Module 4 Study Guide Flashcards
What is the price elasticity of demand? How is it calculated?
Price elasticity of demand gives us more information on consumer demand than simply the law of demand (quantity demanded increases when price decreases and vice versa). It tells us how much the quantity demanded increases when the price decreases and vice versa. Does it change a lot or a little is what the price elasticity of demand tells us.
It is calculated by….
Price Elasticity of Demand (often abbreviated to just Elasticity) = Percentage change in the quantity of a good A demanded / Percent change in the price of good A
This tell us how big the quantity change is relative to the price change.
The percentage change will never need to be calculated. That will always be given to you.
Explain what it means when we say that demand is elastic? Inelastic?
Inelastic demand means that quantity demanded does not respond strongly the changes in price (This means the elasticity of demand is less than 1 AKA the number on top is smaller than on the bottom in the formula - so the percentage change in quantity is smaller than the percentage change in price) This is often because there are few substitutes for a product, it’s a necessity, or it’s small portion of someone’s income.
Goods where the product demanded is very responsive to changes in price are referred to as elastic goods. These are items that there are lots of substitutes for, luxury goods, or are a large percentage of a person’s income. There percentage change in price is going to be smaller than the percentage change in quantity demanded. That’s how you get that fraction to be greater than one.
What does the price elasticity of demand tell us about the relationship between price and total revenue?
If there’s elastic demand, revenue (price x quantity) will decrease as price increases and vice versa. As price falls, total revenue increases, etc. Price and total revenue move in opposite directions. (price elasticity 11)
When total revenue doesn’t change when the price changes at all that’s unit elastic (price elasticity of 1).
She recommends memorizing these relationships.
How do we know if a product is a normal good or an inferior good?
(Income elasticity of demand)
Normal good: When our income goes up, we buy more of them. When income goes down, we buy less and quantity demanded goes down also. They have a positive income elasticity because income and quantity will always move in the same direction.
Inferior goods: When our income goes up, we buy less of them (quantity demanded goes down). When income goes down, we buy more of them. They have a negative income elasticity because income and quantity will always move in opposite directions. (one negative and one positive number in fraction so always negative)
How do we know if the products are substitutes or complements?
When the price of Product A goes up, quantity demanded of Product B goes up if they’re substitutes. (Coke & Pepsi) So cross elasticity will have a positive sign because they’re moving in the same direction. If the price of Coke went down, the quantity demanded for Pepsi would go down. Both changes would then be negative and still end in a positive fraction. Substitutes always have a positive cross price elasticity.
With complementary goods like coffee and creamer, peanut butter and jelly, cereal and milk, etc. when the price of one product goes up, the quantity demanded of the other product goes down. If the price goes up of peanut butter, they’ll buy less peanut butter and also less jelly. One of the percentage changes will then be negative and the other positive leading to cross elasticity of complements always being negative.
What is the price elasticity of supply?
You measure the price elasticity of supply (eS) as the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged:
eS = % change in quantity supplied% change in price
Because price and quantity supplied usually move in the same direction, the price elasticity of supply is usually positive. The larger the price elasticity of supply, the more responsive the firms that supply the good or service are to a price change.
Supply is price elastic if the price elasticity of supply is greater than 1, unit price elastic if it is equal to 1, and price inelastic if it is less than 1. A vertical supply curve, as shown in Panel (a) of Figure 4.11 “Supply Curves and Their Price Elasticities,” is perfectly inelastic; its price elasticity of supply is zero. The supply of Beatles’ songs is perfectly inelastic because the band no longer exists. A horizontal supply curve, as shown in Panel (b) of Figure 4.11, is perfectly elastic; its price elasticity of supply is infinite. It means that suppliers are willing to supply any amount at a certain price.
