Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 1 Market Behaviour: Markets in action 2012 version

Learning Objectives 1. Define the price elasticity of demand and understand how to calculate it. 2. Understand the determinants of the price elasticity of demand. 3. Understand the relationship between the price elasticity of demand and total revenue. 4. Define the cross-price elasticity of demand and the income elasticity of demand, and understand their determinants and how they are calculated.

Learning Objectives 5. Use price elasticity and income elasticity to analyse economic issues. 6. Define the elasticity of supply, and understand its main determinants and how it is calculated. 7. To investigate the effects on markets of government intervention, i.e. price ceilings, price floors and taxes.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 4 Price Elasticity of Demand The price elasticity of demand is the measure of the responsiveness of the quantity demanded to a change in price of a product

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 5 Price Elasticity is... Q P P1P1 P2P2 Q1Q1 Q2Q2 D As price increases from P 1 to P 2, quantity decreases from Q 1 to Q 2

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 6 Price Elasticity is... (cont.) Q P P2P2 P1P1 Q2Q2 Q1Q1 D As price decreases from P 1 to P 2, quantity increases from Q 1 to Q 2

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 7 Price Elasticity is... (cont.) Q P P1P1 P2P2 Q1Q1 Q2Q2 D But what percentage did price change and what percentage did quantity change?

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 8 Formula for Elasticity The percentage change in price The percentage change in quantity EdEd = PED cannot be equated with the slope of the demand curve, it is really easy to change the slope of a demand curve by changing the units of the vertical or horizontal axis, but changing the units will change the under lying demand conditions.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 9 Price Elasticity of Demand (cont.) Elastic Demand – a given percentage change in price results in a larger percentage change in quantity demanded E d > 1

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 10 Price Elasticity of Demand (cont.) Inelastic Demand – a given percentage change in price results in a relatively smaller percentage change in quantity demanded E d < 1

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 11 Price Elasticity of Demand (cont.) Unit elasticity – a given percentage change in price results in an equal percentage change in quantity demanded E d = 1 Total revenue is maximised

Inelastic and Elastic Demand 6 12 Price Quantity D1D1 Elasticity = 0 Perfectly Inelastic Figure 4.3(a)

Inelastic and Elastic Demand 6 12 Price Quantity D2D Elasticity = 1 Unit Elasticity Figure 4.3(b) PED = 1 curve is a rectangular hyperbola, i.e. P x Q equals a constant.

Inelastic and Elastic Demand 6 12 Price Quantity D3D3 Elasticity = Perfectly Elastic Figure 4.3(c)

Elastic Inelastic Elasticity Along a Linear Demand Curve Elasticity = Price (dollars per smoothie) Quantity (smoothies per hour) Elasticity 1/4 Elasticity =4 Figure 4.4

When demand is inelastic, a price cut decreases total revenue Inelastic demand When demand is elastic, a price cut increases total revenue Elastic demand Price (dollars per smoothie) Total Revenue (dollars) Quantity (smoothies per hour) Unit elastic Maximum total revenue 2.50 Elasticity and Total Revenue 16

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 17 Total Revenue Test Elastic demand – a change in price will cause total revenue to change in the opposite direction Inelastic demand – a change in price will cause total revenue to change in the same direction Unit elasticity – a change in price leaves total revenue unchanged – total revenue is maximised

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 18 Determinants of Price Elasticity of Demand Substitutability Proportion of income Luxuries versus necessities Time

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 19 Price Elasticity of Supply Es=Es= Percentage change in quantity supplied of product X Percentage change in the price of product X This time slope is directly related to PES

Elasticity of Supply The time frame for supply decisions – The more time that passes after a price change, the greater is the elasticity of supply. – Momentary supply is perfectly inelastic. The quantity supplied immediately following a price change is constant. – Short-run supply is somewhat elastic. – Long-run supply is the most elastic. Resource substitution possibilities – The easier it is to substitute among the resources used to produce a good or service, the greater is its elasticity of supply.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 21 Price Elasticity of Supply (cont.) Immediate market Period No Quantity response just a price response PoPoPoPo P Q D1D1D1D1 SmSmSmSm PmPmPmPm D1D1D1D1 D2D2D2D2 D2D2D2D2 QoQo

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 22 D2D2D2D2 Price Elasticity of Supply (cont.) PoPoPoPo PsPsPsPs P Q D1D1D1D1 QoQo SsSsSsSs Short run Large increase in D leads to a small increase in Q. QsQs

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 23 Price Elasticity of Supply (cont.) PoPoPoPo PLPLPLPL P Q D1D1D1D1 QoQo SLSLSLSL Long run: Large increase in D leads to a large quantity response D2D2D2D2 S L QoQo QLQL Q L

Elasticity of Supply Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0. Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that slope is irrelevant.) Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is infinite.

Perfectly Inelastic Supply Price Quantity S1S1S1S1 Elasticity of supply = 0 0 Figure 4.10 (a)

Unit Elastic Supply Price Quantity S2AS2AS2AS2A 0 S2BS2BS2BS2B Elasticity of supply = 1 Figure 4.10 (b)

Elastic Supply Price Quantity S2AS2AS2AS2A 0 S2BS2BS2BS2B

Inelastic Supply Price Quantity S2AS2AS2AS2A 0 S2BS2BS2BS2B

Perfectly Elastic Supply Price Quantity S3S3S3S3 0 Elasticity of supply = Figure 4.10 (c)

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 30 E xy = Percentage change in quantity demanded of good X Percentage change in the price of good Y Substitute goodsPositive sign Complementary goodsNegative sign Independent goodsZero value Cross Price Elasticity of Demand

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 31 Income Elasticity of Demand E i = Percentage change in quantity demanded Percentage change in income Normal goods 0>1 Inferior goods <0 Superior goods > 1

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 32 Price Ceilings D D S S Legal Price Ceiling P PcPcPcPc P Q Shortage QeQe QdQd QsQs

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 33 Price Ceilings and Shortages Price ceiling is the maximum legal price a seller may charge for a product or service. Price ceilings result in shortages. – Wartime price controls – Rent controls Over time both PED and PES increase so the shortage gets bigger. Designed to help poor people, but they end up hurting them, eg overcrowding or black markets.

Rent ceiling A Price (Rent) Ceiling Quantity (thousands of units per month) Rent (dollars per unit per month) D SS A Housing shortage Maximum black market rent Figure 6.2

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 35 Price floors Price support or price floor is a minimum price fixed by government, above equilibrium prices – Minimum wage legislation – Agricultural support prices Price support results in surpluses Over time both PED and PES increase so the surplus gets bigger. In SR they may increase income, but in the long run as DD gets flatter incomes falls.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 36 Price Support and Surpluses D D S S PePePePe Legal Price Support PsPsPsPsQ P Q Surplus QsQs QdQd

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 37 Tax Incidence Price elasticity of demand and supply determines who bears the burden of sales or excise tax, called the incidence of a tax. Slopes of SS and DD reflect relative elasticity. The relatively less elastic side of the market bears the burden of the tax.

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 38 Incidence of a Sales Tax P Q Price ($ per bottle) Quantity demanded (thousands of bottles/month) S D

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 39 Incidence of a Sales Tax (cont.) P Q Price ($ per bottle) Quantity demanded (thousands of bottles/month) Tax $1 S1S1S1S1 S D

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 40 Incidence of a Sales Tax P Q Price ($ per bottle) Quantity demanded (thousands of bottles/month) Tax $1 S1S1S1S1 S D Consumers tax incidence Producers tax incidence

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 41 Elastic Demand and Incidence P Q Price ($ per bottle) Quantity demanded (thousands of bottles/month) Tax $1 S1S1S1S1 S D Consumers tax incidence Producers tax incidence

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia. 42 Inelastic Demand and Incidence P Q Price ($ per bottle) Quantity demanded (thousands of bottles/month) Tax $1 S1S1S1S1 S D Consumers tax incidence Producers tax incidence