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E-201.Study Guide Chapter4.Key Terms and Questions

# E-201.Study Guide Chapter4.Key Terms and Questions -...

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63 4 ELASTICITY K e y C o n c e p t s Price Elasticity of Demand The price elasticity of demand is a units-free measure of responsiveness of the quantity de- manded of a good to a change in its price when all other influences on buyers’ plans remain the same. The price elasticity of demand equals the magnitude of: ave ave P / P Q / Q Δ Δ = price) in change e (percentag demanded) quantity in change e (percentag where “ ave ” stands for average. When the elasticity equals 0, the good has perfectly inelastic demand and the demand curve is vertical. When the elasticity is less than 1 and greater than 0, the good has inelastic demand . When the elasticity equals 1, the good has unit elastic demand . When the elasticity is greater than 1 and less than infinity, the good has elastic demand . When the elasticity equals infinity, the good has perfectly elastic demand and the demand curve is horizontal. Elasticity is not equal to the slope of the demand curve. Moving along a linear demand curve the slope ( Δ P/ Δ Q ) is constant but the elasticity falls in magnitude moving downward along the curve. Price elasticity and total revenue ( P ) × ( Q ): When demand is A price cut results in Inelastic (elasticity < 1) a decrease in total revenue Unit elastic (elasticity = 1) no change in total revenue Elastic (elasticity > 1) an increase in total revenue The total revenue test estimates the price elasticity of demand by noting how a change in price affects the total revenue spent on the product. A person’s expenditure on a good follows the same rules. If the good has an elastic demand, a price cut increases expenditure; if it has a unit elastic demand, a price cut does not change expenditure; and, if it has an inelastic demand, a price cut decreases expenditure. The price elasticity of demand depends on three factors: Substitutability — the more close substitutes there are for the good, the larger is its price elasticity. Ne- cessities generally have few substitutes and so have a small elasticity; luxuries generally have many substi- tutes and so have a large elasticity. Proportion of income spent on the good — the greater the proportion of income spent on a good, the lar- ger is its price elasticity of demand. Time elapsed since the price change — the more time that has passed since the price changed, the greater is the price elasticity of demand. More Elasticities of Demand The cross elasticity of demand measures the respon- siveness of demand for a good to a change in the price of a substitute or complement. The cross elasticity of demand equals: . good) related a of price the in change e (percentag demanded) quantity the in change e (percentag The sign of the cross elasticity of demand depends on whether the goods are substitutes or complements.

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