CHAPTER 5

CHAPTER 5 - CHAPTER 5 ELASTICITY ELASTICITY OF DEMAND The...

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CHAPTER 5: ELASTICITY ELASTICITY OF DEMAND The elasticity of demand measures the responsiveness of the demand of a good to changes in variables such as price, income, and the price of other goods. Three types of elasticity of demand: Price elasticity of demand, income elasticity of demand, and Cross-Price elasticity of demand. The Price Elasticity of Demand measures the percentage change in the quantity demanded of a good due to a percentage change in the good’s price. % Change in Quantity Demanded Price Elasticity of Demand = % Change in Price Q / Q 0 = P / P 0 (Q 1 – Q 0 ) / Q 0 = (P 1 – P 0 ) / P 0 Remember that the Law of Demand says that the change in quantity demanded always moves in opposite direction to the change in prices. Example: The price of soda has increased from \$1 to \$1.5, and the market has seen a decrease in sales from 20 million cans a day to 15 million cans a day. What’s the price elasticity of demand of soda? (15,000,000 – 20,000,000) / 20,000,000 Price Elasticity of Demand = (1.5 – 1) / 1 - 0.25 - 0.5 = = 0.5

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What this - 0.5 tells us is that an increase of 1% in the price of soda reduces the quantity demanded of soda by 0.5%. Notice that the sign of the price elasticity of demand is negative. This is because of the Law of Demand. Some authors drop the minus sign because it is implicit. Larger absolute values of the elasticity of demand represent greater responsiveness in the quantity demanded to changes in prices. What determines the magnitude of the elasticity? Presence of close substitutes: Availability of close substitutes increases the elasticity. Necessary goods have smaller elasticities than luxury goods Time Horizon: In the short run you may not be able to change your consumption habits, but in the long run you can find cheaper substitutes. Alternative Method to Calculate Elasticity: The Midpoint Method (Q 1 – Q 0 ) / [(Q 0 + Q 1 ) / 2 ] Price Elasticity of Demand = (Midpoint) (P 1 – P 0 ) / [(P 0 + P 1 ) / 2 ] Ex: Take the example previously used. Then (15’ – 20’) / [(15’ + 20’) / 2 ] -5’ / (35’ / 2) - .714 Price Elasticity of Demand = = = (Midpoint) (1.5 – 1) / [(1.5 +1) / 2 ] .5 / (2.5 / 2) Price Elasticity in Graphs A steeper demand curve represents a less elastic demand. A flatter demand curve represents a more elastic demand.
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