Microeconomics Chapter 6

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If you are a business owner, you need to decide how to price your product.

"How many customers will I gain if I cut my price?" "What will happen to my total revenue if I cut my price?" Knowing the price elasticity of demand for your product can help to answer these questions.

Cross-price elasticity of demand between beer and spirits: -.5

Beer and spirits are also complements, but the relationship is not as strong

Cross-price elasticity of demand between beer and wine: -.83

Beer and wine are complements

Suppose we have a linear demand curve. What happens to total revenue as price increases?

Initially, total revenue rises, suggesting demand is inelastic. But then total revenue starts to fall, suggesting demand is elastic!

If the products are substitutes then the cross-price elasticity of demand will be

positive. Example two brands of tablet computers

perfectly elastic

A horizontal demand curve means quantity demanded is infinitely responsive to price changes. Elasticity is infinite.

Chapter 6

Elasticity: The Responsiveness of Demand and Supply

Percentage Change

Percentage change doesn't work because you will get different answers depending on which point you choose. If you go from 1000 to 1200 you get and increase of 20%. If you go from 1200 to 1000, it is a decrease by 16.7%

Price of elasticity of demand

Percentage change in quantity demanded/percentage in price

Price of elasticity of supply equation

Percentage change in quantity supplied/percentage change in price

If the absolute value of price elasticity is equal to 0, the demand is

Perfectly inelastic

If demand inelastic, then an increase in price

increases revenue because The decrease in quantity demanded is proportionally smaller than the increase in price.

If demand is elastic, then a decrease in price

increases revenue because The increase in quantity demanded is proportionally greater than the decrease in price.

If the absolute value of price elasticity is less than 1, the demand is

inelastic

Price inelastic

if its price elasticity of demand is smaller (in absolute value) than 1. That is, close to zero, indicating that quantity demanded changes little in response to a price change.

If the products are unrelated then the cross-price elasticity of demand will be

zero. Example: tablet computer and peanut butter

Elastic Total revenue

Absolute value of price elasticity is greater than 1, then the effect on Total Revenue of an Increase in Price is that is falls

Inelastic total revenue

Absolute value of price elasticity is less than 1, then the Effect on Total Revenue of an Increase in Price is that it rises

What determines the price elasticity of demand

1. The availability of close substitutes 2. The passage of time 3. Whether the good is a luxury or a necessity 4. The definition of the market 5. The share of a good in a consumer's budget

Price elasticity of demand for beer: -.3

Demand for beer is price inelastic

Unit elastic total revenue

Absolute value of price elasticity is equal to one, then the Effect on Total Revenue of an Increase in Price is unchanged

Items that are inelastic

Beer, water, cocaine, cigarettes, catholic school attendance, milk, gasoline, health insurance

Suppose demand for your product is relatively price inelastic

Customers are not very sensitive to the price of your product. As you decrease the price, you expect to gain few additional customers. The few additional customers do not compensate for the lost revenue, so overall revenue goes down.

Suppose demand for your product is relatively price elastic

Customers are very sensitive to the price of your product. As you decrease the price, you expect to gain many additional customers. The many additional customers more than compensate for the lost revenue, so overall revenue goes up.

perfectly inelastic

Straight up and down A vertical demand curve means that quantity demanded does not change as price changes. So elasticity is zero.

Price elasticity of supply

The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product's price. P

Total Revenue

The total amount of funds received by a seller of a good or service, calculated by multiplying the price per unit by the number of units sold.

Slope and price elasticity

They are related, but not the same thing

If the absolute value of price elasticity is equal to 1, the demand is

Unit elastic

If demand is unit elastic, then an increase in price

does not affect revenue because the decrease in quantity demanded is proportionally the same as than the increase in price.

If demand is unit elastic then a decrease in price

does not affect revenue because the increase in quantity demanded is proportionally the same as than the decrease in price.

If the products are complements then the cross-price elasticity of demand will be

negative. Example Table computers and applications downloaded from online stores

If the income elasticity of demand is positive and greater than 1, then the good is

normal and a luxury. Example: caviar

When supply is inelastic

the price increase will be large.

If supply is elastic

then the resulting price change will be much smaller.

Unit price elastic

if the price elasticity of demand is exactly equal to (negative) 1.

Income elasticity of demand for beer: .09

Beer is a normal good; a necessity

Items that are elastic

Books, dvds, automibles, tide, coca-cola, grapes

If the absolute value of price elasticity is greater than 1, the demand is

Elastic

We can see that knowing the price elasticity of demand would be very useful for a firm. But how can a firm know this information?

For a well-established product, economists can use historical data to estimate the demand curve. To calculate the price elasticity of demand for a new product, firms often rely on market experiments. With market experiments, firms try different prices and observe the change in quantity demanded that results.

Inferior goods

Goods and services for which the quantity demanded falls as income increases

Normal goods

Goods and services for which the quantity demanded increases as income increases

Complements

Goods and services that are used together

Substitutes

Goods and services that can be used for the same purpose

The share of a good in a consumer's budget

If a good is a small portion of your budget, you will likely not be very sensitive to its price. Example: You might buy table salt once a year or less; changes in its price will not affect very much how much you buy. Example: Changes in the price of housing do affect where people choose to live.

The availability of close substitutes

If a product has more substitutes available, it will have more elastic demand. Example: There are few substitutes for gasoline, so its price elasticity of demand is low. Example: There are many substitutes for Nikes (Reeboks, Adidas, etc.), so their price elasticity of demand is high.

Price elastic

If its price elasticity of demand is larger (in absolute value) than 1. So a 10% increase in price would result in a greater than 10% decrease in quantity demanded.

Negative/Positive elasticity

Since price and quantity change in opposite directions on the demand curve, the price elasticity of demand is a negative number. However we often refer to "more negative" elasticities as being "larger" or "higher". A "large" value for the price elasticity of demand means that quantity demanded changes a lot in response to a price change.

While slope and elasticity are not the same, they are related:

If two demand curves go through the same point, the one with the higher slope also has the higher (more negative) elasticity.

Why Is Knowing Price Elasticity of Supply Useful?

Knowing the price elasticity of supply can help us to predict the effect that a change in demand will have. When demand increases, we know equilibrium price and quantity will increase. But if supply is inelastic, quantity supplied cannot change much in response to the demand change; so price will rise a lot. If supply is elastic, price will rise much less.

What formula do you use

Midpoint formula. ((Q2-Q2)/(Q1+Q2/2))/((P2-P1)/(P1+P2/2))

Terminology for price elasticity of supply

Much the same terminology applies to price elasticity of supply as to price elasticity of demand: elastic, inelastic, unit-elastic, perfectly elastic, and perfectly inelastic all have similar meanings.

Why are oil prices so unstable

Oil producers cannot change output very quickly. When demand increases suddenly, price rises, acting as a rationing mechanism for the increased demand. On the other hand, during a recession, demand for oil falls. Oil producers cannot adjust their output quickly, so the price falls dramatically.

The passage of time

Over time, people can adjust their buying habits more easily. Elasticity is higher in the long run than the short run. Example: If the price of gasoline rises, it takes a while for people to adjust their gasoline consumption. How might they do that Buying a more fuel-efficient car. Moving closer to work

Whether the good is a luxury or a necessity

People are more flexible with luxuries than necessities, so price elasticity of demand is higher for luxuries. Example: Many people consider milk and bread necessities; they will buy them every week almost regardless of the price. And if the price goes down, they won't drastically increase their consumption of bread or milk.

If the absolute value of price elasticity is equal to infinity, the demand is

Perfectly elastic

Determinant of the price elasticity of supply

Price elasticity of supply depends on the ability and willingness of firms to alter the quantity they produce as price increases. The time period in question is critically important for determining the price elasticity of supply. Suppose the wholesale price of grapes doubled overnight: Farmers could do little to increase their quantity immediately; the initial price elasticity of supply would be close to 0. Over time, farmers could plant more fields in grapes; so over the course of several years, the price elasticity of supply would rise.

Why are elasticity and total revenue related

So if this is greater than 1 (in absolute terms) then quantity demanded goes up by a higher percentage than price, raising the revenue. A special case occurs when price elasticity of demand is -1: the percentage change in quantity demanded equals the percentage change in price, so revenue does not change.

What is the price elasticity of demand for breakfast cereal?

The answer depends on whether you mean: A particular brand of a particular breakfast cereal, A particular category of breakfast cereal, Breakfast cereal in general. The further down the list we go, the more broadly the market is defined, and hence the fewer close substitutes are available. So we would expect the price elasticity of demand to become smaller as we move down the list.

Total Revenue Along a Linear Demand Curve

The data from the table are plotted in the graphs. As price decreases from $8, revenue rises—hence demand is elastic. As price continues to fall, revenue eventually flattens out—demand is unit elastic. Then as price falls even further, revenue begins to fall—demand is inelastic.

Cutting Price When Demand is Inelastic

The decrease in price does not generate enough extra customers (area E) to offset revenue loss (area C)

Cutting Price When Demand is Elastic

The decrease in price generates enough extra customers (area E) to more than offset revenue loss (area C).

The definition of the market

The more narrowly defined the market, the more substitutes are available, and hence the more elastic is demand. Example: You might believe there is no good substitute for jeans, so your demand for jeans is very inelastic. But if you consider different brands of jeans, you might be more sensitive to the price of a particular brand.

If the income elasticity of demand is negative, then the good is

inferior. Example: ramen noodles

Cross-price elasticity of demand

measures the strength of substitute or complement relationships between goods: (percentage change in quantity demanded of one good)/(percentage change in another good)

Income elasticity of demand

measures the strength of the effect of income on quantity demanded: (percentage change in quantity demanded)/(percentage change in income)

If the income elasticity of demand is positive but less than 1, then the good is

normal and a necessity. Example: bread

If demand is elastic, then an increase in price

reduces revenue because he decrease in quantity demanded is proportionally greater than the increase in price.

If demand is inelastic, then a decrease in price

reduces revenue because the increase in quantity demanded is proportionally smaller than the decrease in price.


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