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ECON 351 Elasticity of Demand & Supply Week 4.1 September 17, 2013

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Review Markets are the interaction of buyers and sellers. Focus on buyers and sellers separately. Ceteris paribus: look at one thing at a time; All other things held equal.

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$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 Demand x Demand shows the amounts purchased at alternative prices (horizontal distances at each price) Qty x /T DxDx DxDx Demand for X

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Supply Curve $Price $10 8 6 4 2 2 4 6 8 10 12 14 16 Qty x/ T

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$Price $ 4 3 2.50 2.00 1.50 1.00.50.25 100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T Demand Supply Surplus at this $ Price

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$Price $ 4 3 2.50 2.00 1.50 1.00.50.25 100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T Demand Supply Shortage at this $ Price

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$Price 4 3 2.50 2.00 1.50 Pe Pe 1.00.50.25 100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T Qe DemandSupply Market Equilibrium Qty D = Qty S

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$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Demand DxDx Pe Qe Total Revenue = P X Q $6x5 = $30

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$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Do DoDo SxSx Effects of Increase in Demand on Price and Quantity Increases Price and Quantity Pe Qe D1D1 D1D1

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$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Demand DxDx S0S0 Effects of an Increase in Supply on Price and Quantity Price decreases and Quantity increases Pe Qe S0S0 S1S1 S1S1

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What causes an increase in price? Increase in Demand orDecrease in Supply $ P S2S2 Q/T D1D1 Q2Q2 Q1Q1 Q1Q1 P2P2 P1P1 Demand S1S1 Q2Q2 P1P1 P2P2 D2D2 Supply Q/T (if you know quantity increased)(if you know quantity decreased)

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What causes an decrease in price? Decrease in Demand orIncrease in Supply $ P S2S2 Q/T D1D1 Q2Q2 Q1Q1 Q1Q1 P2P2 P1P1 Demand S1S1 Q2Q2 P1P1 P2P2 D2D2 Supply Q/T (if you know quantity decreased)(if you know quantity increased)

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$ P x 10 9 8 7 6 5 4 3 2 1 Qty x /T Supply D3D3 SxSx Market Demand Determines Price P1P1 Q2Q2 D2D2 D1D1 Q1Q1 Q3Q3 P3P3 P2P2

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AB PxPx PxPx Q x /T P0P0 Q0Q0 P0P0 Q0Q0 Slope of Supply Shows responsiveness of quantity to a change in Price P1P1 Q1Q1 P1P1 Q1Q1

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Slope Shows Responsiveness of Quantity to a Change in Price A B PxPx PxPx Q x /T P0P0 P0P0 DxDx DxDx Q0Q1Q0Q1 Q0Q0 P1P1 P1P1 Q 1

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AB PxPx PxPx Q x /T P0P0 Q0Q0 P0P0 Q0Q0 Problems using Slope as a measure of responsiveness: Slope depends on the units of measure on the vertical and horizontal axis. P1P1 Q1Q1 P1P1 Q1Q1

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Price Elasticity: a Measure of responsiveness of Quantity to a Change in Price E d = % Δ Q d % Δ Price E s = % Q s % Price

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Computing the Point Price Elasticity of demand E d = % Δ Q d % Δ P % Δ Q d = (Δ Q d / Q 0 ) % Δ P = (Δ P/ P 0 ) E d = (Δ Q d / Q 0 ) (Δ P/ P 0 )

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Problem with measures of Point Elasticity: Evaluate elasticity between two points on the demand curve Point A: Price = $4 Quantity = 120 Point B: Price = $6 Quantity = 80 From A to B: E d = (-33% / 50%) = -.66 From B to A: E d = (50% / -33%) = -1.5 Measuring from either endpoint (P 0, Q 0 ) gives different estimates

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Arc or midpoint price elasticity Instead of using one end of the price, quantity change as the reference point, use the midpoint. E d = (Δ Q d /( (Q 1 + Q 2 )/2 ) / (Δ P/)/ ( (P 1 + P 2 )/2 ) E d = (- 40/100) / ($2/$5) = - 40% / 40% = -1 By using the midpoint formulation the answer will be the same for a price increase or a price decrease and is therefore an unbiased measure of the responsiveness of quantity to a change in price.

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Measures of Elasticity ElasticDemand is Elastic : %Δ Q d > %Δ P; ie |E d | >1. A decrease in Price an increase in Total Revenue. Unitary ElasticDemand is Unitary Elastic: %ΔQ d = %ΔP; ie |E d | = 1. A Change in price no change in Total Revenue. InelasticDemand is Inelastic: %ΔQ d < %ΔP; i.e. |Ed| < 1. An increase in Price an increase in Total Revenue.

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Elasticity varies on a straight line demand curve $Price Qty/T Demand Ed > 1 Ed < 1 Ed = 1

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Elasticity, Price Change & Total Revenue $Px Elastic (upper half) Inelastic (lower half) Q1Q1 Qty/T P0P0 P1P1 Q0Q0 P1P1 P0P0 Q0Q0 Q1Q1

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Increased Demand with elastic Supply $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T SxSx DxDx DxDx SxSx Pe Qe Dx` Qe` Pe`

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$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T SxSx DxDx DxDx SxSx Pe Qe Dx Qe Pe Increased Demand, Inelastic Supply

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Decrease in Supply, Elastic Demand $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T SxSx DxDx DxDx S x Pe QeQe` Pe`

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$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T SxSx DxDx DxDx S x Pe Qe Pe Decrease in Supply, Inelastic Demand

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Determinants of Price Elasticity of Demand Number & Closeness of Substitutes. Information about price change and availability of substitutes. Percentage of Income Spent on good. Second Law of DemandPeriod of time: Second Law of Demand: Demand is more elastic over a longer period of time.

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Factors creating increased elasticity over time 1.More information about price change and substitutes (Beef & Chicken) 2.More substitutes over time (More Hybrids) 3.Increased opportunity to change the complementary basket of goods (Buy a car with higher MPG. Move closer to work.)

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Other Elasticity's A Measure of responsiveness of Quantity to a Change in some other factor

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Income Elasticity: Measure of responsiveness of Quantity to a Change in Income E dI = % Δ Q d % Δ income Normal Goods: Positive Clothing:.95: 10% income 9.5% Stereo: 2.72: 10% income 27.2% Increase may be Quantity or Quality Inferior Goods: Negative

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Cross Price Elasticity: Measure of responsiveness of Quantity to a Change Price of other good E xy = % Δ Q x % Δ P y Substitutes: Positive Complements: Negative

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Uses of Cross Price Elasticity Magnitude of cross price elasticity reflects closeness of substitutes or complements Able to identify your closest competitors Courts use cross-price to measure monopoly power

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Transaction Costs of Exchange Information Costs –Search Costs –Quality Identification Cost Negotiating Costs: Cost of agreeing on what and how much will be exchanged Transportation Costs: Cost of moving goods between parties 34

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