MICRO CH5 Flashcards
5.1 Just How badly do you want it?
- 1 Define and calculate elasticity of demand, and explain three factors that determine it.
- 2 Explain how the relationship between elasticity of demand and total revenue determines business pricing strategies.
- 3 Explain elasticity of supply and how it helps businesses avoid disappointed customers.
- 4 Define cross elasticity and income elasticity of demand, and explain how they measure substitutes and normal goods.
- 5 Use elasticity to explain who pays sales taxes and government tax choices.
Elasticity (Price elasticity of Demand)
How much quantity demanded changes when prices change. The responsiveness of quantity demanded to change in price is related to how badly consumers want the product.
The tool that businesses use to measure consumer responsiveness and make pricing decisions is called price elasticity of demand.
Elasticity measures by how much quantity demanded RESPONDS to a change in price. When ever you see the word “elasticity” think RESPONSIVENESS.
Inelastic Demand
Low responsiveness in quantity demanded when prices change.
Inelastic = “NOT RESPONSIVE.”
ex) insulin
Diabetic has high willingness to pay for insulin. When price rise, not much quantity demanded decreases.
Elastic demands
High responsiveness in quantity demanded when prices change.
Elastic = “RESPONSIVE”
ex) ‘Blue’ earbuds = high response in quantity demanded to change in price of these items.
Calculating Elasticity of Demand
Price of elasticity of demand = % change in quantity demanded / % change in price.
“Calculates responsiveness by getting the ratio of the changes in QD and changes of Price.”
Demand Inelastic when calculation is less than 1.
Demand elastic when calculation is greater than 1.
When calculation is equal to 1, it’s unit-elastic.
Perfect elasticities
Perfectly inelastic demand
Price elasticity of demand equals zero, quantity demanded does not respond to a change in price.
Perfectly elastic demand
Price elasticity of demand equals infinity, Quantity demanded has an infinite response to any change in price.
These are extreme cases that are never observed in real world but may help understand elasticity.
Mid-point formula for elasticity
Divide change in quantity demanded by the average quantity demanded between the two.
You divide that by the change in price divided by average price between the two.
(Change in QD / AVG QD)/(Change in P / AVG P)
Three main factors influencing price elasticity of demand
- Willingness to shop elsewhere to get a low enough price
- Available substitutes, time to adjust
- Proportion of income spent on a product or service.
Available Substitutes influencing elasticity.
The more substitutes there are, the more easier it is to switch away from product or service where price rises, the more elastic the demand.
Time to adjust influencing elasticity
When prices rise, it often takes time to adjust and find substitutes. Time allows consumers to find substitutes. The longer the time to adjust to a price, the more elastic the demand becomes.
Proportion of Income spent influencing elasticity
The greater the proportion of income spent on a product, the greater the elasticity of demand.
ex) Price of salt increasing 100% from $1 to $2, quantity demanded isn’t as responsive (elastic) than say, the price of a freaking car increasing from 40k to 80k by 100%, the responsiveness of quantity demanded (elasticity) will be huge.
We spend a tiny fraction of our income on salt, so big percentage price rise doesn’t increase our total spending as much. But buying a car is one of the largest purchases, so a big percentage price rise makes it unaffordable.
Total Revenue
Total revenue is all the money received from sales, and is equal to the price per unit multiplied by the quantity sold.
All money a business receives from sales, equal to price per unit (P) multiplied by quantity sold (Q)
Total revenue and relation with elasticity
If the demand of the product is elastic, the percentage increase in quantity is greater than the percentage decrease in price, so total revenue (P x Q) increases.
If the demand of the product is inelastic, the percentage increase in quantity is less than the percentage decrease in price, so total revenue (P x Q) decreases.
Unit elastic = stays the same.
Elasticity of Supply
Responsiveness of quantity supplied to a change in price.
Measures how much quantity supplied responds to a change in price.
Inelastic
quantity supplied not responsive to change in price.
ex) farming, gold mining, necessities
Elastic
Quantity supplied responsive to change in price
ex) snow-shoveling service,
Perfectly inelastic supply
Refers to a price elasticity of supply value of zero, and arises in the case of a vertical supply curve.
Totally unresponsive to any percentage change in price.
Calculating Elasticity of Supply
percentage change in quantity supplied/percentage change in price
When supply is inelastic, the number from the calculation is less than 1.
When supply is elastic, the number from the calculation is greater than 1.
