1 Supply & Demand Elasticity & Government Set Prices Chapter 7

2 Price Elasticity of Demand Measured by the responsiveness of consumers to a price change. Formula: % change in quantity demanded % change in price

3 Elimination of Minus Sign Price and quantity have an inverse relationship When using the elasticity formula, it will be a negative number. Ignore the minus sign to avoid any ambiguity

4 Elastic Demand Demand is elastic if % change in price results in a larger % change in quantity demanded Formula results in a number greater than 1

5 Inelastic Demand Demand is inelastic if % change in price produces a smaller % change in demand Formula results in a number less than 1

6 Unit Elastic Demand % change in price and % change in demand are the same Formula equals 1

7 Extreme Cases Perfectly inelastic- price change results in no change in quantity demanded Perfectly elastic- small price reductions cause buyers to increase their purchases from zero to all they can obtain

8 Midpoint Formula Change in quantity÷change in price Sum of quantitiessum of prices

9 QuantityPriceTotal Revenue (Price X Qty) ElasticityE, I, or U 18$

10 Total-Revenue Test Total revenue- total amount sellers receive from sale of a product Price X Quantity sold Total revenue test looks at what happens to total revenue when product price changes

11 Summary Absolute Value Demand Is: Description Impact on TR of a Price increase Impact on TR of a Price decrease >1Elastic Qd changes by a larger % than does price TR decreases TR increases =1Unit ElasticQd changes by the same % as price TR is unchanged <1InelasticQd changes by a smaller % than price TR increasesTR decreases

12 Price Elasticity & Total Revenue Curve Comparison of curves D and TR shows relationship between elasticity and total revenue

13 Determinants of Price Elasticity of Demand Substitutability Proportion of Income Luxuries vs. Necessities Time

14 Price Elasticity of Supply If producers are responsive to a price change, supply is elastic & vice versa Formula: % change in quantity supplied % change in price

15 Cross Elasticity of Demand Measures how sensitive consumer purchases of one product are to a change in price of some other product Formula % change in qty demanded for product x % change in price of product y

16 Income Elasticity of Demand Formula % change in quantity demanded % change in income Measures the responsiveness of consumers to changes in income and the impact it has on demand

17 Government Set Prices Price ceiling- maximum legal price a seller may charge Rationale – enable consumers to obtain an “essential” product that they could not afford at equilibrium.

18 Black Markets Products are bought and sold at prices above the legal limits. Buyers are willing to pay more than the ceiling price which allows companies to make more profits.

19 Price Floors & Surpluses Minimum prices fixed by the government. A price at or above the price floor is legal. Examples include farm products that are already sold at low prices. Government raises the price to assist farmers to earn higher incomes.