Chapter 5 (Microeconomics) Elasticity and its Application

"Perfectly elastic demand"

-(any %)/(0%) = infinity -Demand curve = horizontal -Consumers' price sensitivity : extreme -Elasticity : infinity

Price Elasticity of Demand continued

-Along a demand curve, price and quantity move in opposite directions, which would make price elasticity negative. We wil drop the minus sign and report all price elasticities as positive numbers

"Elastic Demand"

- (>10%/10%) >1 -Demand curve: relatively flat -Consumers' price sensitivity: relatively high -Elasticity > 1

Price Elasticity and Total Revenue

-Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q -A price increase has two effects on revenue: -Higher P means more revenue on each unit you sell. -But you sell few units due to law of demand -Which of these two effects is bigger? It depends on the price elasticity of demand.

Basic Idea of Elasticity

-Elasticity measures how much one variable responds to changes in another variable -One type of elasticity measures how much demand for your websities will fall if you raise your price -Elasticity is a numerical measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

Time Horizon

-Goods tend to have a more elastic demand over longer time horizons. When the price of gasoline rises, the quantity of gasoline demanded falls only slightly in the first few months. Over time, however, people buy more fuel-efficient cars, switch to public transportation, and move closer to where they work. Within several years, the quantity of gasoline dmeanded falls more substantially

Price Elasticity and Total Revenue continued

Price Elasticity of Demand = (% change in Q)/(% change in P) Revenue = P X Q -If demand is elastic, then price elasticity of demand > 1 -% change in Q > % change in price -The fall in revenue from lower quantity is greater than the increase in revenue from higher prices, so revenue falls -When demand is elastic, a price increase causes revenue to fall. -If demand is inelastic, then price elasticity of demand < 1 -% change in Q < % change in P -The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises -When Demand is inelastic, a price increase causes revenue to rise

"Unit elastic demand"

-Demand curve = intermediate slope -Consumers' price sensitivity : intermediate -Elasticity = 1

The Variety of Demand Curves

-Economists clasify demand curves according to their elasticity. Demand is considered elastic when the elasticity is greater than 1, which means the quantity moves proportionately more than the price. Demand is considered inelastic when the elasticity is less than 1, which means the quantity the quanity moves proportionately less than price. If the elasticity is exactly 1, the percentage change in quantity equals equals the percentage change in price, and demand is said to have unit elasticity. Because the price elasticity of demand measures how much quantity demanded responds to changes in the price, it is closely related to slope of the demand curve. The flatter the demand curve that pases through a given point, the greater the price ealsticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand.

Elasticity

-Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. When studying how some event or policy affects a market, we can discurss not only the direction of the effects but also their magnitude.

Availability of Close Substitutes

-Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. For example, butter and margarine are easily substitutable. A smal increase in the price of butter, assuming the price of margarine is held fixed, causes the quanity of butter sold to fall by a large amount. By contrast, because eggs are a food without a close substitute, the demand for eggs is less elastic than the demand for butter. A small increase in the price of eggs does not cause a sizable drop in the quantity of eggs sold

Elastic and Inelastic Trick

-Inelastic curves, looke like the letter I. Big change in price doesn't affect quantity demanded.

Necessities versus Luxuries

-Necessities tend to have inelastic demands, whereas luxuries have elsatic demands. When the price of sailboats rises, the quantity of sailboats demanded falls substantially. The reason is that most people view doctor visits as a necessity and saiboats as a luxury.

Price Elasticity of Demand

-Price elasticity of Demand = (% change in quantity demanded)/(% change in price) -Price elasticity of demand measures how much quantity demanded responds to a change in price -Loosely speaking, it measures the price sensitivity of buyers' demand

Perfectly inelastic demand (one extreme case)

-Price elasticity of demand = % change in Q/% change in P = 0%/10% = 0 -Demand curve is vertical -Cosnumers price sensitivity: none -Elasticity = 0

"Inelastic Demand"

-Price elsticity of demand = % change in Q/ % change in P = < 10%/10% < 1 -Demand Curve: relatively steep -Consumers price sensitivity: relatively low -Elasticity is less than 1

As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall

-Revenue = P X Q -The fall in price reduces revenue, but quantity increases, which increases revenue. Which effect is bigger? -Since demand is elastic, Quantity will increase more than 20%, so revenue rises

Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall?

-Since demand is inelastic, Q will fall less than 10%, so revenue rises

Elasticity of a linear demand curve

-THe slope of a linear demand curve is constant, but its elasticity is not.

The Price elasticity of Demand

-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 said to be inelastic if the quantity demanded responds only slightly to changes in the price. The price elasticity of demand for any good measues how willing consumers are to buy less of the good as its price rises.

Definition of the Market

-The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods. For example, food, a broad category, has a fairly inelastic demand because there are no good substitutes for good. Ice cream, a narrower category, has a more elastic demand because it is easy to substitute other desserts for iece cream. Vanilla ice cream, a very narrow category, has a very elastic demand because other flavors of ice cream are almost perfect substitutes for vanilla.

The Midpoint Method: A better way to calculate % changes and elasticity's

-The midpoint method computes a percentage change by dividing the change by the midpoint (or average) of the initial and final levels. For instance, $5 is the midpoint between $4 and $6. Therefore, according to the midpoint method, a change from $4 to $6 is considered a 40 percent rise because (6-4)/5 x 100 = 40. Similarly, a change from $6 to $4 is considered a 40 percent fal. Because the midpoint method gives the same anser regardless of the direction of change, it is often used when calculating the price elasticity of demand between 2 points.

The Determinants of Price Elasticity:

-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 continued

-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 and the steeper the curve, the smaller the elasticity

Gasoline in the Short run vs. Gasoline in the long run

-The price of gasoline rises 20% -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

Blue Jeans vs Clothing

-The prices of both goods rise by 20% -For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, speedos) -There are fewer substitues available for boradly defined goods. (Are there any substitutes for clothing) -Lesson: Price elasticity is higher for narrowly defined goods than for broadly defined ones

Insulin vs. Caribbean Cruises

-The prices of both of these goods rise by 20% -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

Breakfast Cereal vs. Sunscreen

-The prices of both of these goods rise by 20%. For which good does quantity demanded drop the most -Breakfast cereal has close substitues (e.g. pancakes, 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

Elasticity and total revenue along a Linear Demand Curve

-We know that a traight line has a constat slope. Slope is defined as riser over run, which here is the ratio of the change in price rise to the cahnge in quantit run. Even though the slope of a linear demand curve is constant, the elasticity is not. This is true because the slope is the ratio of changes in the two variables, whereas the elasticity is the ratio of percentage changes in the two variables. The explanation for this fact fome from the arithmetic of percentage changes. When the price is low and consumers arterm-12e buying a lot, a $1 price increase and 2-unit reduction in quantity demanded constitute a large percentage increase in the price and a small percentage decrease in quantity demanded, resulting in a small elasticity. When the price is high and consumers are not buying much, the same $1 price increase and 2-unit reduction in quantity demanded constitute a samll percentage increas in the price and a large percentage decrease in quantity demanded, resulting in a large elasticity.

Calculating Percentage Changes

-We use the midpoint method % change = (end value - start value)/(midpoint) -The midpoint is the number halfway between the start and end values, the average of those values. -It doesn't matter which value you use as the start and which as the end - you get the same asnwer either way!

Total Revenue and the Price Elasticity of Demand

-When studying changes in supply or demand in a market, one variable we often want to study is total revenue, the amount paid by buyers and received by sellers of a good. In any market, toatal revenure is P x Q. The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P X Q. Here at a price of $4, teh quantity demanded is 100 and total revenue is $400. -If demand is inelastic, then an increase in price causes an increase in total revenue. Here an increase in price from $4 to $5 causes the quantity demanded to fall from 100 to 90, so total revenue rises from 400 to 450. An increase in price raises P x Q because the fall in Q is proportionately smaller than the rise in P. -If demand is elastic: an increase in the price causes a decrease in total revenue. Because demand is elastic, the reduction in the quantity demanded is so great that it more than offsets the increase in price.

The Elasticity of Demand

-When we introduced demand in Chapter 4, we noted that consumers usually buy more of a good when its price is lower, when their incomes are higher, when the prices of its substitues are higher, or when the prices of its complements are lower. Our discussion of demand was qualitative, not quantitative. To measure how much consumers respond to changes in these variable, economists use the concept of elasticity

Computing the Price Elasticity of Demand

Economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price. Price elasticity of demand = (Percentage change in quantity demanded)/ (Percentage change in price) -With this convention, a larger price elasticity implies a greater responsiveness of quantity demanded to changes in price

General Total revenue rules

1. When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction: If the price increases, total reveunue also increases. 2. When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directions: If the price increases, total revenue decreases 3. If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes.

A few elasticity's from the real world

Eggs = .1 Healthcare = .2 Rice = .5 Housing = .7 Beef = 1.6 Restaurant meals = 2.3 Mountain dew = 4.4