# Elasticity of Supply & Demand

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Elasticity of Supply & Demand

Consumers will buy more when prices go down and less when prices go up
PRICE ELASTICITY OF DEMAND THE LAW OF DEMAND SAYS... Consumers will buy more when prices go down and less when prices go up HOW MUCH MORE OR LESS? Price Elasticity Provides an Answer

.10 .20 PRICE ELASTICITY OF DEMAND
Measures Responsiveness to Price Changes P The percentage change in quantity The percentage change in price .10 .20 P2 P1 Elasticity is .5 D Q2 Q1 Q

  % Q % P Commonly Expressed as… PRICE ELASTICITY OF DEMAND P D Q
The percentage change in quantity The percentage change in price % Q d % P P2 P1 Elasticity is .5 D Q2 Q1 Q

 Ed = Ed = Elimination of the Minus Sign PRICE ELASTICITY OF DEMAND
The Price-Elasticity Coefficient and Formula Ed = Percentage change in quantity demanded of product X Percentage change in price of product X Or equivalently… Ed = Change in quantity demanded of X Original quantity demanded of X Change in price of X Original price of X Elimination of the Minus Sign

 Price Elasticity is... Inelastic 0 < X < 1
PRICE ELASTICITY OF DEMAND Price Elasticity is... Inelastic 0 < X < 1 Typical of necessities one must have Elastic from 1 < X < Typical of luxuries one wants Unit elastic when exactly = 1 Quantity change offsets Price change

.04 .02 .01 .02 .02 = 2 = .5 = 1 Interpretations of Ed Elastic Demand
PRICE ELASTICITY OF DEMAND Interpretations of Ed Elastic Demand Ed = .04 .02 = 2 Inelastic Demand Ed = .01 .02 = .5 Unit Elasticity Ed = .02 = 1

Extreme Cases PRICE ELASTICITY OF DEMAND Perfectly Inelastic Demand
Ed = 0 Q Perfectly Elastic Demand P D2 Ed =  Q

DETERMINANTS OF PRICE ELASTICITY OF DEMAND
Substitutability Proportion of Income Luxuries versus Necessities Time

  Ed Ed = = More Accurate Calculation – The Midpoint Formula
PRICE ELASTICITY OF DEMAND More Accurate Calculation – The Midpoint Formula Ed = Change in quantity Sum of Quantities/2 price prices/2 Ed = ΔQ AVG Q ΔP AVG P

Lemonade Stand You sell 24 glasses for \$.50 each. P x Q = Total Revenue (TR) \$.50 x 24 = \$12 = Total Revenue -\$4 = Total Cost \$8 = Profit

Total Revenue Total Revenue (TR): The total dollars received by a firm for selling a product. AKA Consumer Expenditures

CIRCULAR FLOW MODEL \$ COSTS \$ INCOMES RESOURCES INPUTS GOODS &
MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET \$ REVENUE \$ CONSUMPTION 13

P D Q PRICE ELASTICITY & TOTAL REVENUE When prices are low,
So is total revenue P TR D Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... P TR D Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... then declines P TR D Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... then declines P TR D Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... then declines P TR D Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... then declines P TR Inelastic Demand D Inelastic Demand Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... then declines P TR Elastic Demand Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded

P D Q PRICE ELASTICITY & TOTAL REVENUE Total revenue rises
with price to a point... then declines P TR Elastic Demand Unit Elastic Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded

TOTAL REVENUE TEST Another way to determine elasticity P x Q = TR
P and Q move opposite each other So how do we know what happens to TR? If P and TR move together demand is inelastic If Q and TR move together demand is elastic If TR doesn’t move demand is unit elastic

Other Elasticities

PRICE ELASTICITY OF SUPPLY
Es= %ΔQS %ΔP

PRICE ELASTICITY OF SUPPLY
Immediate Market period P Sm An increase in demand without enough time to change supply causes… Po D1 Q Qo

PRICE ELASTICITY OF SUPPLY
Immediate Market period P Sm An increase in demand without enough time to change supply causes… an increase in price Pm Po D2 D1 Q Qo

PRICE ELASTICITY OF SUPPLY
Short Run P Ss An increase in demand with more elastic supply causes... Po D1 Qo Q

PRICE ELASTICITY OF SUPPLY
Short Run P Ss An increase in demand with more elastic supply causes... a smaller increase in price Ps Po D2 D1 Qo Qs Q

PRICE ELASTICITY OF SUPPLY
Long Run An increase in demand in the long run allows greater change causing... P SL Po D1 Qo Q

PRICE ELASTICITY OF SUPPLY
Long Run An increase in demand in the long run allows greater change causing... P SL PL Even more elastic response - less price increase Po D2 D1 Qo QL Q

CROSS PRICE ELASTICITY OF DEMAND
Exy = %ΔQDX %ΔPY Positive Sign Goods are Substitutes Negative Sign Goods are Complementary Zero or Near-Zero Value Goods are Unrelated

Ei = Goods are Normal or Superior Goods are Inferior %ΔQD %Δ Income
INCOME ELASTICITY OF DEMAND Ei = %ΔQD %Δ Income Positive Sign Goods are Normal or Superior Negative Sign Goods are Inferior

Price Controls

PRICE CONTROLS Enacted when policymakers believe the market price is unfair to buyers or sellers. 3 3

CONTROLS ON PRICES Price Ceiling Price Floor
A legal maximum on the price at which a good can be sold. Price Floor A legal minimum on the price at which a good can be sold. 4 4

How Price Ceilings Affect Market Outcomes
Two possibilities: Not binding (not effective) Binding (effective) 5 5

A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply Demand \$4 Price ceiling 3 100 Equilibrium price Quantity of Ice-Cream Equilibrium quantity Cones

A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Demand Equilibrium price \$3 2 Price ceiling 75 125 Shortage Quantity of Ice-Cream Quantity supplied Quantity demanded Cones

How Price Ceilings Affect Market Outcomes
A binding price ceiling creates A shortage because QD > QS. Non-price rationing Long lines Discrimination 11 14

CASE STUDY: Lines at the Gas Pump
In the early 1970s the government placed a price ceiling on gas. In 1973, OPEC raised the price of crude oil (input for gas).

The Market for Gasoline with a Price Ceiling
(a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Demand Supply, S1 1. Initially, the price ceiling is not binding . . . Price ceiling P1 Q1 Quantity of Gasoline

The Market for Gasoline with a Price Ceiling
(b) The Price Ceiling on Gasoline Is Binding Price of S2 Gasoline but when supply falls . . . Demand S1 P2 QS QD Price ceiling resulting in a shortage. the price ceiling becomes binding . . . P1 Q1 Quantity of Gasoline

Rent Control

How Price Floors Affect Market Outcomes
Two possibilities: Not binding Binding 12 15

A Market with a Price Floor
(a) A Price Floor That Is Not Binding Price of Ice-Cream Supply Cone Demand Equilibrium price \$3 100 2 Price floor Quantity of Ice-Cream Equilibrium quantity Cones

A Market with a Price Floor
(b) A Price Floor That Is Binding Price of Ice-Cream Supply Cone Demand Surplus \$4 Price floor 80 120 3 Equilibrium price Quantity of Ice-Cream Quantity demanded Quantity supplied Cones

How Price Floors Affect Market Outcomes
A binding price floor causes . . . A surplus because QS > QD. Non-price rationing 15 25

CASE STUDY: MINIMUM WAGE
Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

How the Minimum Wage Affects the Labor Market
Supply Labor demand Equilibrium employment wage Quantity of Labor

How the Minimum Wage Affects the Labor Market
Supply Labor demand Labor surplus (unemployment) Minimum wage Quantity demanded Quantity supplied Quantity of Labor

How Price Controls Affect Total Surplus
Demand Supply PF Q2 PC Price Floor Ceiling A F B D C E P1 Q1 Price Quantity

Price Controls on Drugs

Application: The Costs of Taxation
Review Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers.

When a tax is levied on a good Price paid by buyers rises Price received by sellers falls

The Effects of a Tax Price Demand Supply Price buyers pay
Price sellers receive Quantity with tax Size of tax Price without tax Quantity Quantity

How a Tax Affects Market Participants
A tax places a wedge between the price buyers pay and sellers receive. The quantity sold falls below the pre-tax equilibrium.

How a Tax Affects Market Participants
Tax Revenue T = the size of the tax Q = the quantity of the good sold T  Q = Tax Revenue

Tax Revenue Price Demand Supply Quantity with tax Price buyers pay
Price sellers receive Tax revenue (T × Q) Size of tax (T) Quantity without tax Quantity sold (Q) Quantity

How a Tax Affects Market Participants
Changes in Welfare Deadweight loss is the fall in total surplus.

How a Tax Affects Welfare
Price Demand Supply = PB Q2 PS Price buyers pay sellers receive A F B D C E = P1 Q1 Price without tax Quantity

What determines whether the deadweight loss from a tax is large or small? Elasticities of Demand & Supply More elastic curves bring more loss

Tax Incidence Who pays for the tax? The more inelastic curve pays more

Tax Distortions and Elasticities
Price Demand Supply Size of tax Quantity

Tax Distortions and Elasticities
Price Demand Size of tax Supply Quantity

Tax Distortions and Elasticities
Price Supply Demand Size of tax Quantity

Tax Distortions and Elasticities
Price Supply Demand Size of tax Quantity

How a Tax Affects Market Participants
The combined welfare losses to buyers and sellers exceed the revenue raised by the government.

The Effects of a Tariff A tariff is a tax on goods produced abroad and sold domestically. Tariffs raise the price of imported goods by the amount of the tariff.

The Effects of a Tariff Price of Steel Domestic demand Domestic supply
Equilibrium without trade Price with tariff Q S Q D Tariff Price without tariff World price Q S Q D Imports with tariff Quantity Imports without tariff of Steel

The Effects of a Tariff Consumer surplus before tariff
Price of Steel Domestic demand Consumer surplus before tariff Domestic supply Producer surplus before tariff Equilibrium without trade Price without tariff World price Q S Q D Quantity Imports without tariff of Steel

The Effects of a Tariff Tariff Revenue Price of Steel Domestic demand
supply Tariff Revenue Price with tariff Imports with tariff Q S D E Tariff Price without tariff World Q S Q D price Quantity Imports without tariff of Steel

The Effects of a Tariff Deadweight Loss Price of Steel A Domestic
demand Domestic supply Deadweight Loss B Price with tariff C G D F Q S E Q D Tariff Price without tariff World Q S Q D Imports with tariff price Quantity Imports without tariff of Steel

Consumer Behavior & Utility Maximization

LAW OF DIMINISHING MARGINAL UTILITY
Subjective Difficult to Quantify Total Utility Marginal Utility graphically examined...

1 10 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility,
Utils Marginal Utility, Utils 30 20 10 1 10 Total Utility (utils) Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 10 10 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total
Utils Marginal Utility, Utils 30 20 10 1 10 Total Utility (utils) 10 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 2 10 18 10 8 TOTAL AND MARGINAL UTILITY Tacos consumed per meal
Utils Marginal Utility, Utils 30 20 10 1 2 10 18 Total Utility (utils) 10 8 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 2 3 10 18 24 10 8 6 TOTAL AND MARGINAL UTILITY Tacos consumed
per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 10 18 24 Total Utility (utils) 10 8 6 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 2 3 4 10 18 24 28 10 8 6 4 TOTAL AND MARGINAL UTILITY Tacos consumed
per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 10 18 24 28 Total Utility (utils) 10 8 6 4 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 2 3 4 5 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Tacos
consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 2 3 4 5 6 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Tacos
consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 6 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) Units consumed per meal

1 2 3 4 5 6 7 10 18 24 28 30 10 8 6 4 2 -2 TOTAL AND MARGINAL UTILITY
TU Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 -2 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU Units consumed per meal

Observe Diminishing Marginal Utility
TOTAL AND MARGINAL UTILITY TU Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 Observe Diminishing Marginal Utility 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 -2 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU Units consumed per meal

Utility Maximizing Rule
THEORY OF CONSUMER BEHAVIOR Utility Maximizing Rule The consumer’s income should be allocated so that the last dollar spent on each product yields the same amount of marginal utility. Illustrated...

How should the \$10 income be allocated?
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First How should the \$10 income be allocated?

Examine the two marginal utilities
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Examine the two marginal utilities

Examine the two marginal utilities …per dollar
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Examine the two marginal utilities …per dollar

Decision: Buy 1 Product B for \$2
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Decision: Buy 1 Product B for \$2

What next? First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh What next?

What next? Buy one of each
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh What next? Buy one of each

and then... (\$5 left) First 10 10 24 12 Second 8 8 20 10
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh and then... (\$5 left)

third unit of product B First 10 10 24 12 Second 8 8 20 10
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh third unit of product B

\$3 left... First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh \$3 left...

\$3 left... Buy both! First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh \$3 left... Buy both!

the last dollar spent on
UTILITY MAXIMIZING COMBINATION Product A: Price = \$1 Product B: Price = \$2 \$ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First Second Third Fourth Fifth Sixth Seventh Income is gone... the last dollar spent on each good gave the same utility (8) per dollar

Algebraic Restatement of the Utility Maximization Rule
Consumption Bundles Algebraic Restatement of the Utility Maximization Rule MU of A Price of A MU of B Price of B = 8 Utils \$1 16 Utils \$2 =