Extensions of Demand and Supply Analysis Chapter 4 (and Ch. 5 pp. 93-99) Extensions of Demand and Supply Analysis

Consumer Surplus The difference between what a consumer (or consumers) is willing to pay for a unit of a product or service and its market price. Graph

Producer Surplus The difference between market price and the price at which a producer (or producers) is willing to sell a unit of a good or service. Graph

Efficiency Loss Also called “Deadweight loss” When a good is either over produced or under produced there is a loss of consumer and producer surplus. Any loss of surplus from the free market equilibrium is a loss of efficiency. Graph

Price Elasticity of Demand Elasticity measures the responsiveness or sensitivity of consumers to a change in price. Simple Formula: E = %ΔQ / %ΔP (midpoint formula is more precise) change in Q / change in P sum of quantities/2 sum of Prices/2 Absolute Value – eliminate the negative sign!

Elastic Demand E > 1 A small change in price leads to a large change in quantity demanded Example – Restaurant Meals

Inelastic Demand E < 1 A change in price has little effect on quantity demanded Examples – electricity, milk, gas, cigarettes

Special Situations E = 1 : unit elasticity Perfectly Elastic Demand An increase in price results in demand of zero Horizontal demand curve Example: a single farm’s output—all Q will be demanded at mrkt P  Perfectly Inelastic Demand - A change in price has no influence on quantity demanded. - Vertical demand curve - Examples: Insulin, Heroin

Elasticity varies over various parts of the demand curve. Demand is more elastic in the upper left portion of the demand curve. (E-U-I) Graph Note - Slope does not measure elasticity!

Total Revenue Test TR = P×Q If demand is elastic, a decrease in price will increase TR. (Quantity demanded increases a lot) If demand is inelastic, a decrease in price will decrease TR. (Quantity demanded increases only a little) If demand is unit elastic, a decrease in price will not change TR Graph

Determinants of Elasticity of Demand Substitutability: more substitutes = greater elasticity of demand Lowering trade barriers increases substitutes, increasing elasticity Elasticity varies depending on how narrowly a product is defined. The demand for Honda Accord is more elastic than the demand for automobiles.

Determinants (cont.) Proportion of Income: The demand for low priced items tends to be inelastic (pencils) Luxury or Necessity: The demand for most necessities is inelastic (gas) Time : Elasticity increases over time – people develop tastes for substitutes (soy or almond milk)

Elasticity of Supply If producers are responsive to price changes, then supply is elastic. If they are unresponsive to price changes, then supply is inelastic. E = %ΔQs / %ΔP E>1 : supply is elastic E<1: supply is inelastic E will never be negative (law of supply)

Time: The Main Determinant of Elasticity of Supply Market Period – producers are unable to change output, supply is perfectly inelastic. Ex: apple growers during the growing season. Short Run – plant size is fixed, but the firm is able to use its plant more or less intensively. Ex: work overtime, add a 2nd shift, postpone maintenance of machinery. Long Run – All resources are variable, firms may enter or exit the market. Ex: build another factory, start a new video game company.

Cross Elasticity of Demand Cross Elasticity measures the effect of a change in price of one good on the quantity demanded of a different good E = %ΔQ of y / %ΔP of x Substitute Goods – Cross Elasticity is positive Complementary Goods – Cross Elasticity is negative Independent Goods – Cross Elasticity is 0 or near 0

Income Elasticity E = %ΔQ / %Δ in income Normal Goods – Income Elasticity is positive Inferior Goods – Income Elasticity is negative