Chapter 5: Economics

Other Elasticities

Income elasticity of demand: measures the response of Qd to a change in consumer income Recall from Chapter 4: An increase in income causes an increase in demand for a normal good. Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0. Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken) For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software) Substitutes Goods typically used in place of one another Positive cross-price elasticity Complements Goods that are typically used together Negative cross-price elasticity Price elasticity of supply measures how much Qs responds to a change in P.

The Determinants of Supply Elasticity

The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars. For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.

The Determinants of Price Elasticity: A Summary

The price elasticity of demand depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon—elasticity is higher in the long run than the short run

The Variety of Demand Curves

The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves....

EXAMPLE 1Breakfast Cereal vs. Sunscreen

The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so a price increase would not affect demand very much. Lesson: Price elasticity is higher when close substitutes are available.

EXAMPLE 3Insulin vs. Caribbean Cruises

The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities.

The Elasticity of Demand

Total revenue, TR Amount paid by buyers and received by sellers of a good Price of the good times the quantity sold (P ˣ Q) For a price increase If demand is inelastic, TR increases If demand is elastic, TR decreases

A scenario...

You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won't sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?

EXAMPLE 4Gasoline in the Short Run vs. Gasoline in the Long Run

The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? There's not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to work. Lesson: Price elasticity is higher in the long run than the short run.

EXAMPLE 2"Blue Jeans" vs. "Clothing"

The prices of both goods rise by 20%. For which good does Qd drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). There are fewer substitutes available for broadly defined goods. (Are there any substitutes for clothing?) Lesson: Price elasticity is higher for narrowly defined goods than for broadly defined ones.

The Elasticity of Demand

Determinants of price elasticity of demand Availability of close substitutes Goods with close substitutes: more elastic demand Necessities vs. luxuries Necessities: inelastic demand Luxuries: elastic demand Determinants of price elasticity of demand Definition of the market Narrowly defined markets: more elastic demand Time horizon Demand is more elastic over longer time horizons

In this chapter, look for the answers to these questions

What is elasticity? What kinds of issues can elasticity help us understand? What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure? What is the price elasticity of supply? How is it related to the supply curve? What are the income and cross-price elasticities of demand?

Elasticity

Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. Definition: *Elasticity* is a numerical measure of the responsiveness of Qd or Qs to one of its determinants. Price Elasticity of Demand *Price elasticity of demand* measures how much Qd responds to a change in P. Loosely speaking, it measures the price-sensitivity of buyers' demand.

The Elasticity of Demand

Computing the price elasticity of demand Percentage change in quantity demanded divided by percentage change in price Use absolute value (drop the minus sign) Midpoint method Two points: (Q1, P1) and (Q2, P2)

Summary

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. *The price elasticity of demand* measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is inelastic if the quantity demanded responds only slightly to changes in the price. Measures how willing consumers are to buy less of the good as its price rises. *Availability of Close Substitutes:* People will buy margarine if there is an increase in the price of butter so it has an elastic demand, but eggs do not. *Necessities versus Luxuries:* Necessities tend have inelastic demans, whereas luxuries have elastic demands. (Doctor visits and sail boats) The elasticity of demand in any market depends on boundaries of the market. Narrowly define markets tend to be more elastic demand than broadly defined markets because it is easier to find substitutes for narrowly defined good. For example, food, is a broad category while ice cream is not. *Price elasticity of demand = Percentage change in quantity demanded/Percentage change in price* *Mid point Method* Divide the change by the initial value. = (Q₂- Q₁)/(Q₂ + Q₁)/(P₂ - P₁)[P₂ + P₁)/2 The flatter the demand curve the greater the price elasticity of demand. *Total revenue* The amount paid by buyers and received by sellers of a good. *The income elasticity of demand:* Measures how the quantity demanded changes as consumer income changes. It is calculated as the percentage change in quantity demanded divided by the percentage change in come: Income elasticity of demand = Percentage change in quantity demanded/Percentage change in income *The cross-price elasticity of demand:* Measures how the quantity demanded of one good responds to a change in the price of another good. = Percentage change in quantity demanded of good 1/Percentage change in the price of good 2. *Price of elasticity of supply:* Measures how much the quantity supplied responds to changes in the price.

Summary

Elasticity measures the responsiveness of  Qd or Qs to one of its determinants. Price elasticity of demand equals percentage change in Qd divided by percentage change in P. When it's less than one, demand is "inelastic." When greater than one, demand is "elastic." When demand is inelastic, total revenue rises when price rises. When demand is elastic, total revenue falls when price rises. Demand is less elastic in the short run, for necessities, for broadly defined goods, and for goods with few close substitutes. Price elasticity of supply equals percentage change in Qs divided by percentage change in P. When it's less than one, supply is "inelastic." When greater than one, supply is "elastic." Price elasticity of supply is greater in the long run than in the short run. The income elasticity of demand measures how much quantity demanded responds to changes in buyers' incomes. The cross-price elasticity of demand measures how much demand for one good responds to changes in the price of another good.