Chapter 18 Extensions of Demand and Supply Analysis ECON 202 Microeconomics Chapter 18 Extensions of Demand and Supply Analysis

Review The Law of demand – consumers will buy more of a product when its price declines and less when its price increases.

Elasticity of Demand Measures how much the quantity demanded changes with a given change in price of the item, a change in consumers’ income, or a change in the price of a related product. We use percentages to compute the Elasticity of Demand because using some kind of units measurement may give us the wrong impression of what is really happening, plus, using %s gives us a common measurement of comparison.

Price Elasticity of Demand Law of demand - consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. If consumers are relatively responsive to price changes, demand is said to be relatively elastic. If consumers are relatively unresponsive to price changes, demand is said to be relatively inelastic.

Price Elasticity Coefficient and Formula: Quantitative measure of elasticity % change in quantity Ed = % change in price.

Elimination of the Minus Sign Price-elasticity will always be a negative number  Economists ignore the negative and present the absolute value of the elasticity coefficient.

Elastic Demand Demand is elastic if a specific % change in price results in a larger % change in quantity demanded(pg. 341).

Inelastic Demand Demand is inelastic if a specific % change in price produces a smaller % change in quantity demanded(pg. 341).

Unit Elasticity – The case separating elastic and inelastic demand occurs where a percentage change in the price and the resulting percentage change in quantity demanded are the same.

Inelastic demand does not mean that consumers are completely unresponsive. This extreme situation called perfectly inelastic demand would be very rare, and the demand curve would be vertical. Elastic demand does not mean consumers are completely responsive to a price change. This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal.

Demand is relatively elastic - Example Meals in Restaurants A small change in price greatly impacts the quantity purchased. Therefore, demand for the meal was relatively elastic, or elastic.

Demand is relatively inelastic - Example Toothpaste A small change in price does not greatly impacts the quantity purchased. Therefore demand for the toothpaste was relatively inelastic, or inelastic.

Relatively Inelastic Goods which have a price elasticity below 1.0 are called inelastic goods, and consumers are price-insensitive. Typical inelastic goods are food, tobacco, and gasoline. Inelastic items usually are basic elements of everyday life.

Another Inelastic example Goods with few substitutes tend to have low elasticities. For example, in today’s economy - driving is a fact of life, and there is simply no way for most people avoid buying gasoline.

When prices increase, there will be widespread grumbling, but most people will continue to shell out for gas. In contrast, items with high price elasticity items are less essential items or items with a wide range of substitutes, and are frequently considered luxuries.

Relatively Elastic Goods with a price elasticity above 1.0 are called elastic goods, and consumers are price-sensitive.

Another Elastic example In contrast, items with high price elasticity are less essential items or items with a wide range of substitutes, and are sometimes considered luxuries.

Total Revenue Test (for elasticity) The easiest way to judge whether demand is elastic or inelastic. This test can be used in place of elasticity formula, unless there is a need to determine the elasticity coefficient.

Elastic demand and the total-revenue test: Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue (Price and revenue move in opposite directions).

Demand is more elastic in upper left portion of curve (because price is higher, quantity smaller). Demand is more inelastic in lower right portion of curve (because price is lower, quantity larger).

Determinants of the Price Elasticity of Demand Substitutes for the product: The more substitutes, the more elastic the demand. Proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.

Price elasticity of demand –more determinants Luxury or a necessity? The less necessary the item, the more elastic the demand. Amount of time involved: The longer the time period involved, the more elastic the demand becomes.

Excise taxes Governments look at elasticity of demand when levying excise taxes. Excise taxes on products with inelastic demand will raise the most revenue and have the least impact on quantity demanded for those products.

Demand for drugs Demand for cocaine is highly inelastic (addicts) and presents problems for law enforcement. Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business.

Demand for drugs cont… Opponents of legalization think that occasional users have a more elastic demand and would increase their use at lower, legal prices. Also, that removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right.

Price Elasticity of Supply If producers are relatively responsive to price changes, supply is elastic. If producers are relatively insensitive to price changes, supply is inelastic.

Price Elasticity of Supply The elasticity formula is the same as demand, but substitute “supplied” for the word “demanded” everywhere in the formula. % change in quantity supplied Es = % change in price

Example-price elasticity of supply Antiques and other non-reproducible commodities are inelastic in supply, sometimes the supply is perfectly inelastic. This makes their prices highly susceptible to fluctuations in demand.

Another example Gold prices are volatile because the supply of gold is highly inelastic, and unstable demand resulting from speculation causes prices to fluctuate significantly.

Cross Elasticity and Income Elasticity of Demand: Cross Elasticity of Demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Numerically, the formula is shown for products X and Y. % change in quantity of X Exy = % change in price of Y

Cross-Elasticity If cross elasticity is positive, then X and Y are substitutes. If cross elasticity is negative, then X and Y are complements. Note: if cross elasticity is zero, then X and Y are unrelated, independent products.

Cross-Elasticity examples If cross elasticity is positive, then the goods are substitutes… Evian & Dasani water If cross elasticity is negative, then the goods are complements… digital cameras & memory cards Note: if cross elasticity is zero, then the goods are unrelated, independent products… TVs and lettuce.

Income Elasticity of Demand Income Elasticity of Demand refers to the percentage change in quantity demanded that results from some percentage change in consumer incomes. % change in quantity demanded Ei = % change in income

A positive income elasticity indicates a normal or superior good… consumers increase these as incomes rise A negative income elasticity indicates an inferior good… consumers decrease these as their income rises. Those industries that are income elastic will expand at a higher rate as the economy grows.

Consumer Surplus – difference between the maximum price a consumer is willing to pay for a product and the actual price. The surplus, measurable in dollar terms, reflects the extra utility gained from paying a lower price than what is required to obtain the good.

Producer Surplus - difference between the actual price a producer receives (or producers receive) and the minimum acceptable price. Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences.

Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized. Productive Efficiency is achieved because competition forces producers to use the best techniques and combinations of resources in producing and selling their products. Allocative Efficiency is achieved because the correct quantity of output is produced relative to other goods and services.

Efficiency (Deadweight) Losses Underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity. Overproduction causes inefficiency because past the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to pay.

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