10/18/2012 9:53:00 AM

10/18/2012 9:53:00 AM

10/18/2012 9:53:00 AM

10/18/2012 9:53:00 AM

Chapter 5 Elasticity and its Application

Elasticity measure of how buyers and sellers respond to changes in
market condition

Ritika

Price Elasticity of Demand and its Determinants

Law of demand states that decrease in price of good = increase in demand Price elasticity of demand measures how much quantity demanded responds to a change in price o Elastic quantity demanded changes substantially when there is a change in price o Inelastic quantity demanded responds slightly to changes in price There are general rules that the determine the price elasticity of demand: o Availability of Close Substitutes Goods with close substitutes are more elastic since its easy for consumers to switch Example: butter and margarine o Necessities vs. Luxuries Necessities have inelastic demands while luxuries have elastic demands o Definition of a Market Depends on how we draw boundaries of the market Narrow markets are more elastic than broad ones Example: beverages is not elastic but wine on the other hand is o Time Horizon Good are more elastic over a longer time horizon Example is gasoline Computing the Price Elasticity of Demand Price elasticity of demand =
% change in quantity demanded

/% change in price

o All the price elasticities are positive numbers, aka absolute value o Larger price elasticity implies greater responsiveness of quantity demanded to price Midpoint Method: A Better Way to Calculate % Changes & Elasticities

Price elasticity of demand =

(q1-q2)/[(q2+q1)/2]

/(p2-p1)/[(p2+p1)/2]

o Book focuses on what elasticity represents rather than how its calculated The Variety of Demand Curves o Classified according to elasticity Elastic when elasticity is >1 Inelastic when elasticity is <1 Unit elastic when elasticity = 1 o Measures how quantity demanded responds to change in price Closely related to slope of demand curve The flatter the demand curve the greater the price elasticity, through a given point The steeper the demand curve the smaller the price elasticity, through a given point Inelastic curves look like I and elastic curves look like E Total Revenue and the Price Elasticity of Demand o Total Revenue the price paid by buyers and received by sellers of a good Total Revenue = Price of Good x Quantity Sold Inelastic graph increase in price = increase in total revenue Elastic graph increase in price = decrease in total revenue Unit Elastic graph total revenue stays the same as price increases Elastic and Total Revenue Along a Linear Demand Curve o Consistency of slope doesnt always equate to the consistency of elasticity Slope is ratio of changes in 2 variables Elasticity is ratio of percentage changes in 2 variables o On a graph: Points with low Price & high Quantity = Inelastic demand curve and vice versa Other Demand Elasticities o The Income Elasticity of Demand Measures how quantity demanded changes as income changes

Income Elasticity of Demand =

% in quantity demanded

/% in income

Normal goods have positive income elasticites while inferior goods have negative income elasticities Necessities have low income elasticities because no matter the income people still buy things like food Luxuries have high income elasticities because when income is low people dont buy things like cars o The Cross Price Elasticity of Demand measures quantity demanded of one good changes as the price of another good changes Cross Price Elasticity of Demand=
% quantity demanded G1

/% price G2

if goods are substitutes, # = positive if good are complements, # = negative The Elasticity of Supply o The Price Elasticity of Supply and its Determinants Price elasticity of supply measures how quantity supplied responds to changes in price o Computing the Price Elasticity of Supply

10/18/2012 9:53:00 AM