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Note that there are three parameters, p1, p2, and M in the budget constraint, but
no other parameters appear in the utility function. Lack of parameters of utility
function indicates that the demand functions are derived from a general utility
function. This is why only these three parameters appear in the above demand
functions. If a special utility function were used, its parameters will appear in the
demand functions.
Next, we see how these parameters affect demand curves.
Income Consumption Curve.
%x
x / x
x M
.
%M M / M M x
In the case of an inferior good, the increment in real income causes a decline in
consumption. In a rare case, this negative income effect can more than offset the
initial substitution effect. Figure 6 illustrates such a case where consumption of
the good actually declines (point c is to the left of point a) in response to a
decline in its price.
The initial equibrium a. An increase in the price of good 1 rotates the budget
line from 1 to 2. In this case, budget line 2 is requires to purchase the original
consumption bundle a. This difference between the two budget lines (2 2) is
the cost of living adjustment. But will the consumer stay at point a? No. he
moves to a better point, b.
These two diagrams demonstrate that cost of living adjustment overcompensates
the consumer, and makes him better off.
Price Decline Income may be cut for the cost of living adjustment.
Price Increase Income must be increased for the cost of living adjustment.
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.
P
%P
Q P
P
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MEASUREMENT OF PED
Point elasticity () use initial price and quantity
P (price)
Q (quantity)
20
100
10
200
200 100
2.
= 10100
20
20
Next,
100 200
1
.
= 20200
10
2
10
Thus, PED can change dramatically, depending on what point is used as the
basis. This example shows that point elasticity is reliable only for small price
changes, but not for large price changes. To avoid this problem, we sometimes
use arc elasticity, which is measured in a price interval.
Arc elasticity use average price and average quantity.
Q /(Q1 Q2 )
.
P /( P1 P2 )
100 /150
1.
10 /15
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Price
Q demanded
1909
$900
58,000 cars
1914
$440
472,000
1916
$360
730,000
arc
***
***
***
The record sale between 1910 and 1920 confirmed the wisdom of Chinese saying
(Low margin sells volumes) That is, it is better to sell many cars at a small
margin than to sell few cars at a high margin.
This statement is true only if demand is sufficiently elastic.
Elasticity Categories:
= .5 means that as price declines by 1%, quantity demanded increases by
0.5%.
Actual Quantity changed
Q = P.
Special Cases:
> 1 demand is price elastic.
< 1 demand is price inelastic.
= 1 demand is unitary price elastic. (In this case, the demand curve is a
rectangular hyperbola. The area of the square generated by any point on the
demand curve is the same.)
= demand is perfectly elastic, horizontal demand curve.
= 0 demand is perfectly inelastic, a vertical demand curve.
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A point on a linear demand curve bisects it. When the top and the bottom
segments are of equal length, (e.g., AC = CE), PED = 1. As one moves upward
from that point on the demand curve, the bottom segment becomes longer than
the top, and hence PED increases, approaching at point A. On the other hand,
a downward movement along the demand curve reduces the bottom segment,
approaching zero at point E. (The book expresses elasticities as negative
numbers.)
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Q
R P Q P 1
P (1 ).
(1) Inelastic Demand ( < 1) P and R have the same sign. That is, price and
revenue move in the same direction.
Example: = 0.5, and P = - 10%. Then R 10%(1 0.5) 5%.
(2) Elastic Demand ( > 1) P and R have the opposite signs. Price and
revenue move in the opposite direction.
Example: = 2 P = - 10%. Then R 10%(1 2) 10%.
(3) Unitary Elastic Demand ( = 1).
R = 0. That is, revenue is unaffected by price change.
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Less than a year after he arrived, his Peter Pan line sickened hundreds of people with
salmonella, leading to a massive recall. (Peter Pan is not implicated in the latest episode of
tainted peanut butter.) Critics say he hasn't moved fast enough to ditch marginal brands such as
Crunch 'n Munch, Andy Capp's fries, and Patio Mexican foods. Gimme Credit analyst B. Craig
Hutson notes the stock has shrunk by a third under Rodkin, calling his performance
"disappointing despite many promises of a turnaround."
At least customers are now responding to Rodkin's efforts to keep down the cost of Banquet
dinners. Citigroup analyst David Driscoll says ConAgra is well positioned now. "Where else
can you find dinner for 99 cents?"
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