Chapter 5 Part 1

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Chapter 5 Part 1

• Elasticity

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Elasticity of Demand

• Elasticity a measure of the responsiveness of
  Qd or Qs to changes in market conditions
• Price Elasticity of Demand measure of how much
  the Qd responds to a change in the P
• Computed as change in Qd
• change in P

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Elastic v. Inelastic Demand

• D for a good is elastic if the Qd responds
  substantially to a change in P
• Examples McDonalds hamburgers
• D for a good is inelastic if the Qd responds only
  slightly to a change in P
• Examples Insulin

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Determinants of Price Elasticity of D

• Availability of Close Substitutes - goods w/
  close substitutes tend to be more elastic goods
  w/o close substitutes tend to be more inelastic
  Ex butter
• Necessities vs. Luxuries necessities tend to
  have inelastic demands luxuries tend to have
  elastic demands Ex gas vs. sailboat

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Contd

• Definition of the Market broad categories have
  fairly inelastic demands, narrowly defined
  markets usually are more elastic Ex food vs.
  Green apple
• Time Horizon goods tend to have more elastic
  demands over long time periods. Ex P of gas
  rises, Qd barely falls for a while, but in the
  long run D falls substantially

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Rank the following items from most to least
elastic

• Beef
• Salt
• European vacation
• Steak
• Honda Accord
• Dijon Mustard

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Results?

• European Vacation
• Honda Accord
• Steak
• Dijon Mustard
• Beef
• salt

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Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as the
  percentage change in the quantity demanded
  divided by the percentage change in price.

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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 would be calculated as

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• Along a D curve, P and Q move in opposite
  directions, which would make price elasticity
  negative.
• We will drop the minus sign and report all price
  elasticities as positive numbers (or just take
  the absolute value)

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The Midpoint Method A Better Way to Calculate
Percentage Changes and Elasticities

• The midpoint formula is preferable when
  calculating the price elasticity of demand
  because it gives the same answer regardless of
  the direction of the price change.
• The midpoint is the number halfway between the
  start end values, the average of those values.

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MIDPOINT FORMULA
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The Midpoint Method A Better Way to Calculate
Percentage Changes and Elasticities

• 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

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Types of Elasticities

• When the price elasticity of demand is gt1, demand
  is elastic
• When the price elasticity of demand is lt1, the
  demand is inelastic.
• When the price elasticity of demand is 1, the
  demand has unit elasticity.

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Another way to think about it

• If the ?Qd() gt ?P() then its ELASTIC
• If the ?Qd() lt ?P() then its INELASTIC

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The Variety of Demand Curves

• Perfectly Inelastic
• Quantity demanded does not respond to price
  changes.
• Perfectly Elastic
• Quantity demanded changes infinitely with any
  change in price.
• Unit Elastic
• Quantity demanded changes by the same percentage
  as the price.

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• 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.
• But it is not the same thing as the slope!

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Perfectly Inelastic Demand
(a) Perfectly Inelastic Demand Elasticity Equals
0
Price
Quantity
0
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Inelastic Demand
(b) Inelastic Demand Elasticity Is Less Than 1
Price
Quantity
0
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Unit Elastic Demand
(c) Unit Elastic Demand Elasticity Equals 1
Price
Quantity
0
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Elastic Demand
(d) Elastic Demand Elasticity Is Greater Than 1
Price
Quantity
0
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Perfectly Elastic Demand
(e) Perfectly Elastic Demand Elasticity Equals
Infinity
Price
Quantity
0
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Total Revenue and Price Elasticity of Demand

• Total revenue is 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
• TR is also called Total Expenditure or TE!!

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Total Revenue
Price
When the price is 4, consumers will demand 100
units, and spend 400 on this good.
Quantity
0
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TR TEST

• If D is inelastic P rises, Qd falls gt TR rises
• P falls, Qd rises gt TR falls
• If D is elastic P rises, Qd falls gt TR falls
• P falls, Qd rises gt TR rises
• If D is unit elastic P rises, Qd falls gt TR
• P falls, Qd rises gt TR

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How Total Revenue Changes When Price Changes
Inelastic Demand
Price
Price
An Increase in price from 1 to 3
leads to an Increase in total revenue from 100
to 240
Quantity
0
Quantity
0
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How Total Revenue Changes When Price Changes
Elastic Demand
Price
Price
An Increase in price from 4 to 5
leads to an decrease in total revenue from 200
to 100
Quantity
Quantity
0
0
Note that with each price increase, the Law of
Demand still holds an increase in price leads
to a decrease in the quantity demanded. It is
the change in TR that varies!