YR1SM1 MICROECONOMICS: Chapter 5 Elasticity

Elasticity general definition

the extent to which buyers and sellers respond to changes in market conditions

Price elasticity of demand

measures how much the quantity demanded of a good/service responds to a change in its price

Price Elasticity of Demand 3 different possible symbols; units?

ε^d

E_d

e^d

UNITLESS

How to calculate price elasticity of demand, going from an initial point to the new point

ASSUME THAT THE DEMAND CURVE IS A STRAIGHT LINE

ε^d = (% ∆Qd) / (% ∆P)

How to calculate % change in the quantity demanded, going from the initial to new point

%∆Qd = [(final Qd - initial Qd) ÷ (initial Qd)] * 100

How to calculate % change in the price, going from the initial to new point

%∆P = [(final P - initial P) ÷ (initial P)] * 100

What does the Law of Demand indicate for the possible values of ε^d?

If ε^d is not = 0, then because of the inverse relationship between quantity demanded and price, any movement along the demand curve will result in a negative ε^d value

Common practice when reporting ε^d

Drop the negative sign; the negative sign is assumed

Benefit of using the midpoint method to calculate price elasticity?

Between two points, whether there is a price increase or decrease, the midpoint method reduces confusion by giving the same price elasticity value

Midpoint method equation for calculate price elasticity of demand

(% change in Q) / (% change in P)

still the same, but how we calculate the % changes is different

Midpoint method: % change of a variable equation

[(end value - initial value) / (midpoint)] * 100

Name factors that impact the elasticity of a good/service?

whether or not it has close substitutes

whether it is a narrowly defined good vs a broadly defined good

whether it is a need or a want

whether we’re measuring its elasticity in the short or long run

Narrowly vs broadly defined goods; relation to elasticity? EX?

Narrowly defined goods tend to be a specific product part of a larger category, thus being more elastic; broadly defined goods are like general categories of a good, thus being less elastic

Orange vs citrus

Does a change in price in the same good/service affect Qd more in the short run or long run?

Long run, because more time allows people to change their habits and find alternatives, causing a greater fluctuation in the Qd of that good

Numerical inequality approach to determining elasticity of a good/service

DEMAND IS ELASTIC: Ed > 1
DEMAND IS INELASTIC: Ed < 1

DEMAND HAS UNIT ELASTICITY: Ed = 1

Ed > 1, Ed = 1, and Ed < 1 indicate what about the ratio of % change in Qd over % change in P?

Ed > 1: %∆Qd > %∆P

Ed = 1: %∆Qd = %∆P

Ed < 1: %∆Qd < %∆P

When the demand is perfectly inelastic, what is the Ed =. to and what does the demand curve look like?

Ed = 0

Demand curve is vertical

When the demand is perfectly elastic, what is Ed = to and what does the demand curve look like?

Ed = infinity and the demand curve is horizontal

The flatter the demand curve, the …

greater the Ed of a good/service

Perfectly inelastic demand ratio of %∆Q to %∆P

Price elasticity of demand = (0%) / (any % change in price) = 0

Perfectly elastic demand ratio of %∆Q to %∆P (NOTE: not mathematically correct)

Price elasticity of demand = (any % of Q) / (0%) = infinity

For a linear demand curve, what part of it is constant and what part of it is not constant?

Slope is constant everywhere, but elasticity is not constant everywhere

For a typical demand curve, the upper portion is usually …, the middle portion is usually …, and the lower portion is usually …

elastic; around unit elasticity (Ed = 1); inelastic

Total revenue = in terms of price and quantity

P x Q

For an elastic demand curve, what would happen if you raise the price by 10% and thus the quantity demanded lowers by more than 10%?

Total revenue goes down because the magnitude of the 10% decrease of quantity is greater than the 10% increase in price, thus outweighing any additional revenue gained by the increased price

For an elastic demand curve, what would happen if you lower the price by 10% and thus the quantity demanded rises by more than 10%?

Now, the the magnitude of the 10% rise in quantity outweighs the 10% decrease in price, thus more than making up for any revenue lost by the lowered price

For an inelastic demand curve, what would happen if you raise the price by 10% and thus the quantity demanded decreases by less than 10%?

The magnitude of the 10% increase in price outweighs the less than 10% decrease in quantity demanded, thus more than making up for any revenue loss caused by the decrease in demand

For an inelastic demand curve, what would happen if you lower the price by 10% and thus the quantity demanded increases by less than 10%?

The magnitude of the 10% decrease in price is greater than the less than 10% increase in quantity demanded, thus outweighing any revenue gained by the increase in quantity demanded

How to calculate total revenue from a price change, using a demand quantity graph?

Step 1

Draw the demand curve and focus solely on it

How to calculate total revenue from a price change, using a demand quantity graph?

Step 2

Label the original price and quantity on their respective axes

How to calculate total revenue from a price change, using a demand quantity graph?

Step 3

Draw a vertical and horizontal line starting at the original price and quantity values that meet when they both touch the demand curve

How to calculate total revenue from a price change, using a demand quantity graph?

Step 4

The area created by this box = total revenue

How to calculate total revenue from a price change, using a demand quantity graph?

Step 5

Label the new price and quantity values on their respective axes

How to calculate total revenue from a price change, using a demand quantity graph?

Step 6

The area of the box created by these new values of price and quantity = the new total revenue

How to calculate total revenue from a price change, using a demand quantity graph?

Step 7

Compare the areas of the original box vs the new box

Income elasticity of demand measures

how much the quantity demanded of a good/service changes in response to a change in consumers’ income

Income elasticity of demand (Ɛ^I)equation

(%∆ Qd) ÷ ( %∆ Income)

Calculate %∆ Qd using the midpoint method

(Q2 - Q1) ÷ (Q1+ Q2 / 2)

Calculate %∆ Income using the midpoint method

[(Income 2 - Income 1) ÷ (Income 1 + Income 2 / 2)] * 100

Normal goods have a … income elasticity, while inferior goods have a … income elasticity. WHY?

positive; negative

When income increases/decreases, people will buy more/less normal goods; when income increases/decreases, people will buy less/more inferior goods

Cross price elasticity of demand measures

how much the quantity demanded of one good responds to a change in the price of another good

Cross price elasticity of demand (Ɛ^x,y) = NUMERATOR AND DENOMINATOR

The price of good x changes, thus changing the quantity demanded of good y

Numerator: (Q2^y - Q1^y) ÷ (Q1^y + Q2^y / 2)

Denominator: (P2^x - P1^x) ÷ (P1^x + P2^x / 2)

Substitutes have a … price elasticity, while complements have a … price elasticity; WHY?

positive; negative

When the price of good b rises/falls, people buy more/less of good a; when the price of a related good rises/falls, people buy less/more of its complementary good

Price elasticity of supply (Ɛ^s) measures

how much the quantity supplied of a good responds to a change in its price

Elastic supply vs inelastic supply

Elastic supply responds substantially to a price change, while inelastic supply barely or does not respond to a price change

Ɛ^s should always be a (positive/negative) number?

Positive

Ɛ^s = equation (Numerator and denominator)

NUMERATOR: (Q2 - Q1) ÷ (Q1 + Q2 / 2)

DENOMINATOR: (P2 - P1) ÷ (P1 + P2 / 2)

When supply is perfectly inelastic, price elasticity of supply = , and the supply curve is …

0

vertical

When supply is perfectly elastic, price elasticity of supply = , and the supply curve is …

infinity

horizontal

The flatter the supply curve, the …

greater the price elasticity

With perfectly inelastic supply, (% change in Q) / (% change in P) =

(0%) / (any number %)

With inelastic supply, (% change in Q) / (% change in P) =

10% / more than 10%

doesn’t have to be 10% as long as P has a greater percent change

With unit elastic supply, (% change in Q) / (% change in P) =

10% / 10%

With elastic supply, (% change in Q) / (% change in P) =

more than 10% / 10% change

With perfectly elastic supply, (% change in Q) / (% change in P) =

any % / 0% = infinity

Why is price elasticity of supply so dependent on length of time?

Over time, firms can eventually adjust to price changes by adjusting their production means, such as building new factories and other physical capital, developing technology, liquidating…

What happened in the short run when OPEC cut their oil production?

Less oil production meant a left shift of the supply curve and thus a higher price and lower quantity supplied. Since the world was highly dependent on OPEC for oil, oil was inelastic, so the higher price overpowered the lower quantity demanded and allowed OPEC to increase revenue

What happened in the long run when OPEC cut their oil production?

While oil supply remained lower than before, countries were able to find alternatives to oil, adjust their lifestyles, and find oil supply in other ways, meaning that oil became more elastic and the magnitude of the decrease in quantity demanded exceeded the magnitude of the increase in price