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Elasticity. AP Economics Mr. Bordelon. Why is the demand curve sloped negatively?.
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Elasticity AP Economics Mr. Bordelon
Why is the demand curvesloped negatively? • Substitution effect. The substitution effect of a change in the price of a good is the change in the quantity demanded of that good as the consumer substitutes the good that has become relatively cheaper for the good that has become relatively more expensive. • When the price of one increases, a substitute will look more attractive. Consumer will buy less of the original good.
Why is the demand curvesloped negatively? • Income effect. The income effect of a change in the price of a good is the change in the quantity of that good deamanded that results from a change in the consumer’s purchasing power when the price of the good changes. • In this case, think of income not as a sum of money, but what you can actually buy with that sum. This “purchasing power” is referred to as real income.
Why is the demand curvenegatively sloped? • Normal goods. Goods for which demand decreases when income falls. • Inferior goods. Goods for which demand increases when income falls.
Why is the demand curvesloped negatively? • For the majority of g/s, income effect is not important and has no significant effect on individual consumption. • When the income effect matters, it reinforces the substitution effect. • When the price of a g/s absorbs a substantial share of income, consumers of that good become poorer because real income falls. • Reduction in income leads to reduction in Qd and reinforces substitution effect.
Why is the demand curvesloped negatively? • How does this affect the demand for normal goods? • How does this affect the demand for inferior goods?
What is elasticity? • Elasticity. Measures the responsiveness of one variable to changes in another. • Price elasticity of demand. Ratio of the percent change in Qd to percent change in P along the demand curve.
Hmmm... • Law of demand states that P and Qd will always move in opposite directions. • A positive %ΔP (a rise in price) leads to a negative %ΔQd. • A negative %ΔP (a fall in price) leads to a positive %ΔQd. • So what’s the problem?
Why do we usethe midpoint method? • Suppose you have to measure the price elasticity of demand for steak in two different countries. • Steak in the United States tends to be cheaper than in Germany because of taxes. Steak in the U.S. is $5/pound. Steak in Germany is $10/pound. • Steak between Germany and the U.S. is 100% higher. Steak between the U.S. and Germany is 50% cheaper. • If you calculate it like this, you end up with two different elasticities.
How do I interpret elasticity? • Perfectly inelastic • Price elasticity is = 0.25. • Ed = %ΔQd/% ΔP = 0.25. • Assume for a second that price increased by 1%. What can we predict about Qd, given that Ed = 0.25?
How do I interpret elasticity? • Perfectly inelastic • Price elasticity is = 0.25. Ed = %ΔQd/% ΔP = 0.25. • Assume for a second that price increased by 1%. What can we predict about Qd, given that Ed = 0.25? • Qd will decrease by only 0.25%. Why? • Now, what would be the smallest response possible to a price increase?
How do I interpret elasticity? • Perfectly inelastic • None, or rather 0. Ed = 0%/1% = 0. • A product that is perfectly inelastic has an elasticity of demand of 0, meaning that Qd does not respond at all to a change in price. • When the demand is perfectly inelastic, the demand curve is a vertical line.
How do I interpret elasticity? • Perfectly inelastic • Assume that price elasticity is 10. • Ed = %ΔQd/%ΔP = 10 • Assume that P increases by 1%. If Ed = % ΔQd/1% =10, what can we predict about Qd?
How do I interpret elasticity? • Perfectly inelastic • Assume that price elasticity is 10. • Ed = % ΔQd/% ΔP = 10 • Assume that P increases by 1%. If Ed = % ΔQd/1% =10, what can we predict about Qd? • Qd will decrease by 10%. • What would be the largest response to a price increase?
How do I interpret elasticity? • Perfectly inelastic • Consumers immediately reduce consumption to 0. • Ed = 0
How do I interpret elasticity? • Perfectly elastic • What would be the largest response to a price decrease?
How do I interpret elasticity? • Perfectly elastic • What would be the largest response to a price decrease? • Consumers immediately increase consumption to an infinitely large amount. • If price increased 1%, and an enormous change to Qd, then %ΔQd = ∞. • So in that case, Ed = ∞.
How do I interpret elasticity? Perfectly elastic. Ed = ∞
(Perfectly) Elastic and Inelastic • If a demand curve is closer to vertical (steeper), then this tends to be inelastic. • If a demand curve is closer to horizontal (flatter), then this tends to be elastic.
Elastic, Inelastic, Unit Elastic • Elastic. Ed > 1 • Inelastic. Ed < 1 • Unit elastic. Ed = 1
Who cares? • Ashley asks, “Bordelon, thanks for sharing all this crap about elasticity, but honestly, who cares? Who cares, Bordelon? Why are you doing this to us? Why? WHY?!?”
Businesses Care, Ashley • Total Revenue. Total value of sales of a good or service. Total revenue is equal to price multiplied by quantity sold. • TR = (P)(Q sold) • “Great Bordelon, but that doesn’t answer my question.” • “No, I guess it doesn’t Ashley. I should be ashamed of myself.”
Psych • Actually, Ed affects how businesses set price. • Suppose a business wants to increase TR by increasing price. What can we expect to happen? (Hint: think law of demand!)
Psych • Actually, Ed affects how businesses set price. • Suppose a business wants to increase TR by increasing price. What can we expect to happen? (Hint: think law of demand!) • As the price increases, the quantity demanded will decrease. • Well, this affects TR. Up, down or remain the same?
Total Revenue and Elasticity • Ultimately, the effect on TR depends on which is stronger, higher price or lower quantity. • Price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. • Quantity effect. After a price increase, fewer units are sold, which tends to lower revenue.
Total Revenue and Elasticity • P increases by 1%, Qd decreases by 5%. Identify elasticity.
Total Revenue and Elasticity • P increases by 1%, Qd decreases by 5%. Elastic. • TR decreases because decrease in quantity is stronger than increase in price.
Total Revenue and Elasticity • P increases 10%, Qd decreases 5%. Identify elasticity.
Total Revenue and Elasticity • P increases 10%, Qd decreases 5%. Inelastic. • TR increases because decrease in quantity is weaker than increase in price.
Total Revenue and Elasticity • P increases by 10%, Qd decreases 10%. Identify elasticity.
Total Revenue and Elasticity • P increases by 10%, Qd decreases 10%. Unit elastic. • TR will not change because decrease in quantity is equal to increase in price.
Total Revenue and Elasticity • Suppose initial price of slices of pizza is $2 and 50 slices are sold every day (point A). Calculate total revenue. • TR = PQ
Total Revenue and Elasticity • Suppose initial price of slices of pizza is $2 and 50 slices are sold every day (point A). • TR = PQ • TR = ($2)(50) = $100 • Represented by the TR + L rectangle.
Total Revenue and Elasticity • Assume pizzeria now wishes to increase price to $3 and estimates 40 slices will be sold per day (point B). Calculate total revenue.
Total Revenue and Elasticity • Assume pizzeria now wishes to increase price to $3 and estimates 40 slices will be sold per day (point B). • TR = ($3)(40) = $120 • Represented by the TR + G rectangle.
Total Revenue and Elasticity • Area L represents revenue lost due to decreased quantity, loss of $20. Loss of 10 slices at $2 each. • Area G represents revenue gained due to increased price, gain of $40 in gained revenue. Gain of 40 slices at $1 extra ($3-$2).
Total Revenue and Elasticity • $40 - $20 = $20 total revenue increase from higher price. • If increased price effect is stronger than downward quantity effect, demand must be inelastic. • Converse is also true. • Calculate elasticity using midpoint formula.
Elasticity Along Demand Curve Calculate remaining elasticities using midpoint formula.
Elasticity Along Demand Curve What happens to total revenue here as price increases? How does this relate to elastic, inelastic and unit elastic?
Factors DeterminingPrice Elasticity of Demand • Substitutes. The more substitutes, the more elastic the demand. If a product has many substitutes, and the price increases, consumers will have an elastic response because they can easily find alternatives. • Necessity vs. Luxury. The less necessary the item, the more elastic the demand. For luxuries, if the price increases, consumers will just do without and have an elastic response.
