Midterm 1

# 4 price elasticity is higher in the long run than the

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4. Price elasticity is higher in the long-run than the short-run. SUMMARY: The price elasticity of demand depends on: a) The extent to which close substitutes are available b) Whether the good is a necessity or a luxury c) How broadly or narrowly the good is defined d) The time horizon- Elasticity is higher in the long-run than the short-run The variety of Demand Curves - The price elasticity of demand is closely related to the slope of the demand curve. - RULE: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. -There are five different classifications of Demand curves: 1. Perfectly Inelastic Demand

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2. Unit Elastic Demand 3. Elastic Demand 4. Perfectly Elastic Demand
Elasticity of a Linear Demand Curve At the top of the curve (at E=5.0) the elasticity tends to be high, and at the bottom of the curve (at E=0.2) the elasticity tends to be low. Price Elasticity and Total Revenue - Price and quantity move in opposite directions. i.e. If price increases, quantity demanded decreases and vise versa. - Revenue = Price x Quantity - A price increase has two effects on revenue: 1. Higher price means more revenue on each unit you sell 2. But you sell fewer unit (lower quantity demanded) -If demand is elastic than price elasticity of demand will be bigger than one % change in Q > % change in P -The fall in revenue from lower Quantity is greater than the increase in revenue from higher Price, so revenue falls.

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- If demand is inelastic then price elasticity of demand is smaller than one. % change in Q < % change in P - The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. SUMMARY: Elastic: 1. Price increases = Total revenue decreases 2. Price decreases = Total revenue increases Inelastic: 1. Price increases = Total revenue increases 2. Price decrease = Total revenue decreases EXAMPLE : Q: As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall? A: It is elastic. A lower price will lead people to switch their holidays to luxury cruises. The fall in price reduces revenue, but quantity increase, which increases revenue. Since demand is elastic, quantity will increase more than 20% so revenue rises. APPLICATION : Does Drug interdiction increase or decrease Drug-Related Crime? - One side effect of illegal drug use is crime: Users often turn to crime to finance their habit. - We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime. - For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs. - Demand for illegal drugs is inelastic, due to addiction issues.
POLICY ONE: INTERDICTION POLICY TWO: EDUCATION Price Elasticity of Supply Basic Idea - Price elasticity of supply measures how much Quantity supply responds to a change in Price.

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• Spring '13
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