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Chapter 6

The document discusses elasticity, which measures how much an economic variable responds to changes in another variable. It defines price elasticity of demand as the percentage change in quantity demanded divided by the percentage change in price. Demand is elastic if this is above 1, inelastic below 1, and unit elastic at 1. Factors like substitutes, time, and budget share impact elasticity. Revenue increases with an inelastic price rise but decreases for an elastic rise, as quantity changes are proportionally larger or smaller than the price change. Cross-price elasticity measures how quantity of one good responds to price of another, and income elasticity measures response to income changes. Price elasticity of supply also measures responsiveness of quantity supplied

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139 views5 pages

Chapter 6

The document discusses elasticity, which measures how much an economic variable responds to changes in another variable. It defines price elasticity of demand as the percentage change in quantity demanded divided by the percentage change in price. Demand is elastic if this is above 1, inelastic below 1, and unit elastic at 1. Factors like substitutes, time, and budget share impact elasticity. Revenue increases with an inelastic price rise but decreases for an elastic rise, as quantity changes are proportionally larger or smaller than the price change. Cross-price elasticity measures how quantity of one good responds to price of another, and income elasticity measures response to income changes. Price elasticity of supply also measures responsiveness of quantity supplied

Uploaded by

vivianguo23
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© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Elasticity Chapter 6 How sensitive are we to changes in prices?

? How much will the quantity demanded change as a result of a price increase or decrease? Elasticity is a measure of how much one economic variable responds to changes in another economic variable. The price elasticity of demand is the responsiveness of the quantity demanded to a change in price, measured by dividing the percentage change in the quantity demanded of a product by the percentage change in the products price. Economists use percentage changes when measuring the price elasticity of demand, which are not dependent on units of measurement. Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price The price elasticity of demand is not the same as the slope of the demand curve, which is sensitive to the units chosen for quantity and price. The price elasticity of demand is always negative, but we will often compare using absolute values. Elastic demand occurs when the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value. Inelastic demand occurs when the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value. Unit-elastic demand occurs when the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value. The midpoint formula is used to ensure that we have only one value of the price elasticity of demand between the same two points on a demand curve. o The formula uses the average of the initial and final quantities and the initial and final prices. o Price elasticity of demand:

1. Calculate average quantity and average price for demand curve D1. 2. Calculate percentage change in the quantity demanded and the percentage change in price for demand curve D1. 3. Divide the percentage change in the quantity demanded by the percentage change in price to arrive at the price elasticity for demand curve D1. 4. Calculate the price elasticity of demand curve D2 between these two prices.

If two demand curves intersect, the one with the smaller slope the flatter demand curve is more elastic, and the one with the larger slope the steeper demand curve is less elastic. A perfectly inelastic demand is the case where the quantity demanded is completely unresponsive to price, and the price elasticity of demand equals zero. A perfectly elastic demand is the case where the quantity demanded is infinitely responsive to price, and the price elasticity of demand equals infinity.

Key determinants of the price elasticity of demand are: o Availability of close substitutes o Passage of time o Luxuries versus necessities o Definition of the market o Share of the good in the consumers budget The availability of substitutes is the most important determinant of price elasticity of demand because how consumers react to a change in the price of a product depends on what alternatives they have. o If a product has more substitutes available, it will have more elastic demand. o If a product has fewer substitutes available, it will have less elastic demand. It usually takes consumers some time to adjust their buying habits when prices change. o The more time that passes, the more elastic the demand for a product becomes. Goods that are luxuries usually have more elastic demand curves than goods that are necessities. o The demand curve for a luxury is more elastic than the demand curve for a necessity. In a narrowly defined market, consumers have more substitutes available. o The more narrowly we define a market, the more elastic demand will be. Goods that take only a small fraction of a consumers budget tend to have less elastic demand than goods that take a large fraction. o The demand for a good will be more elastic the larger the share of the good in the average consumers budget.

Total revenue is the total amount of funds received by a seller of a good or service, calculated by multiplying price per unit by the number of units sold. When demand is inelastic, price and total revenue move in the number of units sold. o An increase in price raises total revenue, and a decrease in price reduces total revenue. When demand is elastic, price and total revenue move inversely. o An increase in price reduces total revenue, and a decrease in price raises total revenue. THEN . . . an increase in price reduces revenue a decrease in price increases revenue an increase in price increases revenue a decrease in price reduces revenue an increase in price does not affect revenue a decrease in price does not affect revenue BECAUSE . . . the decrease in quantity demanded is proportionally greater than the increase in price. the increase in quantity demanded is proportionally greater than the decrease in price. the decrease in quantity demanded is proportionally smaller than the increase in price. the increase in quantity demanded is proportionally smaller than the decrease in price. the decrease in quantity demanded is proportionally the same as the increase in price. the increase in quantity demanded is proportionally the same as the decrease in price.

IF DEMAND IS . . .

elastic

elastic

inelastic

inelastic

unit-elastic

unit-elastic

Cross-price elasticity of demand is the percentage change in quantity demanded of one good divided by the percentage change in the price of another good. An increase in the price of a substitute will lead to an increase in quantity demanded, so the crossprice elasticity of demand will be positive. An increase in the price of a complement will lead to a decrease in the quantity demanded, so the cross-price elasticity of demand will be negative. Cross-price elasticity of demand is important to firm managers because it allows them to measure whether products sold by other firms are close substitutes for their products. The income elasticity of demand is a measure of the responsiveness of quantity demanded to changes in income, measured by the percentage change in quantity demanded divided by the percentage change in income. The price elasticity of supply is the responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the products price.

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