Econ Reading - Econ103 Macroeconomic Principles - Fall 2010...

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Econ103 – Macroeconomic Principles - Fall 2010 – Prof: Werner Baer Reading1-p.1 Reading 1 PRICE ELASTICITY OF DEMAND Price elasticity of demand is the percentage change in quantity demanded caused by a percentage change in price. Intuitively, it measures the sensitivity of consumer’s demand to a change in price. So, if price changes by 1%, elasticity tells us how much the quantity demanded changes in percentage terms. P Q E d Δ Δ = % % Looking at Graph 1, the next equation tells us how to calculate elasticity. 2 / ) ( 2 / ) ( price average price in change quantity average quantity in change 2 1 1 2 2 1 1 2 P P P P Q Q Q Q E D D D D + - + - = = Graph 1 E can take any value between 0 and infinity: E<1: Inelastic demand E = 1: Unit Elastic demand E>1: Elastic demand In the unit elastic case, if price increases, quantity demanded decreases by the same %. In the inelastic case, if price increases 1%, quantity demanded decreases less than 1%. Example: goods that people really need to buy, like medicines, or cheap goods (like a 50 cents pen). Remember: price elasticity = sensitivity to changes in price; so, if it is inelastic, people are not sensitive to changes in price. In the elastic demand case, if price increases 1%, quantity demanded decreases more than 1%. Example: most goods, especially if they are reasonably expensive and/or luxurious items. Special cases: E = 0: Perfectly inelastic demand E close to infinity: Perfectly elastic demand In the first case, if E=0, a change in price has no effect on the quantity demanded, i.e., the demand curve is vertical (Graph 2). Some examples could be medicines, gasoline or cigarettes, for many people. Graph 2 In the second case, if E is close to infinity, quantity demanded falls to zero if price increases, i.e., the demand curve is horizontal (Graph 3). Examples are goods that have perfect substitutes, like pizza from Dominos and pizza from Papa Johns (as long as the pizzas are very similar). Graph 3 PRICE ELASTICITY OF SUPPLY Price elasticity of supply is the percentage change in quantity supplied caused by a percentage change in price. It is measuring the sensitivity of producer’s supply to a change in price. So, if price changes by 1%, elasticity tells us how much the quantity supplied changes in percentage terms. P Q E S Δ Δ = % % 2 / ) ( 2 / ) ( 2 1 1 2 2 1 1 2 P P P P Q Q Q Q S S S S + - + - = The formula to calculate this elasticity is similar to the one for elasticity of demand, but we use the quantity supplied instead of quantity demanded.
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Econ103 – Macroeconomic Principles - Fall 2010 – Prof: Werner Baer Reading1-p.2 ELASTICITY AND TAXATION REVENUE AND TAXATION Revenue = P x Q Revenue is determined by quantity sold, thus it depends only on demand. When there is an increase in price, revenue may either increase or decrease, or stay the same. The result depends on the price elasticity of demand. If the demand is unit elastic, the increase in price is
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Econ Reading - Econ103 Macroeconomic Principles - Fall 2010...

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