EC4101 Week 04 Lecture 02 PDF

EC4101 Wk.04 Lec.02 A price change can have one of two effects: 1. Price Effect: Each unit is sold at a new price, which lowers revenue in the case of a price cut and increases it in the case of a price increase. 2. Quantity Effect: After a price change, more/less units are sold,...

EC4101 Wk.04 Lec.02 A price change can have one of two effects: 1. Price Effect: Each unit is sold at a new price, which lowers revenue in the case of a price cut and increases it in the case of a price increase. 2. Quantity Effect: After a price change, more/less units are sold, increasing/decreasing revenue. Elasticity of demand tells us which one dominates in each case. If elastic, a price increase reduces revenue (the quantity effect is stronger) If inelastic, a price increase increases revenue (the price effect is stronger) If unit-elastic, price changes do not affect revenue (both effects offset each other) Fallacy of Composition: 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. Short Run Vs. Long Run: Price elasticity of demand varies according to the length of time in which consumers can adjust their spending patterns when prices change. It is lower in the short run than in the long run when there is more scope to substitute other goods. E.g. if the price of cigarettes rises, smokers may not decrease their consumption, but over the long run, less people will start smoking. Factors Determining Price Elasticity of Demand (Cont. from Lec. 01): Substitutes: Something with few substitutes is less elastic Whether it is a Necessity/Luxury: Necessities are less elastic than luxuries. The share of income spent on the product: When something feels cheap, it is usually less elastic, even if they are expensive and vice versa. E.g. if the price of chocolate rises by 20%, it doesn’t seem as bad as an increase of electricity by 20%. Time since the Price Change: Items are more elastic just after a price change than a long time after. 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. Cross Price Elasticity = % change in quantity of A demanded / % change in price of B - Goods are substitutes if the cross-price elasticity of demand is positive - Goods are complements if the cross-price elasticity of demand is negative - Goods are independent if the cross-price elasticity is/is close to 0  Income Elasticity of Demand: % change in quantity demanded / % change in income Budget Share: The price of a good multiplied by the quantity demanded, divided by total consumer spending or income. I.E. The fraction of total consumer spending for which the good accounts. - When the income elasticity of demand is positive, the good is a normal good - When the income elasticity of demand is negative, the good is an inferior good - When the income elasticity of demand is between 0-1, it’s a necessity - When the income elasticity of demand is more than 1, it’s a luxury good Price Elasticity of Supply: A measure of the responsiveness of the quantity of a good supplied to the price of that good. Always positive. Price Elasticity of Supply = % change in quantity supplied / % change in price - At 0, the price elasticity of supply is perfectly inelastic - The higher, the more elastic it is, it can be infinite Factors Determining Price Elasticity of Supply: The availability of inputs: It tends to be high when inputs are relatively available Time: It tends to grow larger as consumers have more time to respond to a price change References: Notes based on EC4101 Lecture Slides and the relevant readings from Economics (12th Ed.) David Begg.