Demand and Supply Chapter 6 (McConnell and Brue) Chapter 2 (Pindyck) Lecture 4

The Supply and Demand Functions The supply curve is the relationship between the quantity supplied and the price Qs = Qs (P) This implies that supply is a function of price The demand curve shows how much of a good consumers are willing to buy as the price per unit changes Qd = Qd (P)

Revisiting Substitute and Complementary goods Goods are substitutes when an increase in the price of one leads to an increase in the quantity demanded of the other. E.g. Coke and Pepsi, Copper and Aluminium etc Goods are complements when an increase in the price of one leads to a decrease in the qty. demanded of the other. E.g. automobiles and gas!

Price Elasticity of Demand Law of Demand The responsiveness of consumers to a price change is measured by a product’s price elasticity of demand If consumers are very sensitive to a price change (e.g. luxury goods) then we say that consumers have an elastic demand for that particular good Inelastic demand

Price Elasticity Coefficient & Formula ε d = % ∆ in qty. dmd of X % ∆ in price of X % change in X = change in qty dmd of X * 100 original qty. dmd of X % change in price = change in price of X *100 original price of X Get rid of *100 as they cancel out

Price Elasticity Coefficient & Formula – alternate formula ε d = ∆ in Q * P ∆ in P Q Point elasticity - when you consider a particular point on the demand curve or the supply curve. *But what happens when you calculate ε d over a range of prices?

ARC ELASTICITY- USING AVERAGES Mid-point formula (Alternate name) ε d = ∆ in qty. dmd of X ÷ ∆ in price sum of qtys/2 sum of prices/2 This formula simply averages out the two prices and two quantities as the reference points for computing the percentages The solution eliminates up-verses-down problem

Linear Demand Curve (point Elasticity) ε d = ∆ in Q * P ∆ in P Q As we move along the demand curve, (∆Q/∆P) may change, and the P and Q will always change along the curve. Therefore the price elasticity of Demand must be measured at a particular point on the demand curve and ε d will generally change along the curve See Graph – 2.11 (Pindyck – pg 33)

Q = a – bP general form Example : Q = 8 - 2P Here ∆Q/∆P = -2 (it is constant) for a linear demand curve Slope = ∆ in y-axis ∆ in x-axis Hence slope = ∆P/∆Q But since for elasticity we use ∆Q/∆P hence ∆Q/∆P= 1/slope But ratio : P/Q falls along the curve, therefore ε d is falling!

Price Elasticity of Demand Using percentages : if absolute changes were used, then the choice of units would affect results (using dollars Vs pennies). Percentages make it easier to compare consumer responsiveness across goods Ignore minus sign of elasticity, as its always –ve for demand. Absolute values are used (Eg. -4 Vs -2: which is bigger ? )

Interpreting ε d Elastic demand: when the % change in quantity demanded is greater than the % change in price. ε d > 1 Inelastic demand: when the % change in qty. demanded is less than the % change in price ε d < 1

Unit Elasticity : when the % change in qty. demanded is the same as the % change in price ε d = 1 Perfectly Inelastic: A price change results in NO change in the qty. demanded. It’s a horizontal line ε d = 0 Perfectly Elastic : where a small reduction in price causes demand to change from 0 to all they can obtain ε d = infinity

Special Cases D D Q0 0 Q Perfectly elastic demandPerfectly inelastic demand

Income Elasticity of Demand Demand for most goods usually rises when aggregate income rises. The income elasticity of demand is the % change in the qty demanded Q, resulting for a 1% increase in income I ε i = ∆ in Q * i ∆ in i Q

Income Elasticity Normal Goods: income elasticity is positive, meaning that more of them are demanded as income rises. Such goods are called normal or superior goods Inferior Goods: Negative income elasticity coefficient, implies that consumers decrease their purchases of inferior goods as income rises

Cross-price Elasticity of Demand The demand for some goods is also affected by the prices of other goods. A cross-price elasticity of demand refers to the % change in the qty. demanded for a good that results from a 1% increase in the price of another good ε i = ∆ in Qb * Pm ∆ in Pm Qb

Cross-price Elasticity Cross-price elasticity of substitutes is Positive : a rise in price of margarine makes butter cheaper relative to margarine, leading to an increase in qty. dmd. of butter C-P elasticity of complements is Negative: they are used together, an increase in price of one tends to push down the consumption of the other!

Independent Goods A zero or near zero cross-elasticity suggests that the two products being considered are unrelated or independent goods Eg. Books and grapes !

Supply Elasticity ε s = % ∆ in qty. supplied of X % ∆ in price of X The price elasticity of supply is the percentage change in the qty. supplied resulting from a 1% increase in price. ε s is usually positive because a higher price gives producers an incentive to increase output

Supply Elasticity The degree of price elasticity of supply depends on how easily producers can shift resources between alternate uses. The easier it is to shift resources towards the production of the good, the more elastic it’s supply

Elasticity of Demand & Supply Chap 2-The Basics of Demand & Supply - Pindyck Lecture 5

Total Revenue Elasticity of Demand is important for firms with regards to changes in total revenue and thus profits (TR – TC) TR is the total amount the seller receives from the sale of a product in a particular time period TR = P * Q TOTAL REVENUE TEST

TR and Price change in opposite direction when Demand is Elastic If demand is elastic, a decrease in price will increase total revenue The decrease in revenue from decline in price received per unit is more than compensated by the increase in additional units at lower price. GRAPH- pg 343 (Ch.18) An increase in price causes TR to decline

TR and Price change in same direction when Demand is Inelastic If demand is inelastic, a decrease in price will reduce total revenue The increase in sales from a price decline will not fully offset the decline in revenue per unit, and TR will decline. GRAPH- pg 343 (Ch.18) An increase in price causes TR to increase

TR stays constant with Price changes when Demand is Unit elastic If demand is unit elastic, a decrease/increase in price leaves total revenue constant The loss in revenue from a lower price is exactly offset by the gain in revenue from the accompanying increase in sales GRAPH- pg 343 (Ch.18)

Price Elasticity and the Total Revenue Curve Figure 18.3, pg 345 Chap 18

Determinants of PED Substitutability – the more the substitutes available, the more elastic the demand. The elasticity of demand depends on how narrowly the product is defined – (Reebok Vs Shoes) Proportion of Income – the higher the price of a good relative to consumers’ incomes, the greater the PED (low priced items such as pencils Vs cars or houses)

Luxury Vs Necessities – luxury goods have more elastic demands compared to necessity goods (electricity vs jewellery) Time – product demand is more elastic the longer the time period under consideration (SR demand for petrol is more inelastic than it’s LR demand) Salt ? GO OVER “APPLICATIONS OF PRICE ELASTICITY OF DEMAND” in chapter 18