Chapter 5 “Elasticity and Its Application Chp 1

Principles of Micro Chapter 5: “Elasticity and Its Application ” We Will Learn:    1. 2. The Meaning of the Elasticity of Demand and Supply What Determines the Elasticity of Demand and Supply Elasticity: allows us to analyze supply and demand with greater precision. is a measure of how much buyers and sellers respond to changes in market conditions I. The Elasticity of Demand    price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good How much consumers are willing to move away from the good when its price increases It’s the percentage change in quantity demanded divided by the percentage change in price. Determinants of Price Elasticity of Demand     Availability of Close Substitutes: the more substitutes a good has, the more elastic its demand. Necessities versus Luxuries: necessities are more price inelastic. Definition of the market: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food). Time Horizon: goods tend to have more elastic demand over longer time horizons. Determinants of Price Elasticity of Demand  1. 2. 3. 4. Demand tends to be more elastic (people can move away from the good when its price increases) the larger the number of close substitutes if the good is a luxury the more narrowly defined the market the longer the time period Computing the Price Elasticity of Demand   Price Elasticity of Demand = % change in quantity demanded % change in price Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: (10  8)  100 20% 10  2 (2.20  2.00)  100 10% 2.00 Computing the Price Elasticity of Demand  1. 2. The Midpoint Method: A Better Way to Calculate % Changes and Elasticities it gives the same answer regardless of the direction of the change. The midpoint method involves calculating the % changes by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial level itself. (Q2  Q1) /[(Q2  Q1 ) / 2] Price elasticity of demand = (P2  P1) /[(P2  P1) / 2] Computing the Price Elasticity of Demand  Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: (10  8) 22% (10  8) / 2   2.32 (2.20  2.00) 9.5% (2.00  2.20) / 2 The Variety of Demand Curves   Inelastic Demand - Quantity demanded does not respond strongly to price changes. - Price elasticity of demand < 1 Elastic Demand - Quantity demanded responds strongly to changes in price. - Price elasticity of demand > 1 Computing the Price Elasticity of Demand (100 - 50) ED  (4.00 - 5.00) (100  50)/2 (4.00  5.00)/2 Price 67 percent   -3 - 22 percent $5 4 Demand 0 50 100 Quantity Demand is price elastic The Variety of Demand Curves    Perfectly Inelastic - Quantity demanded does not respond to price changes at all. Perfectly Elastic - Quantity demanded changes infinitely with any change in price. Unit Elastic - Quantity demanded changes by the same percentage as the price. The Variety of Demand Curves  Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. Perfectly Inelastic Demand: Elasticity =0 (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price . . . 0 100 Quantity 2. . . . leaves the quantity demanded unchanged. Inelastic Demand: Elasticity < 1 (b) Inelastic Demand: Elasticity Is Less Than 1 Price $5 4 1. A 22% increase in price . . . Demand 0 90 100 Quantity 2. . . . leads to an 11% decrease in quantity demanded. Unit Elastic Demand: Elasticity = 1 (c) Unit Elastic Demand: Elasticity Equals 1 Price $5 4 1. A 22% increase in price . . . Demand 0 80 100 Quantity 2. . . . leads to a 22% decrease in quantity demanded. Elastic Demand: Elasticity > 1 (d) Elastic Demand: Elasticity Is Greater Than 1 Price $5 4 Demand 1. A 22% increase in price . . . 0 50 100 Quantity 2. . . . leads to a 67% decrease in quantity demanded. Perfectly Elastic Demand: Elasticity = infinity (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 3. At a price below $4, quantity demanded is infinite. Quantity Total Revenue and the Price Elasticity of Demand    total revenue: the amount paid by buyers and received by sellers of a good computed as the price of the good times the quantity sold. TR = P x Q Total Revenue Price $4 P × Q = $400 (revenue) P 0 Demand 100 Q Quantity