note_ch5 - Chapter 5 Elasticity and its Applications...

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Chapter 5 Elasticity and its Applications Elasticity is a key concept in economics. In words, elasticity means how sensitive is demand or supply to a change in price. This relates to the slopes of the demand and supply curves. We’ll consider demand first. P rice elasticity of demand is related to the slope of the demand curve. Formally, it is the percentage change in the quantity demanded divided by the percentage change in the price. If demand elasticity is very high, then the slope of the demand curve will tend to be very flat; on the other hand, if demand elasticity is very low, then the demand curve will tend to be very steep. What determines a good’s demand elasticity? (1) The nature of substitutes (2) Whether the good is a necessity or a luxury (3) Defining the market
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(4) Time horizon How to calculate the price elasticity of demand Form the ratio of the percentage change in quantity over the percentage change in price. There is a complication of measuring elasticity for a linear curve, as the elasticity changes over the demand curve, and thus depends where on the curve you are. To deal with this complication, we use the midpoint method, described on page 92 of Mankiw’s text. To determine the price elasticity using the midpoint method,, we pick two prices, call them p(1) and p(2), and we pick the associated quantities with those prices from the demand curve, and call them q(1), which is quantity demanded at p(1), and similarly q(2). Measuring elasticity for a linear curve It depends where on the curve you are, so we use the midpoint method, described on page 92 of Mankiw.
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To determine the price elasticity using the midpoint method, we pick two prices, call them p(1) and p(2), and we pick the associated quantities with those prices from the demand curve, and call them q(1), which is quantity demanded at p(1), and similarly q(2). The formula for price elasticity is to first form the percentage change in quantity as follows: calculate the change in quanities: q(2) – q(1), and divide it by the average: (q(2)+q(1))/2. The midpoint percentage change in quantity is thus given by: {q(2)-q(1)}/{[q(2)+q(1)]/2} Then, divide that percentage change in quantity by the percentage change in price, which we calculate in a similar fashion:
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Calculate the change in price: p(2)-p(1), and divide it by the average rice: (p(2)+p(1))/2.
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