4. Elasticities of demand and supply Flashcards

1
Q

The price elasticity of demand (PED) is the percentage change in the quantity demanded divided by the corresponding percentage change in its price.

PED=(% change in quantity)/(% change in price)

Since demand curves slope down, price and quantity changes always have opposite signs. The demand elasticity is a negative number.

The demand elasticity is high if it is a large negative number. The quantity demanded is sensitive to the price. The demand elasticity is low if it is a small negative number and the quantity demanded is insensitive to the price. ‘High’ or ‘low’ refer to the size of the elasticity, ignoring the minus sign. The demand
elasticity falls when it becomes a smaller negative number and quantity demanded becomes less sensitive to the price

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2
Q

Demand is elastic price elasticity is more negative than −1.
Demand is inelastic if the price elasticity lies between −1 and 0
If the demand elasticity is −1, demand is unit elastic.

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3
Q

The fallacy of composition means that what is true for the individual may not be true for everyone together, and what is true for everyone together may not hold
for the individual.

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4
Q

The short run is the period after prices change but before quantity adjustment can occur.
The long run is the period needed for complete adjustment to a price change. Its length depends on the type of adjustments consumers wish to make.

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5
Q

The cross-price elasticity of demand for good i with respect to changes in the
price of good j is the percentage change in the quantity of good i demanded, divided by the corresponding percentage change in the price of good j.

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6
Q

The budget share of a good is its price multiplied by the quantity demanded, divided by total consumer spending or income.

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7
Q

The income elasticity of demand for a good is the percentage change in quantity demanded divided by the corresponding percentage change in consumer income.

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8
Q

A normal good has a positive income elasticity of demand.
An inferior good has a negative income elasticity of demand.
A luxury good has an income elasticity above unity.
A necessity has an income elasticity below unity.

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9
Q

The incidence of a tax describes who eventually bears the burden of that tax.

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10
Q

Unless otherwise specified, the elasticity of demand refers to the own-price elasticity. It measures the sensitivity of quantity demanded to changes in the own price of a good, holding constant the prices of other goods and income. Demand elasticities are negative since demand curves slope down. In general, the demand elasticity changes as we move along a given demand curve. Along a straight-line demand curve, elasticity falls as price falls.

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11
Q

Demand is elastic if the price elasticity is more negative than −1 (for example, −2). Price cuts then increase total spending on the good. Demand is inelastic if the demand elasticity lies between −1 and 0. Price cuts then reduce total spending on the good. Demand is unit-elastic if the demand elasticity is −1. Price changes
then have no effect on total spending on the good.

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12
Q

The demand elasticity depends on how long customers have to adjust to a price change. In the short run, substitution possibilities may be limited. Demand
elasticities will typically rise (become more negative) with the length of time allowed for adjustment. The time required for complete adjustment varies from good to good.

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13
Q

The cross-price elasticity of demand measures the sensitivity of quantity demanded of one good to changes in the price of a related good. Positive cross-price elasticities tend to imply that goods are substitutes, negative cross-price elasticities that goods are complements.

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14
Q

The income elasticity of demand measures the sensitivity of quantity demanded to changes in income, holding constant the prices of all goods.

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15
Q

Inferior goods have negative income elasticities of demand. Higher incomes reduce the quantity demanded and the budget share of such goods. Luxury goods have income elasticities larger than 1. Higher incomes raise the quantity demanded and the budget share of such goods

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16
Q

Goods that are not inferior are called normal goods and have positive income elasticities of demand. Goods that are not luxuries are called necessities and have income elasticities of less than 1. All inferior goods are necessities but normal goods are necessities only if they are not luxuries.

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17
Q

Doubling all nominal variables should have no effect on demand since it alters neither the real value (purchasing power) of incomes nor the relative prices of goods. In examining data from economies experiencing inflation, it is often best to look at real prices and real incomes, adjusting prices and incomes for the effect
of inflation.

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18
Q

The supply elasticity measures the percentage response of quantity supplied to a 1 per cent increase in the price of the commodity. Since supply curves slope up, the supply elasticity is positive.

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19
Q

Tax incidence measures who eventually pays the tax. Since taxes induce changes in equilibrium prices and quantities, this can be very different from the people
from whom the government appears to collect the money.

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20
Q

For specific taxes, slopes of supply and demand curves are relevant. For ad valorem taxes, elasticities of supply and demand are relevant. In either case, it is the more price-insensitive side of the market that bears more of the burden of a tax.

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21
Q

Harvest failures (and bumper crops) are a feature of agricultural markets. Because the demand elasticity for many agricultural products is very low, harvest failures produce large increases in the price of food. Conversely, bumper crops induce very large falls in food prices. When demand is very inelastic, shifts in the supply curve lead to large fluctuations in price but have little effect on equilibrium quantities.

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22
Q

Consider a price cut in the market. This creates two effects:

A

(1) A price effect: each unit of the good is now sold at a lower price, which tends to decrease total spending.
(2) A quantity effect: after the price cut, more units are sold, which tends to raise total spending.

23
Q

Case C shows the point on the demand curve at which the price elasticity of demand is −1 (quantity change −1 per cent; price change −1 per cent). If demand is elastic, as in case A, a 1 per cent price cut leads to an increase in quantity by more than 1 per cent. Hence total spending rises. Conversely, when demand is inelastic, as in case B, a 1 per cent price cut leads to an increase in quantity by less than 1 per cent. Hence total spending falls.

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24
Q

Spending and revenue reach a maximum at the point of unit-elastic demand.

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25
Q

Elasticities measure the response of quantity demanded to separate variations in three factors: the own-price, the price of related goods and income.
When all nominal variables change by the same proportion, the sum of these three effects is exactly zero.

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26
Q

Only keep track of the supply response to an increase in the own-price of a good or service.
Supply elasticity = (% change in quantity supplied)/(% change in price)
Because supply curves slope upwards, the elasticity of supply is always positive.
The more elastic is supply, the larger the percentage
increase in quantity supplied in response to a given percentage change in price. Thus, elastic supply curves are relatively flat and inelastic supply curves relatively
steep.

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27
Q

Therefore the tax introduction has the following effects on equilibrium:

(1) It increases the price paid by consumers.
(2) It decreases the price received by the suppliers.
(3) It reduces the equilibrium quantity in the market.

Notice an important thing: it does not matter if the government charges the suppliers or the consumers, the results will be the same: PS = PD − t implies that PD=PS + t. Using one equation instead of the other in our model will not change the final result.

Government revenues from the tax are given by the tax rate multiplied by the
equilibrium quantity after the introduction of the tax, that is: tQ*D.

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