Econ a Highly Testable Concept. concepts, further, higher

hariRaj

There are 2 concepts in Economics, that I find highly testable.
1. For a downward sloping Demand Curve, Price Elasticity of Demand is high at higher Prices and low at lower Prices.
2. This leads to Total Revenues increasing as Demand moves up the Demand Curve to a point where Price Elasticity is unitary. At this point Total Revenues are maximized. Then, as Demand moves further up from this point, Total Revenues start to decrease.
Please go thru texts for these concepts and make sure you understand them. It is highly likely that you would see questions from these in both sessions.

kd26gioi

Can you please explain one thing here: why is total revenues maximized at unitary elasticity?
Assume price increase by 20% and quantity reduces accordingly
1. When elasticity is high Change in Revenue = 1.2x.7 = .84
2. When elasticity is unit Change in Revenue = 1.2x.8 = .96
3. When elasticity is low Change in Revenue = 1.2x.9 = 1.08–revenue is maximized here  not at unit elasticity??????

Flok

Total Revenue is: Price x Quantity
You have to take the effect of both, when calculating Total Revenues.
At high elasticity, any change in Price, will affect bigger change in Quantity demanded.
And at lower elasticity, any change in Price will not affect so much change in demanded Quantity.
It is mathematically proven that their product (Price x Quantity) is maximized at unitary elasticity.
I dont understand your example above. Take 3 specific elasticities (0.5, 1, 2) and take a smaller %age change in Price. (20% change in Price is too big. With that change in Price, you would travel a long distance on your Demand Curve and thus change elasticities while moving along the curve). And then you should see desired results.
Anyways, you dont have to prove this theory for the exam, you just need to understand it and retain it.

Iginla2010

Hey, rus1bus, can you do this with macro economics?

bchadwick

Thanks rus1bus.
This is very interesting stuff. Agreed that #1 proves that elasticity is not a slope.
Not important for the exam, but just out of curiosity  would like to get your views on #2. The %change is a similar methodology used in deriving the slope of a duration. I think the %change implies a first derivative of the xy function with respect to x. So, I am not entirely convinced that %change in values means that it is not a slope.
The following is from Schweser on one of the definitions of duration:
“…duration is the slope of the priceyield curve at the bond’s current YTM. Mathematically, the slope of the priceyield curve is the first derivative of the priceyield curve with respect to yield…”
Source: Schweser, SS16, page 140
Many thanks for your help!
Cheers

Dapper425

Wow Sujan, great thinking.
If you have a curve, THEN slope of the curve at a given point is the derivative. But, if you have a linear line, then slope of that line is simply (Y2  Y1) / (X2  X1). (no need of derivative)
And coming back to Elasticity, it is ((X2  X1)/X1) / ((Y2  Y1)/Y1)
So, you see, there is difference in equations for Slope and Elasticity.

Benjiko

hkalra32  yes, the effect is opposite. I would slightly rephrase your sentence this way: 1% price cut ‘…increases revenue as we move down…’ to the point of unitary elasticity (the point of highest total revenue) from this point the ‘…revenue decreases…’.
rus1bus  good point, although demand curves, however, can be nonlinear. For example, a demand curve for marginal revenue product tends to be convex. And I suppose this just proves that because we use the elasticity formula, ((X2  X1)/X1) / ((Y2  Y1)/Y1), to solve for elasticity even though the curve is convex, the end result is just the elasticity (and no where near a slope). Good stuff!