1. Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 4 EXTENSIONS OF DEMAND AND SUPPLY ANALYSIS AND THE EFFICIENCY OF MARKETS Part Two: Microeconomics of Product Markets

2. ©2007 McGraw-Hill Ryerson Ltd.Chapter 42 In this chapter you will learn: 4.1 About price elasticity of demand and how it can be applied 4.2 The usefulness of the total revenue test for price elasticity of demand 4.3 About price elasticity of supply and how it can be applied 4.4 About cross elasticity of demand and income elasticity of demand 4.5 To apply the concept of elasticity to various real-world situations 4.6 About consumer surplus, producer surplus, and efficiency losses

3. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.13 Price Elasticity of Demand THE LAW OF DEMAND SAYS… An increase in price causes a decrease in quantity demanded (and vice-versa) But HOW MUCH does quantity demanded change in response to a change in price? Elasticity gives us a measure of RESPONSIVENESS

4. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.14 Price Elasticity of Demand When Q D responds STRONGLY to a change in P, demand is ELASTIC When Q D responds WEAKLY to a change in P, demand is INELASTIC

5. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.15 Calculate the average: If the quantity demanded increased from 4 to 5 units %ΔQ d = ΔQ d /Q 0 = ¼ x 100 = 25% The Price Elasticity Coefficient and Formula If the price dropped $5 to $4 %ΔP = ΔP/P 0 = 1/5 x 100 = 20%

6. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.16 Price Elasticity of Demand Average price and quantity –avoids confusion about start and end points

7. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.17 The Price Elasticity Coefficient and Formula Price elasticity of demand: –Use of Percentages –Elimination of the Minus Sign Interpretation of E d : –Elastic Demand –Inelastic Demand –Unit Elasticity –Extreme Cases

8. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.28 The Total-Revenue Test Total revenue (TR) –TR = P x Q TR and E d are related –If TR changes in the opposite direction from price, demand is elastic –If TR changes in the same direction from price, demand is inelastic –If TR does not change when price changes, demand is unit elastic

9. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.29 P D P2P2P2P2 P1P1P1P1 Q2Q2Q2Q2 Q1Q1Q1Q1 Quantity is very responsive to a change in price Q Elastic Demand When P changes from P1 to P2, TR increases

10. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.210 Quantity is NOT very responsive to a change in price P D P2P2P2P2 P1P1P1P1 Q2Q2Q2Q2 Q1Q1Q1Q1 Q Inelastic Demand When P changes from P1 to P2, TR decreases

11. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.211 % change in quantity is equal to % change in price P D P2P2P2P2 P1P1P1P1 Q2Q2Q2Q2 Q1Q1Q1Q1 Q Unit Elastic When P changes from P1 to P2, TR does not change

12. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.212 Price Elasticity along a Linear Demand Curve For all straight-line and most other demand curves –demand is more elastic toward the upper left –demand is less elastic toward the lower right

13. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.213 The Total-Revenue Test TR = P X Q What happens to total revenue when product price changes?

14. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.214 Table 4-1 E d and Total Revenue QdQd PEdEd TR 188,000 2714,000 3618,000 4520,000 54 6318,000 7214,000 818,000 5.00 2.60 1.57 1.00 0.64 0.38 0.20 ELASTIC DEMAND: when price decreases, total revenue increases ELASTIC DEMAND: when price decreases, total revenue increases INELASTIC DEMAND: when price decreases, total revenue decreases INELASTIC DEMAND: when price decreases, total revenue decreases UNIT ELASTIC DEMAND: when price decreases, total revenue stays the same UNIT ELASTIC DEMAND: when price decreases, total revenue stays the same

15. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.215 D D TR ElasticUnit Elastic Inelastic TR Increases TR Decreases Max TR

16. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.216 Determinants of E d Substitutability Proportion of Income Luxuries versus Necessities Time

17. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.217 Applications of E d Large Crop Yields Sales Taxes Decriminalization of Illegal Drugs Minimum Wage

18. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.318 Es=Es=Es=Es= Percentage change in quantity supplied of product X Percentage change in the price of product X Price Elasticity of Supply The main determinant of E s is the amount of time producers have for responding to a change in product price

19. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.319 Immediate Market Period PoPoPoPo P Q D1D1D1D1 QoQoQoQo An increase in demand without enough time to change supply causes... SmSmSmSm Figure 4-4 Time and the Elasticity of Supply PmPmPmPm D2D2D2D2 A Large Increase in Price - Perfect Inelastic Supply

20. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.320 Short Run PoPoPoPo P Q D1D1D1D1 An increase in demand with some supply response will cause... SsSsSsSs PmPmPmPm QoQoQoQo Time and the Elasticity of Supply PsPsPsPs D2D2D2D2 QsQsQsQs An Increase in Price - More elastic Supply

21. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.321 Long Run PoPoPoPo P Q D1D1D1D1 An increase in demand in the long run allows a greater supply response.... SLSLSLSL PmPmPmPm QoQoQoQo Time and the Elasticity of Supply PLPLPLPL D1D1D1D1 QLQLQLQL D2D2D2D2 A small Increase in Price - More elastic Supply

22. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.322 Applications of Price Elasticity of Supply Antiques and Reproductions Volatile Gold Prices

23. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.423 E xy = Percentage change in quantity demanded of product X Percentage change in the price of product Y Substitute Goods -positive sign Complementary Goods -negative sign Independent Goods -near zero Cross Elasticity of Demand

24. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.424 Cross Elasticity of Demand Applications Coca-Cola vs. Sprite Assessing competition

25. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.425 E i = Percentage change in quantity demanded Percentage change in income Normal Goods -positive sign Inferior Goods -negative sign Insights Income Elasticity of Demand

26. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.526 Figure 4-5 The Incidence of a Tax Tax of $2 per unit S shifts up $2 Equilibrium price rises to $9 Consumer’s burden is the amount of the price increase = $1 Firm’s burden = tax-consumer’s burden =$2 - $1 = $1 $2$2$2$2$9

27. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.527 Figure 4-6 Demand Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and elastic demand P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Producer bears most of the tax burden

28. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.528 Demand Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and inelastic demand P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Consumer bears most of the tax burden

29. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.529 Figure 4-7 Supply Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and elastic supply P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Consumer bears most of the tax burden

30. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.530 Supply Elasticity and the Incidence of a Tax D SSSSSSSS Tax incidence and inelastic supply P1P1P1P1 Q1Q1Q1Q1 S Q0Q0Q0Q0 P0P0P0P0 PaPaPaPa TAX Producer bears most of the tax burden

31. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.531 The Economics of Agricultural Price Supports Net income stabilization Supply management programs: –dairy, poultry products, and eggs –Canadian Wheat Board

32. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.532 Offers to Purchase Surplus Output –misallocation of resources –higher taxes Loss to Consumers –higher prices –higher taxes Gain to Farmers

33. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.533 D D S S PePePePe The result of imposing a floor (support) price is a...P Q QeQeQeQe PSPSPSPS Support price Figure 4-8 Price Supports and Supply Restriction – Offers to Purchase SURPLUS Government must purchase this amount

34. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.534 Deficiency Payments Subsidies to make up the difference between the market price and government-supported price Elasticity of supply & demand –effect of elasticity the same as that of a sales tax

35. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.535 D S S PePePePe At price P S, farmers Increase output from Q e to Q S P Q QeQeQeQe PSPSPSPS QsQsQsQs P0P0P0P0 D Figure 4-8 Deficiency Payments Government must pay farmers this amount S S Supply curve (consumer)

36. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.536 Comparison Farmers benefit equally from offers to purchase and deficiency payments Consumers prefer deficiency payments, because of lower prices When subsidies are taken into account, total payments by the public are identical

37. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.537 Resource Overallocation Both approaches encourage overallocation of resources to agriculture Efficiency loss

38. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.538 Supply Restrictions Crop restrictions Quotas With highly price-elastic supply, offers to purchase or deficiency payments result in surpluses higher than original quantity demanded Supply restriction is the only option

39. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.539 D PePePePe PrPrPrPr QeQeQeQe QrQrQrQr QfQfQfQf P Q SURPLUS D S SfSf Figure 4-8 Supply Restrictions SfSf All costs are borne by con- sumers

40. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.640 Consumer and Producer Surplus Consumer surplus –is the benefit surplus received by a consumer or consumers in a market –is the difference between the maximum price a consumer is willing to pay for a product and the actual price

41. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.641 Figure 4-9 Consumer Surplus P Q D Equilibrium Price = $8 Consumer Surplus

42. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.642 Table 4-5 Consumer Surplus PersonMaximum price willing to pay Actual PriceConsumer surplus Bob138 Barb128 Bill118 Bart108 Brent98 Betty88 PersonMaximum price willing to pay Actual PriceConsumer surplus Bob1385 Barb1284 Bill1183 Bart1082 Brent981 Betty880

43. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.643 Figure 4-10 Producer Surplus P Q S Equilibrium Price = $8 Producer Surplus

44. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.644 Table 4-6 Producer Surplus PersonMaximum acceptable price Actual PriceConsumer surplus Carlos38 Courtney48 Chuck58 Cindy68 Craig78 Chad88 PersonActual PriceProducer surplus 85 84 83 82 81 80

45. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.645 Figure 4-11 Efficiency Revisited P Q S Equilibrium Price = $8 D Consumer Surplus Producer Surplus Productive Efficiency is achieved since CS and PS are maximized

46. ©2007 McGraw-Hill Ryerson Ltd.Chapter 4.646 Figure 4-12 Efficiency Losses (or Deadweight Losses) P Q S Equilibrium Price = $8 D Quantity levels less than efficiency quantity create efficiency losses Efficiency Losses

47. ©2007 McGraw-Hill Ryerson Ltd.Chapter 447 Chapter Summary 4.1 Price Elasticity of Demand 4.2 The Total-Revenue Test 4.3 Price Elasticity of Supply 4.4 Cross Elasticity and Income Elasticity of Demand 4.5 Elasticity and Real-World Applications - Excise Tax - The Economics of Agricultural Price Supports 4.6 Consumer and Producer Surplus