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Price Elasticity of Demand

Price Elasticity of Demand

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Abstract

One of the main measures that are constantly used in the fields of economics to determine the effect of the Law of Demand on consumers is the Price Elasticity of Demand. Regardless of the inconsistency that is associated with the measure, the Price Elasticity of Demand is used considerably to determine the effect arising from changes in prices for commodities or services on consumer demand. Consequently, as a computational measure, the Price Elasticity of Demand provides a platform for determining the elasticity and inelasticity of consumer demand with respect to a respective product or service.

Price Elasticity of Demand

Price Elasticity of Demand is a measure that is usually employed in economics to determine the relationship between changes in price and changes in quantity in relation to the Law of Demand. The Price Elasticity of Demand provides the change in the quantity demanded in percentage, in response to a change in price equal to one percent (Taussig, 2007). Usually, the Price Elasticity of Demand is computed by dividing the proportionate change in the demanded quantity by the balanced change in price. The measure is usually in negative values, in order to illustrate the conformity of the prices to the Law of Demand. Alternately, price elasticities that are in positive values represent Ostentatious/Giffen goods or Veblen goods. These commodities do not conform to the Law of Demand (Taussig, 2007; Bowles, 2004).

Question 1

The price of a gallon of paint increases from US$ 3.00 to US$ 3.50 per gallon. The usage of paint drops from 35 gallons to 20 gallons a month. Compute the price elasticity of demand.

Solution

Percentage change in Quantity demanded = (New Quantity-Old Quantity)/Old Quantity

= (20 – 35)/35

= (-15)/35

= -0.4286

Percentage change in Price = (New Price – Old Price)/Old Price

= (3.50 – 3.00)/3.00

= (0.50)/3.00

= 0.1667

Therefore, Price Elasticity of Demand = (Percentage Change in Quantity demanded)/ (Percentage change in Price)

= (-0.4286)/ (0.1667)

= -2.571

= 2.571

Question 2

The Price Elasticity of Demand for the change in price is 2.571. The negative is ignored in order to ensure the difference between elasticity and inelasticity of prices based on a scale of 1. As evidently seen, the Price Elasticity of Demand for the paint is greater than 1. This indicates that the demand for the paint is price elastic. Therefore, it is correct to assert that the demand, which is elastic, illustrates that the demand for the commodity is affected by the changes in the commodity’s price.

Question 3

The Price Elasticity of Demand is usually used in economics to determine the sensitivity of a commodity’s demand to a price change. The measure often assumes that other demand determinants such as income, purchasing power of consumers, accessibility to substitutes and other factors are constant in the market. If the price elasticity is high, then consumers are bound to be more sensitive to the changes in price. A high price elasticity of demand illustrates that the moment the price of the specific commodity increases, then consumers will purchase an exceedingly small quantity of the respective product. Alternately, if the price elasticity of demand for the product decreases, then consumers will purchase a considerable amount of the respective product (Perloff, 2004). In addition, low price elasticity for a product illustrates that the change in price has slight control on demand.

In this case, the price elasticity of demand was computed as 2.571. As previously mentioned, it is important to discard the negative sign when assessing price elasticity. Hence, the price elasticity of demand is constantly positive. The commodity, which was paint, possessed a price elasticity of demand of 2.571, which was positive. Additionally, the price elasticity of demand was greater than 1, which enables the economist to assert that the good in question, paint, was price elastic. This means that the commodity possessed demand that was regularly affected by the changes in the prices. Therefore, the demand was very sensitive to the price changes.

Price elasticity of demand

PEG is a long term sport; NAB, not so much 3. Sisters abuse: all else equal -+ focusing only on their opportunity cost and not their past and/or background G. Link between graph and opportunity cost: slope of APP = opportunity cost 1 . Increasing opportunity cost principle: Concave shape -+ higher opportunity cost as you go down and to the right of the curve a. Absolute value of the slope 2. Reason for increasing opportunity cost principle a. Imperfect substitution among resources b. Cannot expect a computer specialist to be as good at a person who is producing cars c.

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More difficult to make the transformation, more concave the APP I. More unrelated, more concave H. Growth: producing more of the goods -+ outward shift of the POMP 1 . Growth can come about from increase in resources or technology 2. Reason for economic decline: manmade/natural disasters a. Manmade disasters examples: war b. WI, Germany -+ outward during war, inward decline after c. Hawaii hit hardest by 9/1 1 because of fear of flying Ill. Comparative Advantage 1. David Richard said gains can be made from trade a. Have a competitive advantage with a lower opportunity cost b.

Countries can both benefit mutually 2. Adam Smith, 1776, Wealth of Nations (Father of Economics) a. Absolute Advantage if they produce more or use fewer resources 3. Tarry: no trade B. Example: Shirt Game 1. 0 1. 2 players: USA and China 2. Winner will be USA because everyone in the USA can be used 3. 3 players: USA, China, and India 4. Answers who can make the most, not who can make the lowest cost C. Example: U. S. Vs.. Japan (See graphs in notebook) 1. U. S. Has an advantage in cars because opportunity cost is lower 2. Japan has advantage in computers because opportunity cost is lower a.

U. S. Should move to A’ because of complete specialization b. Japan should move to B’ c. Specialization improves world production of both goods D. Terms of Trade . 1 for 1 because it lies between 2 countries’ price ratios 2. Both benefit from trade (A” and B” outside of opportunity cost) ‘V. Supply and Demand – Chapter 3 A. Prices are determined by market forces: buyers and sellers 1. SQ: quantity demanded -+ units P: price of product 2. SQ = f(P), inverse -+ P up, SQ down 3. The law of demand (Alfred Marshall) P = f(S,D) a. B. Inverse demand function (P on y-axis, SQ on x-axis . SQ=50-UP

To find y- and x- intercepts, convert into Inverse Demand Function (solve for price) I’. P=25-O. SQ What other factors or variables affect demand in general? (D. Curve shifters) 1 . Income Increased income and increased demand = normal good Increased income and decreased demand = inferior good . Low cost cars (Haunted), fast food . Buying things because it’s cheaper Tastes Ex: eggs, frozen yogurt Population (number of buyers) Higher population, higher demand Price of substitutes 4. Higher price of substitute, higher demand of original Ex: higher price of Pepsi, higher demand of Coke

Price of complements 5. Higher price of complements, lower demand of original 6. Expectations Higher expected price leads to increased demand today SQ and D . Change in P -+ movement along the curve Demand itself shifts the entire curve Rightward shift = more demand Leftward shift = less demand Same shifts for supply Supply 1. SQ positive, P up, SQ up Law of Supply E. What other factors of variables that affect supply in general? (S. Curve shifters) 1. Price of inputs a. Inverse relationship: higher price of input, lower supply b. Can’t make as many houses if lumber costs more c.

In other words: Higher production cost, lower supply 2. Technology a. Direct relationship: better technology, more supply b. Makes attaining supply faster, easier, cheaper 3. Number of sellers a. Direct relationship: more competition, more overall market supply b. More computer firms in the market, higher potential for total number of computers 4. Price of alternate a. Inverse: Higher price of alternate, decreased supply of other b. Ex: price of corn increases, supply of wheat decreases I. Corn is more profitable, so there is less wheat that will be produced in the market 5. Tax and regulation a.

Inverse: More tax on product, decrease supply of product b. Ex: increased taxes on coal, decreased supply of coal 6. Expectations a. Inverse: Higher expected price leads to lowered supply today F. Equilibrium 1. Satisfied if SQ=SQ 2. Market-clearing price 9/16/13 l. Predicting future price/quantity with Supply and Demand A. Demand change 1. Stronger demand -+ higher price, higher quantity Market 2. If price doesn’t change, shortage -+ price will increase B. Supply change 1. Lower supply -+ higher price, lower quantity C. Supply and Demand Change 1. Increase demand and supply: Unambiguous (certain): quantity increases a.

Ambiguous: price may increase if there is a stronger demand increase than the supply increase b. Price may decrease if there is a stronger supply increase than demand increase c. Price stays same if S increase = D increase II. Chapter 4: Elasticity Elasticity is the responsiveness of D to delta P P down, Q up, and vice versa. (By how much? ) c. 1. % A BTW old(XX) and problem with this formula: same change in value, different relative % 3. This problem: Midpoint formula Difference divided by average: (XX – XI)/(BAG: XSL ,XX) Inelastic if 1 Perfectly inelastic: demand curve vertical, Pep = O

Perfectly elastic: demand curve horizontal, Pep = Factors affect the elasticity of demand . Necessity Vs.. Luxuries Availability of close substitutes Demand for bread Vs.. Demand for diamond Bread is much more inelastic because less substitutes Scope of the market Shoes Vs.. Nikkei Shoes is more inelastic because more broad To fix . Nikkei is elastic because there are other brands you can buy 4. Time horizon Personal income . Slope elasticity . Practice Exercise #1 . Required textbooks or mystery novels Mystery novels more elastic because no other options for required textbooks 2.

Beethoven recordings or classical music recordings in general a. Beethoven more elastic because other substitutes by other composers 3. Heating oil during the next 6 months or heating oil during next 5 years a. Heating oil during next 5 years more elastic demand because long run is more elastic (more options to change over time) Root beer or water Root beer is more elastic because water is a necessity Applications of Elasticity G. . Elasticity and Total Revenue TRY=PIX = (rise) + (goes down) = +10% in P + (-5% Sq) suppose (E=O. 5) iii. ‘v. = +5% total revenue highest total revenue when elasticity = 1 (midpoint)

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