CH 5 Q&A w/ terms

The price elasticity of demand for a particular product depends on the availability

of substitutes.

Price elasticity ranges from

perfectly inelastic to unit elasticity to perfectly elastic. Along a linear demand curve, elasticity is greater than one above the midpoint of the demand curve and less than one below the midpoint.

If price elasticity of demand is zero, it is

perfectly inelastic. The quantity demanded does not change no matter what happens to the price, so the demand curve is vertical.

Total revenue is

the money a firm generates from selling its product = Price per unit × quantity sold.

Price Elasticity along a Linear Demand Curve

1.Elasticity is not slope. a.Elasticity is a measure of relative percentage changes. b.Slope is a measure of relative absolute changes. 2.Percentage changes are the key. 3.Upper half of the curve is elastic. 4.Lower half of the curve is inelastic. 5.Midpoint of the curve is unit elastic.

Other Determinants of the Price Elasticity of Demand

1.If the product represents a large fraction of the consumer's budget, the demand will be elastic. If a good is unimportant to the budget, demand is relatively inelastic. For large budget-share items, consumers are more responsive because the amount spent on the good is high relative to consumer income. 2.If a good is a luxury good, it tends to have an elastic demand.

Using Elasticity to Predict the Revenue Effect of Price Changes

1.Market versus Brand Elasticity 2.Bus Fares and Deficits 3.A Bumper Crop Is Bad News for Farmers 4.Antidrug Policies and Property Crime. The demand for illegal drugs is inelastic.

The Role of Time: Short-Run versus Long-Run Supply Elasticity

1.Short-run supply is less elastic than long-run supply because, in the short run, production facilities and the number of firms is fixed. 2.In the long run, a price change will alter the number of firms, and the quantity will change more.

Suppose that in a month the price of coffee mugs increases from $1 to $2. At the same time, the quantity of coffee mugs demanded decreases from 100 to 80. The price elasticity of demand for coffee mugs (calculated using the initial value formula) is a. 0.2 b. 0.5 c. 5 d. 20

A

Suppose that in a month the price of roses increases from $1 to $1.50. At the same time, the quantity of roses demanded decreases from 200 to 190. Elasticity of demand for roses (calculated using the initial value formula) is a. 0.1 b. 0.5 c. 10 d. 20

A

If the price elasticity of demand is very elastic, which of the following could be a possible value of the elasticity? a. 3 b. 1 c. 1/2 d. 0

A Any elasticity less than one in absolute value is considered inelastic so A is the only possibility

The cross elasticity of demand between orange juice and grapefruit juice is most likely a. positive. b. negative. c. zero. d. no way to tell.

A Because they are likely substitutes. If you raise the price of one good people will respond by buying more of the other good. Since both movements are in the same direction (increases in this case) the cross price elasticity will be positive. If you reduced the price of orange juice people would buy less grapefruit juice { again the movement is in the same direction so the elasticity would still be positive

On a linear demand curve, demand is ______ at low quantities than it is at the middle of the demand curve. a. more elastic b. less elastic c. equally elastic d. impossible to tell

A It turns out that the price elasticity of demand on a linear demand curve can be written as ¢Q ¢P P Q , where ¢Q ¢P is the slope of the demand curve. For a linear demand curve the slope is constant so the only thing we need to be concerned about is P Q . Now, clearly, if Q is very small (because P is very high), then this fraction is approaching in¯nity. That is, as the price rises, quantity demanded falls to zero. If something in a denominator approaches zero the entire fraction goes to in¯nity (assuming, as is the case here, the numerator is not also going to zero). As price falls quantity rises, so the elasticity goes to zero. You should draw a linear demand curve and label the vertical intercept as having jEdj = 1 and the horizontal intercept as having jEdj = 0. This of course means there is a point in between these two points that is unit elastic. In fact, every possible value of the price elasticity of demand occurs somewhere on a linear demand curve.

If a product is a necessity and has no substitute at all, demand for the product is most likely to be a. very inelastic. b. inelastic. c. unitary elastic. d. elastic.

A Pharmaceutical drugs are an example.. If you need a drug to survive you must pay whatever price the pharmaceutical companies charge. The pharmaceutical companies are granted patents in order to encourage innovation. That is, we allow them to be monopolies, and to charge monopoly prices, so that they may recover the costs of researching and developing the drugs. This is a good thing in that it results in more e®ective drugs. It is a bad thing in that many people must pay high prices for drugs and, in some cases, they go without. This is why prescription drug reform was such a big issue in the 2000 presidential campaign. Unfortunately the people of A¯rica don't have a lobbying group as powerful as the AARP and most of the AIDS patients there (and there are many) cannot a®ord to buy the drugs they need to survive.

Which of the following products has the most elastic demand? a. Raspberry Mocha Kona coffee blend at Starbuck's b. Starbuck's coffee c. coffee d. all beverages

A The more specific the good is the more elastic demand for it will be. The demand for frozen pizza is much more elastic than food in general.

Income elasticity of demand

A measure of the responsiveness of the quantity demanded to changes in consumer income. 1.Equal to the (% change in quantity demanded)/(% change in income). 2.Goods with positive income elasticities are called normal; as income rises, consumers will purchase more of these goods. 3.Goods with negative income elasticity are called inferior; as income rises, consumers will purchase less of such goods.

If the demand for school ball caps is inelastic, an increase in price will a. decrease profits. b. increase total revenues. c. decrease total revenues. d. increase quantity demanded.

B

If quantity demanded of a good falls by 2 percent when income falls by 10 percent, the good's demand is a. price sensitive. b. income inelastic. c. income elastic. d. price insensitive.

B Because people responding to the loss of income by buying a reducing consumption by a lower percentage

Suppose that in a month the price of pizza increases from $4 to $5. At the same time, the quantity of pizzas demanded decreases from 200 to 190. The price elasticity of demand for pizza (calculated using the initial value formula) is a. 0.1 b. 0.2 c. 1 d. 10

B Since, using the initial value formula

Suppose we observe that as a firm increases its price its total revenue decreases. What do we know? a. demand is price inelastic b. demand is price elastic c. demand is unitary elastic d. demand is perfectly price inelastic

B Total revenue is P¢ Q. When a ¯rm increases its price people will buy less of their good so it is not immediatley clear whether a price increase will increase their revenue. That is increasing price is good in the sense that each unit sold generates more revenue, but bad because they won't be able to sell as many units. That is, as we increase price, total revenue acts like " P¢ # Q, so we need to know which change is grreater in percentage terms. This is what the price elasticity of demand tells us. If the ¯rm's revenue decreases as a result of this price increase we know that the percentage # Q is greater than the percentage " P. In other words ¯ ¯ ¯ %¢Q %¢P ¯ ¯ ¯ > 1, since %¢Q > %¢P, in absolute value. Demand is elastic. Table 5.4 in the book is excellent and you should understand it before you take the exam.

Suppose that you have a budget of $20 for movies every month. You see the same number of movies every month no matter what happens to the price of movies. This suggests that your demand for movies is a. very elastic. b. very inelastic. c. unitary elastic. d. not something that can be characterized without knowing the prices of the movies.

B Very inelastic because you are not responsive to price changes.

If the price elasticity of supply is 1, supply is a. unaffected by price changes. b. inelastic. c. unitary elastic. d. elastic.

C

Suppose that the elasticity of demand for a product is 4.0 and price decreases by 20%. By what percentage will quantity demanded increase? a. 5% b. 20% c. 80% d. 200%

C I wish they didn't drop the signs on the price elasticity of demand because it kind of matters on questions like these.. To do this problem you need to write down the de¯nition of price elasticity of demand (I am going to include the negative sign): %¢Q %¢P = ¡4:0 =) %¢Q ¡0:20 = ¡4:0 =) %¢Q = ¡4:0 ¢ ¡0:20 = 0:80: So quantity demanded rises by 80% (the %¢P is negative because it is a price decrease).

If consumers have a long time to respond to an increase in electricity prices, their demand is likely to be ________ than if they are only given a short time. a. no different b. higher c. more elastic d. less elastic

C In the short run it would be di±cult to replace all of the electrical appliances in your abode so you simply pay the higher prices. So, in the short run the demand for electricity is inelastic. However, in the long run you could replace your electric stove with a gas one, for example. So, if you ha

When the price of hamburger went from 3 to 4 dollars a pound, the quantity demanded of buns changed from 30 to 25 packages a day. The cross elasticity of demand for buns (using the initial value formula) is a. 1.4 b. 0.5 c. -0.5 d. -1.4

C The cross price elasticity is

When the price of a Toyota Celica increases by $10 the quantity demanded hardly changes. When the price of a Santana CD increases by $10 the quantity demanded falls dramatically. This suggests that a. Santana CD's have more elastic demand than Toyota Celicas, although both are elastic. b. Toyota Celicas have less elastic demand than Santana CDs, although both are in elastic. c. Santana CD's have very elastic demand and Toyota Celicas have very inelastic demand. d. Not enough information is g

D A $10 change in the price of CDs is a fairly large percentage change, since the price of CDs is so low. On the other hand a $10 change in the price of automobiles is negligible, i.e. a very small percentage change. Therefore it is impossible to determine whether these goods are elastic or inelastic from the information given. Since the price of the CD changed dramatically, we observe a dramatic change in quantity demanded of CDs. Since the price of an automobile changed very little, we see very little change in the quantity demanded of automobiles. I would consider this a very hard question

Demand for low budget items, such as candy, is generally _____________ than demand for large budget items, such as automobiles. a. higher b. lower c. more elastic d. less elastic

D If the price of a pack of chewing gum rose from $0.25 to $0.50 it would probably not have to much impact on the quantity demanded of chewing gum(really I hav to assume that ALL chewing gum manufacturers rose their prices). This is because, even though the price rose by 100% { a large percentage increase { it is still dirt cheap. People tend to not respond to much to price changes in very inexpensive items in their budget.

The supply curve will be more elastic when a. a good has many substitutes. b. demand is elastic. c. demand is inelastic. d. firms have more time in which to respond to the price change.

D In the short run ¯rms may have to ful¯ll contractual obligations. So they may not be able to alter there output much. In the long run they can negotiate new contracts. Also in the long run they can expand their facility to produce more in response higher prices.

The price elasticity of demand reflects the responsiveness of a. how firms respond to changes in demand. b. demand to a change in price of a substitute good. c. demand to a change in price. d. quantity demanded to a change in price.

D This is simply the defnition of the price elasticity of demand.

If a product has a great many identical substitutes, demand for the product is most likely to be a. very inelastic. b. inelastic. c. elastic. d. very elastic.

D Very elastic since people can simply switch to consuming one of the identical substitutes if the ¯rm tries to raise its price. This will be a very important issue when we study the behavior of ¯rms in a perfectly competitve market.

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS

D.Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply 1.If supply is vertical, it is perfectly inelastic, or has an elasticity of zero. The quantity supplied does not change no matter what happens to the price. 2.If supply is horizontal, it is perfectly elastic, or has an elasticity of infinity. The quantity supplied falls to zero at any price above the vertical intercept. E.Predicting Changes in Quantity Supplied 1.By rearranging the elasticity formula, we can predict the effect of price changes on the quantity supplied.

The Price Effects of a Change in Supply

In terms of supply the formula is as follows: a.Percentage change in equilibrium price = 2 (Percentage change in supply) / (Es + Ed)

The Price Effects of a Change in Demand

The Price-Change Formula: A formula that shows the percentage change in equilibrium price resulting from a change in demand or supply, given values for the price elasticity of supply (Es) and the price elasticity of demand (Ed). In terms of demand - the formula is as follows: a. Percentage change in equilibrium price = (Percentage change in demand) / (Es + Ed)

Factors affecting the slope of the supply curve affect the elasticity.

a.If marginal cost increases rapidly with total output (e.g., crude oil prices increase with gasoline production), the supply curve is relatively steep and supply is relatively inelastic. b.If marginal cost increases slowly with total output (e.g., the price of wood isn't affected much by increase in pencil production), the supply curve is relatively flat, and supply is relatively elastic.

percentage changed can be computed in two ways.

a.The simplest approach to compute a percentage change is to use the initial value of the variable in the denominator. b.The midpoint method is more precise. Here we compute the percentage change by dividing the change in the variable by the average value of the variable, or the midpoint between the old value and the new one.

The demand for a product will be relatively elastic if:

a.There are good substitutes for the product. b.Consumers have time to respond to the price change: It takes time to find alternatives; thus, demand will be more elastic the greater the time period considered.

Elastic versus Inelastic Demand

a.When a firm increases its price, there are two effects: A gain from the increased price on each ticket sold, and a reduction in the number of tickets sold. Which effect is larger? b.If demand is elastic, a negative relationship between price and total revenue exists. Consumers will purchase many fewer units, and the price increases on the remaining tickets will not compensate for lost revenues from the reduction in units. Thus, total revenue will fall because the percentage change in quantity is greater than the percentage change in price. c.If demand is inelastic, a positive relationship between price and total revenue exists. Consumers will purchase a few units less, but the price rise on the remaining tickets will more than compensate for lost revenues from the reduction in units. Thus, total revenue will rise because the percentage change in quantity is less than the percentage change in price. d.If demand is unit elastic, consumers will purchase fewer units, and the price rise on the remaining tickets will exactly compensate for lost revenues from the reduction in units. Thus, total revenue will remain constant because the percentage change in quantity is equal to the percentage change in price. e.Similarly, for a price reduction, total revenue rises when demand is elastic and falls when demand is inelastic.

price elasticity of demand

demand is a measure of the responsiveness of the quantity demanded to changes in the price; equal to the absolute value of the percentage change in quantity demanded divided by the percentage change in price.

If price elasticity of demand is greater than 1

demand is elastic.

If price elasticity of demand is less than 1

demand is inelastic.

If price elasticity of demand is equal to 1,

demand is unit elastic.

Price elasticity is calculated by

dividing the percentage change in quantity demanded by the percentage change in price.

Values greater than one

indicate elastic demand consumers change quantities demanded more than proportionately when prices change

Values less than one

indicate inelastic demand consumers change quantities demanded less than proportionately when prices change.

If price elasticity of demand is infinite,

it is perfectly elastic. The quantity demanded falls to zero at any price above the vertical intercept, so the demand curve is horizontal.

The price elasticity of supply

measures the responsiveness of quantity supplied to changes in price. 1.Equal to the (% change in quantity supplied)/(% change in price). 2.Numerical example: When the price of milk increases from $1/gallon to $1.20/gallon, the quantity supplied increases from 100 million gallons to 102 million gallons (using the initial-value method). a.The percentage change in price is the absolute change ($0.20) divided by the initial quantity ($1.00), or 20 percent. b.In Figure 5.3 [20.3] panel (A), the percentage change in quantity is the absolute change (2 million) divided by the initial quantity (100 million), 2 percent, resulting in an elasticity of 2/20 = 0.10 (inelastic). c.In Figure 5.3 [20.3] panel (B), the percentage change in quantity is 50 million divided by 100 million, 50 percent, resulting in an elasticity of 50/20 = 2.5 (elastic).

Price elasticity is related to the

slope of the supply curve.

Elasticity will be greater when

there are many substitute products, when the good is important to the consumer's budget, and when the time period considered is long.

Elasticity information tells firms whether price changes will

will increase or decrease total revenue. For an elastically demanded good, price increases reduce the firm's total revenue. If demand is inelastic, price increases increase the firm's total revenue. The price elasticity of supply is calculated similarly; supply is expected to be more elastic as the time period being considered increases