Application on Demand and Supply Chapter 4 Application on Demand and Supply

Dr Mohamed I. Migdad Associate Professor in Economics Chapter 4 Dr Mohamed I. Migdad Associate Professor in Economics

Application of supply and demand 4.1 price elasticity of demand and supply 4.2 price ceiling and price floor 4.3 other topics, minimum wages, price control

Elasticity Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

How to measure elasticity

Price Elasticity of Demand A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product.

How to measure P.E.D Price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price of the product.

How to measure P.E.D

The absolute term The value of demand elasticity is always negative, but it is stated in absolute terms.

The negative sign The negative sign of the P.E.D show the negative relation between price and quantity demanded.

Slope and Elasticity The value of the slope of the demand curve and the value of elasticity are not the same. Unlike the value of the slope, the value of elasticity is a useful measure of responsiveness.

Slope and Elasticity

Slope and Elasticity when we calculate slope in the two graphs: The slope of the first graph equals change in price / change in quantity = -1/5 = -20% The slope of the second graph equals -1/ 80 = -1.25%

Slope and Elasticity But when we calculate elasticity in the two graphs: The elasticity of the first graph = % change in quantity / % change in price = q2-q1/q1 divided by p2-p1/p1= 10-5 / 5 divided 2-3/3 = 1/ -0.33 = -3 The elasticity of the second graph = 160-80/80 divided 2-3/3 =1/-0.33 = -3

continue Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical. And as a result the elasticity is the same, in both graphs and equals -3

Types of Elasticity Unitary elasticity = -1 Elastic demand > -1 Inelastic demand < -1 Perfectly elastic demand = ∞ Perfectly inelastic demand = 0

Hypothetical Demand Elasticity for Four products Types of Elasticity Hypothetical Demand Elasticity for Four products

% CHANGE IN QUANTITY DEMANDED (%DQD) ELASTICITY (%DQD d %DP) Hypothetical Demand Elasticities for Four Products PRODUCT % CHANGE IN PRICE (%DP) % CHANGE IN QUANTITY DEMANDED (%DQD) ELASTICITY (%DQD d %DP) Insulin +10% 0% 0.0 Perfectly inelastic Basic telephone service -1% -0.1 Inelastic Beef -10% -1.0 Unitarily elastic Bananas -30% -3.0 Elastic

Elastic and Inelastic Demand Curves Different graphs that show different types of elasticity

Perfectly Elastic and Perfectly Inelastic Demand Curves

Perfect inelasticity When demand does not respond at all to a change in price, demand is perfectly inelastic, this is the horizontal demand curve.

Perfect elasticity Demand is perfectly elastic when quantity demanded drops to zero at the slightest increase in price, this is the vertical demand curve.

Calculating Elasticities The elasticity of the first graph = % change in quantity / % change in price = q2-q1/q1 divided by p2-p1/p1

% change in Quantity

Calculating Elasticities

Calculating Elasticities

Elasticity is a ratio of percentages. Using the values on the graph to compute elasticity, using percentage changes yields the following result:

Price Elasticity

Calculating Elasticities

The midpoint formula A more accurate way of computing elasticity than percentage changes is the midpoint formula:

The midpoint formula

The midpoint formula

Interpret Elasticities Here is how to interpret two different values of elasticity: When e = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded. When e = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

Elasticity Changes along a Straight-Line Demand Curve

Elasticity along a Straight-Line Price elasticity of demand decreases as we move downward along a straight line demand curve. This is because quantity is large.

Elasticity along a Straight-Line Demand is elastic in the upper range and inelastic in the lower range of the line, this is because quantity is small .

Elasticity Along the elastic range, elasticity values are greater than one. Along the inelastic range, elasticity values are less than one. And in the middle elasticity equals one

Elasticity and Total Revenue

Change in quantity versus change in price Type of demand Value of Ed Change in quantity versus change in price Effect of an increase in price on total revenue P↑ Effect of a decrease in price on total revenue P ↓ Elastic Greater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases Inelastic Less than 1.0 Smaller percentage change in quantity Unitary elastic Equal to 1.0 Same percentage change in quantity and price Total revenue does not change

Elasticity and Total Revenue When demand is inelastic, price and total revenues are directly & positively related. Price increases generate higher revenues.

Price increases generate lower revenues. continue When demand is elastic, price and total revenues are indirectly & negatively related. Price increases generate lower revenues.

The Determinants of Demand Elasticity Availability of substitutes - demand is more elastic when there are more substitutes for the product. Time dimension -- demand becomes more elastic over time.

continue Importance of the item in the budget -- demand is more elastic when the item is a more significant portion of the consumer’s budget.

Home Exam Define economics and it main branches. What is elasticity, and what is its application? Give example to calculate price elasticity of demand & explain its importance.

Exam Explain the relation between elasticity & revenue? How to use the relation in decision making? Give numerical examples. What are factors determines the elasticity? Use Graphs and numerical examples as much as you can in answers.

Other Important Elasticities Income elasticity of demand – measures the responsiveness of demand to changes in income.

The form

Other Important Elasticities Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good.

The form

Other Important Elasticities Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.

The form

Other Important Elasticities Elasticity of labor supply: A measure of the response of labor supplied to a change in the price of labor.

The form

Constraints on the Market A price ceiling is a maximum price that sellers may charge for a good, usually set by government.

price ceiling In 1974, the government set a price ceiling to distribute the available supply of gasoline. At an imposed price of 57 cents per gallon, the result was excess demand.

Prices and the Allocation of Resources Price changes resulting from shifts of demand cause profits to rise or fall. Profits attract capital; losses lead to disinvestment.

price ceiling Higher wages attract labor and encourage workers to acquire skills. At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.

Price Floors A price floor is a minimum price below which exchange is not permitted. The most common example of a price floor is the minimum wage, which is a floor set under the price of labor.

Price Floors The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded.

Impact of tax and subsidies on price and quantity Taxes shift supply curve up to the left And we reach a new equilibrium point Pe will increase and Qe will decrease

How tax or tariffs on imports affect foreign trade This depend on the elasticity of demand and supply.

Energy price control An example for government intervention comes when the Gov. legislates a maximum price ceiling.