Chapter 4

• Demand elasticity can be computed with respect to any factor affecting demand:

  • By how much does demand change when the price of the good changes? → price elasticity of demand (most used)
  • By how much does demand change when consumers income changes? → income elasticity of demand
  • By how much does demand change when the price of another, related, good changes? → cross-price elasticity of demand
• 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, computed as the to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.
• Calculating price elasticity of demand:

  (Percentage change in quantity demanded) / (percentage change in price)
• Calculating percentage change:

  (final value - initial value) / initial value (*100)
• Calculate the price elasticity of demand → an increase in the price of an ice-cream from €2 to €2.20 causes the amount of ice-cream you buy to fall from 10 to 8 per month.

  → -2
• Midpoint method:

  (final value - initial value)/ (midpoint of final and initial values)
• Price elasticity of demand

  A) number before P

  B) the slope of the demand curve

  C) Quantity demanded

  D) price

  E) derivative

  
• Demand is price elastic if elasticity >1 → quantity demanded responds strongly to price changes
• Demand is price inelastic i elasticity <1 → quantity demanded does not respond strongly to price changes
• Demand is price unit elastic if elasticity = 1 → quantity demanded changes by the same percentage as price
• Demand is price perfectly elastic if elasticity = infinity

  → Quantity demanded changes infinitely with any change in price

  
• Demand is price perfectly inelastic if elasticity = 0

  → Quantity demanded does not respond to price changes

  
• The price elasticity of demand is closely related to the slope of the demand curve

  • How steeper the demand curve is, the less price elastic (price inelastic) demand will be.
  • Demand curve is flat → demand is price elastic
• Price elasticity

  A) Price elastic → not much people have it

  B) unit elastic

  C) price inelastic

  
• Calculating total revenue:

  Consumer expenditures = total revenue

  → = price of good (P x Q) * quantity sold (→ paid by consumers or received by firms)

  
• Price inelastic demand → Increase in the price leads to an increase in total reveneu
• Price elastic demand → Increase in the price leads to a decrease in total revenues.
• Unit elastic demand → Increase in price does not affect total revenue
• What determines how elastic demand for a good is?

  • Availability close substitutes
  • Goods with close substitutes have more elastic demand
  • Necessities vs. luxuries
  • Necessities have more inelastic demand
  • Definition of the market
  • Narrowly defined markets have more elastic demand
  • Proportion of income spent on goods
  • Goods for which a higher proportion of income is spent have more elastic demand
  • Time horizon
  • Demand over longer time horizons is more elastic
• Income elasticity of demand is the responsiveness of demand to a change in income.
• Income elasticity = (percentage change in quantity demanded)/(percentage change in income)
• Inferior goods

  When your income increases, you buy less of it → example: second hand clothes
• If the income elasticity is:

  • Normal goods
  • Positive income elasticity
  • Inferior goods
  • Negative income elasticity
  • Necessities
  • Small income elasticity (<1)
  • Luxuries
  • High income elasticity (>1)
• Cross-price elasticity of demand measures how much the quantity demanded of a good responds to change in the price of a related good, computed as the percentage change in quantity demanded divided by the percentage change in the price of the related good.
• Cross-price elasticity of demand = (percentage change in quantity demanded)/(percentage change in price of related good)
• Cross price elasticity example → How much does the demanded quantity change for Pepsi, when the price for Coca-Cola changes?
• If the cross price elasticity of demand is:

  • Positive → the goods are substitutes
  • Negative → the goods are complements
  • High (in absolute value) → goods are highly related
  • Low (in absolute value) → goods are unrelated
• Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of the good, computed as the percentage change in quantity supplied divided by the percentage change in price.
• Price elasticity of supply depends on the flexibility of sellers to change the amount of good they produce.
• Examples of elastic and inelastic supply:

  • Beach front land has inelastic supply (almost impossible to produce more of it)
  • Manufactured goods (books, cars, ...) have elastic supply because firms that produce them can run their factories longer in response to higher prices.
• Price elasticity of supply = (percentage change in quantity supplied)/(percentage change in price)
• • Supply is price elastic if elasticity >1
  • Supply is price inelastic if elasticity <1
  • Supply is price unit elastic if elasticity = 1
  • Supply is perfectly elastic if elasticity = infinity
  • Supply is price perfectly inelastic if elasticity = 0