20 - 1 price elasticity of demand determinants of price elasticity price elasticity and total...

20 - 1

Price Elasticity of Demand

Determinants of Price Elasticity

Price Elasticity and Total Revenue

Other Elasticities

Price Controls

Taxation & Deadweight Loss

Consumer Utility Maximization

Elasticity of

Supply & Demand

20 - 2




Other Elasticities

Price Controls



HOW MUCH MORE OR LESS?

THE LAW OF DEMAND SAYS...

PRICE ELASTICITY OF DEMAND

Consumers will buy more when prices go down and less when prices go up

Price Elasticity Provides an Answer

20 - 3




Other Elasticities

Price Controls



The percentage change in price

The percentage change in quantity

.10

.20

Elasticity is .5Q

P

P1

P2

Q1Q2

D

Measures Responsiveness to Price Changes


20 - 4




Other Elasticities

Price Controls



The percentage change in price

The percentage change in quantity

Q

P

P1

P2

Q1Q2

D

Commonly Expressed as…


% P% Q d

Elasticity is .5

20 - 5




Other Elasticities

Price Controls



The Price-Elasticity Coefficient and Formula


Ed =

Percentage change in quantitydemanded of product X

Percentage change in priceof product X

Or equivalently…

Ed =Change in quantity demanded of X

Original quantity demanded of X

Change in price of X Original price of X

Elimination of the Minus Sign

20 - 6




Other Elasticities

Price Controls



Inelastic 0 < X < 1Typical of necessities one must have

Typical of luxuries one wants

Elastic from 1 < X <

Unit elastic when exactly = 1Quantity change offsets Price change

Price Elasticity is...PRICE ELASTICITY OF DEMAND

20 - 7




Other Elasticities

Price Controls



Interpretations of Ed


Elastic Demand

Ed =.04.02

= 2

Inelastic Demand

Ed =.01.02

= .5

Unit Elasticity

Ed =.02.02

= 1

20 - 8




Other Elasticities

Price Controls



Extreme CasesPRICE ELASTICITY OF DEMAND

Perfectly Inelastic Demand

Perfectly Elastic DemandP

0

P

0

D1

Ed = 0

D2

Ed =

Q

Q

20 - 9




Other Elasticities

Price Controls



DETERMINANTS OF PRICEELASTICITY OF DEMAND

•Substitutability•Proportion of Income•Luxuries versus Necessities

•Time

20 - 10




Other Elasticities

Price Controls



More Accurate Calculation – The Midpoint Formula


Ed =

Change inquantity

Sum ofQuantities/2

Change inprice

Sum ofprices/2

Ed =ΔQ

AVG Q

ΔP

AVG P

20 - 11




Other Elasticities

Price Controls



Lemonade Stand

You sell 24 glasses for $.50 each.

P x Q = Total Revenue (TR)

$.50 x 24 = $12 = Total Revenue

-$4 = Total Cost

$8 = Profit

20 - 12




Other Elasticities

Price Controls



Total Revenue

• Total Revenue (TR): The total dollars received by a firm for selling a product.

• AKA Consumer Expenditures

20 - 13




Other Elasticities

Price Controls



CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

20 - 14




Other Elasticities

Price Controls



Q

P

D

When prices are low,

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

So is total revenue

20 - 15




Other Elasticities

Price Controls



Q

P

D

Total revenue riseswith price to a

point... TR

Quantity Demanded


20 - 16




Other Elasticities

Price Controls



Q

P

D


point...

then declines

TR

Quantity Demanded


20 - 17




Other Elasticities

Price Controls



Q

P

D


point...

then declines

TR

Quantity Demanded


20 - 18




Other Elasticities

Price Controls



Q

P

D


point...

then declines

TR

Quantity Demanded


20 - 19




Other Elasticities

Price Controls



Q

P

D


point...

then declines

InelasticDemand

InelasticDemand

TR

Quantity Demanded


20 - 20




Other Elasticities

Price Controls



Q

P

D


point...

then declines

ElasticDemand

ElasticDemand

InelasticDemand

TR

Quantity Demanded


InelasticDemand

20 - 21




Other Elasticities

Price Controls



Q

P

D


point...

then declines

ElasticDemand

ElasticDemand

InelasticDemand

TR

Quantity Demanded


InelasticDemand

UnitElastic

20 - 22




Other Elasticities

Price Controls



TOTAL REVENUE TESTAnother way to determine elasticity• P x Q = TR• P and Q move opposite each other• So how do we know what happens

to TR?– If P and TR move together demand is

inelastic– If Q and TR move together demand is

elastic– If TR doesn’t move demand is unit

elastic

20 - 23




Other Elasticities

Price Controls



Other Elasticities

20 - 24




Other Elasticities

Price Controls



PRICE ELASTICITY OF SUPPLY

Es=%ΔQS

%ΔP

20 - 25




Other Elasticities

Price Controls



Po

P

Q

D1

Qo

An increase indemand withoutenough time tochange supplycauses…

Sm

Immediate Market periodPRICE ELASTICITY OF SUPPLY

20 - 26




Other Elasticities

Price Controls



Po

Pm

P

Q

D1

Qo

D2

An increase indemand withoutenough time tochange supplycauses… anincrease in price

Sm

Immediate Market periodPRICE ELASTICITY OF SUPPLY

20 - 27




Other Elasticities

Price Controls



Po

P

Q

D1

Qo

Short RunPRICE ELASTICITY OF SUPPLY

An increase indemand withmore elasticsupply causes...

Ss

20 - 28




Other Elasticities

Price Controls



Po

P

Q

D1

Qo

D2

Short RunPRICE ELASTICITY OF SUPPLY

Ps

An increase indemand withmore elasticsupply causes...a smallerincrease in price

Ss

Qs

20 - 29




Other Elasticities

Price Controls



Po

P

Q

D1

Qo

Long RunPRICE ELASTICITY OF SUPPLY

An increase indemand in thelong run allowsgreater changecausing...

SL

20 - 30




Other Elasticities

Price Controls



Po

P

Q

D1

Qo

D2

Long RunPRICE ELASTICITY OF SUPPLY

PL

An increase indemand in thelong run allowsgreater changecausing...

SL

QL

Even more elasticresponse - lessprice increase

20 - 31




Other Elasticities

Price Controls



CROSS PRICE ELASTICITY OF DEMAND

Exy =%ΔQDX

%ΔPY

Positive Sign Goods are SubstitutesNegative Sign Goods are ComplementaryZero or Near-Zero Value Goods are Unrelated

20 - 32




Other Elasticities

Price Controls



INCOME ELASTICITY OF DEMAND

Ei =%ΔQD

%Δ Income

Positive Sign Goods are Normal or Superior

Negative SignGoods are Inferior

20 - 33




Other Elasticities

Price Controls



Price Controls

20 - 34




Other Elasticities

Price Controls



PRICE CONTROLS

• Enacted when policymakers believe the market price is unfair to buyers or sellers.

20 - 35




Other Elasticities

Price Controls



CONTROLS ON PRICES

• Price Ceiling – A legal maximum on the price at

which a good can be sold. • Price Floor

– A legal minimum on the price at which a good can be sold.

20 - 36




Other Elasticities

Price Controls



How Price Ceilings Affect Market Outcomes

• Two possibilities:– Not binding (not effective)– Binding (effective)

20 - 37




Other Elasticities

Price Controls



A Market with a Price Ceiling

(a) A Price Ceiling That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

$4 Priceceiling

Equilibriumprice

Demand

Supply

3

100

20 - 38




Other Elasticities

Price Controls



A Market with a Price Ceiling

(b) A Price Ceiling That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

2 PriceceilingShortage

75

Quantitysupplied

125

Quantitydemanded

Equilibriumprice

$3

20 - 39




Other Elasticities

Price Controls



How Price Ceilings Affect Market Outcomes

• A binding price ceiling creates– A shortage because QD > QS.

– Non-price rationing• Long lines• Discrimination

20 - 40




Other Elasticities

Price Controls



CASE STUDY: Lines at the Gas Pump

• In the early 1970s the government placed a price ceiling on gas.

• In 1973, OPEC raised the price of crude oil (input for gas).

20 - 41




Other Elasticities

Price Controls



The Market for Gasoline with a Price Ceiling

(a) The Price Ceiling on Gasoline Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

1. Initially,the priceceilingis notbinding . . . Price ceiling

Demand

Supply, S1

P1

Q1

20 - 42




Other Elasticities

Price Controls



The Market for Gasoline with a Price Ceiling

(b) The Price Ceiling on Gasoline Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

S1

S2

Price ceiling

QS

4. . . . resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1

20 - 43




Other Elasticities

Price Controls



Rent Control

20 - 44




Other Elasticities

Price Controls



How Price Floors Affect Market Outcomes

• Two possibilities:– Not binding– Binding

20 - 45




Other Elasticities

Price Controls



A Market with a Price Floor

(a) A Price Floor That Is Not Binding


Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

20 - 46




Other Elasticities

Price Controls



A Market with a Price Floor

(b) A Price Floor That Is Binding


Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3

20 - 47




Other Elasticities

Price Controls



How Price Floors Affect Market Outcomes

• A binding price floor causes . . .– A surplus because QS > QD.

– Non-price rationing

20 - 48




Other Elasticities

Price Controls



• Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

CASE STUDY: MINIMUM WAGE

20 - 49




Other Elasticities

Price Controls



How the Minimum Wage Affects the Labor Market

Quantity ofLabor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage

20 - 50




Other Elasticities

Price Controls



How the Minimum Wage Affects the Labor Market

Quantity ofLabor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied

20 - 51




Other Elasticities

Price Controls



How Price Controls Affect Total Surplus

A

F

B

D

C

E

Quantity0

Price

Demand

Supply

PF

Q2

PC

PriceFloor

PriceCeiling

P1

Q1

Price

20 - 52




Other Elasticities

Price Controls



Price Controls on Drugs

20 - 53




Other Elasticities

Price Controls




20 - 54




Other Elasticities

Price Controls



Application: The Costs of Taxation

Review• Buyers and sellers receive

benefits from taking part in the market.

• The equilibrium in a market maximizes the total welfare of buyers and sellers.

20 - 55




Other Elasticities

Price Controls



THE DEADWEIGHT LOSS OF TAXATION

• When a tax is levied on a good– Price paid by buyers rises– Price received by sellers falls

20 - 56




Other Elasticities

Price Controls



The Effects of a Tax

Size of tax

Quantity0

Price

Price buyerspay

Price sellersreceive

Demand

Supply

Pricewithout tax

Quantitywithout tax

Quantitywith tax

20 - 57




Other Elasticities

Price Controls



How a Tax Affects Market Participants

• A tax places a wedge between the price buyers pay and sellers receive.

• The quantity sold falls below the pre-tax equilibrium.

20 - 58




Other Elasticities

Price Controls




• Tax RevenueT = the size of the tax

Q = the quantity of the good sold

T Q = Tax Revenue

20 - 59




Other Elasticities

Price Controls



Tax Revenue

Taxrevenue (T × Q)

Size of tax (T)

Quantitysold (Q)

Quantity0

Price

Demand

Supply

Quantitywithout tax

Quantitywith tax

Price buyerspay

Price sellersreceive

20 - 60




Other Elasticities

Price Controls




• Changes in Welfare– Deadweight loss is the fall in total

surplus.

20 - 61




Other Elasticities

Price Controls



How a Tax Affects Welfare

A

F

B

D

C

E

Quantity0

Price

Demand

Supply

= PB

Q2

= PS

Pricebuyers

pay

Pricesellers

receive

= P1

Q1

Pricewithout tax

20 - 62




Other Elasticities

Price Controls



DETERMINANTS OF DEADWEIGHT LOSS

• What determines whether the deadweight loss from a tax is large or small?– Elasticities of Demand & Supply– More elastic curves bring more loss

20 - 63




Other Elasticities

Price Controls



Tax Incidence

• Who pays for the tax?• The more inelastic curve

pays more

20 - 64




Other Elasticities

Price Controls



Tax Distortions and Elasticities

Price

0 Quantity

Demand

Supply

Size of tax

20 - 65




Other Elasticities

Price Controls




Price

0 Quantity

Demand

SupplySizeoftax

20 - 66




Other Elasticities

Price Controls




Demand

Supply

Price

0 Quantity

Size of tax

20 - 67




Other Elasticities

Price Controls




Price

0 Quantity

Sizeoftax Demand

Supply

20 - 68




Other Elasticities

Price Controls




• The combined welfare losses to buyers and sellers exceed the revenue raised by the government.

20 - 69




Other Elasticities

Price Controls



The Effects of a Tariff

• A tariff is a tax on goods produced abroad and sold domestically.

• Tariffs raise the price of imported goods by the amount of the tariff.

20 - 70




Other Elasticities

Price Controls




Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Pricewith tariff Tariff

Importswithout tariff

Equilibriumwithout trade

Pricewithout tariff

WorldpriceImports

with tariff

QSQS QD QD

20 - 71




Other Elasticities

Price Controls




Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand


Equilibriumwithout trade

Pricewithout tariff

Worldprice

QS QD

Producer surplusbefore tariff

Consumer surplusbefore tariff

20 - 72




Other Elasticities

Price Controls




E

Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand



Pricewithout tariff

Worldprice

QS

Importswith tariff

QS QD QD

Tariff Revenue

20 - 73




Other Elasticities

Price Controls




C

G

A

ED F

B

Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand



Pricewithout tariff

WorldpriceImports

with tariff

QSQS QD QD

Deadweight Loss

20 - 74




Other Elasticities

Price Controls



Consumer Behavior & Utility Maximization

20 - 75




Other Elasticities

Price Controls



LAW OF DIMINISHINGMARGINAL UTILITY

• Utility • Subjective• Difficult to Quantify•Total Utility•Marginal Utility

graphically examined...

20 - 76




Other Elasticities

Price Controls



TOTAL AND MARGINAL UTILITYTacos

consumedper meal

TotalUtility,Utils

MarginalUtility,Utils

01

010

Units consumed per meal


30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 77




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


01

010 10



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 78




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


012

01018

10 8



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 79




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


0123

0101824

10 8 6

0 1 2 3 4 5 6 7



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

1 2 3 4 5 6 7

20 - 80




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


01234

010182428

10 8 6 4 Units consumed per meal


30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 81




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


012345

01018242830

10 8 6 4 2



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 82




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


0123456

0101824283030

10 8 6 4 2 0



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 83




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


01234567

010182428303028

10 8 6 4 2 0 -2



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

TU

MU

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

20 - 84




Other Elasticities

Price Controls




consumedper meal

TotalUtility,Utils


01234567

010182428303028

10 8 6 4 2 0 -2



30

20

10Tota

l U

tili

ty (

uti

ls)

Mar

gin

al

Uti

lity

(u

tils

)

10 8 6 4 2 0 -2

TU

MU

0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

ObserveDiminishing

MarginalUtility

20 - 85




Other Elasticities

Price Controls



THEORY OF CONSUMER BEHAVIOR

Utility Maximizing Rule

The consumer’s income should be allocated so that the last dollar spent on each product yields the same amount of marginal utility.

Illustrated...

20 - 86




Other Elasticities

Price Controls



First 10 10 24 12

$ 10 income

UTILITY MAXIMIZING COMBINATION

How should the $10 income be allocated?

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 87




Other Elasticities

Price Controls



First 10 10 24 12

$ 10 income


Examine the twomarginal utilities

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 88




Other Elasticities

Price Controls



First 10 10 24 12

$ 10 income


Examine the twomarginal utilities

…per dollar

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 89




Other Elasticities

Price Controls



First 10 10 24 12

$ 10 income


Decision: Buy 1Product B for $2

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 90




Other Elasticities

Price Controls



First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income


What next?

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 91




Other Elasticities

Price Controls




$ 10 income


What next?Buy one of each

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 92




Other Elasticities

Price Controls




$ 10 income


and then...($5 left)

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 93




Other Elasticities

Price Controls




$ 10 income


third unit of product B

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 94




Other Elasticities

Price Controls




$ 10 income


$3 left...

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 95




Other Elasticities

Price Controls




$ 10 income


$3 left...Buy both!

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 96




Other Elasticities

Price Controls




$ 10 income


Income is gone...the last dollar spent on

each good gave the sameutility (8) per dollar

Unit ofproduct




Marginalutility per

dollar(MU/price)


Marginalutility per

dollar(MU/price)

20 - 97




Other Elasticities

Price Controls



Algebraic Restatement of theUtility Maximization Rule

MU of A

Price of A

MU of B

Price of B=

Consumption Bundles

8 Utils

$1

16 Utils

$2=

20 - 1 price elasticity of demand determinants of price elasticity price elasticity and total...

Documents

priceelasticity coefficient

price elasticity total

price of product x

q d elasticity

price sum of prices2

unit elasticity e d

total revenue slide

law of demand