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Elasticity of Demand and Supply – Sophia Lobo

I. Price Elasticity of Demand –measures a consumers responsiveness to a products change in price.

Determinants –
 Substitutability – the larger the number of substitute goods, the greater the price elasticity of demand.
 Proportion of Income – the higher the price of the good relative to the consumers income, the greater the price
elasticity of demand.
 Luxury or Necessity
 The longer the time period under consideration the more elastic it is because people become more
sensitive to price. Also durability of goods affects this decision.

II. Price Elasticity of Supply –measures a suppliers responsiveness to a change in price.

 The short-run supply elasticity is more inelastic though Industrial producers are able to make some output
changes by having workers work overtime or by bringing on an extra shift.
 The long-run supply elasticity is the most elastic, because more adjustments can be made over time and
quantity can be changed more relative to a small change in price. Extreme Cases

 If the elasticity is a number greater than one, we say demand is elastic;


if it is less than one, we say demand is inelastic. A special case is if it
equals one; this is called unit elasticity.

III. Elasticity varies over range of prices.


1. Demand is more elastic in upper left portion of curve (because
price is higher and quantity smaller).
2. Demand is more inelastic in lower right portion of curve (because price is lower and quantity larger).

IV. Total-Revenue test (used in place of an elasticity formula) = P * Q


1. Demand is elastic if a decrease in price results in a rise in total revenue. (Price and revenue move in opposite
directions).
2. Demand is inelastic if a decrease in price results in a fall in total revenue. (Price and revenue move in same
direction).
3. Unit elasticity exist if total revenue does not change with price.

V. Cross Elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another
product.
If cross elasticity is positive, then X and Y are substitutes; if negative, then they are complements; and if zero,
then they are unrelated, independent products.

VI. Income Elasticity of Demand refers to the percentage change in quantity demanded that results from some percentage
change in consumer incomes.

A positive number indicates a normal or superior good; a negative one indicates an inferior good.
Those industries that are income elastic will expand at a higher rate as the economy grows.

Consumer Behavior and Utility Maximization

I. Law of Demand (reasons for a downward sloping curve)


1. Income Effect – describes the impact a change in price has on a consumers real income and thus demand. If
the price of a good decreases, the consumers purchasing power increases, thus they demand more consumer
goods.
2. Substitution Effect – describes the impact that a change in price of a product, relative to others, has on its
demand. When a good becomes cheaper in comparison to its substitutes the demand for that good increases.
3. Law of Diminishing Marginal Utility – although a consumers need maybe insatiable, the more of a good he
affords the less utility (satisfaction one gets from consumption; measured in utils) it brings.
Total utility – total satisfaction derived from some quantity (reaches a maximum)
Marginal utility – extra satisfaction a consumer obtains from additional purchase of the quantity or the
change in total utility at the purchase of 1 more unit.

Since marginal utility decreases with quantity, the consumers will only buy more of it
if it were to cost less. Therefore the demand curve is downward sloping. If marginal
utility falls sharply with each successive unit of consumption demand is inelastic.

II. Theory of Consumer Behavior


Consumer choice and Budget Constraints
1. Consumers seek to maximize their total utility or get the most for their buck (rational behavior.)
2. Consumers provide finite human and property resources, thus they earn a limited income (budget constraints).
3. Choices are limited by consumer preference and by the price of g&s.

III. Utility Maximizing Rule – consumers should allocate their income so that each, even the last dollar, spent yields the
same amount of marginal utility. [Equilibrium]
1. When comparing utility for assorted goods, we compare their utility per dollar.
As long as one good provides more utility per dollar than another, the consumer will buy more of the
first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility
per dollar just equals that of the other product.

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