Elasticity Notes PDF

Elasticity 1  Look for the answers to these questions: What is elasticity? What kinds of issues can elasticity help us understand? What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure? What is the...

Elasticity 1  Look for the answers to these questions: What is elasticity? What kinds of issues can elasticity help us understand? What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure? What is the price elasticity of supply? How is it related to the supply curve? What are the income and cross-price elasticities of demand? 2  A scenario: You design websites for local businesses. – You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time) – You consider raising the price to $250. The law of demand: you won’t sell as many websites if you raise your price. – How many fewer websites? – How much will your revenue fall, or might it increase? 3  The Elasticity of Demand Elasticity – 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 the price of that good Loosely speaking, it measures the price- sensitivity of buyers’ demand 4 Price Elasticity of Demand Price elasticity of demand = percentage change in Q d P = percentage change in P P rises P2 15% = = 1.5 by 10% P1 10% D Along a D curve, P and Q move in opposite directions, Q which would make price Q2 Q1 elasticity negative. Q falls by 15% We will drop the minus sign and report all price elasticities as positive numbers. 5 Calculating Percentage Changes Standard method of computing the Demand for your percentage (%) change: websites P end value − start value B =  100% $250 start value A Going from A to B: $200 the % change in P = ($250– D $200)/$200 = 25% Q the % change in Q = - 33% 8 12 Price elasticity = 33/25 = 1.33 Going from B to A: the % change in P = - 20% the % change in Q = 50% We get different values! Price elasticity = 50/20 = 2.5 6  The Price Elasticity of Demand Midpoint method – The midpoint is the number halfway between the start and end values The average of those values end value - start value percentage change =  100% midpoint (Q2 − Q1 ) / [(Q2 + Q1 ) / 2 ] Price elasticity of demand = (P2 − P1 ) / [(P2 + P1 ) / 2 ] 7 Calculating Percentage Changes Demand for your websites P B $250 Using the midpoint method of A computing % changes: $200 D Q 8 12 $250 − $200 % change in P =  100% = 22.2% $225 12 − 8 % change in Q =  100% = 40% 10 40% Price elasticity = = 1.8 22.2% 8  Calculate an elasticity Use the following information to calculate the price elasticity of demand for iPhones: if P = $400, Qd = 10,600 if P = $600, Qd = 8,400 Use the midpoint method to calculate percentage changes. 9  Answers Using the midpoint method to calculate percentage changes: % change in P = [($600 - $400)/$500] ×100 = 40% % change in Qd = [(10,600 – 8,400)/9,500] ×100 = 23.16% Price elasticity of demand = = % change in Qd / % change in P = 23.16/40 = 0.58 10  The Price Elasticity of Demand Determinants of price elasticity of demand – We look at a series of examples comparing two common goods In each example: – Suppose prices of both goods rise by 20% – Which good has the highest price elasticity of demand? Why? – What lesson we learn about the determinants of price elasticity of demand? 11  The Price Elasticity of Demand Example 1: Breakfast cereal vs. Sunscreen – Prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? Breakfast cereal has close substitutes, so buyers can easily switch if the price rises Sunscreen has no close substitutes, so a price increase would not affect demand very much Price elasticity is higher when close substitutes are available 12