ECON 351 Elasticity of Demand & Supply Week 4.1 September 17, 2013

Review Markets are the interaction of buyers and sellers. Focus on buyers and sellers separately. Ceteris paribus: look at one thing at a time; All other things held equal.

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Demand x Demand shows the amounts purchased at alternative prices (horizontal distances at each price) Qty x /T DxDx DxDx Demand for X

Supply Curve $Price $ Qty x/ T

$Price $ Q x/ T Demand Supply Surplus at this $ Price

$Price $ Q x/ T Demand Supply Shortage at this $ Price

$Price Pe Pe Q x/ T Qe DemandSupply Market Equilibrium Qty D = Qty S

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T Supply Demand DxDx Pe Qe Total Revenue = P X Q $6x5 = $30

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T Supply Do DoDo SxSx Effects of Increase in Demand on Price and Quantity Increases Price and Quantity Pe Qe D1D1 D1D1

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T Demand DxDx S0S0 Effects of an Increase in Supply on Price and Quantity Price decreases and Quantity increases Pe Qe S0S0 S1S1 S1S1

What causes an increase in price? Increase in Demand orDecrease in Supply $ P S2S2 Q/T D1D1 Q2Q2 Q1Q1 Q1Q1 P2P2 P1P1 Demand S1S1 Q2Q2 P1P1 P2P2 D2D2 Supply Q/T (if you know quantity increased)(if you know quantity decreased)

What causes an decrease in price? Decrease in Demand orIncrease in Supply $ P S2S2 Q/T D1D1 Q2Q2 Q1Q1 Q1Q1 P2P2 P1P1 Demand S1S1 Q2Q2 P1P1 P2P2 D2D2 Supply Q/T (if you know quantity decreased)(if you know quantity increased)

$ P x Qty x /T Supply D3D3 SxSx Market Demand Determines Price P1P1 Q2Q2 D2D2 D1D1 Q1Q1 Q3Q3 P3P3 P2P2

AB PxPx PxPx Q x /T P0P0 Q0Q0 P0P0 Q0Q0 Slope of Supply Shows responsiveness of quantity to a change in Price P1P1 Q1Q1 P1P1 Q1Q1

Slope Shows Responsiveness of Quantity to a Change in Price A B PxPx PxPx Q x /T P0P0 P0P0 DxDx DxDx Q0Q1Q0Q1 Q0Q0 P1P1 P1P1 Q 1

AB PxPx PxPx Q x /T P0P0 Q0Q0 P0P0 Q0Q0 Problems using Slope as a measure of responsiveness: Slope depends on the units of measure on the vertical and horizontal axis. P1P1 Q1Q1 P1P1 Q1Q1

Price Elasticity: a Measure of responsiveness of Quantity to a Change in Price E d = % Δ Q d % Δ Price E s = % Q s % Price

Computing the Point Price Elasticity of demand E d = % Δ Q d % Δ P % Δ Q d = (Δ Q d / Q 0 ) % Δ P = (Δ P/ P 0 ) E d = (Δ Q d / Q 0 ) (Δ P/ P 0 )

Problem with measures of Point Elasticity: Evaluate elasticity between two points on the demand curve Point A: Price = $4 Quantity = 120 Point B: Price = $6 Quantity = 80 From A to B: E d = (-33% / 50%) = -.66 From B to A: E d = (50% / -33%) = -1.5 Measuring from either endpoint (P 0, Q 0 ) gives different estimates

Arc or midpoint price elasticity Instead of using one end of the price, quantity change as the reference point, use the midpoint. E d = (Δ Q d /( (Q 1 + Q 2 )/2 ) / (Δ P/)/ ( (P 1 + P 2 )/2 ) E d = (- 40/100) / ($2/$5) = - 40% / 40% = -1 By using the midpoint formulation the answer will be the same for a price increase or a price decrease and is therefore an unbiased measure of the responsiveness of quantity to a change in price.

Measures of Elasticity ElasticDemand is Elastic : %Δ Q d > %Δ P; ie |E d | >1. A decrease in Price an increase in Total Revenue. Unitary ElasticDemand is Unitary Elastic: %ΔQ d = %ΔP; ie |E d | = 1. A Change in price no change in Total Revenue. InelasticDemand is Inelastic: %ΔQ d < %ΔP; i.e. |Ed| < 1. An increase in Price an increase in Total Revenue.

Elasticity varies on a straight line demand curve $Price Qty/T Demand Ed > 1 Ed < 1 Ed = 1

Elasticity, Price Change & Total Revenue $Px Elastic (upper half) Inelastic (lower half) Q1Q1 Qty/T P0P0 P1P1 Q0Q0 P1P1 P0P0 Q0Q0 Q1Q1

Increased Demand with elastic Supply $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T SxSx DxDx DxDx SxSx Pe Qe Dx` Qe` Pe`

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T SxSx DxDx DxDx SxSx Pe Qe Dx Qe Pe Increased Demand, Inelastic Supply

Decrease in Supply, Elastic Demand $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T SxSx DxDx DxDx S x Pe QeQe` Pe`

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T SxSx DxDx DxDx S x Pe Qe Pe Decrease in Supply, Inelastic Demand

Determinants of Price Elasticity of Demand Number & Closeness of Substitutes. Information about price change and availability of substitutes. Percentage of Income Spent on good. Second Law of DemandPeriod of time: Second Law of Demand: Demand is more elastic over a longer period of time.

Factors creating increased elasticity over time 1.More information about price change and substitutes (Beef & Chicken) 2.More substitutes over time (More Hybrids) 3.Increased opportunity to change the complementary basket of goods (Buy a car with higher MPG. Move closer to work.)

Other Elasticity's A Measure of responsiveness of Quantity to a Change in some other factor

Income Elasticity: Measure of responsiveness of Quantity to a Change in Income E dI = % Δ Q d % Δ income Normal Goods: Positive Clothing:.95: 10% income 9.5% Stereo: 2.72: 10% income 27.2% Increase may be Quantity or Quality Inferior Goods: Negative

Cross Price Elasticity: Measure of responsiveness of Quantity to a Change Price of other good E xy = % Δ Q x % Δ P y Substitutes: Positive Complements: Negative

Uses of Cross Price Elasticity Magnitude of cross price elasticity reflects closeness of substitutes or complements Able to identify your closest competitors Courts use cross-price to measure monopoly power

Transaction Costs of Exchange Information Costs –Search Costs –Quality Identification Cost Negotiating Costs: Cost of agreeing on what and how much will be exchanged Transportation Costs: Cost of moving goods between parties 34