Econ Chapter 5

luxuries vs. necessities

goods that are necessities have inelastic demand goods that are luxuries have elastic demand

definition of a market

the more narrow the definition of a market, the more elastic the good

elasticity

tool used to measure the response of one variable to a change in another

if the price elasticity of supply is equal to 1, then the good has

unit-elastic supply

elasticity of A with respect to B

%ΔA/ %ΔB

price elasticity demanded

%ΔQd/ %ΔP always negative, but sign is dropped

εs

%ΔQs/ %ΔP

εxy

%ΔQxd/ %ΔPy

percentage change midpoint formula

(new value - initial value/(new value + initial value/2)) x 100

percentage change

(new value - initial value/initial value) x 100

if the goods have a cross-price elasticity demand of 0, then the goods are

not related

inelastic

0 < εd < 1 if the quantity demanded changes a little if the price of the good changes. demand is some what responsive to changes in price. a number between 0 and -1 and graphically the demand curve will be relatively steep. For example, suppose the price elasticity of demand for milk is 0.4. A 10% increase in the price of milk will reduce the quantity demanded of milk by 4%. Goods that are considered necessities will have an inelastic demand curve

elastic

1 < εd < ∞ if the quantity demanded changes a lot when the price of the good changes. A good that has elastic demand will be very responsive to changes in price. The price elasticity of demand will be a number greater than 1, and graphically the demand curve will be relatively flat. For example, suppose that the price elasticity of demand for lobster is 6.7. A 10% increase in the price of lobsters will reduce the quantity demanded by 67%. Goods that are considered luxuries will have an elastic demand curve.

determinants of price elasticity of demand

1. availability of substitutes 2. share of the good in the consumer's budget 3. luxuries vs. necessities 4. definition of a market 5. time horizon

time horizon

a good becomes more elastic as time passes. people will have time to adjust their behavior and preferences

if the goods have a negative cross-price elasticity of demand then the goods are

complements

if the price elasticity of supply is greater than 1, then the good has

elastic supply

if the good has an elastic demand a decrease in price will result in

higher total revenue increase TR = decrease P x increase qd

if the good has an inelastic demand, then an increase in prices will result in

higher total revenue increase TR = increase P x decrease qd

if the price elasticity = ∞, then the supply curve is

horizontal and is perfectly elastic

availability of substitutes

if a good has a lot of substitutes, then the quantity demanded would be very responsive to price changes goods with a lot of close substitutes will have an elastic demand

if the price elasticity of supply is less than 1, then the good has

inelastic supply

price elasticity of demand is important to firms because

it can tell firms what would happen to total revenues if they increase or decrease the price they charge for a good. It allows firms to decide what price is optimal to maximize total revenue.

if the good has an inelastic demand, then a decrease in prices will result in

lower total revenue decrease TR = decrease P x increase qd

if the good has an elastic demand an increase in price will result in

lower total revenue decrease TR = increase P x decrease qd

total revenue

price x quantity

income elasticity of demand

shows the effect of a change in income on the quantity demanded of a good %ΔQd/ %ΔI interested in both the magnitude and the sign of the elasticity

if the goods have a positive cross-price elasticity of demand then the goods are

substitutes

if the income elasticity of demand is negative, then

the good is inferior

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

the good is normal and is considered a luxury good

if the income elasticity of demand is positive and between 0 and 1, then

the good is normal and is considered a necessity

share of a good on the consumer's budget

the larger the share of the good on a household's budget, the more elastic the good the more inexpensive a good is relative to a household's income, the more inelastic it will be

if the price elasticity = 0, then the supply curve is

vertical and is perfectly inelastic

as we move down the demand curve we go from

very elastic demand to inelastic demand

perfectly inelastic

ε d = 0 if the quantity demanded does not change at all when there is a change in price. In other words demand is completely unresponsive to price changes. The price elasticity of demand (εd ) is equal to 0. Graphically, a perfectly inelastic demand curve will be vertical. if P increase by 10%, qd will decrease by 0%

unit elasticity

εd = 1 if the quantity demanded changes by the exact same percentage as the change in price. If an increase in 10% in the price of good X will result in a decrease of 10% in the quantity demanded of good X we say that good X is unit elastic.

perfectly elastic

εd = ∞ if the demand drops to 0 even if the price changes by 1 penny. The price elasticity of demand will be equal to negative infinity, and graphically the demand curve will be horizontal. An example of a good with perfectly elastic demand is most farm goods. There is nothing to distinguish the wheat from farmer A from farmer B. If farmer A tries to sell his wheat at a higher price than his neighbor farmer B, everyone will just buy from farmer B and thus the demand for farmer A's wheat will go to 0.

price elasticity of supply

εs examines the positive relationship between the price of the good and the quantity supplied measures the percentage change in Qs given a percentage change in P

cross-price elasticity of demand

εxy measures the effect of a percentage change in the qd of good x given a percentage change in the price of good y