Chapter 4 Notes

-​ Price elasticity of demand

-​ When supply decreases, the equilibrium price rises and the equilibrium quantity
decreases
-​ If the demand curve is steep, the price rises by a lot, if the demand curve is almost
flat, the price barely rises
-​ To measure responsiveness we need a measure that is independent of units of
measurement
-​ Elasticity is such a measure
-​ The price elasticity of demand is a units-free measure of the responsiveness of the
quantity demanded of a good to a change in its price when all other influences on
buying plans remain the same
-​ Formula for elasticity of demand
-​ (Percentage change in the quantity demanded)/(percentage change in the price)
-​ We express the change in price as a percentage of the average price - the average
of the initial and new price and we express the change in the quantity demanded
as a percentage of the average quantity demanded - the average of the initial and
new quantity

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 -​ Initially the price of a pizza is $20.50 and the quantity demanded is 9 pizzas per
hour
-​ The price of a pizza falls to $19.50 and the quantity demanded increases to 11
pizzas an hour
-​ The price falls by $1 and the quantity demanded increases by 2 pizzas an hour
-​ That means the average price is $20 and average demand is 10 pizzas an hour
-​ The percentage change in quantity demanded is calculated as 2 (change in
quantity from 9 to 11) over 10 (average quantity demanded) so (2/10)(100)=20%
-​ The percentage change in price is calculated as (1/20)(100)=5%
-​ Hence the price elasticity of demand is 20%/5%=4
-​ Average price and quantity
-​ By using the average price and average quantity, we get the same elasticity value
regardless of whether the price rises or falls
-​ Percentages and proportions
-​ The ratio of two proportionate changes is the same as the ratio of two percentage
changes i.e %ΔQ/%ΔP=ΔQ/ΔP
-​ A units-free measure
-​ Elasticity is a ratio of percentages, so a change in the units of measurement of
price or quantity leaves the elasticity value the same
-​ Minus sign and elasticity
-​ The formula yields a negative value, because price and quantity move in opposite
directions
-​ But it is the magnitude or absolute value that reveals how responsive the quantity
change has been to a price change
-​ Inelastic and elastic demand
-​ Demand can be inelastic, unit elastic, or elastic and can range from zero to infinity
-​ If the quantity demanded doesn't change when the price changes, the price
elasticity of demand is zero and the good has a perfectly inelastic demand
-​
-​ If the percentage change in the quantity demanded equals the percentage change in price
the price elasticity of demand equals 1 and the good has unit elastic demand
-​
-​ If the percentage change in the quantity demanded is smaller than the percentage change
in price the price elasticity of demand is less than 1 and the good has inelastic demand
-​ If the percentage change in quantity demanded is greater than the percentage change in
price then the price elasticity of demand is greater than 1 and the good has elastic
demand
-​ If the percentage change in the quantity demanded is infinitely large when the price
barely changes the price elasticity of demand is infinite and the good has a perfectly
elastic demand
-​ The factors that influence the elasticity of demand
-​ The closeness of substitutes
-​ The closer the substitutes for a good or service, the more elastic is the
demand for the good or service
-​ Necessities such as food or housing generally have inelastic demand
-​ Luxuries such as exotic vacations generally have elastic demand
-​ The proportion of income spent on the good
-​ The greater the proportion of income consumers spend on a good, the
larger is the elasticity of demand for that good
-​ The time elapsed since a price change
-​ The more time consumers have to adjust to a price change, or the longer
that a good can be stored without losing its value, the more elastic is the
demand for that good
-​ Elasticity along a linear demand curve

-​
-​ At the midpoint of the demand curve, demand is unit elastic
-​ At prices above the midpoint of the demand curve, demand is elastic
-​ At prices below the midpoint of the demand curve, demand is inelastic
-​ For example, if the price falls from $25 to $15, the quantity demanded
increases from 0 to 20 pizzas an hour
-​ The average price is $20 and the average quantity is 10 pizzas
-​ The price elasticity of demand is 20/10 by 10/20 or 2/0.5 which is 4
-​ If the price falls from $10 to $0 and the quantity demanded increases from
30 to 50 pizzas an hour
-​ The average price is $5 and average quantity is 40 pizzas
-​ The price elasticity is (20/40) by (10/5) which is ¼
 -​ If the price falls from $15 to $10 the quantity of pizza demanded increases
from 20 to 30 pizzas an hour
-​ The average price of pizza is $12.50 and the average quantity of pizza is
25 pizzas
-​ The price elasticity is (10/25) by (5/12.50) which is 1
-​ Total revenue and elasticity
-​ The total revenue from the sale of a good or service equals the price of the
good multiplied by the quantity sold
-​ When the price changes, total revenue also changes
-​ But a rise in price doesn't always increase total revenue
-​ The change in total revenue due to a change in price depends on the
elasticity of demand:
-​ If demand is elastic, a 1 percent price cut increases the quantity
sold by more than 1 percent, the total revenue increases
-​ If demand is inelastic, a 1 percent price cut increases the quantity
sold by less than 1 percent and total revenues decreases
-​ If demand is unit elastic, a 1 percent price cut increases the
quantity sold by 1 percent and total revenue remains unchanged
-​ The total revenue test is a method of estimating the price elasticity of
demand by observing the change in total revenue that results from a price
change (when all other influences on the quantity sold remain the same)
-​ If a price cut increases total revenue, demand is elastic
-​ If a price cut decreases total revenue, demand is inelastic
-​ If a price cut leaves total revenue unchanged, demand is unit
elastic
-​
-​ As the price of a pizza falls from $25 to $12.50, the quantity demanded
increases from 0 to 25 pizzas an hour
-​ Demand is elastic and total revenue increases
-​ At $12.50 a pizza, demand is unit elastic and total revenue stops
increasing
-​ As the price of a pizza falls from $12.50 to 0, the quantity demanded
increases from 25 to 50 an hour
-​ Demand is inelastic and total revenue begins to decrease
-​
-​ As the quantity increases from 0 to 25 pizzas an hour, demand is elastic and total
revenue increases. As quantity increases from 25 to 50 pizzas an hour, demand is
inelastic and the total revenue decreases
-​ Your expenditure and your elasticity
-​ If your demand is elastic, a 1 percent price cut increases the quantity you buy by
more than 1 percent and your expenditure on the item increases
-​ If your demand is inelastic, a 1 percent price cut increases the quantity you buy by
less than 1 percent and your total expenditure decreases
-​ If your demand is unit elastic, a 1 percent price cut increases the quantity you buy
by 1 percent and your expenditure does not change
-​ Income elasticity of demand
-​ The income elasticity of demand measures how the quantity demanded of a good
response to a change in income, other things remaining the same
-​ The formula for calculating the income elasticity of demand is
-​ %ΔD/%ΔI
 -​ If income elasticity of demand is greater than 1, demand is income elastic and the
good is a normal good
-​ If the income elasticity of demand is greater than zero but less than 1, demand is
income inelastic and the good is a normal good
-​ If the income elasticity of demand is less than zero the good is an inferior good
-​ Cross elasticity of demand
-​ The cross elasticity of demand is a measure of the responsiveness of demand for a
good to a change in the price of a substitute or a complement, other things
remaining the same
-​ The formula for calculating cross elasticity is
-​ %ΔD/%Δ price of substitute or complement
-​ The cross elasticity of demand between goods that are
-​ Substitutes is positive
-​ Complements is negative

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-​ The figure shows the decrease in the quantity of pizza demanded when the price
of a soft drink (a complement of pizza) rises