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Micro Chapter 7 Consumer Choice and Elasticity This chapter is an extension of the first part of Chapter 3 on demand and consumer theory Refer back to your Chapter 3 notes and mentally combine them with Chapter 7 notes 6 Learning Goals 1) List the key factors influencing consumer behavior (repeat from Chapter 3 and on your own) 2) Apply the concept of marginal utility to determine how a demand curve is derived (repeat from Chapter 3 and on your own) 3) Define, calculate, and graph elasticity of demand 4) Relate demand elasticity to total revenue 5) Define and calculate income elasticity 6) Define and graph elasticity of supply Elasticity of Demand Law of demand states that if price rises (falls), quantity demanded falls (rises) Elasticity gives us more information about the consumer Price elasticity seeks to quantify how much quantity demanded falls (rises) Other questions to consider: By how much does price need to rise to decrease quantity demanded by X%? By how much does price need to fall to increase quantity demanded by Y%? Price elasticity of demand= percentage change in quantity demanded / percentage change in price Elasticity = Values of price elasticity If ε > 1, then elastic Consumers change their behavior a lot If ε < 1, then inelastic Consumers change their behavior a little If ε = 1, then unitary elastic Consumers don’t change their behavior Key point: Price elasticity is NOT the slope of the demand curve – A straight-line demand curve will have constant slope but a different elasticity at every point What determines elasticity? (1) Availability of substitutes – More substitutes, more elastic (more responsive) (2) Share of budget – Greater share, more elastic (3) Time – More time, more elastic How Demand Elasticity and Price Changes Affect Total Expenditures (or Revenues) on a Product Price elasticity of demand Elasticity coefficient (in absolute value) Elastic 1 to Unitary Elastic 1 Inelastic 0 to 1 Impact of higher price on total consumer expenditures or a firm’s total revenue decrease -- unchanged-increase Impact of lower price on total consumer expenditures or a firm’s total revenue increase -- unchanged-decrease Don’t memorize this chart! Use it as a tool Think about what elasticity tells us and then apply it to total revenue Total Revenue (TR) to the firm is Total Expenditure (TE) by the consumer. TR = TE = P x Q If elastic and price falls: ↓ P x ↑Q = ↑TR – Lower price and lots more is bought, Q dominates equation ↓Q = ↓TR If elastic and price rises: ↑ P x – Raise price and lots less is bought, Q dominates equation ↓P x If inelastic and price falls: ↑Q = ↓TR – Lower price and a little more is bought, P dominates equation If inelastic and price rises: ↑Px ↓Q = ↑TR – Raise price and a little less is bought, P dominates equation A different way to look at this: 4 graphs Income Elasticity Price elasticity measures the change in consumer purchases when price changes Income elasticity measures the change in consumer purchases when income changes Income elasticity = Values of income elasticity If positive, consumers buy more when income rises Normal good - a good that consumers will buy more of when income rises If negative, consumers buy less when income rises Inferior good - a good that consumers will buy less of when income rises Price Elasticity of Supply Price elasticity of supply measures the responsiveness of quantity supplied to price changes How much does quantity supplied increase (or decrease) when price rises (or falls)? Graphs: