Or, how I learned to love percentages

Direction of Change versus Sensitivity A summary of the all of the determinants of demand and supply are given in their respective functions. These functions assist in distinguishing between a movement from a shift of a curve AND the direction of change for each of the determinants. To increase the explanatory power of the demand and supply model, and to make it more interesting, we need to not only know the direction of change but how much each of the determinants affects demand and supply. This concept of responsiveness is called elasticity.

Measuring Responsiveness or Sensitivity The initial candidate for measuring sensitivity is the concept of slope. Slope tells us the change in the quantity demanded or demand from a change in one of its determinants (i.e. ΔQ d /ΔP in the case of prices) The problems with slope are: Slope is unit dependent. If the units in which the currency (dollars to pesos) or quantity changes (boxes of apples to individual apples) it will change the slope. For example, the change from dollars to pesos will decrease the slope. Slope gives no indication of the beginning point. It also doesn’t tell us where we started (e.g. a stock goes up by a $1. A large increase if the purchases price was $1 a small increase if the purchase price was $1,000) Therefore, we use percentage changes. Percentages are not unit dependent. If the measure of quantity is changed from boxes to individual apples the percentage change will remain the same. Percentages always refer to a starting point. Since percentage are always taken from a starting point, the base, they better measure the extent of change. We will return to this point shortly when we calculate elasticities along a straight-line (constant slope) demand curve.

Various Elasticities Ep = Price elasticity of demand = %change in quantity demanded/% change in price Ey = Income elasticity of demand = %change in demand/% change in income Ex =Cross-price elasticity of demand = %change in demand/% change in the price of a related good Or, any other elasticity is simply the %change in something/% change in something else

An Intuitive Approach to Elasticity Since price elasticity of demand (Ep) is always negative (law of demand) we ignore the negative sign and take the absolute value of price elasticity. %ΔQ d = Output Effect and %ΔP = Price Effect E p > 1 or Elastic %ΔQ d > %ΔP a given %ΔP creates a larger %ΔQ d or Output Effect > Price Effect Quantity demanded is sensitive to price. If price falls slightly, quantity demanded will increase by a large amount, or vice versa. E p < 1 or Inelastic %ΔQ d < %ΔP a given %ΔP creates a smaller %ΔQ d or Output Effect < Price Effect Quantity demanded is not sensitive to price. If price falls significantly, quantity demanded will increase slightly, or vice versa. E p = 1 or Unit Elastic %ΔQ d = %ΔP a given %ΔP creates an equal %ΔQ d or Output Effect = Price Effect If price falls, quantity demanded will increase by the same relative amount, or vice versa. Note, in the above descriptions percentages are a easier and clearer way of explaining sensitivity.

Using Elasticity: The Relationship between P, Q and TR As P ↑ the law of demand tells us that Q ↓. What happens to TR is not clear (P ↑ x Q ↓ = TR ?) The increase in price, the price effect, increases TR, ceteris paribus, but the decrease in quantity demanded, the output effect, ceteris paribus, would increase would TR. So, change in TR hinge about the relative strength of the price and output effects. Elasticity provides the key because it tells us the size of the price and output effect. The strength of the price effect is measured by the %ΔP and that of the output effect by the %ΔQ d. For example, if the %ΔP = 5% and the %ΔQd =10%, the output effect is larger that the price effect. So if P ↓ the Q ↑ will strong enough to cause TR ↑. Second example, For example, if the %ΔP = 10% and the %ΔQd =5%, the price effect is larger that the output effect. So, the P ↓ will be stronger than the Q ↑ and TR ↓.

Summary of P, Q and TR E p > 1 Responsive or elastic %ΔQ d > %ΔP or Output Effect > Price Effect - if P goes down (up) total revenue goes up (down) E p < 1 Not responsive or inelastic %ΔQ d < %ΔP Output Effect < Price Effect - if P goes down (up) total revenue goes down (up) E p = 1 unit elastic %ΔQ d = %ΔP Output Effect = Price Effect - if P goes down (up) total revenue stays the same

Figure 2 Total Revenue Copyright©2003 Southwestern/Thomson Learning Demand Quantity Q P 0 Price P × Q = $400 (revenue) $4 100

Figure 2 Total Revenue Demand Quantity Q 0 Price $4 100 $3 120 P↓ -$1 Q =100→∆TR = -$100 $300 Q↑ +20 P=$3 → ∆TR= $+60 Price Effect Output Effect

E>1 E=1 E<1 As P↓ and Q↑ the P base is smaller so the price effect grows. As P↓ and Q↑ the Q base is larger so the output effect shrinks.

Determinants of Price Elasticity Availability of close substitutes Necessity versus luxury Definition of the market Time horizon Percentage of consumer budget

Elasticity of Other Demand Curves Perfectly Elastic Perfectly Inelastic Unit Elastic

Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Quantity 0 Price $4 Demand 2. At exactly $4, consumers will buy any quantity. 1. At any price above $4, quantity demanded is zero. 3. At a price below $4, quantity demanded is infinite.

Figure 1 The Price Elasticity of Demand Copyright©2003 Southwestern/Thomson Learning (a) Perfectly Inelastic Demand: Elasticity Equals 0 $5 4 Quantity Demand An increase in price leaves the quantity demanded unchanged. Price

Figure 6 The Price Elasticity of Supply Copyright©2003 Southwestern/Thomson Learning (e) Perfectly Elastic Supply: Elasticity Equals Infinity Quantity 0 Price $4 Supply 3. At a price below $4, quantity supplied is zero. 2. At exactly $4, producers will supply any quantity. 1. At any price above $4, quantity supplied is infinite.

Other Demand Elasticities Income Elasticity of Demand - Sign is important: Normal Good E Y >0 Inferior Good E Y <0 E Y >1 Income-elastic and a luxury good because as Y ↑ the % of Y spend on the good (TE/Y) ↑ E Y <1 Income-inelastic and a necessity because as Y ↑ the % of Y spend on the good (TE/Y) ↓ EY=1 Income-unit elastic because as Y ↑ the % of Y spend on the good (TE/Y) stays constant Cross-price Elasticity – Sign is important: Substitute E x >0 (P R ↑ Q R ↓ Q ↑ ) Complement Ex<0 (P R ↑ Q R ↓ Q ↓ )

Elasticity of Supply Price elasticity of supply = %change in quantity supplied/% change in price E s = %ΔQ s / %ΔP = (Q 2 - Q 1 )/[(Q 2 + Q 1 )/2] (P 2 - P 1 )/[(P 2 + P 1 )/2] Perfectly elastic and inelastic supply Relatively elastic, relatively inelastic and unit elastic (crossing the Q or P axis or the origin) Supply curves where elasticity varies

Figure 6 The Price Elasticity of Supply Copyright©2003 Southwestern/Thomson Learning (a) Perfectly Inelastic Supply: Elasticity Equals 0 $5 4 Supply Quantity An increase in price leaves the quantity supplied unchanged. Price

Figure 6 The Price Elasticity of Supply Copyright©2003 Southwestern/Thomson Learning (b) Inelastic Supply: Elasticity Is Less Than $ Quantity 0 1. A 22% increase in price... Price leads to a 10% increase in quantity supplied. Supply

Figure 6 The Price Elasticity of Supply Copyright©2003 Southwestern/Thomson Learning (d) Elastic Supply: Elasticity Is Greater Than 1 Quantity 0 Price 1. A 22% increase in price leads to a 67% increase in quantity supplied $5 200 Supply

Figure 6 The Price Elasticity of Supply Copyright©2003 Southwestern/Thomson Learning (c) Unit Elastic Supply: Elasticity Equals $ Quantity 0 Price leads to a 22% increase in quantity supplied. 1. A 22% increase in price... Supply

Determinants of elasticity of supply Ability to increase or decrease production (e.g Ellensburg agates, farm crops, automobiles) Time period

Applications of Elasticity Farmers : fallacy of composition and good crop/bad revenue years The economics of addictive drugs Pricing decisions and your future business Getting to Mr./Ms. Rich: Luxury Tax on Yachts

Consumer, Producer and Markets

Efficiency Defined Overall: Greatest human satisfaction from scarce resources. Allocative Efficiency – resources are dedicated to the combination of goods and services that best satisfy consumer wants Production Efficiency – goods and services are produced using the least cost combination of resources and technology Dynamic Efficiency – how the economy over time promotes allocative and productive efficiency

Efficiency: Positive versus Normative Perspectives Positive – an objective analysis of how economic variables are related Normative – a prescriptive analysis to help determine what ought to be. Welfare economics – the study of how the allocation of resources affects economic well-being.

Problem of Revealed Preference Economic agents, unlike many variables in other sciences, are not passive. Therefore, it is difficult to measure willingness to pay. Normal Auction – Ascending price with sale to the highest bidder. May yield the person who most highly values the item, but does not measure their maximum willingness to pay. Dutch Auction – Descending Price with sale to first bidder. May yield the person who most highly values the good and the maximum willingness to pay.

Measuring Economic Welfare: Consumer Surplus So far, we have demonstrated that people maximize total net benefits from an activity at the point where MB=MC Marginal benefits are equal to the (max.) willingness to pay and decline as quantity demanded increase because of the law of diminishing marginal utility (jelly bean example). Since consumer as price takers in competitive markets, the price equals the marginal costs to consumers. Consumer surplus equals willingness to pay minus the price, which is the same as net benefits we have discussed before.

Using the demand curve to measure consumer surplus Before: giving a price and finding the corresponding quantity demanded Now: giving the quantity and finding the amount people are willing to pay for a good or go without it MB=MC occurs where price intersects the demand curve and total net benefits=consumer surplus is maximized. Cool, no!

Using the Individual Demand and Supply Curves to Determine Values and Costs The demand curve is usually ready as – at a given price how much will a consumer buy. The maximum willingness to pay is just the buyer value in Aplia and our measure of the MB. Consumer surplus is the difference between what the consumer is willing to pay and the price(s) that they have to pay. Note that, if the demand curve is the marginal benefit curve and the price is the marginal cost, consumer equilibrium is nothing more that MB=MC and we are back to the stack of boxes example.

The supply curve is usually ready as – at a given price how much will a firms sell. The minimum willingness to sell is just the seller cost in Aplia and our measure of the MC. Producer surplus is the difference between the price(s) sellers receive and minimum willingness to sell or MC. Note that, if the supply curve is the marginal cost curve and the price is the marginal benefit, the seller equilibrium is nothing more that MB=MC and we are back to the stack of boxes example.

Figure 2 Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (a) Price = $80 Price of Album $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20)

Figure 2 Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (b) Price = $70 Price of Album $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10)

Figure 3 How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C

Figure 3 How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Initial consumer surplus Quantity (b) Consumer Surplus at Price P Price 0 Demand A B C DE F P1P1 Q1Q1 P2P2 Q2Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers

Producer Surplus Consumer surplus measures the difference between the (max.) willingness to pay and the price. Producer surplus measure the difference between the (min.) needed to be willing to sell and the price.

Remember, the Law of Diminishing Marginal Returns causes marginal costs to rise in the short- run as output increases. As more the the variable input is added to the fixed input, its marginal product eventually begins to diminish (production exercise in class). If all workers are paid the same wage, the LDMR implies that the extra (marginal) costs of producing extra (marginal) outputs increases.

If the seller is a price taker, they receive the same price for very output sold. So the difference between the price and the marginal cost (the willingness to sell) is the: Producer Surplus

Figure 4 The Supply Schedule and the Supply Curve

Figure 5 Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (a) Price = $600 Supply Grandma’s producer surplus ($100)

Figure 5 Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply

Figure 6 How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

Figure 6 How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Quantity (b) Producer Surplus at Price P Price 0 P1P1 B C Supply A Initial producer surplus Q1Q1 P2P2 Q2Q2 Producer surplus to new producers Additional producer surplus to initial producers D E F

Competitive Markets and Efficiency Assume competitive markets (many buyers and sellers, identical products, free entry and exit, price takers, etc.) Assume that consumer surplus measures consumers economic well-being and producer surplus that of sellers. So, MB = willingness to pay by consumers and MC = willingness to sell to producers

MB=MC Occurs where the demand and supply curve intersect, and Total Well-being is Maximized

Figure 7 Consumer and Producer Surplus in the Market Equilibrium Copyright©2003 Southwestern/Thomson Learning Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

Figure 8 The Efficiency of the Equilibrium Quantity Copyright©2003 Southwestern/Thomson Learning Quantity Price 0 Supply Demand Cost to sellers Cost to sellers Value to buyers Value to buyers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. Equilibrium quantity

Efficiency Competitive markets result in the combination of goods and services that maximize consumer well- being (allocative efficiency) and produce goods at least possible cost (production efficiency). Over time, competitive forces will move to promote allocative and production efficiency (dynamic efficiency).

Economic Efficiency and the Liberal Revolution Adam Smith, building on the work of other philosophers, was the first to develop a comprehensive argument for the efficiency of markets. The efficiency of markets has proven a powerful force in altering historical perspectives on effective ways humans can interact. The revolutionary idea that the pursuit of self-interest, tempered by competition, promotes social interest is the basis for the tremendous economic growth of the last century.

Case Studies A market for transplantable organs Current price is zero and there is a shortage of transplantable organs Allowing companies to contract with individuals to donate organs for a price would likely increase the supply of organs Positive versus normative considerations Pilgrims, communal agriculture, and starvation

Figure 8 An Increase in Supply in the Market for Wheat Copyright©2003 Southwestern/Thomson Learning Quantity of Wheat 0 Price of Wheat and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. Demand S1S1 S2S leads to a large fall in price When demand is inelastic, an increase in supply $3 100