Elasticity - Part II Chapter 6 Elasticity of Demand Why is...

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Part II Chapter 6 Elasticity of Demand Why is it so important? In 2004, the price of gasoline started to rise. California gas producers shut down some production. Consumer advocates accused them of doing this to gain profit. By why would they? And if they were not in some evil conspiracy, why did the price rise so far and so fast? Vermont dairy farmers are facing record low revenues and profits due to – yes – improvements in the quantity of milk they are producing. What? Other producers gain profits when output increases. In the last chapter, we saw that as price rises, the quantity consumers demand of a good will increase and as price falls, the quantity demanded will increase. However, what happens to revenues depends on how much consumers respond to the price change. If a price decrease causes a strong response from consumers, revenues will actually increase. For example, Ralphs recently had a special on strawberries, selling them for $2.50 a pint. The manager said that the store made twice as much on strawberries as they did the previous week when the price was $3.50. In the case of milk, however, consumers bought more milk, but not very much more and the total revenues for Vermont farmers decreased. Price Elasticity of Demand In a market system, buyers and sellers interact indirectly: price and quantity sold act as incentives for each side to adjust its behavior, which in turn affects the outcome. The degree of responsiveness of buyers or sellers to various changes is called elasticity . The examples above involve the responsiveness of consumer demand to price, which is called price elasticity. It is very important to producers since it determines the change in revenues as price rises or falls. If producers have some power to set price, the price elasticity affects the incentive for producers to raise prices. At the same time, it is important to consumers, since their expenditure on a good, which is equal to revenues to producers, is similarly affected. As we will see when we look at the complete market, price elasticity determines how much of a cost increase or a tax is borne by the consumers and how much by the producers. Measuring price elasticity How should we measure price elasticity? Think of what happens in demand. We know from the Law of Demand that if price decreases, the quantity that consumers demand will always increases. If demand is more elastic, consumers would be more responsive, that increase will be relatively larger. . If demand is less elastic, consumers would be less responsive, that decrease will be relatively larger. The Figure below shows two demand curves that have the same quantity (Q1) demanded at the the same price (P1). In the graph to the left, as the price decreases to P3, consumers increase the quantity they
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demand up to Q3. In the graph to the right, the change in price, from P1 to P3 is the same, but the response in quantity demanded (from Q1 to Q3 is much larger. Thus the graph to the right at that price, will be more elastic with respect to price than the demand
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Elasticity - Part II Chapter 6 Elasticity of Demand Why is...

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