copyright 2008 the mcgraw-hill companies 18 extensions of demand and supply analysis
TRANSCRIPT
Copyright 2008 The McGraw-Hill Companies
18Extensions of Demand and Supply Analysis
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Chapter Objectives• Price Elasticity of Demand and
How It Can Be Applied• The Usefulness of the Total
Revenue Test for Price Elasticity of Demand
• Price Elasticity of Supply and How It Can Be Applied
• Cross Elasticity of Demand and Income Elasticity of Demand
• Consumer Surplus, Producer Surplus, and Efficiency Losses
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What is Elasticity?
• A term economists use to describe sensitivity or responsiveness: for example, how sensitive is quantity demanded to a change in price?
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The percentage change in quantity demanded divided by the percentage change in price
How do we measure the Price How do we measure the Price Elasticity of Demand?Elasticity of Demand?
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Price Elasticity of Demand• Price-Elasticity Coefficient
and FormulaPercentage Change in Quantity
Demanded of Product X
Percentage Change in Priceof Product X
Ed =
O 18.1
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Notes on Ed
• Ed negative, but ignore negative
• use of % change-not affected by units of measurement
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Classifying Ed
• Ed = 1 Unitary elasticity
• Ed > 1 Elastic demand
• Ed < 1 Inelastic demand
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Extreme elasticities
• Ed = 0 Perfectly inelastic (vertical demand curve)
• Ed = Perfectly elastic (horizontal demand curve)
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Price Elasticity of DemandExtreme CasesPerfectly Inelastic Demand
Perfectly Elastic Demand0
P
Q
P
0Q
D1
D2
PerfectlyInelasticDemand(Ed = 0)
PerfectlyElasticDemand(Ed = ∞)
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Problem - When we move along a demand curve between two points, we get different answers to elasticity depending if we are moving up or down the demand curve
Calculating Elasticities
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If there is an If there is an increase increase from from 33 units to units to 55, what is the , what is the percentage increase?percentage increase?
2/3 = 66%
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If there is a If there is a decreasedecrease from from 55 units to units to 33, what is the percentage , what is the percentage
decrease?decrease?
2/5 = 40%
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One way to deal with this problem is to work with averages ...
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Price Elasticity of Demand
• Using Averages• Midpoint Formula
W 18.1
Change in QuantityEd = Sum of Quantities/2
÷Change in Price
Sum of Prices/2
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Practice: calculating Ed
• You usually buy 4 cd’s per month at a price of $14, but when the price rises to $18, you purchase only 3 per month. What is your elasticity of demand for cd’s over this range of prices?
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Elasticity and Total Revenue (TR)
• TR = PQ, price times quantity
• Ed = % change in Q
• % change in P
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Summary, elasticity, price changes, and total revenue
Ed = 1 Total revenue same
Total revenue same
Ed > 1 Total revenue falls Total revenue rises
Ed < 1 Total revenue rises Total revenue falls
Price increase
Price Decrease
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$3
2
1
0 10 20 30 40 Q
P
The Total Revenue Test• Total Revenue (TR) TR = P x Q Elastic Demand
a
b
D1
W 18.2
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$4
1
0 10 20 Q
P
The Total Revenue Test• Total Revenue (TR) TR = P x Q Inelastic Demand
c
d
D2
W 18.2
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$3
2
1
0 10 20 30 Q
P
The Total Revenue Test• Total Revenue (TR) TR = P x Q Unit-Elastic
e
fD3
W 18.2
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Elasticity on a Linear Demand Curve
1
2
3
4
5
6
7
8
8
7
6
5
4
3
2
1
5.00
2.60
1.57
1.00
0.64
0.38
0.20
$8,000
14,000
18,000
20,000
20,000
18,000
14,000
8,000
Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
(1)Total Quantity of
Tickets DemandedPer Week, Thousands
(2)Price Per Ticket
(3)Elasticity
Coefficient (Ed)
(4)Total Revenue
(1) X (2)
(5)Total-Revenue
Test
]]]]]]]
]]]]]]]
Price Elasticity of Demand for Movie Tickets as Measured by the ElasticityCoefficient and the Total-Revenue Test
Graphically…
G 18.1
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Price Elasticity and the Total-Revenue Curve
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
Quantity Demanded
Quantity Demanded
Pri
ceT
ota
l Rev
enu
e(T
ho
usa
nd
s o
f D
olla
rs)
$201816141210
8642
$87654321
a
bc
de
fg
h
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
D
TR
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Determinants of Price Elasticity of Demand
• Substitutability• Proportion of Income• Luxuries versus
Necessities• Time
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The more substitutes a good has, the more elastic demand for the product is.
What do substitutes have to do with What do substitutes have to do with elasticity?elasticity?
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The lower the % of ones budget a good is, the less sensitive consumers are to a price change, thus the more inelastic the demand.
What does % of income a good makes What does % of income a good makes up have with elasticity?up have with elasticity?
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In general, luxuries have a more elastic demand, necessities a more inelastic demand.
What do luxuries vs. necessities What do luxuries vs. necessities have to do with elasticity?have to do with elasticity?
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Price Elasticity of Supply
O 18.2
Percentage Change in QuantitySupplied of Product X
Percentage Change in Priceof Product X
Es =
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E s = % Q supplied % Price
• E s = 1 Unitary
• E s > 1 Elastic
• E s < 1 Inelastic
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Extreme cases of E s
• E s = 0, perfectly inelastic (vertical supply curve
• E s = , perfectly elastic (horizontal supply curve)
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Elasticity of Supply
• Time periods important: • Market period: vertical supply curve, too short of
a time to alter amount supplied• Short run: too short to change plant capacity but
can use existing capacity more or less intensively. Supply becomes somewhat more elastic
• Long run: long enough time for firms to change plant sizes, new firms to enter or leave, etc. making for more elastic supply
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Cross Elasticity of Demand
• Substitute Goods – Positive Sign
• Complementary Goods- Negative Sign
• Independent Goods – Zero or Near-Zero Value
Percentage Change in QuantityDemanded of Product X
Percentage Change in Priceof Product Y
Exy =
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Income Elasticity of Demand
• Normal Goods – Positive
Sign
• Inferior Goods- Negative Sign
• Among normal goods, basic
necessities often have low income
elasticities, while luxuries have higher
income elasticities.
Percentage Change in QuantityDemanded
Percentage Change in IncomeEi =
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Elasticity of demand
• Applications:–Large Crop Yields–Excise Taxes–Decriminalization of Illegal Drugs
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Price Elasticity of Supply• Applications
– Antiques and Reproductions
– Volatile Gold Prices
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What is What is Consumer Surplus?Consumer Surplus?
The difference between the maximum amount that a consumer is willing to pay for something and what he actually pays
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Consumer SurplusConsumer Surplus
• Graphically, we approximate CS as the area under the demand curve but above the market price.
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P
Q
Consumer Surplus
37
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Consumer and Producer Surplus
Consumer Surplus
D
Pri
ce
(P
er B
ag
)
P1
Q1
Quantity (Bags)
ConsumerSurplus
Equilibrium Price = $8
O 18.3
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What happens to Consumer Surplus as Market Price changes?
• It increases when price falls and falls when prices increase
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Consumer and Producer Surplus
Producer Surplus
SP
ric
e (
Per
Ba
g)
P1
Q1
Quantity (Bags)
ProducerSurplus
Equilibrium Price = $8
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Producer Surplus• Producer surplus is the difference between
the actual price a producer receives and the minimum acceptable price: approximated by the area below the actual price but above the supply curve.
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Consumer and Producer Surplus
Efficiency Revisited
D
SP
ric
e (
Per
Ba
g)
P1
Q1
Quantity (Bags)
ConsumerSurplus
ProducerSurplus
Equilibrium Price = $8
W 18.3
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Consumer and Producer Surplus
Efficiency Revisited
D
SP
ric
e (
Per
Ba
g)
P1
Q1
Quantity (Bags)
EfficiencyLosses
Q2 Q3
Efficiency Losses (Deadweight Losses)
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Elasticity and Pricing Power:Last
Word
Why Different Consumers Pay Different Prices
• All Buyers in a Highly Competitive Market Pay the Same Price Regardless of Their Elasticities
• Difficulty in Applying Different Prices
• Observe Differences in Group Elasticities– Business Travelers– Leisure Travelers– Discounting for Children– Different Net Prices for College
Tuition
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Key Terms• price elasticity of demand• midpoint formula• elastic demand• inelastic demand• unit elasticity• perfectly inelastic demand• perfectly elastic demand• total revenue test (TR)• total-revenue test
• price elasticity of supply• market period• short run• long run• cross-elasticity of demand• income elasticity of
demand• consumer surplus• producer surplus• efficiency losses
(deadweight losses)