Ch 18. Extensions of Demand & Supply

A.Price elasticity of demand – responsiveness (sensitivity) of consumers to a price change ($ Δ). Three ideas: Price elasticity Price elasticity Cross elasticity – buying response of consumers of one product when the price of another product changes. Cross elasticity – buying response of consumers of one product when the price of another product changes. Income elasticity – the buying response of consumers when their income changes. Income elasticity – the buying response of consumers when their income changes. LAW OF DEMAND:  $ =  Purchases  $ =  Purchases

B.Price-elasticity Coefficient & Formula C.Midpoint formula – simplest solution: Economists measure the degree of price elasticity or inelasticity of demand with the coefficient E d, defined as: percentage change in quantity E d = demanded of product X percentage change in price of product X -- % are better than absolute amounts; eliminate the minus sign for clarification. Quantity demanded = Qd Δ in Q Δ in $ Ed = sum of Q / 2 √ sum of prices / 2 **USE THIS FORMULA**

Elastic demand – % Δ in price results in a larger % Δ in Qd (E d > 1), Elastic demand – % Δ in price results in a larger % Δ in Qd (E d > 1), Ex: A 2%  in $  4%  in Q d E d =.04 = 2 (demand is elastic) ● Inelastic demand – % Δ in $ results in a smaller % Δ in Qd (E d < 1), Ex: A 2%  in $  1%  in Q d E d =.01 =.5 (demand is inelastic) E d =.01 =.5 (demand is inelastic) D.Interpretations of E d

Unit elasticity – % Δ in $ and the resulting % Δ in Qd are the same (E d = 1), Unit elasticity – % Δ in $ and the resulting % Δ in Qd are the same (E d = 1), Ex: A 2%  in $  2%  in Q d E d =.02 = 1 (unit elasticity).02 ● Perfectly inelastic (rare) – coefficient is zero due to consumers being unresponsive to a $ Δ.

E.Perfectly inelastic – a $ Δ results in no Δ in demand. F.Perfectly elastic – infinite coefficient (∞). Perfectly Inelastic has relatively little “quantity stretch” Perfectly Elastic has considerable “quantity stretch” **Important for Popcorn simulation** VERTICAL HORIZONTAL

Price Elasticity of Demand Why Use Percentages? Why Use Percentages? Elimination of the Minus Sign Elimination of the Minus Sign Interpretations of E d Interpretations of E d Elastic Demand Inelastic Demand Unit Elasticity E d = = 2E d = =.5E d =.02 = 1

$ Q P The Total Revenue Test Total Revenue (TR) Total Revenue (TR) TR = P x Q TR = P x Q Elastic Demand Elastic Demand a b D1D1 2 X 10 (a) = 20 1 X 40 (b) = 40 Pt ‘b’ is greater Ed (Midpoint formula) = Δ in Q Δ in $ sum of Q/2 √ sum of $/2

$ Q P The Total Revenue Test Total Revenue (TR) Total Revenue (TR) TR = P x Q TR = P x Q Inelastic Demand Inelastic Demand c d D2D2 4 X 10 (c) = 40 1 X 20 (d) = 20 Pt ‘c’ is greater Ed (Midpoint formula) = Δ in Q Δ in $ sum of Q/2 √ sum of $/2

$ Q P The Total Revenue Test Total Revenue (TR) Total Revenue (TR) TR = P x Q TR = P x Q Unit-Elastic Unit-Elastic e f D3D3

Midpoint Formula – finding the price elasticity coefficient. Midpoint Formula – finding the price elasticity coefficient. Is the demand for tickets elastic or inelastic? Is the demand for tickets elastic or inelastic? Try using averages of two tickets and two quantities as the reference point. Try using averages of two tickets and two quantities as the reference point. E d = Δ in quantity √ Δ in $ sum of quantities/2 sum of price/2 Using data from the $5 - $4 price range: Ed = 1 √ 1 = 1 9/2 9/2

G.Total Revenue (TR) – total amount the seller receives from the sale of product in particular time period. -- Firms want to know the effect of price changes on total revenue and thus profits (total revenue minus total costs). -- ‘Total-revenue test’ looks at what happens to TR when product $ Δ. -- Graph: Lowering the tix price from $8 to $5 (elastic range) increased TR. -- Lowering price from $4 to $1 (inelastic range) lowered TR. TR = price (P) X quantity (Q) **Important for Popcorn simulation** $  & TR  = D is elastic. $  & TR is unchanged = D is unit-elastic. $  & TR  = D in inelastic

Relationship between price elasticity of demand for movie tickets. Relationship between price elasticity of demand for movie tickets. Demand curve D is based on table Demand curve D is based on table More price elastic between $5-8 price range of D than between $4-1 range. More price elastic between $5-8 price range of D than between $4-1 range. Graphical Analysis **Important for Popcorn simulation**

Price Elasticity and the Total-Revenue Curve Quantity Demanded Price Total Revenue (Thousands of Dollars) $ $ a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR

Determinants of Price Elasticity of Demand Substitutability ● Luxuries v. Necessities Substitutability ● Luxuries v. Necessities Proportion of Income ● Time Proportion of Income ● Time

Applications of Price Elasticity of Demand Large crop yields Large crop yields Excise tax Excise tax Decriminalize illegal drugs Decriminalize illegal drugs Minimum wage ($8/CA, $7.25/Fed) Minimum wage ($8/CA, $7.25/Fed) Typical examples of excise duties are taxes on gasoline, tobacco and alcohol (sometimes referred to as sin taxes).

H.Price elasticity of Supply – if producers relatively responsive to $ Δ = supply is elastic; if not = inelastic. -- The degree of price elasticity of supply depends on how easily (how quickly) producers can shift resources between alternative uses. -- Faster shift =  elasticity of supply; Slower response =  inelasticity. % Δ in quantity E s = supply of product X % Δ in $ of product X OR An increase in the $ of a good from $4 to $6 increases the quantity supplied from 10 units to 14 units. The % Δ in $ would be 2/5, or 40%, and the % Δ in quantity would be 4/12, or 33%:.33 E s =.40 =.83

I.Market period -- Market period: period that occurs when the time immediately after a Δ in market price is too short for producers to respond w/ a Δ in quantity supplied. -- Ex: a tomato farmer only has one truck full of tomatoes to sell; line is vertical (perfectly inelastic) due to not having time to respond to change in demand (D 1 to D 2 ). -- P 0 to P m determines which buyers get the fixed quantity supplied. Price Elasticity of Supply in Microeconomics Market supply

P Q Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = Unit Elastic Supply E s = 1 Market Period: Not Enough Time to Shift Resources D1D1 D2D2 SmSm Q0Q0 PmPm P0P0 Greatest Price Impact

1.Short run 2.Long run Price Elasticity of Supply in Microeconomics -- Short run – period of time too short to change plant capacity but long enough to use fixed plant more or less inexpensively (fixed land/farm machinery, but can use more labor/fertilizer) for more output (more elastic). -- Long run – time period long enough for firms to adjust their plant sizes & for new firms to enter (or existing to leave) the industry (still more elastic). -- There is no total-revenue test for elasticity of supply. -- Supply shows a positive (direct relationship) between $ & amount supplied.

Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = Inelastic Supply E s < 1 Short Run: Resources Not Easily Shifted to Alternative Uses P Q D1D1 D2D2 SsSs Q0Q0 PsPs P0P0 QsQs Lower Price Impact

Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = Elastic Supply E s > 1 Long Run: Resources Easily Shifted to Alternative Uses P Q D1D1 D2D2 SlSl Q0Q0 PlPl P0P0 QlQl Least Price Impact

J.Cross elasticity of demand – measures how sensitive customers purchases are to 2 products. 1.Substitute goods 2.Complimentary goods 3.Independent goods % Δ in Q d of product X E xy =% Δ in Q d of product Y -- One product is X, the other is Y. -- The cross-price elasticity allows us to quantify/understand substitute and complimentary goods (Ch 3).

K.Income elasticity of demand – measures degree consumers respond to Δ in their incomes by buying more/less of a good. 1.Normal goods 2.Inferior goods % Δ in Q d E i =% Δ in I -- For most goods, income-elasticity coefficient Ei is positive (more are demanded as income rises); called normal or superior goods. -- Inferior goods have a negative income-elasticity (more $ = lower sales). -- Insights: we do not eat more when our income rises, we eat better! -- When income declines, food purchases stay same but buy fewer electronics.

Cross Elasticity of Demand Substitute Goods – Positive Sign Substitute Goods – Positive Sign Complementary Goods- Negative Sign Complementary Goods- Negative Sign Independent Goods – Zero or Near-Zero Value Independent Goods – Zero or Near-Zero Value Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y E xy =

Income Elasticity of Demand Normal Goods – Positive Sign Normal Goods – Positive Sign Inferior Goods- Negative Sign Inferior Goods- Negative Sign Insights into the Economy Insights into the Economy Percentage Change in Quantity Demanded Percentage Change in Income E i =

Consumer and Producer Surplus Consumer Surplus D Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Consumer Surplus Equilibrium Price = $8

Consumer and Producer Surplus Efficiency Revisited D S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Efficiency Losses Q2Q2 Q3Q3 Efficiency Losses (Deadweight Losses)