Advanced Topics

Elasticity and Equilibrium Price Changes

Changes in Equilibrium When events cause a supply or demand curve to shift, the equilibrium price will shift. But how much? Knowledge of elasticities can provide the answer to this question.

Quantitative Changes Equilibrium Effects

Negative Supply Shock Negative supply shock like embargo on Iranian oil would raise prices and reduce quantity of oil available. – But how much? Clearly depends on the supply

Equilibrium Change in Price A 1% shift out in the demand curve leads to a change in equilibrium price. A 1% shift out in the supply curve leads to a change in equilibrium price.

Example 1 Elasticity of demand for oil is e D = and elasticity of supply is e S =.04. World oil demand goes up by 1%. How much does the price change? Answer:

Example 2 What would happen to oil prices for Geo- Political reasons there were a shut-down of Iranian oil production and there was an inward shift in the oil supply curve of 4.9%?

A shift in the supply schedule ( Spreadsheet ) A 4.9% shift in the supply schedule At the new supply curve there is excess demand for oil. Excess demand will induce additional supply and cut back in demand. What is the new equilibrium?

Example 3 The cross price elasticity of bacon with respect to eggs is -.2. The elasticity of demand for bacon is -.5. The elasticity of supply for bacon is.5. The price of eggs goes up by 1%. What happens to the price of bacon?

Example What would the oil price change be in the long run, if world income went up permanently by 10% and no shift in supply curve?

Excise Tax

Own Price Elasticity Matters as well. A less important effect is that the steepness of the demand curve will also impact the size of a demand shift. The steepness of the supply curve will impact the size of a supply shift.

. P Q Q*Q* P* D1 Steeper (less elastic) demand curve means that a demand shift will have a bigger impact on both price and quantity. D2 Q1 ** P1** Q2 ** P2** D1’ D2’ 1 0 2

. P Q Q*Q* S1 P* D Steeper (less elastic) supply curve means that a supply shift will have a stronger impact on quantity and bigger impact on price. S2 Q1 ** P1** Q2 ** P2** S2’ S1’ 1 0 2

Gains from Trade Advanced Topic

Market System A free market allows people to sell goods that they value relatively little to buyers who value them more. A price can be obtained between buyers and sellers valuations at which they can both benefit. You own shares of stock that you think are worth $5 and someone else thinks are worth $9 per share. If you sell them at $7 both the buyer and the seller are happy.

Demand Curves are Valuation Curves To measure the benefits of the market, economists invert the meaning of the demand curve. Standard definition of the demand curve: how many units of Q will buyers want at price P. Inverted definition: What is the maximum price that buyers are willing to pay to buy the Qth unit of the good. Implication: What is the value that the consumer places on the Qth good.

. P Q Maximum that the buyer on the fence will pay to for Q 1 th good is P 1 Q1Q1 P1DP1D D Demand curve

Supply Curves are Valuation Curves To measure the benefits of the market, economists invert the meaning of the supply curve. Standard definition of the supply curve: how many units of Q will sellers want at price P. Inverted definition: What is the minimum price that sellers are willing to accept for the Qth unit of the good. Implication: What is the value that the seller places on the Qth good.

. P Q Maximum that the buyer on the fence will pay to for Q 1 th good is P 1 Q1Q1 P1SP1S S Supply curve

Equilibrium Price Price will be between the value that the seller places on the Qth good and what the buyer places on the same good. Both buyer and seller benefit. We can calculate exactly how much each benefits by comparing the value they place on the good vs. either the price they pay for it or sell it for. The gains from trade on the final good Q * is zero.

. P Q Q1Q1 P1SP1S S Gains from Trade of selling Q 1 is [P 1 D – P 1 S ]. Buyers Benefit is [P 1 D – P * ]. Sellers benefit is [P*- P 1 S ]. P* P1DP1D D

Surplus The sum total of gains from trade is the sum of the benefits from each good. This sum of gains of trade, called surplus, can be divided into two parts…consumer surplus and producer surplus.

. P Q Q1Q1 S Sum of the benefits from all goods.

. P Q Q1Q1 S Represented as a triangle

. P Q Q1Q1 S Triangle can be split into two triangles, total consumer benefit and total producer benefit. P* Consumer Surplus Producer Surplus