Midterm 1

# Prices are signals that guide the allocation of

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- Prices are signals that guide the allocation of resources. - A competitive market has many buyers and sellers each of whom has little or no influence on the market price. - Economists use the supply and demand model to analyze competitive markets. - The downward sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good’s price. CHAPTER FIVE: Elasticity and Its Application Basic Idea: - Elasticity measures how much one variable responds to changes in another variable. - Elasticity is a measure of responsiveness. Price Elasticity of Demand - Price Elasticity of Demand measures how much Quantity demanded responds to a change in Price. - Elasticity of Demand = Percentage change in Quantity demanded/ Percentage change in Price

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*NOTE: Along a Demand curve, Price and Quantity move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. Midpoint Measure - The standard way of computing percentage change does not apply in the case of demand elasticity because the movement from Point A to Point B is different from the movement from Point B to Point A. Therefore, we use the Midpoint Measure . *Midpoint= Average of the two = [(Q2-Q1)/ Average of the two] / [(P2-P1)/Average of the two) The midpoint is the number halfway between the start and end values, the average of those values. It doesn’t matter which value you use as the “start” and which as the “end”. You get the same answer either way! NOTE: However, we can use the standard method if we are looking at small changes, if the change is more than one unit we use the Midpoint Measure. -Example: Use the following information to calculate the price elasticity of demand for hotel rooms. a) Price= \$70 Quantity Demanded=5000 b) Price= \$90 Quantity Demanded= 3000 Use the midpoint method to calculate the % change in quantity demanded: (5000-3000) / 4000 = 50% * Quantity 2- Quantity 1/ Average of the two= Answer
% change in Price: (\$90-\$70)/ \$80 = 25% Therefore, the price elasticity of demand is... 50% / 25% = 2.0 What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods: Example: Breakfast cereal vs. Sunscreen Q: The prices of both of these goods rise by 20%. For which good does quantity demanded drop the most? Why? A: Breakfast cereals has close substitutes, such as pancakes, eggo waffles etc. So buyers can easily switch if the price rises. However, sunscreen has no close substitutes so consumers would probably not buy less if its price rises. RULES: 1. Price elasticity is higher when close substitutes are available. 2. Price elasticity is higher for narrowly defined goods than broadly defined ones. 3. Price elasticity is higher for luxuries than for necessities.

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• Spring '13
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