Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 4 EXTENSIONS OF DEMAND AND SUPPLY ANALYSIS AND THE EFFICIENCY OF MARKETS Part Two: Microeconomics of Product Markets

©2007 McGraw-Hill Ryerson Ltd.Chapter 42 In this chapter you will learn: 4.1 About price elasticity of demand and how it can be applied 4.2 The usefulness of the total revenue test for price elasticity of demand 4.3 About price elasticity of supply and how it can be applied 4.4 About cross elasticity of demand and income elasticity of demand 4.5 To apply the concept of elasticity to various real-world situations 4.6 About consumer surplus, producer surplus, and efficiency losses

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.13 Price Elasticity of Demand THE LAW OF DEMAND SAYS… An increase in price causes a decrease in quantity demanded (and vice-versa) But HOW MUCH does quantity demanded change in response to a change in price? Elasticity gives us a measure of RESPONSIVENESS

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.14 Price Elasticity of Demand When Q D responds STRONGLY to a change in P, demand is ELASTIC When Q D responds WEAKLY to a change in P, demand is INELASTIC

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.15 Calculate the average: If the quantity demanded increased from 4 to 5 units %ΔQ d = ΔQ d /Q 0 = ¼ x 100 = 25% The Price Elasticity Coefficient and Formula If the price dropped $5 to $4 %ΔP = ΔP/P 0 = 1/5 x 100 = 20%

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.16 Price Elasticity of Demand Average price and quantity –avoids confusion about start and end points

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.17 The Price Elasticity Coefficient and Formula Price elasticity of demand: –Use of Percentages –Elimination of the Minus Sign Interpretation of E d : –Elastic Demand –Inelastic Demand –Unit Elasticity –Extreme Cases

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.28 The Total-Revenue Test Total revenue (TR) –TR = P x Q TR and E d are related –If TR changes in the opposite direction from price, demand is elastic –If TR changes in the same direction from price, demand is inelastic –If TR does not change when price changes, demand is unit elastic

©2007 McGraw-Hill Ryerson Ltd.Chapter 4.29 P D P2P2P2P2 P1P1P1P1 Q2Q2Q2Q2 Q1Q1Q1Q1 Quantity is very responsive to a change in price Q Elastic Demand When P changes from P1 to P2, TR increases

©2007 McGraw-Hill Ryerson Ltd.Chapter Quantity is NOT very responsive to a change in price P D P2P2P2P2 P1P1P1P1 Q2Q2Q2Q2 Q1Q1Q1Q1 Q Inelastic Demand When P changes from P1 to P2, TR decreases

©2007 McGraw-Hill Ryerson Ltd.Chapter % change in quantity is equal to % change in price P D P2P2P2P2 P1P1P1P1 Q2Q2Q2Q2 Q1Q1Q1Q1 Q Unit Elastic When P changes from P1 to P2, TR does not change

©2007 McGraw-Hill Ryerson Ltd.Chapter Price Elasticity along a Linear Demand Curve For all straight-line and most other demand curves –demand is more elastic toward the upper left –demand is less elastic toward the lower right

©2007 McGraw-Hill Ryerson Ltd.Chapter The Total-Revenue Test TR = P X Q What happens to total revenue when product price changes?

©2007 McGraw-Hill Ryerson Ltd.Chapter Table 4-1 E d and Total Revenue QdQd PEdEd TR 188, , , , , , , ELASTIC DEMAND: when price decreases, total revenue increases ELASTIC DEMAND: when price decreases, total revenue increases INELASTIC DEMAND: when price decreases, total revenue decreases INELASTIC DEMAND: when price decreases, total revenue decreases UNIT ELASTIC DEMAND: when price decreases, total revenue stays the same UNIT ELASTIC DEMAND: when price decreases, total revenue stays the same

©2007 McGraw-Hill Ryerson Ltd.Chapter D D TR ElasticUnit Elastic Inelastic TR Increases TR Decreases Max TR

©2007 McGraw-Hill Ryerson Ltd.Chapter Determinants of E d Substitutability Proportion of Income Luxuries versus Necessities Time

©2007 McGraw-Hill Ryerson Ltd.Chapter Applications of E d Large Crop Yields Sales Taxes Decriminalization of Illegal Drugs Minimum Wage

©2007 McGraw-Hill Ryerson Ltd.Chapter Es=Es=Es=Es= Percentage change in quantity supplied of product X Percentage change in the price of product X Price Elasticity of Supply The main determinant of E s is the amount of time producers have for responding to a change in product price

©2007 McGraw-Hill Ryerson Ltd.Chapter Immediate Market Period PoPoPoPo P Q D1D1D1D1 QoQoQoQo An increase in demand without enough time to change supply causes... SmSmSmSm Figure 4-4 Time and the Elasticity of Supply PmPmPmPm D2D2D2D2 A Large Increase in Price - Perfect Inelastic Supply

©2007 McGraw-Hill Ryerson Ltd.Chapter Short Run PoPoPoPo P Q D1D1D1D1 An increase in demand with some supply response will cause... SsSsSsSs PmPmPmPm QoQoQoQo Time and the Elasticity of Supply PsPsPsPs D2D2D2D2 QsQsQsQs An Increase in Price - More elastic Supply

©2007 McGraw-Hill Ryerson Ltd.Chapter Long Run PoPoPoPo P Q D1D1D1D1 An increase in demand in the long run allows a greater supply response.... SLSLSLSL PmPmPmPm QoQoQoQo Time and the Elasticity of Supply PLPLPLPL D1D1D1D1 QLQLQLQL D2D2D2D2 A small Increase in Price - More elastic Supply

©2007 McGraw-Hill Ryerson Ltd.Chapter Applications of Price Elasticity of Supply Antiques and Reproductions Volatile Gold Prices

©2007 McGraw-Hill Ryerson Ltd.Chapter E xy = Percentage change in quantity demanded of product X Percentage change in the price of product Y Substitute Goods -positive sign Complementary Goods -negative sign Independent Goods -near zero Cross Elasticity of Demand

©2007 McGraw-Hill Ryerson Ltd.Chapter Cross Elasticity of Demand Applications Coca-Cola vs. Sprite Assessing competition

©2007 McGraw-Hill Ryerson Ltd.Chapter E i = Percentage change in quantity demanded Percentage change in income Normal Goods -positive sign Inferior Goods -negative sign Insights Income Elasticity of Demand

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-5 The Incidence of a Tax Tax of $2 per unit S shifts up $2 Equilibrium price rises to $9 Consumer’s burden is the amount of the price increase = $1 Firm’s burden = tax-consumer’s burden =$2 - $1 = $1 $2$2$2$2$9

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-6 Demand Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and elastic demand P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Producer bears most of the tax burden

©2007 McGraw-Hill Ryerson Ltd.Chapter Demand Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and inelastic demand P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Consumer bears most of the tax burden

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-7 Supply Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and elastic supply P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Consumer bears most of the tax burden

©2007 McGraw-Hill Ryerson Ltd.Chapter Supply Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and inelastic supply P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Producer bears most of the tax burden

©2007 McGraw-Hill Ryerson Ltd.Chapter The Economics of Agricultural Price Supports Net income stabilization Supply management programs: –dairy, poultry products, and eggs –Canadian Wheat Board

©2007 McGraw-Hill Ryerson Ltd.Chapter Offers to Purchase Surplus Output –misallocation of resources –higher taxes Loss to Consumers –higher prices –higher taxes Gain to Farmers

©2007 McGraw-Hill Ryerson Ltd.Chapter D D S S PePePePe The result of imposing a floor (support) price is a...P Q QeQeQeQe PSPSPSPS Support price Figure 4-8 Price Supports and Supply Restriction – Offers to Purchase SURPLUS Government must purchase this amount

©2007 McGraw-Hill Ryerson Ltd.Chapter Deficiency Payments Subsidies to make up the difference between the market price and government-supported price Elasticity of supply & demand –effect of elasticity the same as that of a sales tax

©2007 McGraw-Hill Ryerson Ltd.Chapter D S S PePePePe At price P S, farmers Increase output from Q e to Q S P Q QeQeQeQe PSPSPSPS QsQsQsQs P0P0P0P0 D Figure 4-8 Deficiency Payments Government must pay farmers this amount S S Supply curve (consumer)

©2007 McGraw-Hill Ryerson Ltd.Chapter Comparison Farmers benefit equally from offers to purchase and deficiency payments Consumers prefer deficiency payments, because of lower prices When subsidies are taken into account, total payments by the public are identical

©2007 McGraw-Hill Ryerson Ltd.Chapter Resource Overallocation Both approaches encourage overallocation of resources to agriculture Efficiency loss

©2007 McGraw-Hill Ryerson Ltd.Chapter Supply Restrictions Crop restrictions Quotas With highly price-elastic supply, offers to purchase or deficiency payments result in surpluses higher than original quantity demanded Supply restriction is the only option

©2007 McGraw-Hill Ryerson Ltd.Chapter D PePePePe PrPrPrPr QeQeQeQe QrQrQrQr QfQfQfQf P Q SURPLUS D S SfSf Figure 4-8 Supply Restrictions SfSf All costs are borne by con- sumers

©2007 McGraw-Hill Ryerson Ltd.Chapter Consumer and Producer Surplus Consumer surplus –is the benefit surplus received by a consumer or consumers in a market –is the difference between the maximum price a consumer is willing to pay for a product and the actual price

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-9 Consumer Surplus P Q D Equilibrium Price = $8 Consumer Surplus

©2007 McGraw-Hill Ryerson Ltd.Chapter Table 4-5 Consumer Surplus PersonMaximum price willing to pay Actual PriceConsumer surplus Bob138 Barb128 Bill118 Bart108 Brent98 Betty88 PersonMaximum price willing to pay Actual PriceConsumer surplus Bob1385 Barb1284 Bill1183 Bart1082 Brent981 Betty880

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-10 Producer Surplus P Q S Equilibrium Price = $8 Producer Surplus

©2007 McGraw-Hill Ryerson Ltd.Chapter Table 4-6 Producer Surplus PersonMaximum acceptable price Actual PriceConsumer surplus Carlos38 Courtney48 Chuck58 Cindy68 Craig78 Chad88 PersonActual PriceProducer surplus

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-11 Efficiency Revisited P Q S Equilibrium Price = $8 D Consumer Surplus Producer Surplus Productive Efficiency is achieved since CS and PS are maximized

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 4-12 Efficiency Losses (or Deadweight Losses) P Q S Equilibrium Price = $8 D Quantity levels less than efficiency quantity create efficiency losses Efficiency Losses

©2007 McGraw-Hill Ryerson Ltd.Chapter 447 Chapter Summary 4.1 Price Elasticity of Demand 4.2 The Total-Revenue Test 4.3 Price Elasticity of Supply 4.4 Cross Elasticity and Income Elasticity of Demand 4.5 Elasticity and Real-World Applications - Excise Tax - The Economics of Agricultural Price Supports 4.6 Consumer and Producer Surplus