Chapter 5

Applications of Supply and Demand

Elasticity

• The responsiveness of quantities demanded and supplied to changes in price

• If price changes, how much more or less is purchased and supplied

Price Elasticity of Demand

• Coefficient of demand elasticity =change in quantity demandedaverage quantity demanded

change in priceaverage price

or• Ed = Qd/Av. Qd

P/Av. P

Price Elasticity of Demand

• Example:Price drops from $10 to $6, Quantity Demanded increase from 20 to 30

Ed = (30-20) / 25 = 0.4 = 0.8 (10-6) / 0.5

• Quantity demanded increased by less than the price dropped

Price Elasticity of Demand

Rules for Coefficients over the price ranges:

• If Ed < 1 Demand is inelastic

businesses will raise price to increase revenue

• If Ed = 1 Demand has unitary elasticity

• If Ed > 1 Demand is elastic

businesses will lower price to raise revenue

Factors Affecting Demand Elasticity

• Availability of substitutes – demand is more elastic with more substitutes

• Nature of the item – necessities are more inelastic

• Fraction of income spent on item – expensive items are more elastic

• Amount of time available – more time leads to more elasticity

Elasticity of Supply

• How responsive is a seller to a rise or fall in price

• coefficient = Quantity Supplied/Average Supply

Price/Average Price

• Same rules apply for inelastic, unitary and elastic supply as for demand

Factors Affecting Supply Elasticity

• Time – suppliers can’t change supply in the short run but can over time

• Ease of Storage – increases elasticity if easy to do

• Cost Factors – overtime in the short run but some industries need new capital, others don’t (e.g. cds)

Utility Theory

• Alfred Marshall suggested we buy to satisfy needs and wants using utility or usefulness

• Marginal utility is the extra satisfaction we get from buying one more unit

• we buy products until our marginal utility is equal

• formula: MU/Price A = MU/Price B• at that point we’re in consumer equilibrium• explains the demand curve: as we buy more

the extra satisfaction declines and we’re willing to pay less 

Adam Smith’s Paradox of Value

• Why are diamonds worth more than water?

• Answer: the total utility from water is greater but the marginal utility of diamonds is much greater

Consumer Surplus

• the extra value amount consumers get based on what they are willing to pay over what they do pay

• it ends when our demand stops (A below)

Government Intervention

• Ceiling prices: below equilibrium, leads to shortage and possible black market

• Floor Prices: above equilibrium, leads to surplus

• Subsidy: is financial help to producers; leads to increased supply but taxes are needed and inefficient producers kept in business

• Quotas: restrictions on supply to keep more producers in business; marketing boards keep prices higher

Government Intervention

• Rent Controls are a ceiling on price below the market equilibrium

• Landlords may charge additional sums, allow buildings to be run down

Government Intervention

• Minimum Wages: price for labour higher than equilibrium leads to a surplus of workers