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Principles of EconomicsPartⅡ　How markets worksChapter5 Elasticity and Its Application

2010/3/28(Sun)

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Index

Ø 1 The elasticity of demand

Ø 2 The elasticity of supply

Ø 3 Applications of supply,demand and elasticity

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Key Concepts

Ø elasticity

Ø elastic and inelastic

Ø price elasticity of demand

Ø income elasticity of demand

Ø cross price elasticity of demand

Ø price elasticity of supply

Ø total revenue

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0. How would consumers respond to the higher price of gasoline?

Following to the law of demand,consumers would by less.

(the derection of the effects)

→By how much would consumption of gasoline fall?

(the magnitude of the effects)

■Past Studies showed A 10% increase in gasoline prices reduces gasoline consumption by

Ø  about 2.5% after a year and

Ø  about 6% after five years

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1 the elasticity of demand

The price elasticity of demand measures

Ø  how much the quantity demanded responds to a change in price.

Ø  how willing consumers are to buy less of the goods as its price rises.

→The elasticity reflects the many economic,social,and psychological forces that shape consumer preferences.

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1.1.1 elastic and inelastic

elastic inelastic

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Goods with close substitues (butter and margarine)

1Goods without close substitues(eggs)

2 Luxuries (sail boats) Necessities (doctor) 3 Narrowly defined markets Broadly defined market 4 Long term Short term

Ø  elastic:the quantity demaded responds to a change in price

Ø  inelastic:the quantity demaded responds only slightly to achange in price

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1.1.2 Computing the price elasticity of demand

price elasticity of demand=

ex) a 10% increase in the price of an increase of an ice-cream

causes the amount of ice cream to fall by 20 % →Price elasticity of demand

※common practice of dropping the minus sign and reporting all price elasticity of demand as positive number(absolute value)

pricein change Percentage demandedquantity in change Percentage

2percent 10percent 20

=

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1.1.3 An annoying problem of the culculation for elasticity

•  The elasticity from point A to point B seems different from the elasticity from point B to point to A

elasticity

A to B 33/50(=0.66) B to A 50/33(=1.5)

Point Price Quantity

A 4 120 B 6 80

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1.1.4 Mid Point Method

)/2]/[()(]2/(/[)(

1212

1212

PPPPQQQQ

＋

）＋

−

−

•  Price rlasticity of demand＝

The mid point method gives the same answer regardless of the direction of change.

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1.2.1 The variety of demand curves1

Ø  elastic:the elasticity is greater than 1

Ø  inelastic:the elasticity is less than 1

a)Perfect inelastic demand:elasticity equals 0

b)Inelastic demand:elasticity is less than 1

c)Unit elastic demand:elasticity equals 1

d)Elastic demand:elasicity is greater than 1

e)Perfect elastic demand:elasticity equals infinity

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1.2.2 The variety of demand curves 2

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1.3.1 Total revenue and the price elasticity of demand

•  Total revenue:Price ×　Quantity (the price of the good times the quantity of the goods solds) How does total revenue change as one moves along the demand curve? →It depends on th price elasticity of demand.

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1.3.2 Price and total revenue

Ø  elastic(the price elasticity is greater than1) :price and total revenue move in opposite directions. Ø  inelastic(the price elasticity is less than1) :price and total revenue move in the same directions. Ø  unit elastic(a price elasticity exactly equal to 1) :total revenue remains constant when price changes

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1.3.3elasticity and total revenue along a linar demand curve

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1.3.4 elasticity is not constant even if the slope of the demand curve is?

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1.4 Other demand elasticity

Ø  The income elasticity of demand

→It measures how the quantity demanded changes as consumer income changes.

ex)Normal goods:positive income elasticity.

Inferior goods:negative income elasticity.

Ø  The cross price elasticity of demand

→It mesures how the quantity demanded of one goods responds to a change in the price of another goods.

ex)Substitues:the cross price elasticity is positive.

Complements:the cross price elasticity is negative.

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2 the elasticity of supply

The price elasticity of supply measures •  how much the quantity supplied responds to a change in

price.

Ø  elastic:the quantity supplied responds to substantially to change in price.(ex manufactured goods, car, books)

Ø  inelastic:the quantity supplied responds to only slightly to

change in price.(ex beach land) ※I n most markets ,a key determinant of the price elasticity of

supply is the time period being considered.In the long run, the quantity supplied can respond substantially to price change.

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2.1 Computing the price elasticity of supply

•  price elasticity of supply=

ex) a 10% increase in the price of milk raise milk the amount the amount that farmers produce by 20 %

→Price elasticity of supply

pricein change Percentage suppliedquantity in change Percentage

2percent 10percent 20

=

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2.2 the variety of supply curves

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3 Three questions about applications of supply,demand and elasticity

•  Can good news for farming be bad news for farmers?

•  Why did OPEC fail to keep the price of oil high?

•  Does drug interdictionn increase or decrease drug-related crime?

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3.1.1Can good news for farming be bad news for farmers?

•  Researchers have devised a new hybrid of wheat that raises the amount farmrs can produce.

→the quantity of wheat sold increases and price of wheat falls owing to the supply curve shifting to the right.

→Does the discovery make farmers better off??Whether total revenue

rises or falls depends on the elasticity of demand. →Wheats is usually inelastic.Thus, total revenue of farmers falls because of

the discovery of the new hybrid!!Farmers are worse off!! So, what?? ■Adavnces in farm technology

1 increase in food supply. 2 caused farm revenue to fall. 3 encouraged people to leave farming. ※Despite the 70 percent drop in the number of farmers,U.S. farmers now

produce more than twice the output of crops and livestock tha they did in 1950.

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3.1.2 Implication from example of Adavnces in farm technology

•  Improvement in farm technology can be bad for farmers because it makes farmers increasingly unnesessary,but it is surely good for consumers who pay less for food.

•  A policy aimed at reducing the supply of farm products may raise the incomes of farmers,but it does so at the expense of consumers.

•  It is important to keep in mind what is good for farmers is not necessarily good for society as a whole.

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3.2 Why did OPEC fail to keep the price of oil high?

•  In the 1970s,member of the OPEC decided to raise the world price of oil to increase their incomes.

•  In the 1980s,OPEC found it difficult to maitain high price.

Why?

Ø  In the short run,the price rose by so much that OPEC incomes rose.

Ø  In the long run,when supply and demand more elastic,the same reduction in supply caused a smaller increase in the price.

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3.3.1 Does drug interdiction increase or decrease drug-related crime?

Ø Drug interdicition reduces quantity of drug supplied at any given price.

Ø  The demand for drug is not changed. →The fall in the equilibrium quantity shows that drug

interdiction does reduce drug use. But,what about the amount of drug-related crime? If demand is inelastic,then an increase in price raises total

revenue in the drug revenue. →Addicts who already had to steal to support their habits

would have an even greater need for quick cash. →

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3.3.2 Drug related crime in the short run and the long run

Ø  short run The demand for drug is probably inelasticity over short periods →Addicts who already had to steal to support their habits would have an

even greater need for quick cash. →Drug interdicition could increase drug-related crime. Ø  Long run Higher prices of drugs would discourage experimentation with drugs among

the young . →This lead to fewer drug addicts over time. →Drug interdicition would decrease drug-related crime. ※In contrast to drug interdication, drug education can reduce both drug

use and drug-related crime.

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Summary

Ø  Elasticity is a measure of how much buyers and sellers respond to changes in market conditions.

Ø  Total revenue depends on the price elasticity of demand.

Ø  Supply is more elastic in the long run than in the shot run.