20.1 The Price Elasticity of Demand

• Price elasticity of demand (Ed) is a measure of the responsiveness of the quantity demanded to changes in price; equal to the absolute value of the percentage change in quantity demanded divided by the percentage change in price.

  • The equation is represented as:

    • Ed = |percentage change in quantity demanded/percentage change in price|

• We can compute a percent change in two ways using the initial- value method as seen in Chapter 1 or using the midpoint method.

• For example, if the price increases from $20 to $22, the average or midpoint value is $21 and the percentage change is $2 divided by $21, or 9.52 percent:

  • Percent change with midpoint= 2/20 + 22/2 x 100 = 2/21 x 100 = 9.52%

• Elastic demand is the price elasticity of demand is greater than one, so the percentage change in quantity exceeds the percentage change.

• Inelastic demand is the price elasticity of demand is less than one, so the percentage change in quantity is less than the percentage change in price.

• Unit elastic demand is the price elasticity of demand is one, so the percentage change in quantity equals the percentage change in price.

• Perfectly inelastic demand is the price elasticity of demand is zero.

• Perfectly elastic demand is the price elasticity of demand is infinite.

• The key factor in determining the price elasticity for a particular product is the avail-ability of substance of substitute products.

• Two factors that help to determine the price elasticity of demand for a production is

  • The elasticity is generally larger for goods that take a relatively large part of a consumer’s budget. If a good represents a small part of the budget of the typical consumer, demand is relatively inelastic.

  • Another factor is whether the product is a necessity or a luxury good.

20.2 Using Price Elasticity

• If we know the price elasticity of demand for a particular good, we can quantify the law of demand, predicting the change in quantity resulting from a change in price and we can use an estimate of the price of demand to predict how a change in price affects a firm’s total revenue.

• If we have value for two of the three variables in the elasticity formula, we can compare the value of the third using the equation:

  • Percentage change in quantity demand = percentage change in price x Ed

• Total revenue is the money a firm generates from selling its product. The equation is:

  • Total revenue = price per unit x quantity sold

• If you know the price elasticity, you can determine whether a price hike will increase or decrease the firm’s total revenue.

• If the demand for the good is elastic there would be an increase in price which increases total revenue.

• In elastic demand, the relationship between price and total revenue is negative:

  • An increase in price decreases total revenue p, a decrease in price increases total revenue.

• In inelastic demand, the ****relationship between price and total revenue is positive:

  • An increase in price increases total revenue,a decrease in price decreases total revenue.

• Unit elastic demand, total revenue does not vary with price.

• Market versus Brand Elasticity is the demand for a specific brand of a product is more elastic than the demand for the product.

• Bus fares and deficits are in every large city in the United States, the public bus system runs a deficit which is operating costs exceeding revenues for passenger fares.

• A bumper crop is bad news for farmers whereas a bumper crop of soybeans brings good and bad news for farmers. The good news is that they will sell more bushels of soybeans. The bad news is that the increase in supply will decrease the equilibrium price of soybeans, so farmers will get less money per bushel.

  • Unfortunately for farmers, the demand for soybeans and many other agricultural products is inelastic, meaning that to sell the extra output, the price must fall by a relatively large amount.

• Antidrug policies and property crime is when the government uses various policies to restrict the supply of illegal drugs, and the decrease in supply increases the equilibrium price. Since the demand for illegal drugs is inelastic, the increase in price will increase total spending on illegal drugs.

  • A policy that increases drug prices will reduce drug consumption, but will also increase the amount or property crime committed by addicts who continue to abuse drugs.

20.3 Elasticity and Total Revenue for a Linear Demand Curve

• The price elasticity of demand decreases as we move downward along the linear demand curve.

• On the upper half of a linear demand curve, demand is elastic; on the lower half of the curve, demand is inelastic.

• At the midpoint of a linear demand curve, demand is unit elastic.

20.4 Other Elasticities of Demand

• Income elasticity of demand is a measure of the responsiveness of demand to change in constant income; equal to the percentage change in the quantity demanded divided by the percentage change in income.

  • It is represented as the the equation:

    • Et = percentage change in quantity demanded/percentage change in income

• The cross-price elasticity of demand measures the responsiveness of demand to changes in the prices of other goods, indicating how much more or less of a particular product is purchased as other prices change.

  • It is represented as the the equation:

    • Exy = percentage change in quantity of X  demanded/percentage change in price of Y

20.5 The Price Elasticity of Supply

• Elasticity of supply measures the responsiveness of the quantity supplied to changes in price.

  • It is represented as the equation:

    • Et = percentage change in quantity supplied/preventable change in price

• Short run is when higher price encourages existing firms to increase their output by purchasing more materials and hiring more working

• Long run is when new firms enter the market and existing firms expand their production facilities to produce more output.

• A perfectly inelastic is the price elasticity of supply equals zero.

• A perfectly elastic supply is the price elasticity of supply is equal to infinity.

  • Using the price elasticity of supply it can be used to predict the effect of price changes on the quantity supplied using the equation:

    • Percent change in quantity supplied = Es  x percentage change in price

20.6 Using Elasticities to Predict Changes in Prices

• Small increase in demand is if the shift of the demand curve is relatively small, the gap between the new demand and the old supply will be relatively small, and the small excess demand can be eliminated with a relatively small increase in price.

• Highly elastic demand is ****if consumers are very responsive to changes in price, the increase in price caused by excess demand will cause a large reduction in the quantity demanded. As a result, the excess demand will be eliminated with a relatively small increase in price.

• Highly elastic supply is if producers are very responsive to changes in price, the increase in price caused by excess demand will cause a large increase in the quantity supplied. As a result, the excess demand will be eliminated with a relatively small increase in price.

• The price-change formula can be used to predict the change in the equilibrium price resulting from a change in demand.

  • The formula is represented as:

    • Percentage change in equilibrium price = percentage change in demand/ Es + Ed

• Small decrease in supply is if the shift of the supply curve is relatively small, the gap between the new supply and the old demand will be relatively small, and the small excess demand can be eliminated with a relatively increase in price.

• Highly elastic demand is if consumers are very responsive to changes in price, the increase in price caused by excess demand will cause a large reduction in the quantity demanded. As a result, the excess demand will be eliminated with a relatively small increase in price.

• Highly elastic supply is if producers are very responsive to change in price, the increase in price caused by excess demand will cause a large increase in the quantity supplied. As a result, the excess demand will be eliminated with a relatively small increase in price.

• The price-change formula is used to predict the price effects of a change in supply.

  • The formula is represented as:

    • Percentage change in equilibrium price = - percentage change in supply/ Es + Ed