1011 Elasticity 92815 Chapter 6 C Crossprice elasticity of demand ratio of the percent change in the quantity demanded W D E of one good to the percent change in the price of the other 1 Crossprice elasticity of demand between goods A and B change in quantity of A demanded change in price of B When two goods are substitutes the cross price elasticity of demand is positive 1 Its size is measured by how close of substitutes the goods are a high number indicates the two are close substitutes When two goods are complements the cross price elasticity of demand is negative 1 It s size is measured by how strong of complements the goods are the further from zero the number is the stronger complements the two goods are The sign is very important it toeless whether the goods are complements or substitutes Elasticity is a unitfree measure doesn t depend on units in which goods are measured 1 Elasticity is defined as a ratio of percent changes so confusion over units doesn t occur The Income Elasticity of Demand Income elasticity of demand measure of how much the demand for a good is affected by changes in consumer s incomes 1 Allows us to determine whether a good is inferior of normal 2 Measures how intensely the demand for a good responds to changes in income 3 Income elasticity of demand change in quantity demanded change in income Can be either positive or negative 1 If income elasticity of demand is positive the good is a normal good a Quantity demanded at any price increases as income increases 2 If income elasticity of demand is negative the good is an inferior good a Quantity demanded at any price decreases as income increases Used to predict which industries will grow quickest as incomes of consumers grow Incomeelastic income elasticity of demand for the good is greater than 1 1 As income rises demand for these goods rise faster than income Incomeinelastic income elasticity of demand for the good is positive but less than 1 1 As income rises demand for these goods rise but not as quickly as income IX Measuring the Price Elasticity of Supply A C D Price elasticity of supply defined the same way as the price elasticity of demand no minus sign 1 Price elasticity of supply change in quantity supplied change in price Ex Consider the price of tomatoes 1 Price of tomatoes raises by 10 if the quantity of tomatoes supplied increase by 10 the price elasticity of supply is 1 10 10 unitelastic 2 Price of tomatoes raises by 10 if the quantity of tomatoes supplied increases by 5 the price elasticity of supply is 05 inelastic 3 Price of tomatoes raises by 10 if the quantity of tomatoes suppled increases by 20 the price elasticity of supply is 2 elastic Perfectly inelastic supply a case in which the price elasticity of supply is zero Perfectly elastic supply a tiny increase in price leads to a huge increase in the quantity supplied the price elasticity of supply is more or less infinite X What Factors Determine the Price Elasticity of Supply A The main determinant of the price elasticity of supply is the availability of inputs Econ 1011 Elasticity 92815 Chapter 6 quotquotU 1 The Availability of Inputs a Large when inputs are easily accessible and can be shifted in and out of production at a low cost b Small when inputs are difficult to obtain and can be shifted in and out of production at a high cost 2 Time a Grows larger as producers have more time to respond to a price change b Longrun price elasticity of supply is usually higher than the shortrun Most industries have large price elasticities of supply they can be readily expanded because they don t require special resources Given enough time producers are able to change the amount they produce in response to a price change Shortrun elasticity of supply a few weeks or months Longrun elasticity of supply several years 1 Usually longrun elasticity is larger than shortrun elasticity

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