WEEK 3 - Chapter 5: Elasticity and its Application Flashcards
Why is elasticity?
A measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants.
Our discussion of demand was qualitative, not quantitative in chapter 4. That is, we discussed the direction in which quantity demanded moves, but not the size of the change. To measure how much demand responds to changes in its determinants, economists use the concept of elasticity.
What is the price elasticity of Demand?
A measure of how much the quantity demanded of a good responds to a change in the price of that good, calculated as the percentage change in quantity demanded divided by the percentage change in price.
What does the price elasticity of Demand for a good measure?
Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.
The price elasticity of demand for any good measures how willing consumers are to buy less of the good as its price rises. Because a demand curve reflects the many economic, social and psychological forces that shape consumers’ preferences, there is no simple, universal rule for what determines a demand curve’s elasticity. Based
on experience, however, we can state some general rules about what influences the price elasticity of demand.
What influences the price elasticity of Demand?
. Availability of close substitutes
. Necessities vs luxuries
. Definition of the market
. Time horizon
Availability of close substitutes.
Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others.
Eg. butter and margarine are easily substitutable. A small increase in the price of butter, assuming the price of margarine is held fixed, causes the quantity of butter sold to fall by a large amount.
In contrast, because eggs are a food without a close substitute, the demand for eggs is probably less elastic than the demand for butter. A small increase in the price of eggs does not cause a sizeable drop in the quantity of eggs sold.
Necessities Vs Luxuries.
Necessities tend to have inelastic demands, whereas goods that are luxuries have elastic demands.
When the price of a visit to the doctor rises, people will not dramatically alter the number of times they go to the doctor, although they might go a little less often.
In contrast, when the price of yachts rises, the quantity demanded falls substantially. The reason is that most people view visits to the doctor as a necessity and yachts as a luxury.
Whether a good is a necessity or a luxury depends not on the intrinsic properties of the good but on the preferences of the buyer. For an avid sailor with few health concerns, a yacht might be a necessity with inelastic demand and visits to the doctor a luxury with elastic demand.
Definition of the market.
The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly defined markets, since it is easier to find close substitutes for narrowly defined goods.
Eg. food, a broad category, has a fairly inelastic demand because there are no good substitutes for food. Ice-cream, a more narrow category, has a more elastic demand because it is easy to substitute other desserts for ice-cream. Vanilla ice-cream, a very narrow category, has a very elastic demand because other flavours of ice-cream are almost perfect substitutes for vanilla.
Time horizon.
Goods tend to have more elastic demand over longer time horizons. When the price of petrol rises, the quantity of petrol demanded falls only slightly in the first few months.
Over time, however, people buy more fuel-efficient cars, switch to public transport or move closer to where they work. Within several years, the quantity of petrol demanded falls more substantially.
Computing the price elasticity of Demand.
Economists calculate the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in the price.
That is:
Price elasticity of demand = Percentage change in quantity demanded ➗Percentage change in price
Midpoint formula (preferred): PEoD = (Q2 - Q1)/[(Q2 + Q1)/2] ➗(P2 - P1)/[(P2 + P1)/2] For example, suppose that a 10 per cent increase in the price of an ice-cream causes the amount of ice-cream you buy to fall by 20 per cent. We calculate your elasticity of demand as: Price elasticity of demand = 20% ➗10% = 2 In this example, the elasticity is 2, reflecting that the change in the quantity demanded is proportionately twice as large as the change in the price.l
The variety of Demand curves.
Economists classify demand curves according to their elasticity.
Demand is elastic when the elasticity is greater than 1, so that quantity moves proportionately more than the price.
Demand is inelastic when the elasticity is less than 1, so that quantity moves proportionately less than the price.
If the elasticity is exactly 1, the percentage change in quantity equals the percentage change in price; demand is said to have unit elasticity.
Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.
What is the rule of thumb for Demand elasticity?
The following rule of thumb is a useful guide: The flatter the demand curve that passes through a given point, the greater the price elasticity of demand; the steeper the demand curve that passes through a given point, the smaller the price elasticity of Demand.
The 5 cases of Demand elasticity (figure 5.1, page 100).
In the extreme case of a zero elasticity, demand is perfectly inelastic, and the demand curve is vertical - In this case, regardless of the price, the quantity demanded stays the same.
As the elasticity rises, the demand curve gets flatter and flatter. As inelasticity rise the curve gets more vertical.
At the opposite extreme, demand is perfectly elastic - This occurs as the price elasticity of demand approaches infinity and the demand curve becomes horizontal, reflecting the fact that very small changes in the price lead to huge changes in the quantity demanded.
Then there is unit elasticity where elasticity = 1.
What is total revenue (in a market)?
The amount paid by buyers and received by sellers of a good, calculated as the price of the good times the quantity sold.
Total revenue and the price elasticity of Demand.
How does total revenue change as one moves along the demand curve? The answer depends on the price elasticity of demand.
With an inelastic Demand curve, an increase in price leads to a decrease in quantity Demand that is proportionally smaller than the change the price. Thus total revenue increases.
With an elastic Demand curve, an increase in price leads to a decrease in quantity demanded that is proportionally larger than the change in price. Thus total revenue decreases.
Remember: increasing revenues is not the same as increasing profit.
Other Demand elasticities.
In addition to the price elasticity of demand, economists also use other elasticities to describe the behaviour of buyers in a market.
. The income elasticity of Demand
. The cross-price elasticity of demand