Copyright 2008 The McGraw-Hill Companies 18 Extensions of Demand and Supply Analysis

Copyright 2008 The McGraw-Hill Companies Chapter Objectives Price Elasticity of Demand and How It Can Be Applied The Usefulness of the Total Revenue Test for Price Elasticity of Demand Price Elasticity of Supply and How It Can Be Applied Cross Elasticity of Demand and Income Elasticity of Demand Consumer Surplus, Producer Surplus, and Efficiency Losses

Copyright 2008 The McGraw-Hill Companies What is Elasticity? A term economists use to describe sensitivity or responsiveness: for example, how sensitive is quantity demanded to a change in price?

Copyright 2008 The McGraw-Hill Companies The percentage change in quantity demanded divided by the percentage change in price How do we measure the Price Elasticity of Demand?

Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Price-Elasticity Coefficient and Formula Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X E d = O 18.1

Copyright 2008 The McGraw-Hill Companies Notes on E d E d negative, but ignore negative use of % change-not affected by units of measurement

Copyright 2008 The McGraw-Hill Companies Classifying E d E d = 1 Unitary elasticity E d > 1 Elastic demand E d < 1 Inelastic demand

Copyright 2008 The McGraw-Hill Companies Extreme elasticities E d = 0 Perfectly inelastic (vertical demand curve) E d =  Perfectly elastic (horizontal demand curve)

Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Extreme Cases Perfectly Inelastic Demand Perfectly Elastic Demand 0 P Q P 0 Q D1D1 D2D2 Perfectly Inelastic Demand (E d = 0) Perfectly Elastic Demand (E d = ∞)

Copyright 2008 The McGraw-Hill Companies Problem - When we move along a demand curve between two points, we get different answers to elasticity depending if we are moving up or down the demand curve Calculating Elasticities

Copyright 2008 The McGraw-Hill Companies If there is an increase from 3 units to 5, what is the percentage increase? If there is an increase from 3 units to 5, what is the percentage increase? 2/3 = 66%

Copyright 2008 The McGraw-Hill Companies If there is a decrease from 5 units to 3, what is the percentage decrease? 2/5 = 40%

Copyright 2008 The McGraw-Hill Companies One way to deal with this problem is to work with averages...

Copyright 2008 The McGraw-Hill Companies Price Elasticity of Demand Using Averages Midpoint Formula W 18.1 Change in Quantity E d = Sum of Quantities/2 ÷ Change in Price Sum of Prices/2

Copyright 2008 The McGraw-Hill Companies Practice: calculating E d You usually buy 4 cd’s per month at a price of $14, but when the price rises to $18, you purchase only 3 per month. What is your elasticity of demand for cd’s over this range of prices?

Copyright 2008 The McGraw-Hill Companies Elasticity and Total Revenue (TR) TR = PQ, price times quantity E d = % change in Q % change in P

Copyright 2008 The McGraw-Hill Companies Summary, elasticity, price changes, and total revenue E d = 1 Total revenue same E d > 1 Total revenue fallsTotal revenue rises E d < 1 Total revenue risesTotal revenue falls Price increase Price Decrease

Copyright 2008 The McGraw-Hill Companies $ Q P The Total Revenue Test Total Revenue (TR) TR = P x Q Elastic Demand a b D1D1 W 18.2

Copyright 2008 The McGraw-Hill Companies $ Q P The Total Revenue Test Total Revenue (TR) TR = P x Q Inelastic Demand c d D2D2 W 18.2

Copyright 2008 The McGraw-Hill Companies $ Q P The Total Revenue Test Total Revenue (TR) TR = P x Q Unit-Elastic e f D3D3 W 18.2

Copyright 2008 The McGraw-Hill Companies Elasticity on a Linear Demand Curve $8,000 14,000 18,000 20,000 18,000 14,000 8,000 Elastic Unit Elastic Inelastic (1) Total Quantity of Tickets Demanded Per Week, Thousands (2) Price Per Ticket (3) Elasticity Coefficient (E d ) (4) Total Revenue (1) X (2) (5) Total-Revenue Test ] ] ] ] ] ] ] ] ] ] ] ] ] ] Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test Graphically… G 18.1

Copyright 2008 The McGraw-Hill Companies Price Elasticity and the Total-Revenue Curve Quantity Demanded Price Total Revenue (Thousands of Dollars) $ $ a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR

Copyright 2008 The McGraw-Hill Companies Determinants of Price Elasticity of Demand Substitutability Proportion of Income Luxuries versus Necessities Time

Copyright 2008 The McGraw-Hill Companies The more substitutes a good has, the more elastic demand for the product is. What do substitutes have to do with elasticity?

Copyright 2008 The McGraw-Hill Companies The lower the % of ones budget a good is, the less sensitive consumers are to a price change, thus the more inelastic the demand. What does % of income a good makes up have with elasticity?

Copyright 2008 The McGraw-Hill Companies In general, luxuries have a more elastic demand, necessities a more inelastic demand. What do luxuries vs. necessities have to do with elasticity?

Copyright 2008 The McGraw-Hill Companies Price Elasticity of Supply O 18.2 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s =

Copyright 2008 The McGraw-Hill Companies E s = %  Q supplied %  Price E s = 1 Unitary E s > 1 Elastic E s < 1 Inelastic

Copyright 2008 The McGraw-Hill Companies Extreme cases of E s E s = 0, perfectly inelastic (vertical supply curve E s = , perfectly elastic (horizontal supply curve)

Copyright 2008 The McGraw-Hill Companies Elasticity of Supply Time periods important: Market period: vertical supply curve, too short of a time to alter amount supplied Short run: too short to change plant capacity but can use existing capacity more or less intensively. Supply becomes somewhat more elastic Long run: long enough time for firms to change plant sizes, new firms to enter or leave, etc. making for more elastic supply

Copyright 2008 The McGraw-Hill Companies Cross Elasticity of Demand Substitute Goods – Positive Sign Complementary Goods- Negative Sign Independent Goods – Zero or Near-Zero Value Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y E xy =

Copyright 2008 The McGraw-Hill Companies Income Elasticity of Demand Normal Goods – Positive Sign Inferior Goods- Negative Sign Among normal goods, basic necessities often have low income elasticities, while luxuries have higher income elasticities. Percentage Change in Quantity Demanded Percentage Change in Income E i =

Copyright 2008 The McGraw-Hill Companies Elasticity of demand Applications: –Large Crop Yields –Excise Taxes –Decriminalization of Illegal Drugs

Copyright 2008 The McGraw-Hill Companies Price Elasticity of Supply Applications –Antiques and Reproductions –Volatile Gold Prices

Copyright 2008 The McGraw-Hill Companies What is Consumer Surplus? The difference between the maximum amount that a consumer is willing to pay for something and what he actually pays

Copyright 2008 The McGraw-Hill Companies Consumer Surplus Graphically, we approximate CS as the area under the demand curve but above the market price.

Copyright 2008 The McGraw-Hill Companies P Q Consumer Surplus 37

Copyright 2008 The McGraw-Hill Companies Consumer and Producer Surplus Consumer Surplus D Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Consumer Surplus Equilibrium Price = $8 O 18.3

Copyright 2008 The McGraw-Hill Companies What happens to Consumer Surplus as Market Price changes? It increases when price falls and falls when prices increase

Copyright 2008 The McGraw-Hill Companies Consumer and Producer Surplus Producer Surplus S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Producer Surplus Equilibrium Price = $8

Copyright 2008 The McGraw-Hill Companies Producer Surplus Producer surplus is the difference between the actual price a producer receives and the minimum acceptable price: approximated by the area below the actual price but above the supply curve.

Copyright 2008 The McGraw-Hill Companies Consumer and Producer Surplus Efficiency Revisited D S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Consumer Surplus Producer Surplus Equilibrium Price = $8 W 18.3

Copyright 2008 The McGraw-Hill Companies Consumer and Producer Surplus Efficiency Revisited D S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Efficiency Losses Q2Q2 Q3Q3 Efficiency Losses (Deadweight Losses)

Copyright 2008 The McGraw-Hill Companies Elasticity and Pricing Power: Last Word Why Different Consumers Pay Different Prices All Buyers in a Highly Competitive Market Pay the Same Price Regardless of Their Elasticities Difficulty in Applying Different Prices Observe Differences in Group Elasticities –Business Travelers –Leisure Travelers –Discounting for Children –Different Net Prices for College Tuition

Copyright 2008 The McGraw-Hill Companies Key Terms price elasticity of demand midpoint formula elastic demand inelastic demand unit elasticity perfectly inelastic demand perfectly elastic demand total revenue test (TR) total-revenue test price elasticity of supply market period short run long run cross-elasticity of demand income elasticity of demandincome elasticity of demand consumer surplus producer surplus efficiency losses (deadweight losses)efficiency losses (deadweight losses)