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Chapter 4

Application on Demand and Supply

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Elasticity

Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

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How to measure elasticity

e lastic ity o f A w ith resp ec t to BA

B

%

%

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Price Elasticity of Demand

A popular measure of elasticity isA popular measure of elasticity is price elasticity of demand price elasticity of demand measures how responsive measures how responsive consumers are to changes in the consumers are to changes in the price of a product.price of a product.

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How to measure P.E.D

p rice e las tic ity o f d em an d % ch an g e in q u an tity d em an d ed

ch an g e in p rice

%

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The absolute term

• The value of demand elasticity is always negative, but it is stated in absolute terms.

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Slope and Elasticity

The value of the slope of the demand curve and the value of elasticity are not the same.

Unlike the value of the slope, the value of elasticity is a useful measure of responsiveness.

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Slope and Elasticity

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continue

Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical.

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Types of Elasticity

Hypothetical Demand Elasticities for Four Products

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Hypothetical Demand Elasticities for Four Products

PRODUCT

%CHANGE IN PRICE

(%P)

%CHANGE IN QUANTITY

DEMANDED (%QD)ELASTICITY(%QD %P)

Insulin+10%0%0.0Perfectly inelastic

Basic telephone service

+10%-1%-0.1Inelastic

Beef+10%-10%-1.0Unitarily elastic

Bananas+10%-30%-3.0Elastic

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Perfectly Elastic andPerfectly Inelastic Demand Curves

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Perfect elasticity

When demand does not respond at all to a change in price, demand is perfectly inelastic.

Demand is perfectly elastic when quantity demanded drops to zero at the slightest increase in price.

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Calculating Elasticities

% ch an g e in p rice x 1 0 0 %2P P

P1

1

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%change in Quantity

% ch an g e in q u an tity d em an d ed x 1 0 0 %2Q Q

Q1

1

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Calculating Elasticities

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Elasticity

Elasticity is a ratio of percentages.

Using the values on the graph to compute elasticity, using percentage changes yields the following result:

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Price Elasticity

p rice e las tic ity o f d em an d

1 0 0 %

3 3 3 %3 0

..

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Calculating Elasticities

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The midpoint formula

A more accurate way of computing elasticity than percentage changes is the midpoint formula:

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The midpoint formula

%

%

( ) /

( ) /

Q

P

Q QQ QP PP P

d

2 1

1 2

2 1

1 2

21 0 0 %

2

x

x 1 0 0 %

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The midpoint formula

%

%( ) /

( ) /

. .Q

Pd

1 0 55 1 0 2

1 0 0 %

2 33 2 2

57 5 1 6 7

x

x 1 0 0 %

x 1 0 0 %

-12 .5

x 1 0 0 % =

6 6 .7 %

-4 0 .0 %

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Interpret Elasticities

Here is how to interpret two different values of elasticity:

When = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded.

When = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

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Elasticity Changes along aStraight-Line Demand Curve

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Elasticity along a Straight-Line

Price elasticity of demand decreases as we move downward along a straight line demand curve.

Demand is elastic in the upper range and inelastic in the lower range of the line.

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Elasticity

Along the elastic range, elasticity values are greater than one.

Along the inelastic range, elasticity values are less than one.

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Elasticity and Total Revenue

TR P Q

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Type of demand

Value of Ed

Change in quantity versus change in price

Effect of an increase in

price on total revenue

Effect of a decrease in

price on total

revenue

ElasticGreater than 1.0

Larger percentage change in quantity

Total revenue decreases

Total revenue increases

InelasticLess than 1.0

Smaller percentage change in quantity

Total revenue increases

Total revenue decreases

Unitary elastic

Equal to 1.0

Same percentage change in quantity

and price

Total revenue does not change

Total revenue does not change

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Elasticity and Total Revenue

When demand is inelastic, price and total revenues are directly related. Price increases generate higher revenues.

When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues.

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The Determinants of Demand Elasticity

Availability of substitutes -- demand is more elastic when there are more substitutes for the product.

Time dimension -- demand becomes more elastic over time.

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continue

Importance of the item in the budget -- demand is more elastic when the item is a more significant portion of the consumer’s budget.

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Home Exam

Define economics and it main branches. What is elasticity, and what is its application? Give example to calculate price elasticity of demand

& explain its importance. Explain the relation between elasticity & revenue?

How to use the relation in decision making? Give numerical examples.

What are factors determines the elasticity? Use Graphs and numerical examples as much as

you can in answers.

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Other Important Elasticities

Income elasticity of demand – measures the responsiveness of demand to changes in income.

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The form

in co m e e la stic ity o f d em an d % ch an g e in q u an tity d em an d ed

ch an g e in in co m e

%

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Other Important Elasticities

Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good.

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The form

cro ss - p rice e las tic ity o f d em an d % ch an g e in q u an tity o f d em an d ed

ch an g e in p rice o f

Y

X%

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Other Important Elasticities

Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.

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The form

e lastic ity o f su p p ly % ch an g e in q u an tity su p p lied

ch an g e in p rice

%

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Other Important Elasticities

Elasticity of labor supply: A measure of the response of labor supplied to a change in the price of labor.

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The form

e lastic ity o f lab o r su p p ly% ch an g e in q u an tity o f lab o r su p p lied

ch an g e in th e w ag e ra te

%

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The Price System:Rationing and Allocating

Resources

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The market system

The market system, performs two important and closely related functions:

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The first

1. Resource allocation: the market system determines the allocation of resources among produces and the final mix of outputs.

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The second

2.Price rationing: the market system distributes goods and services on the basis of willingness and ability to pay.

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Price Rationing

A decrease in supply creates a shortage at the original price.

The lower supply is rationed to those who are willing and able to pay the higher price.

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Price Rationing

There is some price that will clear any market.

• The price of a rare painting will eliminate excess demand until there is only one bidder willing to buy the single available painting.

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Constraints on the Market

A price ceiling is a maximum price that sellers may charge for a good, usually set by government.

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In 1974, the government set a price ceiling to distribute the available supply of gasoline.

At an imposed price of 57 cents per gallon, the result was excess demand.

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Prices and the Allocation of Resources

Price changes resulting from shifts of demand cause profits to rise or fall.

Profits attract capital; losses lead to disinvestment.

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Higher wages attract labor and encourage workers to acquire skills.

At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.

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Price Floors

A price floor is a minimum price below which exchange is not permitted.– The most common example of a

price floor is the minimum wage, which is a floor set under the price of labor.

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The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded.

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Consumer Surplus

Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price.

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Consumer Surplus

Some consumers are willing to pay as much as $5 each for hamburgers.

Since the price is only $2.50, they receive a consumer surplus of $2.50.

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Consumer Surplus

Others are willing to pay something less than $5.00 but more than $2.50.

Consumer surplus is the area below the demand curve and above the price level

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