1 MICRO ECONOMICS~ CHAPTER FOUR CHAPTER FOUR PRICE ELASTICITY OF DEMAND You know that when supply increases, the equilibrium price falls and the equilibrium quantity increases THE PRICE ELASTICITY OF DEMAND~ is a units free measure of the responsiveness of the quantity demanded of a good to change in its price when all other influences on buying plans remain the same CALCULATING PRICE ELASTICITY OF DEMAND Formula: Price of elasticity of demand= Percentage change in quantity demanded Percentage change in price = %ΔQ %ΔP Proportionate change in: %ΔP= (ΔP/P average) x100 (price) %ΔQ= (ΔQ /Q average) x100 (quantity demanded) To calculate the price of elasticity of demand we express the change in price as a percentage of the average price and the change in the quantity demanded as a percentage of the average quantity. By using the average price and average quantity, we calculate the elasticity at a point on the demand curve midway between the original point and the new point. AVERAGE PRICE AND QUANTITY Average price and average quantity give the most precise measurement of elasticity (at the midpoint between the original price and the new price). By using percentages of the average price and average quantity we get the same value for the elasticity regardless if the price rises or falls. PERCENTAGES AND PROPORTIONS Elasticity is the ratio of two percentage changes. A percentage change is a proportionate change multiplied by 100. A UNITS FREE MEASURE Elasticity is a unit free measure because the percentage change in each variable is independent of the units in which the variable is measured. The ratio of the two percentages is a number without units.
2 MINUS SIGN AND ELASTICITY When the price of a good rises, the quantity demanded decreases. Because a positive change in price brings a negative change in the quantity demanded, the price elasticity of demand is a negative number but it is the magnitude or absolute value of the price elasticity of demand that tells us how responsive the quantity demanded is. Compare price elasticity s of demand we must use the magnitude of the elasticity and ignore the minus sign. INELASTIC AND ELASTIC DEMAND The quantity demand is constant regardless of the price. If the quantity demanded remains constant when the price changes, then the price elasticity of demand is zero and the good is said to have~ PERFECTLY INELASTIC DEMAND. If the percentage change in the quantity demanded equals the percentage change in the price, then the price elasticity equals1 and the good is said to have a~ UNIT ELASTIC DEMAND. Between the other to cases, there is the general case in which the percentage change in the quantity demanded is less than the percentage change in the price. In this case, the price elasticity of demand is between zero and 1 and the good is said to have in~ INELASTIC DEMAND. (Foods and shelter) If the quantity demanded changes by an infinitely large percentage in response too a tiny price change, then the price elasticity of demand is infinity and the good is said to have~ PERFECTLY ELASTIC DEMAND. Between the two cases before the general case in which the percentage change in the quantity demanded exceeds the percentage change in price. In this case, the price elasticity of demand is greater than 1 and the good is said to have an~ ELASTIC DEMAND (automobiles and furniture). ELASTICITY ALONG A LINEAR DEMAND CURVE Elasticity and slope are NOT the same. A linear demand curve has a constant slope but a varying elasticity. At prices above the midpoint, demand is elastic. At prices below the midpoint prices are inelastic. LOOK AT THE EXAMPLE ON PAGE 87 TO UNDERSTAND THE CALCULATIONS!!!! TOTAL REVENUE AND ELASTICITY TOTAL REVENUE~ from the scale of a good equals the price of the good multiplies by the quantity sold. When a price changes, total revenue also changes. BUT A CUT does not always decrease total revenue Depends on elasticity o If demand is elastic, a 1% price cut increases the quantity sold by more o than 1% and total revenue increases If demand is inelastic, a 1% price cut increases the quantity sold by less than 1% and total revenue decreases o If demand is unit elastic, a 1% price cut increases the quantity sold by 1% and total revenue does not change
3 A price cut in the elastic range brings an increase in total revenue o The percentage increase in the quantity demanded is greater than the percentage decrease in price. A price cut in inelastic range brings a decrease in total revenue The percentage increase in the quantity demanded is less than the percentage decrease in price. At unit elasticity, total revenue is at a maximum. THE TOTAL REVENUE METHOD~ is a method of estimating the price elasticity of demand by observing the change in total revenue the results from a change in the price, when all other influences on the quantity sold remain the same. o If a price cut increase total revenue, demand is elastic o If a price cut decreases total revenue, demand is inelastic o If a price cut leaves total revenue unchanged, demand is unit elastic YOU RE EXPENDITURE AND YOUR ELASTICITY When a price changes, the change in your expenditure on the good depends on your elasticity of demand o If demand is elastic, it increases the quantity you buy and your expenditure on the item increase o If demand is inelastic, increases the quantity you buy and your expenditure o on the item decreases If demand is unit elastic, it increases the quantity you buy and your expenditure on the item does not change. If you spend more when price falls= demand elastic, if you spend the same amount= demand unit elastic, if you spend less=demand inelastic THE FACTORS THAT INFLUENCE THE ELASTICITY OF DEMAND Closeness of substitutes The closer the substitute for a good or service, the more elastic is the demand for it. The degree of substitutability depends on how narrowly we define a good. A necessity has poor substitutes and is crucial for a well being (inelastic demand). A luxury has many substitutes (elastic demand). Proportion of income spent on the good Other things remaining the same, the greater the proportion of income spent on a good, the more elastic is the demand for it. Time elapsed since price change The longer the time that has elapsed since a price change, the more elastic is demand.
4 MORE ELASTICITIES OF DEMAND CROSS ELASTICITY OF DEMAND CROSS ELASTICITY OD DEMAND~ is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same. Cross elasticity of demand= %change in quantity demanded %Change in price of a substitute Or complement The cross elasticity of demand can be positive or negative. Positive=substitute, negative= complement A rise in the price of an object brings an increase to the demand for its substitute product, the cross elasticity of demand for the substitute with respect to the price of the original product is positive. Both the product and quantity change in the same direction. A rise in the price of a product brings a decrease in the demand for its compliment, the cross elasticity of the compliment with respect to the price of the original product is negative. The price and quantity change in opposite directions The magnitude of the cross elasticity of demand determines how far the demand curve shifts. The larger the cross elasticity (absolute value), the greater is the change in demand and the larger the shift in the demand curve. INCOME ELASTICITY OF DEMAND~ Is a measure of the responsiveness of the demand for a good or service to change in income, other things remaining the same Income elasticity of demand= %change in quantity demanded %Change in income Income Elastic Demand When the demand for a good is income elastic, the percentage of income spent on that good increases as income increases. Income Inelastic Demand When the demand for a good is inelastic, the percentage of income sent on that good decreases as income increases. Inferior Goods If the income elasticity of demand is negative, the good is an INFERIOR good. The quantity demanded of an inferior good and the amount spent on it DECREASE when income INCREASES. Low income consumers buy most of these products (potatoes, rice). ELASTIC OF SUPPLY
5 CALCULATING THE ELASTICITY OF SUPPLY ELASTICITY OF SUPPLY~ measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. Elasticity of supply= %change in quantity supplied % Change in price No matter how steep the supply curve is, if it is linear and passes through the origin, supply is unit elastic. If there is a price at which the sellers are willing to offer any quantity for sale, the supply curve is horizontal and the elasticity of supply is infinite, which is perfectly elastic. If the quantity supplied is fixed regardless of the price, the supply curve is vertical and the elasticity of supply is zero, this is perfectly inelastic. THE FACTORS THAT INFLUENCE THE ELASTICITY OF SUPPLY Resource Substitution Possibilities Some goods and services can be produced only by using unique or rare productive resources= low or perhaps zero elasticity. Other goods and services can be produced by using commonly available resources that could be used for many task= high elasticity supply. (When a good is produced in many different countries (beef) the supply of the good is highly elastic) The quantity produced can be increased but only by incurring a higher cost if a higher price is offered, the quantity supplied increases. Goods and services have elasticity between zero and infinity. Time Frame For the Supply Decision To study the influence of the amount of time elapsed since a price change, three time frames of supply: Momentary Supply: When the price of a good changes, is the immediate response of the quantity supplied is determined by the momentary supply of that good. When you don t have an option/ control it is perfectly inelastic momentary supply. When you have a control you would create a perfectly elastic momentary supply. REFEERNCE PAGE 96 FOR A GOOD EXAMPLE!!!!!! Short run supply: The response of the quantity supplied to a price change when only some of the possibilities adjustments to production can be made is determined by short run supply. Most goods have an inelastic short run supply. Increases output short run= overtime or additional workers. Decrease their output short run= lay of workers, reduce hours Long run Supply: The response of the quantity supplied to a price change after all the technologically possible ways of adjusting supply have been exploited is determined by long term supply. Most goods it is elastic or perfectly elastic.
6 MY ECON LAB The supply of apples in the short run will be less elastic than the supply in the long run and more elastic then the supply today If the cross elasticity of demand for a donut with respect to the price of a chocolate chip cookie is positive, then donuts and chocolate chip cookies are substitutes If the cross elasticity of demand for golf clubs with respect to the price of a golf lesson is negative, then golf clubs and golf lessons are complements o The closer the substitutes for a good or service, the more elastic is demand o The greater the proportion of income spent on a good, the more elastic is o demand The longer the time that has elapsed since a price change, the more elastic is demand In the market for farm crops momentary supply is less elastic than short run supply In the market for farm crops, short run supply is less elastic than long run supply The demand for air travel between two cities doubles. The elasticity of the supply of air travel between these cities will become more elastic, the longer the time since demand doubled