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The midpoint formula, Exams of Economics

Economics

We can use the midpoint formula to ensure that we have only one value of the price elasticity of demand between the same two points on the same demand.

Typology: Exams

2021/2022

Uploaded on 09/12/2022

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The midpoint formula
We can use the midpoint formula to ensure that we have only one value of the
price elasticity of demand between the same two points on the same demand
curve. The midpoint formula uses the average of the initial and final quantity
and the average of the initial and final price. If Q1 and P11 are the initial
quantity and price, and Q2 and P2 are the final quantity and price, the
midpoint formula is (also shown on page 96):
Price elasticity of demand= (Q2-Q1)/ (Q1+Q2 /2) / (P2 - P1)/ (P1 + P2)/2
When demand curves intersect, the flatter curve is more elastic
Polar cases of perfectly elastic and perfectly inelastic demand
If a demand curve is a vertical line it is perfectly inelastic. In this case the
quantity demanded is completely unresponsive to price changes and the price
elasticity of demand equals zero, e.g. for the drug insulin for diabetic people.
If a demand curve is a horizontal line it is perfectly elastic. In this case the
quantity demanded would be infinitely responsive to price changes and the
price elasticity of demand equals infinity.
The Determinates of the Price Elasticity of Demand
Why do price elasticities differ between products? The key determinates of the
price elasticity of demand are as follows:
Availability of close substitutes
The availability of substitutes is the most important determinant of price
elasticity of demand because how consumers react to a change in the price of
a product depends on what alternatives they have. They other following key
determinants of the price elasticity of demand that follow in this section are
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The midpoint formula We can use the midpoint formula to ensure that we have only one value of the price elasticity of demand between the same two points on the same demand curve. The midpoint formula uses the average of the initial and final quantity and the average of the initial and final price. If Q1 and P11 are the initial quantity and price, and Q2 and P2 are the final quantity and price, the midpoint formula is (also shown on page 96): Price elasticity of demand= (Q2-Q1)/ (Q1+Q2 /2) / (P2 - P1)/ (P1 + P2)/ When demand curves intersect, the flatter curve is more elastic Polar cases of perfectly elastic and perfectly inelastic demand If a demand curve is a vertical line it is perfectly inelastic. In this case the quantity demanded is completely unresponsive to price changes and the price elasticity of demand equals zero, e.g. for the drug insulin for diabetic people. If a demand curve is a horizontal line it is perfectly elastic. In this case the quantity demanded would be infinitely responsive to price changes and the price elasticity of demand equals infinity. The Determinates of the Price Elasticity of Demand Why do price elasticities differ between products? The key determinates of the price elasticity of demand are as follows: Availability of close substitutes The availability of substitutes is the most important determinant of price elasticity of demand because how consumers react to a change in the price of a product depends on what alternatives they have. They other following key determinants of the price elasticity of demand that follow in this section are

largely based on the availability of substitutes. In general, if a product has more substitutes available, it will have more elastic demand. If a product has fewer substitutes available, it will have less elastic demand. Length of time involved It usually takes consumers some time to adjust their buying habits when prices change. Also, over time more substitutes will be developed. The more time that passes, the more elastic the demand for a product becomes. Luxuries versus necessities The demand curve for a luxury is more elastic than the demand curve for a necessity. E.g. the demand for milk is inelastic, and concert ticket demand is elastic. Definition of the market In a narrowly defined market consumers will have more substitutes available. The more narrowly we define a market, the more elastic demand will be. Share of the good in the consumer’s budget Goods that only take a small fraction of a consumer’s budget tend to have less elastic demand than goods that take a large fraction. In general, the demand for a good will be less elastic if purchasing the good involves a small share of the average consumer’s budget. The Relationship Between Price Elasticity and Total Revenue A firm is interested in price elasticity because it allows the firm to calculate how changes in price will affect its total revenue. Total revenue is the total amount of funds received by a seller of a good or service, calculated by multiplying price per unit by the number of units sold.

Formula: Cross-price elasticity of demand= percentage change in quantity demanded of one good/ percentage change in price of another good An increase in the price of a substitute will lead to an increase in quantity demanded of the first good, so the cross-price elasticity of demand will be positive. An increase in the price of a complement will lead to a decrease in the quantity demanded of the first good, so the cross-price elasticity of demand will be negative. If the two products are unrelated, the cross-price elasticity demand will be zero. Cross-price elasticity of demand is important to managers because it allows them to measure whether products sold by other firms are close substitutes for their products. Cross-price elasticity of demand is also important to managers because it allows them to predict the effect on the demand for their product if the price of a complement for their product changes. Income elasticity of demand The income elasticity of demand measures the responsiveness of quantity demanded to changes in income. When measuring income, disposable income is usually used, which is consumer income after income taxation has been paid to the government. Formula: Income elasticity of demand = percentage change in quantity demanded / percentage change in income If the quantity demanded of a good or service increases as income increases, then the product is a normal good. Normal goods are often further subdivided into luxury goods and necessity goods. A good or service is a luxury if the quantity demanded is very responsive to changes in income, so that a 10 percent increase in income results in more than a 10 percent increase in quantity demanded. A good or service is a necessity if the quantity demanded is not very responsive to changes in income, so that a 10 percent increase in income results in less than a 10 percent increase in quantity demanded. The

calculated income demand is between 0 and 1 for necessity goods, and greater than 1 for luxury products. The calculated income elasticity of demand for an inferior good is negative. Using Elasticity to Analyse the Disappearing Family Farm The concepts of price elasticity and income elasticity can help us understand many economic issues, for example in Australia people are concerned than the family farm is becoming endangered in Australia. This is because farm numbers are lowering. Rapid productivity growth in farm production has combined with low price and income elasticities for most food products to make family farming difficult in Australia. This increase in production resulted in a substantial decline in prices. Two key factors explain this decline in prices:

  1. the demand for agricultural products is price inelastic and
  2. the income elasticity of demand for agricultural products is low. The Price Elasticity of Supply and its Measurement We can use the concept of elasticity to measure the responsiveness of firms to a change in price, just as we used it to measure the responsiveness of consumers. We know from the law of supply that when the price of a product increases, the quantity supplied increases. To measure by how much quantity supplied increases when price increases we use the price elasticity of supply. Measuring the price elasticity of supply Price elasticity of supply: The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price.

Polar cases of perfectly elastic and perfectly inelastic supply It is possible for supply to fall into one of the polar cases of price elasticity. If a supply curve is a vertical line it is perfectly inelastic. In this case the quantity supplied is completely unresponsive to price changes and the price elasticity of supply equals zero. If a supply curve is a horizontal line it is perfectly elastic. In this hypothetical case the quantity supplied is infinitely responsive to price changes and the price elasticity of supply equals infinity. If a supply curve is elastic, a small increase in price causes a large increase in quantity supplied. Using price elasticity of supply to predict changes in price When demand increases, the amount that price increases depends on the price elasticity of supply.