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