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Unit 3 Objectives Explain the concept of elasticity. Discuss why the measurements of elasticity are important. Contrast elastic and inelastic. Calculate elasticity of demand, elasticity of income, and cross elasticity. Apply the concept of utility to the decision making process.
More Objectives for Unit 3 Analyze the law of diminishing marginal returns. Contrast the various costs and revenue associated with a business. Differentiate between the long-run and short-run.
Elasticity means Responsiveness! When you think of elastic, you usually think of a rubber band, the waist band on slacks, or a balloon. Each of these items are responsive to something; tension, size of waist, or the amount of air in the balloon. Before air is added. After air is added. The balloon is responsive to air. Elasticity.
Price Elasticity of Demand Measures the percentage change in the quantity demanded of a product divided by the percentage change in the price of the same product. Determines if the consumers were very responsive to the price change or not. Formula: X Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 Note: This formula is how you calculate the formula given in the text. % Q % P
Formula: Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X Q2 represents the second or new quantity. Q1 represents the first or original quantity. P2 represents the second or new price. P1 represents the first or original price.
Sample Calculation: Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X The original, current, price is $3 and the company wishes to increase the price $4. At the price of $3 the quantity demanded is 20 and if the price is increased to $4 the new quantity demanded will equal $12. What is the elasticity for this scenario? P1 = $3 P2 = $4 Q1 = 20 Q2 = 12 12 - 20 4 - 3 4 + 3 20 + 12 X= -8 1 7 32 X= e = -8 X.219 = -1.752 e =
Price elasticity of demand equals -1.752 (for this example) Remember: use the absolute factor of your answer. The answer will always be negative for the price elasticity of demand because price and quantity are inversely related. The answer would be stated as 1.752.
What does 1.752 mean? This depends on your calculated answer. If e > 1, the demand is said to be elastic. If e = 1, the demand is said to be unit elastic. If e < 1, the demand is said to be inelastic. Therefore, the scenario given is said to have an elastic demand.
Elasticity Definitions Elastic: Means that consumers are very responsive to the price change. Unit Elastic: Means that consumers are responsive to the price change, however the total revenue for the business was not changed. Inelastic: Means that consumers are not very responsive to the price change.
Problem: Price Elasticity Currently, the price of a pound of sugar is $.50 (at the retail level) with a quantity demanded of 300 pounds. If the the price is increased to $.60 per pound, the quantity demanded decreases to 280 pounds. Calculate the price elasticity of demand for sugar, and determine if the demand is elastic, inelastic, or unit elastic.
Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X P1 = $.50 P2 = $.60 Q1 = 300 Q2 = 280 e = 280 - 300.60 -.50 X.60 +.50 280 + 300 e=-20.10 X 1.10 580 e = -200 X.0019 = -.38 Inelastic--Consumers are not very responsive to the price change
Inelastic Demand P Q 0 300280.50.60 Sugar Total Revenue Test: (Price X Quantity) P1=.50 X 300 = 150 P2 =.60 X 280 = 180 Total Revenue increased with this price change (Not necessarily profits) D
Elastic Demand P Q 0 300150 $3.00 $4.50 Total Revenue Test: (Price X Quantity) P1= 3.00 X 300 = 900 P2 = 4.50 X 150 = 675 Total Revenue decreased with this price change (Not necessarily profits) Movie Theater Tickets D
Unit Elastic P Q 0 300 150 $3.00 $6.00 Total Revenue Test: (Price X Quantity) P1= 3.00 X 300 = 900 P2 =6.00 X 150 = 900 Total Revenue remained unchanged with this price change (Not necessarily profits) D
To Increase Revenue If in the elastic range of the demand curve, lower the price. If in the inelastic range of the demand curve, raise the price. Every demand curve has elastic, unit elastic, and inelastic points. Remember: It depends on the specific prices and quantities demanded that determines the elasticity of demand.
Determinants of Price Elasticity of Demand The existence of substitutes The importance of the product in the consumer’s total budget The time period under consideration
Elasticities Continued The greater the substitutes and the less the necessity of a product, the more elastic the demand. Examples: Candy or automobiles. The fewer the substitutes and the greater the necessity of a product, the more inelastic the demand. Examples: Electricity or Blood Pressure Medicine.
Situation Your water heater just quick working this morning, while you were taking your shower. You can save $100 off a new water heat if you will wait 2 weeks for delivery. Most people would not wait the two weeks. We would be willing to forgo the $100 because of the time consideration.
Continued Situation It has now been 2 years since you purchased your new water heater and it is working perfectly. You notice a sale in which you could save $250 if you purchase a new water heater today. Would you purchase the water heater? Probably not. This is not an item that we have extras setting around in case the one we have quits working. Again it is the consideration of time.
Cross Elasticity Measures percentage change in the demand for one good divided by the percentage change in the price of another good. Cross elasticity is often used when dealing the substitutes and complements.
Cross Elasticity: Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X Currently their are two roller skating rinks in town. Skate Key has a quantity demanded of 50 skaters at the price of $4, while Roller Wheels has a quantity demanded of 70 skaters at the same price. If Skate Key lowers the admission fee to $3 Roller Wheels anticipates a decrease in demand to 50 skaters.
Is the cross elasticity for Roller Wheels elastic, inelastic, or unit elastic? Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X Ce = 50 - 70 3 - 4 X 3 + 4 50 + 70
Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X Ce = 50 - 70 3 - 4 X 3 + 4 50 + 70 Is the cross elasticity for Roller Wheels elastic, inelastic, or unit elastic? Ce = -20 X 7 120
Q2 - Q1 P2 - P1 P2 + P1 Q2 + Q1 X Ce = 50 - 70 3 - 4 X 3 + 4 50 + 70 Ce = -20 X 7 120 Is the cross elasticity for Roller Wheels elastic, inelastic, or unit elastic? Ce = 20 X.0583 = 1.166 Elastic--Roller Wheels business would be affected by the reduction in price of Skate Key. Roller Wheels should try and offset this reduction in price. They might reduce price, but they could offer other incentives to skaters that may be more appealing.
Income Elasticity Measures the percentage change in the demand a good divided by the percentage change in income. Ie = Q2 - Q1 Y2 - Y1 X Y2 + Y1 Q2 + Q1 Income elasticity is calculated the same way. The only difference is that we are measuring the change in behavior based on income instead of price.
Definitions Normal goods: products for which the income elasticity is positive. As our income increases we, consumers, tend to consumer more of these products. Automobiles are normal goods. Inferior goods: goods for which the income elasticity of demand is negative. As our income rises we tend to eat less bologna and hot dogs and eat more of higher cuts of meat.
Price Elasticity of Supply Measures the percentage change in the quantity supplied divided by the percentage change in price. NOTE: The only difference between the price elasticity of supply and the price elasticity of demand is the side of the market being studied.
Short-Run vs. Long-Run Short-Run: a period of time short enough that resources can not be changed quickly. For example: A company can not quickly build a new plant or start a new product into production. Long-Run: A period of time long enough that all resources are variable.
One last definition in chapter 6 Tax incidence: a measure of who pays a tax. Example A: If the Government places an additional excise tax on cigarettes and the cigarette companies have highly elastic demands, the cigarette manufacturers may choose to bear the cost of the additional tax instead of raising prices. Example B: If the Government places an additional tax on electric companies, they may choose to pass the tax along to the consumer because utilities have an inelastic demand.
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