econ ch 5

Elasticity and Its Application

Our Scenario

• We don’t know if you’ll be making a profit because your price will go up but demand for your services will go down

• Demand may be sensitive to changes in price

• It will depend

The Elasticity of Demand

• Elasticity 

- Measure of how much buyers and sellers respond to changes in market conditions

- Measure of the responsiveness of Qd or Qs to a change in one of its determinants 

• Price elasticity of demand 

- How much the quantity demanded of a good responds to a change in its price 

- Loosely speaking, it measures the price-sensitivity of buyers’ demand

• 1.5 = per 1% change in price, demand falls by 1.5%

Calculating Percentage Changes

• The Midpoint Method

• Standard method of computing the % change in a variable

• Going from A to B: 2500-2000/2000 (x100)= 25%

• 8-12/12 (x100)= -33%

• Price elasticity 33/25= 1.33

• Going from B to A: different price elasticity

• Midpoint method

- the midpoint is the number halfway between the start and end values

- the average of those values

Cheerios vs. Airfare

• Prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? 

- cheerios has many close substitutes, so buyers can easily switch if the price rises

- traveling by airplane has no close substitutes, so a price increase would not affect demand very much

• Price elasticity is higher when close substitutes are available

Gasoline, Short Run vs. Long Run

• The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why?

- There’s not much people can do in the short run, other than ride the bus or carpool

- In the long run, people can buy smaller cars or live closer to work. 

• Price elasticity is higher in the long run

The Variety of Demand Curves

• Demand is elastic

- price elasticity of demand > 1

• Demand is inelastic

- Price elasticity of demand < 1

• Demand has unit elasticity

- price elasticity of demand = 1

• Demand is perfectly inelastic

- price elasticity of demand = 0

- demand curve is vertical

• Demand is perfectly elastic

- price elasticity of demand = infinity

- demand curve is horizontal

• The flatter the demand curve

- the greater the price elasticity of demand

Perfectly Inelastic Demand

Elastic Demand

Elasticity Along a Linear Deman Curve

• The slope of a linear demand curve is constant, but its elasticity is not

• Elasticity tends to have an inverse relationship with the slope (be careful)

• Change your price if your good is inelastic

Price Elasticity and Total Revenue

• For a price increase, if demand is elastic

- TR decreases: the fall in Q is proportionately greater than the rise in P

• For a price increase, if demand is inelastic  

- TR increases: the fall in Q is proportionately smaller than the rise in P

Income Elasticity of Demand

• Income elasticity of demand

- How much the quantity demanded of a good responds to a change in consumers’ income

- % change in quantity demanded divided by the percentage change in income

• Normal goods: income elasticity >0

• Inferior goods: income elasticity < 0

Cross-Price Elasticity of Demand

• Cross-price elasticity of demand

• How much the Qd of one good responds to a change in the price of another good

- % percentage change in Qd of the first good divided by the % change in the price of the second good

• Substitutes: cross-price elasticity > 0 

• Complements: cross-price elasticity < 0 

The Price Elasticity of Supply

• Price elasticity of supply

• How much the quantity supplied of a good respond to a change in its price

- % change in quantity supplied divided by the % change in price

• It measures sellers’ price-sensitivity 

• Elastic supply: the quantity supplied responds substantially to price changes 

• Inelastic supply: if the quantity supplied responds only slightly

Calculating Price Elasticity of Supply

Price Elasticity of Supply (PES) is calculated using the formula:[ PES = \frac{% \text{ change in quantity supplied}}{% \text{ change in price}} ]This measure helps determine how responsive producers are to changes in market prices, allowing businesses to make informed decisions on production levels.