Lecture 3 notes - Applying the Supply and Demand Model:...

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BE 530 Page 1 of 5 Mercedes Miranda Applying the Supply and Demand Model: Chapter Review Introduction In lecture 2, we learned that an increase in price reduces the quantity demanded and increases the quantity supplied in a market. In this lecture, we will develop the concept of elasticity so that we can address how much the quantity demanded and the quantity supplied responds to changes in market conditions such as price. The Elasticity of Demand To measure the response of demand to its determinants, we use the concept of elasticity . Price elasticity of demand measures how much the quantity demanded responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. If the quantity demanded changes substantially from a change in price, demand is elastic . If the quantity demanded changes little from a change in price, demand is inelastic . Whether a demand curve tends to be price elastic or inelastic depends on the following: Availability of close substitutes: The demand for goods with close substitutes is more sensitive to changes in prices and, thus, is more price elastic. Necessities versus luxuries: The demand for necessities is inelastic while the demand for luxuries is elastic. Since one cannot do without a necessity, an increase in the price has little impact on the quantity demanded. However, an increase in price greatly reduces the quantity demanded of a luxury. Definition of the market: The more narrowly we define the market, the more likely there are to be close substitutes and the more price elastic the demand curve. Time horizon: The longer the time period considered, the greater the availability of close substitutes and the more price elastic the demand curve. The formula for computing the price elasticity of demand is: Price elasticity of demand = Percentage change in quantity demanded/Percentage change in price
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BE 530 Page 2 of 5 Mercedes Miranda Since price elasticity of demand is always negative, it is customary to drop the negative sign. When we compute price elasticity between any two points on a demand curve, we get a different answer depending on which point we choose to start and which point we choose to finish if we take the change in price and quantity as a percent of the starting value for each. To avoid this problem, economists often employ the midpoint method to calculate elasticities. With this method, the percentage changes in quantity and price are calculated by dividing the change in the variable by the average or midpoint value of the two points on the curve, not the starting point on the curve. Thus, the formula for the price elasticity of demand using the midpoint method is: Price elasticity of demand = ( Q 2 Q 1 )/[( Q 2 + Q 1 )/2] ( P 2 P 1 )/[( P 2 + P 1 )/2] If price elasticity of demand is greater than one, demand is elastic. If elasticity is less than one, demand is inelastic. If elasticity is equal to one, demand is said to
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Lecture 3 notes - Applying the Supply and Demand Model:...

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