Chapter 6 and 7

Price Elasticity of Demand

A measure of consumers' responsiveness to price changes, calculated as the ratio of the percentage change in quantity demanded to the percentage change in price.

Elastic Demand

Demand is considered elastic if the percentage change in price results in a larger percentage change in demand (Ed > 1).

Inelastic Demand

Demand is considered inelastic if the percentage change in price results in a smaller percentage change in demand (Ed < 1).

Unit Elasticity

Demand is unit elastic when the percentage change in price and the percentage change in demand are equal (Ed = 1).

Perfectly Inelastic Demand

Demand that does not change at all with price changes (Ed = 0), resulting in a vertical demand curve.

Perfectly Elastic Demand

Demand that is infinitely responsive to price changes (Ed = ∞), resulting in a horizontal demand curve.

Total Revenue Test

A method to determine elasticity of demand based on how total revenue changes in response to a price change.

Midpoint Formula

A method used to calculate the percentage change in quantity demanded and price by averaging the initial and final values.

Substitutability

The concept that the existence of substitute goods affects the elasticity of demand; more substitutes generally lead to greater elasticity.

Proportion of Income

The idea that the higher the price of a good relative to consumer's income, the greater the price elasticity of demand.

Luxuries versus Necessities

Price elasticity of demand tends to be higher for luxury goods than for necessities, which are essential and less elastic.

Cross Elasticity of Demand

Measures how the quantity demanded of one product (X) responds to a change in the price of another product (Y).

Normal Goods

Goods for which the income elasticity of demand is positive; demand increases as consumer incomes rise.

Inferior Goods

Goods for which the income elasticity of demand is negative; demand decreases as consumer incomes rise.

Marginal Utility

The additional satisfaction or utility gained from consuming one more unit of a good or service.

Law of Diminishing Marginal Utility

As consumption of a good increases, the additional satisfaction gained from consuming an additional unit decreases.

Utility Maximizing Rule

The principle stating that to maximize total utility, a consumer should allocate income so that the last dollar spent on each good yields the same marginal utility.

Price Elasticity of Demand Formula

The formula is Ed = (% Change in Quantity Demanded) / (% Change in Price).

Total Revenue Formula

Total Revenue (TR) = Price (P) × Quantity Sold (Q).

Cross Elasticity of Demand Formula

The formula is Exy = (% Change in Quantity Demanded of Good X) / (% Change in Price of Good Y).

Income Elasticity of Demand Formula

The formula is Ey = (% Change in Quantity Demanded) / (% Change in Income).

Marginal Utility Formula

Marginal Utility (MU) = Change in Total Utility / Change in Quantity of Good Consumed.

Utility Maximizing Condition

The condition is MUx/Px = MUy/Py, where MU is marginal utility and P is price.

Consumer Behavior

The study of how individuals make decisions to spend their available resources on consumption-related items.

Utility

The satisfaction or benefit derived from consuming a good or service.

Marginal Utility Theory

The theory that consumers make decisions based on the additional utility gained from consuming one more unit of a product.

Budget Constraint

The limitation on the consumption choices of individuals based on their income and the prices of goods.

Indifference Curve

A graph showing combinations of two goods that give the consumer equal satisfaction and utility.

Consumer Equilibrium

The point at which a consumer maximizes their utility given their budget constraint.

Diminishing Marginal Utility

Consumer satisfaction decreases as more units of a good are consumed.

Income Effect

The change in demand for a good due to a change in consumer income.

Substitution Effect

The change in demand for a good resulting from a change in its price relative to substitute goods.

Consumer Surplus

The difference between what consumers are willing to pay for a good and what they actually pay.

Demand Curve

A graphical representation of the relationship between the price of a good and the quantity demanded.

Factors Influencing Elasticity of demand

availability of substitutes, proportion of income spent, necessity versus luxury, and time period.

Short-Run Elasticity

The price elasticity of demand measured in the short term, typically showing less elasticity due to consumer adjustments.

Long-Run Elasticity

The price elasticity of demand observed over a longer period, often showing greater elasticity as consumers fully adjust their behavior.

Total Revenue Effect

In elastic demand, lowering prices increases total revenue, whereas in inelastic demand, lowering prices decreases total revenue.

Consumer Expectation

Anticipated future price changes can affect current demand; if consumers expect prices to rise, current demand may increase.

Time Horizon

The timeframe over which consumers can adjust their purchasing behavior, affecting the elasticity of demand.

Market Definition

The specific definition of the market being analyzed can influence demand elasticity due to the availability of substitutes.

Advertising Effect

The impact of marketing and advertising on consumer preferences, potentially affecting demand elasticity.

Price Discrimination

The practice of charging different prices to different consumers for the same good, often based on elasticity differences among groups.

Availability of Substitutes

The more substitutes available for a good, the more elastic the demand; consumers can easily switch to alternatives.

Necessity vs. Luxury

Necessities tend to have inelastic demand while luxuries have more elastic demand; consumers view luxuries as optional.

Proportion of Income Spent

Goods that take up a larger share of a consumer's income typically have more elastic demand than those that do not.

Time Period

Demand elasticity can change over time; demand is often more elastic in the long run compared to the short run.

Consumer Preferences

Changes in consumer tastes and preferences can affect demand elasticity; shifts toward a product can increase elasticity.

Price Elasticity of Supply

A measure of producers' responsiveness to price changes, calculated as the ratio of the percentage change in quantity supplied to the percentage change in price.

Elastic Supply

Supply is considered elastic if the percentage change in quantity supplied results in a larger percentage change in price (Es > 1).

Inelastic Supply

Supply is considered inelastic if the percentage change in quantity supplied results in a smaller percentage change in price (Es < 1).

Unit Elastic Supply

Supply is unit elastic when the percentage change in quantity supplied is equal to the percentage change in price (Es = 1).

Perfectly Inelastic Supply

Supply that does not change at all with price changes (Es = 0), resulting in a vertical supply curve.

Perfectly Elastic Supply

Supply that is infinitely responsive to price changes (Es = ∞), resulting in a horizontal supply curve.

Factors Affecting Supply Elasticity

time period for adjustment, availability of factors of production, and production flexibility.

Short-Run Supply Elasticity

The price elasticity of supply measured in the short term, typically showing less elasticity as producers have limited adjustments.

Long-Run Supply Elasticity

The price elasticity of supply observed over a longer period, often showing greater elasticity as producers can fully adjust their production.

Price Elasticity of Supply

A measure of producers' responsiveness to price changes, calculated as the ratio of the percentage change in quantity supplied to the percentage change in price.

Factors Affecting Supply Elasticity

time period for adjustment, availability of factors of production, and flexibility in production methods.

Short-Run Supply Elasticity

The price elasticity of supply measured in the short term, typically showing less elasticity because producers have limited ability to adjust inputs.

Long-Run Supply Elasticity

The price elasticity of supply observed over a longer time frame, showing greater elasticity as producers can fully adjust their production levels.

Perfectly Inelastic Supply

Supply that does not change with price changes, resulting in a vertical supply curve (Es = 0).

Perfectly Elastic Supply

Supply that is infinitely responsive to price changes, resulting in a horizontal supply curve (Es = ∞).

Unit Elastic Supply

Supply is unit elastic when the percentage change in quantity supplied equals the percentage change in price (Es = 1).

Elastic Supply

Supply is considered elastic if changes in price result in larger percentage changes in quantity supplied (Es > 1).

Inelastic Supply

Supply is inelastic if changes in price lead to smaller percentage changes in quantity supplied (Es < 1).

Cross Elasticity of Demand Definition

indicates how the quantity demanded of one good changes in response to the price change of another good.

High Cross Elasticity

A high cross elasticity of demand (Exy > 1) indicates that the two goods are strong substitutes.

Low Cross Elasticity

A low cross elasticity of demand (Exy < 0) indicates that the goods are complements.

Income Elasticity of Demand Definition

measures how the quantity demanded of a good responds to changes in consumer income.

Normal Goods Income Elasticity

For normal goods, the income elasticity of demand is positive (Ey > 0); demand increases with income.

Inferior Goods Income Elasticity

For inferior goods, the income elasticity of demand is negative (Ey < 0); demand decreases as income rises.

Luxury Goods Income Elasticity

Luxury goods typically have an income elasticity greater than 1 (Ey > 1), indicating demand increases more than proportionally as income rises.

Necessity Goods Income Elasticity

have income elasticity between 0 and 1 (0 < Ey < 1), indicating demand increases less than proportionally with income.

High Income Elasticity

High income elasticity (Ey > 1) indicates luxury goods, where demand increases more than proportionally with income.

Low Income Elasticity

(0 < Ey < 1) indicates necessity goods, meaning demand increases less than proportionally as income rises.

Unit Income Elasticity

(Ey = 1) suggests that a percentage change in income results in an equal percentage change in quantity demanded.

Income Effect on Demand

refers to the change in quantity demanded of a good resulting from a change in consumer income.

Elasticity Categories

Goods are categorized based on income elasticity into normal goods (positive), inferior goods (negative), and luxury goods.

Relationship between Income and Demand

As consumer income increases, demand for normal goods increases while demand for inferior goods decreases.

Practice Problem: Price Elasticity of Demand

If the price of a good increases by 10% and the quantity demanded decreases by 20%, what is the price elasticity of demand?

Practice Problem: Total Revenue Test

If a company lowers the price of its product and total revenue increases, what does this indicate about the elasticity of demand for that product?

Practice Problem: Calculate Cross Elasticity

If the price of good Y rises by 5% and the quantity demanded of good X increases by 15%, what is the cross elasticity of demand between good X and good Y?

Practice Problem: Income Elasticity Calculation

If a consumer's income rises by 25% and the quantity demanded for a normal good increases by 10%, what is the income elasticity of demand?

Practice Problem: Demand Curve Analysis

Given the demand curve equation Qd = 100 - 2P, find the quantity demanded when the price is set at $20.

Practice Problem: Marginal Utility Maximization

If a consumer spends $30 on two goods and derives marginal utilities of 15 from good X and 10 from good Y, should they adjust their spending?

Practice Problem: Short-Run vs Long-Run Elasticity

Discuss how the elasticity of demand for gasoline is likely to differ in the short run compared to the long run.

Practice Problem: Utility Maximization Rule

A consumer has a budget of $50, prices of goods X and Y are $10 and $5 respectively. Determine the optimal consumption of each good if marginal utilities are equal.