Microeconomics Chapter 6
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.
