Chapter 5 Applications of Supply and Demand

Elasticity The responsiveness of quantities demanded and supplied to changes in price If price changes, how much more or less is purchased and supplied

Price Elasticity of Demand Coefficient of demand elasticity = change in quantity demanded average quantity demanded change in price average price or E d =  Q d/Av. Qd  P /Av. P

Price Elasticity of Demand Example: Price drops from $10 to $6, Quantity Demanded increase from 20 to 30 Ed = (30-20) / 25 = 0.4 = 0.8 (10-6) / 0.5 Quantity demanded increased by less than the price dropped

Price Elasticity of Demand Rules for Coefficients over the price ranges: If Ed < 1 Demand is inelastic businesses will raise price to increase revenue If Ed = 1 Demand has unitary elasticity If Ed > 1 Demand is elastic businesses will lower price to raise revenue

Factors Affecting Demand Elasticity Availability of substitutes – demand is more elastic with more substitutes Nature of the item – necessities are more inelastic Fraction of income spent on item – expensive items are more elastic Amount of time available – more time leads to more elasticity

Elasticity of Supply How responsive is a seller to a rise or fall in price coefficient =  Quantity Supplied/Average Supply  Price/Average Price Same rules apply for inelastic, unitary and elastic supply as for demand

Factors Affecting Supply Elasticity Time – suppliers can’t change supply in the short run but can over time Ease of Storage – increases elasticity if easy to do Cost Factors – overtime in the short run but some industries need new capital, others don’t (e.g. cds)

Utility Theory Alfred Marshall suggested we buy to satisfy needs and wants using utility or usefulness Marginal utility is the extra satisfaction we get from buying one more unit we buy products until our marginal utility is equal formula: MU/Price A = MU/Price B at that point we’re in consumer equilibrium explains the demand curve: as we buy more the extra satisfaction declines and we’re willing to pay less

Adam Smith’s Paradox of Value Why are diamonds worth more than water? Answer: the total utility from water is greater but the marginal utility of diamonds is much greater

Consumer Surplus the extra value amount consumers get based on what they are willing to pay over what they do pay it ends when our demand stops (A below)

Government Intervention Ceiling prices: below equilibrium, leads to shortage and possible black market Floor Prices: above equilibrium, leads to surplus Subsidy: is financial help to producers; leads to increased supply but taxes are needed and inefficient producers kept in business Quotas: restrictions on supply to keep more producers in business; marketing boards keep prices higher

Government Intervention Rent Controls are a ceiling on price below the market equilibrium Landlords may charge additional sums, allow buildings to be run down

Government Intervention Minimum Wages: price for labour higher than equilibrium leads to a surplus of workers