Law of demand
price increase, decrease in quantity demanded
- BUT how much does quantity demanded change in response to a change in price
ELASTICITY gives us a measure of the responsiveness (sensitivity) of consumers to a price change
elasticity
measure of the responsiveness of consumers to a change in price
Formula
Ed = (percentage in quantity demanded for product x) / (percentage change in price of product x)
= % delta Qd / % delta P
When quantity demanded responds strongly to chnage in P
demand is elastic
When Qd responds weakly to change in P
demand is inelastic
Midpoint formula
to avoid the problems that arise in the other formula
- always take hte absolute value, no matter what set of values you are given, your number will come out to be negative because of the inverse relationships
Ed= [change in quantity / (sum of quantites/2)] / [change in price / (sum of prices / 2)]
Ed = [delta Q/ ((Q0 + Q1) / 2)) / ((delta P / (P0 + P1) / 2))]
When is response strong or weak
- if answer is less than one, there is a weak response
- if answe is greater than one, there is a strong response
perfect elastic
- horizontal demand curve.
- quantity will change but the price is 0, no percent change in price
- Ed = infinity
perfectly inelastic
- vertical demand curve
- Ed = 0
price of elastity coefficient, why percentage rather than absolute amount?
- unit free measure
- compare responsiveness across products
- eliminate the negative sign (easier to comapre elasticites)
price elasticity along a linear demand curve
- for all stright line and most other demand curves
- demand is more elastic toward upper lefts
- demand is less elastic toward lower right
Total revenue test
- if TR moves in opposite direction from price, demand is elastic. so if P falls, TR rises, demand is elastic
- If TR changes in the same direction as price, demand is inelastic. P falls, TR also falls, demand is inelastic
- if TR does not chnage when price changes, demand is unit elastic
determinants of elasticity
- substitutability (larger number of available substitutes, the greater the elasticity- depends on how narrowly the product is defined)
- proportion of income (greater the proportion of income spent on a good, the greater the price elasticity of demand for it)
- luxeries vs necessisties (more luxiourious, more elastic)
- time ( product demand is more elastic the longer the period of consideration)
large crop yields
the inelastic demand for farm products means that a larger crop may be undesirable
sales tax
a higher tax on a product with elastic demand will bring in less revenue
- legislatures seek out products with inelastic demand, liquor, gas, cigs
decriminalization of illegal drigs
demand is highly inelastic
cross elasticity of demand
Exy = (percentage change in quantty demanded of product x) / (percentage change in price of product y)
- substitute goods = + sign
- complementary goods = - sign
- independent goods = near 0
applications of cross price elasticity
- coke vs sprite.
- will a price cut in sprite increase or decrease total revenue
- assessing competition
- coke and pepsi are strong subs (govnt would likely block a merger between coke and pepsi becuase it would substatinally decrease competition)
income elasticity of demand
Ei= (percentage change in quantity demanded of product x) / (percentage change in income)
- normal goods = + sign
- inferior goods = - sign
income elasticity insights
- high income elasticities
- product with relatively high income elasticity co-efficents are hit hardest by recessions
- low or negative income elasticities are least effected by recessions
