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PRICE ELASTICITY OF DEMAND

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Main Question: How sensitive is quantity demanded to a change in price? (elasticity = responsiveness)

1) Calculating Price Elasticity of Demand

2) Categories of Price Elasticity of Demand

3) Elasticity and Total Revenue

4) Price Elasticity and the Linear Demand Curve

5) Constant-Elasticity Demand Curves

1) Calculating Price Elasticity of Demand

2) Categories of Price Elasticity of Demand

3) Elasticity and Total Revenue

4) Price Elasticity and the Linear Demand Curve

5) Constant-Elasticity Demand Curves

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1) Calculating Price Elasticity of Demand

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the price elasticity of demand measures how responsive consumers are to a change in price

a) Elasticity = Responsiveness

- expresses a relationship between two amounts: the percentage change in quantity demanded and the percentage change in price

- price and quantity demanded are inversely related, so the change in price and the change in quantity demanded move in opposite directions

Price Elasticity of Demand = Percentage Change in Quantity Demanded/Percentage Change in Price

OR

[(Q1 - Q2)/(Q1+Q2/2)]/[(P1-P2)/(P1+P2/2)]

a) Elasticity = Responsiveness

- expresses a relationship between two amounts: the percentage change in quantity demanded and the percentage change in price

- price and quantity demanded are inversely related, so the change in price and the change in quantity demanded move in opposite directions

Price Elasticity of Demand = Percentage Change in Quantity Demanded/Percentage Change in Price

OR

[(Q1 - Q2)/(Q1+Q2/2)]/[(P1-P2)/(P1+P2/2)]

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2) Categories of Price Elasticity of Demand

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a) Inelastic Demand (less than one) = a change in price has relatively little effect on quantity demanded; the percentage change in quantity demanded is less than the percentage change in price; the resulting price elasticity has an absolute value less than 1.0 (UNRESPONSIVE)

b) Unit Elastic Demand (is 1) = the percentage change in quantity demanded equals the percentage change in price; the resulting price elasticity has an absolute value of 1.0

c) Elastic Demand (greater than 1) = a change in price has a relatively large effect on quantity demanded; the percentage change in quantity demanded exceeds the percentage change in price; the resulting price elasticity has an absolute value exceeding 1.0

b) Unit Elastic Demand (is 1) = the percentage change in quantity demanded equals the percentage change in price; the resulting price elasticity has an absolute value of 1.0

c) Elastic Demand (greater than 1) = a change in price has a relatively large effect on quantity demanded; the percentage change in quantity demanded exceeds the percentage change in price; the resulting price elasticity has an absolute value exceeding 1.0

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3) Elasticity and Total Revenue

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a) Total Revenue (TR) = Price (p) multiplied by quantity demanded (q) at that price

TR = p x q

- if the demand is ELASTIC, the percentage increase in quantity demanded exceeds the percentage decrease in price --> total revenue INCREASES

- if the demand is UNIT ELASTIC, the percentage increase in quantity demanded just equals the percentage decrease in price --> total revenue remains UNCHANGED

- if demand is INELASTIC, the percentage decrease in price has relatively little effect on quantity demanded --> total revenue DECREASES

TR = p x q

- if the demand is ELASTIC, the percentage increase in quantity demanded exceeds the percentage decrease in price --> total revenue INCREASES

- if the demand is UNIT ELASTIC, the percentage increase in quantity demanded just equals the percentage decrease in price --> total revenue remains UNCHANGED

- if demand is INELASTIC, the percentage decrease in price has relatively little effect on quantity demanded --> total revenue DECREASES

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4) Price Elasticity and the Linear Demand Curve

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a) Linear Demand Curve = a straight-line demand curve; such a demand curve has a constant slope but usually has a varying price elasticity

- the price elasticity of demand is larger on the higher-price end of the demand curve than on the lower-price end

- if the demand curve is linear, consumers are more responsive (elastic) to a given price change when the initial price is high than when it's low

- the halfway point divides a linear demand curve into an elastic upper half and an inelastic lower half

b) Elastic = a price decline increases total revenue/a price incline decreases total revenue (because the price has a large effect on quantity demanded)

c) Inelastic = a price decline decreases total revenue (because the price has little effect on quantity demanded)/a price incline increases total revenue

- the price elasticity of demand is larger on the higher-price end of the demand curve than on the lower-price end

- if the demand curve is linear, consumers are more responsive (elastic) to a given price change when the initial price is high than when it's low

- the halfway point divides a linear demand curve into an elastic upper half and an inelastic lower half

b) Elastic = a price decline increases total revenue/a price incline decreases total revenue (because the price has a large effect on quantity demanded)

c) Inelastic = a price decline decreases total revenue (because the price has little effect on quantity demanded)/a price incline increases total revenue

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5) Constant-Elasticity Demand Curves

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a) Constant-Elasticity Demand Curve = the type of demand that exists when price elasticity is the same everywhere along the curve; the elasticity value is unchanged

a) Perfectly Elastic Demand Curve

b) Perfectly Inelastic Demand Curve

c) Unit Elastic Demand Curve

Price Elasticity = measures the responsiveness of consumers to a change in price

a) Perfectly Elastic Demand Curve

b) Perfectly Inelastic Demand Curve

c) Unit Elastic Demand Curve

Price Elasticity = measures the responsiveness of consumers to a change in price

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Perfectly Elastic Demand Curve

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a) Perfectly Elastic Demand Curve = a horizontal line reflecting a situation in which any price increase would reduce quantity demanded to zero; the elasticity has an absolute value of infinity

- consumers demand all that is offered for sale at the given price

- if price rises above p, quantity demanded drops to zero

- consumers demand all that is offered for sale at the given price

- if price rises above p, quantity demanded drops to zero

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Perfectly Inelastic Demand Curve

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a) Perfectly Inelastic Demand Curve = a vertical line reflecting a situation in which any price change has no effect on the quantity demanded; the elasticity value is zero

- quantity demanded does not vary when the price changes

ex: when you are extremely rich and need insulin to survive, price would be no object

- quantity demanded does not vary when the price changes

ex: when you are extremely rich and need insulin to survive, price would be no object

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Unit Elastic Demand Curve

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a) Unit Elastic Demand Curve = everywhere along the demand curve, the percentage change in price causes an equal but offsetting percentage change in quantity demanded, so total revenue remains the same; the elasticity has an absolute value of 1.0

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DETERMINANTS OF THE PRICE ELASTICITY OF DEMAND

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1) Availability of Substitutes

2) Share of the Consumer's Budget Spend on the Good

3) Duration of Adjustment Period

4) Elasticity Estimates

2) Share of the Consumer's Budget Spend on the Good

3) Duration of Adjustment Period

4) Elasticity Estimates

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1) Availability of Substitutes

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the greater the availability of substitutes and the more similar these substitutes are to the good in question, the greater that good's price elasticity of demand

- the more narrow the definition, the more substitutes and, thus, the more elastic the demand

- the more narrow the definition, the more substitutes and, thus, the more elastic the demand

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2) Share of the Consumer's Budget Spend on the Good

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the more important the item is as a share of the consumer's budget, other things constant, the greater is the income effect of a change in price, so the more elastic is the demand for the item

ex: the income effect of a higher price reduces the quantity demanded, yet the income effect of an increase in the price of paper towels is trivial because paper towels represent such a tiny share of any budget

ex: the income effect of a higher price reduces the quantity demanded, yet the income effect of an increase in the price of paper towels is trivial because paper towels represent such a tiny share of any budget

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3) Duration of Adjustment Period

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the longer the period of adjustment, the more responsive the change in quantity demanded is to a given change in price

ex: sharp increase in room and board fees is effective next term; therefore, some students will have time to move off campus before that term begins to find other choices

ex: sharp increase in room and board fees is effective next term; therefore, some students will have time to move off campus before that term begins to find other choices

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4) Elasticity Estimates

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the price elasticity of demand is greater in the long run because consumers have more time to adjust

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PRICE ELASTICITY OF SUPPLY

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a) Price Elasticity of Supply = measures the responsiveness of quantity supplied to a price change; the percentage change in quantity supplied divided by the percentage change in price

Price Elasticity of Supply = Percentage Change in Quantity Supplied/Percentage Change in Price

OR

[(Q1 - Q2)/(Q1+Q2/2)]/[(P1-P2)/(P1+P2/2)]

b) Inelastic Supply (less than 1) = a price change has relatively little effect on quantity supplied; the percentage change in quantity supplied is less than the percentage change in price; the price elasticity of supply is less than 1.0

c) Unit Elastic Supply (is 1) = the percentage change in quantity supplied equals the percentage change in price; the resulting price elasticity has an absolute value of 1.0

c) Elastic Supply (greater than 1) = a change in price has a relatively large effect on quantity supplied; the percentage change in quantity supplied exceeds the percentage change in price; the resulting price elasticity has an absolute value exceeding 1.0

1) Constant Elasticity of Supply Curves

2) Determinants of Supply Elasticity

Price Elasticity of Supply = Percentage Change in Quantity Supplied/Percentage Change in Price

OR

[(Q1 - Q2)/(Q1+Q2/2)]/[(P1-P2)/(P1+P2/2)]

b) Inelastic Supply (less than 1) = a price change has relatively little effect on quantity supplied; the percentage change in quantity supplied is less than the percentage change in price; the price elasticity of supply is less than 1.0

c) Unit Elastic Supply (is 1) = the percentage change in quantity supplied equals the percentage change in price; the resulting price elasticity has an absolute value of 1.0

c) Elastic Supply (greater than 1) = a change in price has a relatively large effect on quantity supplied; the percentage change in quantity supplied exceeds the percentage change in price; the resulting price elasticity has an absolute value exceeding 1.0

1) Constant Elasticity of Supply Curves

2) Determinants of Supply Elasticity

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Constant Elasticity Supply Curves

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a) Perfectly Elastic Supply Curve

b) Perfectly Inelastic Supply Curve

c) Unit-Elastic Supply Curve

b) Perfectly Inelastic Supply Curve

c) Unit-Elastic Supply Curve

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Perfectly Elastic Supply Curve

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a horizontal line reflecting a situation in which any price decrease drops the quantity supplied to zero; the elasticity value is infinity

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Perfectly Inelastic Supply Curve

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a vertical line reflecting a situation in which a price change has no effect on the quantity supplied; the elasticity value is zero

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Unit Elastic Supply Curve

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a percentage change in price causes an identical percentage change in quantity supplied; depicted by a supply curve that is a straight line from the origin; the elasticity value equals 1.0

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2) Determinants of Supply Elasticity

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a) Slow Rising Marginal Cost = More Elastic

b) Time Horizon or The Longer Period of Adjustment = More Elastic

b) Time Horizon or The Longer Period of Adjustment = More Elastic

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OTHER ELASTICITY MEASURES

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1) Income Elasticity of Demand

2) Cross-Price Elasticity of Demand

2) Cross-Price Elasticity of Demand

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1) Income Elasticity of Demand

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a) Income Elasticity of Demand = the percentage change in demand divided by percentage change in consumer income; the value is positive for normal goods and negative for inferior goods

b) Inferior Goods = goods with income elasticities less than zero (used clothing)

c) Normal Goods = goods with income elasticities greater than zero (new clothing)

- Income Inelastic = normal goods with income elasticities less than 1 (necessities)

- Income Elastic = goods with income elasticity greater than 1 (luxuries)

b) Inferior Goods = goods with income elasticities less than zero (used clothing)

c) Normal Goods = goods with income elasticities greater than zero (new clothing)

- Income Inelastic = normal goods with income elasticities less than 1 (necessities)

- Income Elastic = goods with income elasticity greater than 1 (luxuries)

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2) Cross-Price Elasticity of Demand

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a) Cross-Price Elasticity of Demand = the percentage change in the demand of one good divided by the percentage change in the price of another good; it's positive for substitutes, negative for complements, and zero for unrelated goods

- the responsiveness of the demand for one good to changes in the price of another good

- the responsiveness of the demand for one good to changes in the price of another good

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Substitutes

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an increase in the price of one good leads to an increase in the demand for another good

- CROSS PRICE ELASTICITY IS POSITIVE

- CROSS PRICE ELASTICITY IS POSITIVE

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Complements

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an increase in the price of one good leads to a decrease in the demand for another good

- CROSS PRICE ELASTICITY IS NEGATIVE

- CROSS PRICE ELASTICITY IS NEGATIVE