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Substitution effect of a lower price creates an increase in QD. Income Effect. Change in the price of a good is the change in the quantity of that good ...
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Substitution Effect. Change in the price of a good is the change in the quantity of that good demanded as the consumer substitutes the good that has become relatively more expensive. Substitution effect of a lower price creates an increase in QD. Income Effect. Change in the price of a good is the change in the quantity of that good demanded that results from a change in the consumerās purchasing power when the price of the good changes. Combining substitution and income effects, lower prices create increased QD, thus explaining the law of demand. Note on inferior and normal goods. If the good is an inferior good then a lower price creates an income effect to purchase less of such a good. In order for demand curves to be downward sloping, the substitution effect must dominate the income effect for inferior goods. Law of demand states that consumers will respond to a decrease in price by buying more of a product (other things remaining constant), but it does not tell us how much more. Thatās where elasticity comes in. Price elasticity of demand. Ratio of the percent change in QD to percent change in P as we move along demand curve. Sensitivity of consumers to a change in price is measured by price elasticity of demand. The terms elastic or inelastic describe the degree of responsiveness.
Ignore negative sign because downward sloping demand curves will insure a negative price elasticity, whatās important is the magnitude of that elasticity. For the digital camera, the % decrease in QD (the effect) was twice as large as the % increase in P (the cause). Consumers have exhibited an elastic response to a higher price.
Example. P of milk increases by 10% and QD decreases by 5%. šø! =
For the milk, the % decrease in QD (the effect) was only half the size as the % increase in P (the cause). Consumers have exhibited an inelastic response to a higher price. % change equationāNOOO! %ā =
Example. The price of a doughnut rises from $1.00 to $1.15 and Bob reduces his weekly doughnut consumption from 20 to 19. %āš =
Bobās ED for doughnuts is 5%/15% = 0.33. Midpoint Method. Elasticity computations change if the new and old prices (or quantities) are reversed. Example. If a variable goes from a value of 100 to a value of 110, it is a 10% increase. If the variable were to go from a value of 110 to a value of 100, it is a 9.1% decrease. Because of this, the value of the price elasticity will change, depending upon whether the price is increasing or decreasing. In order to account for this, economists sometimes use the average price and average quantity between two points on a demand curve. šø! =
Example. Now assume that ED = 10. ED = %ĪQD/%ĪP = 10. Assume P increases by 1%. Since, ED = %ĪQD/ 1 % = 10, it can be predicted that QD will decrease by a 10%, which is a big response.
Example. P increases 10%, QD decreases 10%, unit elastic (ED = 1). TR will not change, because downward quantity effect is equal to upward price effect. Example. Initial price of pizza slices is equal to $2 and 50 slices are sold every day. This is point A on D. TR = (P)(QD) = ($2)( 50 ) = $ This is the area marked TR on the graph, the rectangle below D. Pizzeria wishes to increase P of a slice to $ and estimates that 40 slices will be sold each day. This is point B on D. TR = (P)(QD) = ($3)( 40 ) = $ The $20 gain can be seen through both P and Q effects. Area L is revenue lost due to decreased Q. Ten slices were lost, at $2 each, so area L represents $20 of lost revenue. Area G is revenue gained due to increased P. Forty slices were sold, at a price $1 higher than before, so area G represents $40 of gained revenue. Area G ā Area L = $40 - $20 = $20, which is the total increase from the higher price. If upward price effect is stronger than downward quantity effect, demand must be inelastic. If upward price effect is weaker than downward quantity effect, demand must be elastic.
why even bother? Look at the D curve above again, noting where unit elastic is. Unit-elastic is the dividing point between elastic and inelastic. Itās also the highest point of total revenue. Factors Determining ED
Price Elasticity of Supply. Measure of the responsiveness of the QS of a good to P of that good. It is the ratio of the percent change in QS to percent change in price as it moves along the S curve. ES = %ĪQS/%ĪP Elastic: ES > 1 Inelastic: ES < 1 Unit elastic: ES = 1 Perfectly Inelastic and Elastic Supply. Same analysis as in elasticity of demand. This graph shows an upward sloping supply curve, a perfectly elastic supply curve, and a perfectly inelastic supply curve. A vertical S curve like S 3 implies that even at the highest of prices, there is something that prevents firms from increasing QS. (e.g., technological problem or seasonal issue). A horizontal S curve like S 2 implies that even smallest increase in P would dramatically increase QS. A small decrease in P would decrease Qs to zero. Factors Determining ES