1. Chapter 2: Fundamentals of Welfare Economics
-In order to evaluate government policies, we need a general framework
-We can’t evaluate each policy on a case-by-case basis
-ie: Lower interest rates lowers unemployment, then raising minimum wage increases unemployment (counter-productive)
-Welfare Economics – the branch of economic theory concerned with the social desirability of alternate economic states and policies

2. Chapter 2: Fundamentals of Welfare Economics
First Fundamental Theorem of Welfare Economics
Second Fundamental Theorem of Welfare Economics

3. Starting Point: Pure Exchange Economy
We start with a simple model:
2 people
2 goods, each of fixed quantity
Determine good allocation
The important results of this simple, 2-person model hold in more real-world cases of many people and many commodities

4. Pure Exchange Economy Example
Two people: Maka and Susan
Two goods: Food (f) & Video Games (V)
We put Maka on the origin, with the y-axis representing food and the x axis representing video games
If we connect a “flipped” graph of Susan’s goods, we get an EDGEWORTH BOX, where y is all the food available and x is all the video games:

5. Maka’s Goods Graph Food Video Games Ou is Maka’s food, and Ox
Is Maka’s Video Games u
Food O x
Maka
Video Games

6. Edgeworth Box Food Video Games Susan y O’
O’w is Susan’s food, and O’y is Susan’s Video Games r
Total food in the market is Or(=O’s) and total Video Games is Os (=O’r) u
Food w
Each point in the Edgeworth Box represents one possible good allocation O x s
Maka
Video Games

7. Edgeworth and utility
We can then add INDIFFERENCE curves to Maka’s graph (each curve indicating all combinations of goods with the same utility)
Curves farther from O have a greater utility
(For a review of indifference curves, refer to Intermediate Microeconomics)
We can then superimpose Susan’s utility curves
Curves farther from O’ have a greater utility

8. Maka’s Utility Curves Food Video Games
Maka’s utility is greatest at M3
Food M3 M2 M1 O
Maka
Video Games

9. Edgeworth Box and Utility
Susan O’
Susan has the highest utility at S3 r S1 S2 A S3
At point A, Maka has utility of M3 and Susan has Utility of S2
Food M3 M2 M1 O s
Maka
Video Games

10. Edgeworth Box and Utility
Susan O’
If consumption is at A, Maka has utility M1 while Susan has utility S3 r A B S3 C
By moving to point B and then point C, Maka’s utility increases while Susan’s remains constant
Food M3 M2 M1 O s
Maka
Video Games

11. Pareto Efficiency Food Video Games Susan O’
Point C, where the indifference curves barely touch is called PARETO EFFICIENT, as one person can’t be made better off without harming the other. r S3 C
Food M3 M2 M1 O s
Maka
Video Games

12. Pareto Efficiency
When an allocation is NOT pareto efficient, it is wasteful (at least one person could be made better off)
Pareto efficiency evaluates the desirability of an allocation
A PARETO IMPROVEMENT makes one person better off without making anyone else worth off (like the move from A to C)
However, there may be more than one pareto improvement:

13. Pareto Efficiency Food Video Games Susan O’ If we start at point A:
-C is a pareto improvement that makes Maka better off
-D is a pareto improvement that makes Susan better off
-E is a pareto improvement that makes both better off r A S3 C S4
Food S5 E M3 M2 D M1 O s
Maka
Video Games

14. Pareto Efficiency Condition
The Contract Curve
Assuming any possible starting point, we can find all possible pareto efficient points and join them to create a CONTRACT CURVE
All along the contract curve, opposing indifferent curves are TANGENT to each other
Since the slope of the indifference curve is the willingness to trade, or MARGINAL RATE OF SUBSTITUTION (x for y) (MRSxy), along this contract curve:
Pareto Efficiency Condition

15. The Contract Curve
Susan O’ r
Food O s
Maka
Video Games

16. Starting Point: Economy with production
A production economy can be analyzed using the PRODUCTION POSSIBILITIES CURVE/FRONTIER
The PPC shows all combinations of 2 goods that can be produced using available inputs
The slope of the PPC shows how much of one good must be sacrificed to produce more of the other good, or MARGINAL RATE OF TRANSFORMATION (x for y) (MRTSxy)
Note that although the slope is negative, the negative is assumed and rarely shown in simple calculations

17. Production Possibilities Curve
Here the MRTSpr is equal to (7-5)/(2-1)=-2, or two robots must be given up for an extra pizza. 10 9 8
The marginal cost of the 3rd pizza, or MCp=2 robots 7 6
The marginal cost of the 6th and 7th robots, or MCr=1 pizza
Robots 5 4
Therefore, MRTSxy=MCx/MCy 3 2
Therefore, MRTSpr=2/1=2 1 1 2 3 4 5 6 7 8
Pizzas

18. Efficiency and Production
If production is possible in an economy, the Pareto efficiency condition becomes:
Assume that MRT>MRS. A person could transform x into y at the rate of MRS and have x left over, thus increasing his utility
Assume that MRT<MRS. A person could transform y in x at the rate of MRS and have y left over, thus increasing utility
Pareto Efficiency cannot occur at inequality

19. Efficiency & Production Example
Assume MRTpr=3/4 and MRSpr=2/4.
Therefore Maka could get 3 more robots by transforming 4 pizzas
BUT Maka only needs to get 2 robots for 4 pizzas to maintain utility
Therefore his utility increases from the extra robot, Pareto efficiency isn’t achieved
We can therefore reinterpret Pareto efficiency as:

20. First Fundamental Theorem Of Welfare EconomicsIF
All consumers and producers act as perfect competitors (no one has market power)
and
2) A market exists for each and every commodity
Then
Resource allocation is Pareto Efficient

21. First Fundamental Theorem of Welfare Economics Origins
From microeconomic consumer theory, we know that:
Since this holds true for all people:
Which is the first requirement for Pareto efficiency, before production is considered

22. First Fundamental Theorem of Welfare Economics Origins
From basic economic theory, a perfect competitive firm produces where P=MC, therefore:
But we know that MRT is the ratio of MC’s, therefore:

23. First Fundamental Theorem of Welfare Economics Origins
Again from microeconomic consumer theory, this changes to:
But we know that MRT is the ratio of MC’s, therefore:

24. The Law of Demand
There is an inverse relationship between the quantity of anything that people will want to purchase and the price they must pay to obtain it:
ceteris paribus (all else held equal)
This causes demand curves to be downward sloping
When prices increase, people buy less
When prices decrease, people buy more

25. The Individual’s Demand ScheduleB C D E 5 4 3
Price of Songs ($) 2
Change in Price
Movement along
the Demand 1 10 20 30 40 50
Number of Songs per Year

26. Note:
We always graph P on vertical axis and Q on horizontal axis, but we write demand as Q as a function of P… If P is written as function of Q, it is called the inverse demand:
Normal Form: Qd=100-2P
Inverse form: P =50 - Qd/2
Markets defined by commodity, geography, time.

27. Movement Along Demand/
Changes in Quantity Demanded
A change in a good’s own price
results in a change in quantity demanded
the same thing as a movement along the same demand curve.

28. Shifts/Changes in Demand*
A change in one or more of the non-price determinants of demand (income, tastes, etc)
results in a change in demand *
also called a shift in demand*
*The whole demand schedule

29. A Shift in the Demand Curve
Suppose universities
outlaw the use of
MP3 Players
Suppose the federal
government gives
every student a SanDisk
MP3 player D3
Decrease
in Demand 5 4 D2
Increase
in Demand 3
Price of Songs ($) 2 1 D1 20 30 40 50 60 70 80
Quantity of Songs Demanded

30. “Everything Else” : The “Determinants”/ “Shifters” of “Demand”
Factors other than Price which affect “Demand” :
1) Income, wealth
2) Tastes and preferences
3) The price of related goods
Complements
Substitutes
4) Expectations
Future prices
Income
Product availability
5) Population (market size)
What movement would these factors cause?

31. Review of Demand Terminology
Demand: a schedule of quantities that will be bought/unit of time, at various prices, ceteris paribus.
Quantity Demanded: a specific amount that will be demanded /unit of time at a specific price, ceteris paribus.
There is a difference between between a change in the Quantity Demanded and a shift in Demand.

32. Shift vrs. Movement A policy to discourage smoking (no smoking in
public buildings) shifts
the demand curve left
Price of Cigarettes, per pack
Number of Cigarettes
smoked per day 10 20 $2 D
Price of Cigarettes, per pack
Number of Cigarettes
smoked per day 10 20 $2 $4
A tax raises the price of
cigarettes, resulting in a
movement along the
demand curve D’ D

33. Normal vrs. Inferior Goods
For normal goods,
Demand decreases
With income
For inferior goods,
Demand increases
When income decrease
Price of Chicken
Chicken eaten in a month 10 20 $2 D
Price of Kraft Dinner
Kraft Dinner eaten
in a month 10 20 $2 D D’ D’ 30

34. Supply: Profit
The Cost side of the profit equation depends on the Costs of Production which depend on
the kinds of inputs (factors of production) used
the amount of each input used
prices of inputs used
technology

35. Supply: Definition
A schedule that shows how much of a product a firm will supply at alternative prices for a given time period “ceteris paribus”.

36. The Law of Supply
The price of a product or service and the quantity supplied are directly related: “ceteris paribus”
Causes an upward sloping supply curve
The higher the price of a good, the more sellers will make available
The lower the price of a good, the fewer sellers will make available
All else being equal

37. The Individual Producer’s Supply Schedule
Qnty of
Songs
Supplied
Price / (thousands /
Song year) J I H G F 5 4
Change in Price
Movement along
The Supply 3
F $ G H I J
Price of Song ($) 2 1
100
200
300
400
500
600
Quantity of Songs Supplied
(thousands of constant-quality units per year)

38. Movement Along Supply/
Changes in Quantity Supplied
A change in a good’s own price
leads to a change in quantity supplied.
that is, a movement along the supply curve.

39. Shifts/Changes in Supply
A change in one or more of the non-price determinants of supply leads to a
change in supply which is the same thing as a
shift of the supply curve.

40. A Shift in the Supply Curve
When supply decreases the quantity supplied
will be less at each price: ie: Singers form a union and successfully negotiate higher wages 5 S2 S2 S1 a c b d
When supply increases
the quantity supplied
will be greater at each
price:
ie: producer finds that she can use some cheaper singers from Newfoundland 4 b d 3
Price of Songs ($) 2 1 20 40 60 80
100
120
140
Quantity of Songs Supplied
(millions of constant-quality units per year)

41. “Everything Else” : The “Determinants”/“Shifters” of Supply
Factors other than Price that affect Supply
1) Cost of inputs (price in factor markets)
2) Technology and Productivity
3) Taxes and Subsidies
4) Price Expectations (in the product market)
5) Number of firms in the industry
How will these shift supply?

42. Market Equilibrium Price & Quantity
Market: where prices tend toward equality through the continuous interaction of buyers and sellers: the market forces of demand and supply
Single Equilibrium Price

43. Putting Demand and Supply Together: Finding Market Equilibrium
(1) (2) (3) (4) (5)
Difference
Price per Quantity Supplied Quantity Demanded (2) - (3)
Constant-Quality (Songs (Songs (Songs
Song per year) per year) per year) Condition
$5 100 million 20 million 80 million
4 80 million 40 million 40 million
3 60 million 60 million
2 40 million 80 million -40 million
1 20 million 100 million -80 million
Excess quantity
supplied (surplus)
demanded (shortage)

44. Market Equilibrium: Definition
The condition in a market when quantity supplied equals quantity demanded at a particular price; a point from where there tends to be no movement
Excess quantity supplied at price $5 S D 5 4
Market clearing, or
equilibrium, price E
QD= QS 3
Price pef Song ($) 2
Excess quantity demanded at price $1 A B 1 20 40 60 80
100
Quantity of Songs
(millions of constant-quality units per year)

45. The Law of Supply & Demand
The price of any good will adjust until the price is such that the quantity demanded is equal to the quantity supplied
A high price will result in excess supply, pushing price down, and a low price will result in excess demand, pushing price up
the market clears resulting in a single market clearing or equilibrium price.

46. Example: The Market for Cranberries
Qd = 500 – 4p
QS = p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of
barrels per year

47. a. The equilibrium price of cranberries is calculated by equating demand to supply:
Qd = QS … or…
500 – 4p = p
…solving,
=2p+4p
p* = $100
plug equilibrium price into either demand or supply to get equilibrium quantity:
Qd = 500-4d
Qd = 500-4(100)
Qd = 100

48. Example: The Market For Cranberries
Price
Price
125
Market Supply: P = 50 + QS/2
Market Supply: P = 50 + QS/2
P*=100 50
Market Demand: P = Qd/4
Quantity
Quantity

49. • Example: The Market For Cranberries Price 125
Market Supply: P = 50 + QS/2 •
P*=100 50
Market Demand: P = Qd/4
Q* = 100
Quantity

50. Comparative Statics: Shifts in Demand &/or Supply
Suppose something in the demand &/or the supply “ceteris paribus” assumptions changes.
How is the MARKET affected?
1.) Decide whether Demand &/or Supply is affected.
2.) Decide in which direction the affected Demand &/or Supply will move.
3.) Use a Demand and Supply diagram to determine the new equilibrium.
4.) Calculate the new equilibrium (if possible)

51. Comparative Statics: Gas Prices
Summer 2009: Gas prices at equilibrium at $1.07 per liter
Winter arrives and certain drivers limit or end their driving for the season (shift in demand)
The new market equilibrium is $0.87 per liter
Cold Weather causes a decrease in gas prices

52. Ford Escape Market Consider the market for Ford Escapes.
For each event identify whether demand or supply is affected.
Determine the direction of change.
Draw a diagram to illustrate how equilibrium is changed. S D1 P1 Q1 E1

53. Steelworkers Strike Raises Steel Prices
Ford
Escape
Market
Steelworkers Strike Raises Steel Prices S2 E2 S1 D P2 Q1 P1 E1 Q2

54. New Automated Machinery Introduced
Ford
Escape
Market
New Automated Machinery Introduced S1 P1 Q1 E1 D S2 P2 Q2 E2

55. Price of Station Wagons Rises
Ford Escape
Market
Price of Station Wagons Rises S P2 Q2 E2 D1 D2 P1 Q1 E1

56. Stock Market Crash Lowers Wealth
Ford Escape
Market
Stock Market Crash Lowers Wealth S D1 D2 P1 Q1 E1 P2 Q2 E2

57. Simultaneous Shifts only  supply P, Q. only  demand P, Q.
Example of a double shift.
2 events
1.  supply
2.  demand
only  supply P, Q.
only  demand P, Q.

58. Shifts in Demand and in SupplyQ2 E2 P1 Q1 E1

59. Simultaneous Shifts S1 S2 D2 D1 P1 Q1 E1 P2 Q2 E2

60. Simultaneous Shifts second possibility only  supply P, Q.
Example of a double shift.
second possibility
2 events
1.  supply
2.  demand
only  supply P, Q.
only  demand P, Q

61. Shifts in Demand and in SupplyQ1 P2 E2 Q2

62. Shifts in Demand and in SupplyQ1 P1 E1 Q2 P2 E2

63. Example: The Market for Cranberries
Qd = 500 – 4p
QS = p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of
barrels per year
Assume that a plague reduced cranberry supply and fear of inflection likewise reduced cranberry demand so that:
Qd = 400 – 4p
QS = p

64. a. The new equilibrium price of cranberries is calculated by equating demand to supply:
Qd = QS … or…
400 – 4p = p
…solving,
=2p+4p
p* = $100
plug equilibrium price into either demand or supply to get equilibrium quantity:
Qd = 400-4d
Qd = 400-4(100)
Qd = 0

65. • Example: The Market For Cranberries
New Market Supply: P = QS/2
Price
125
Old Market Supply: P = 50 + QS/2 •
POLD=PNew 50
Old Market Demand: P = Qd/4
QOLD
QNew
Quantity
New Market Demand: P = Qd/4

66. Elasticity: Percentage Change
Consider the following:
An increase of 50 cents or an increase of 50% in the price of a hamburger
An increase of $100 or an increase of 1% in the price of a new car
Percentage changes are easier to grasp than the amount of change
Therefore economists often use elasticities to examine percentage change or responsiveness 6

67. Price Elasticity of Demand
Price Elasticity of Demand (Є Q,p)
The responsiveness of quantity demanded of a commodity to changes in its price
Related to the slope, but concerned with percentage changes 6

68. Impact of a Change in Supply & Therefore Price on the Quantity Demanded
40.00 S0
… a large
fall in price... S1
An increase
in supply
brings ...
30.00
Large price change and
small quantity change
Price (dollars per pizza)
20.00
10.00
… and a small
increase in quantity
5.00 Da 5 10 13 15 20 25
Quantity (pizzas per hour)

69. Impact of a Change in Supply…
An increase
in supply
brings ...
40.00 S0 S1
15.00
30.00
… a small
fall in price...
Small price change and
large quantity change
Price (dollars per pizza)
20.00 Db
10.00
… and a large
increase in quantity 5 10 15 17 20 25
Quantity (pizzas per hour)

70. Solution: Price Elasticity of Demand
Percentage change in quantity demanded
ЄQ,P 
Percentage change in price
The ratio of the two percentages is a
number without units. 8

71. Price Elasticity Example Price of oil increases 10%
Quantity demanded decreases 1%
When calculating the price elasticity of demand, we often ignore the minus sign for % change in Q. 10

72. TYPES OF ELASTICITY -Hypothetical Demand Elasticities

73. Price Elasticity Ranges: Extreme Price Elasticities
Perfect elasticity, infinite elasticity,
the slightest increase
in price will
lead to
zero sales.
Quantity Demanded per Year
(millions of units)
Price D 8
Perfect inelasticity,
zero elasticity,
no matter how
much Price
changes,
Quantity
stays the same;
insulin P0 P1
P1 is
the demand curve 30 P1 D
Price
Quantity Demanded per Year
(millions of units) 39

74. Price Elasticity Ranges Summary from Table
Elastic Demand
Unit Elastic
Inelastic Demand 35

75. Elasticity of Demand Calculating elasticity or or Change in Q
Change in P
ЄQ,P 
Sum of quantities/2
Sum of prices/2
Change in Q
Change in P or
ЄQ,P = ( Q + Q
)/2 ( P + P
)/2
Always use
the mid-point
formula 1 2 1 2 D Q D P or =
ЄQ,P
Avg. Q
Avg. P 23

76. Calculating the Elasticity of Demand
Price (dollars/pizza)
Original
point
ΔP=1
20.50
Elasticity = = 4
/Qave
/Pave
2/10
1/20 =
20.00
New
point
19.50 D
Quantity (pizzas/hour)
Qave =1/2(11+9)=10
Pave =1/2( )=20
ΔQ=2

77. Elasticity of Demand (mid-point)
D Q = 2
X 100
%D Q =20%
Q Q2 (9 + 11)
= 10 2
20% 5% = 4
= ЄQ,P =
ЄQ,P =
D P = $1.00
X 100
%D P =5%
P P2 ($ $19.50)
= $20 2
Always use the mid-point formula for calculating elasticity

78. Elasticity: Example
You are the consulting economist to the Guelph transportation commission,
The current fare is $.95
There are 17,500 riders per day
For each $.10 increase in the fare, rider ship decreases by 10,000 riders per day.
What is the price elasticity of demand at the current fare?
Should fares be raised or lowered?
What fare will maximize revenue?

79. Total Revenue and Elasticity
Total Revenue = Price Per Good X # of Goods Sold
TR = P X Q
Assumption : Costs are constant

80. Elasticity and Total Revenue
1.10
Elastic
demand
.80
Unit
elastic
Price
.55
Elasticity and Total Revenue
Inelastic
demand
Quantity
3.00
Maximum
total revenue
When demand is elastic, price cut
increases total revenue
When demand
is inelastic,
price cut decreases
total revenue
Total Revenue
(dollars)
Quantity

81. Relationship Between Price Elasticity of Demand and Total Revenues
Price Elasticity Effect of Price Change
of Demand on Total Revenues (TR)
Price Price
Decrease Increase
Inelastic (ЄQ,P < 1) TR ¯ TR ­
Unit-elastic (ЄQ,P = 1) No change No change Elastic (ЄQ,P > 1) TR ­ TR ¯
Note: It is possible to classify elasticity by observing the change in revenue from a price change 55

82. Question 2 drivers - Tom & Jerry each drive to to a gas station.
Before looking at the price, each places an order.
Tom says, “I’d like 10 litres of gas”.
Jerry says, “I’d like $10 of gas”.
What is each driver’s price elasticity of demand?

83. Determinants of Price Elasticity of Demand
Existence of substitutes
Goods are more price elastic if substitutes exist
Share of budget
Goods are more price elastic when a consumer’s expenditure on the good is large (in dollar terms or relatively)
Necessity
Goods are less price elastic when seen as a necessity 58

84. Market and Brand Elasticities
Market and Brand Elasticities are not equal
Although a water addict is very price inelastic to the price of bottled water in general, he/she would quickly switch to another brand if only 1 brand of water increased in price
GENERALLY, Brand price elasticity of demand is higher than market price elasticity of demand 58

85. Special Case: Linear Demand Curve
Qd = a – bp
a,b are positive constants
p is price
-b is the slope
a/b is the choke price (price at which nothing is sold)

86. the elasticity is
Q,P = (Q/p)(p/Q) …definition…
= -b(P/Q)
Since the slope of the graph is –b.
Therefore…elasticity falls from 0 to - along the linear demand curve, but slope is constant.
if Qd = 400 – 10p, and p = 30,
Q,P = (-10)(30)/(100) = -3 "elastic"

87. Changes in Elasticity Along a Linear Demand
1.10
Unit-elastic (ЄQ,P = 1)
Elastic (ЄQ,P > 1)
1.00
.90
.80
Inelastic (ЄQ,P < 1)
.70
.60
Price per Minute ($)
.50
.40
.30
.20 D
.10 1 2 3 4 5 6 7 8 9 10 11
Quantity per Period (billions of minutes) 50

88. The Relationship Between Price Elasticity of Demand and Total Revenues for Cellular Phone Service
Quantity Total Elasticity
Price Demanded Revenue ЄQ,P $
1.0
1.8
2.4
2.8
3.0
21.000
Elastic
6.333
3.400
2.143
1.144
1.000
Unit-elastic
.692
Inelastic
.467
.294
.158 47

89. Special Case: Constant Elasticity Curve
Qd = Ap
 = elasticity of demand and is
negative
p = price
A = constant
Elasticity is constant, but the slope of demand falls from 0 to -.
In another form, if
Ln(Qd)=μLN(P),
μ= Price Elasticity of Demand

90. • Example: A Constant Elasticity versus a Linear Demand Curve Price
Quantity
Price Q P •
Observed price and quantity
Constant elasticity demand curve
Linear demand curve

91. Elasticity of Supply Calculating elasticity or or Change in Q
Change in P
ЄQs,P 
Sum of quantities/2
Sum of prices/2
Change in Q
Change in P or =
ЄQs,P
Always use
the mid-point
formula ( Q + Q
)/2 ( P + P
)/2 1 2 1 2 D Q D P or
ЄQs,P =
Avg. Q
Avg. P 23

92. How a Change in Demand Changes Price and Quantity
An increase
in demand
brings ...
40.00 Sa D1
Large price change and small quantity change
30.00 13
Price (dollars per pizza)
… a large
price rise...
20.00
10.00
… and a small
quantity increase D0 5 10 15 20 25
Quantity (pizzas per hour)

93. How a Change in Demand Changes Price and Quantity
Small price change and
large quantity change
An increase
in demand
brings ... D1
40.00
30.00
Price (dollars per pizza) Sb
21.00
… a small
price rise...
20.00
10.00
… and a large
quantity increase D0 5 10 15 20 25
Quantity (pizzas per hour)

94. Elasticity of Supply Elasticity of supply ranges
(from) Perfectly Elastic Supply
Quantity supplied falls to 0 when there is any decrease in price
(to) Perfectly Inelastic Supply
Quantity supplied is constant no matter what happens to price
Notice: There is no total revenue test for supply since price and quantity are directly related 89

95. Supply Elasticity Ranges
Elasticity of supply = 0
Price
Price
Elasticity of supply = S
Quantity supplied is
the same for any
price!
Suppliers will offer
ANY quantity at this
price
Quantity
Quantity

96. Elasticity of Supply: Depends On:
Resource substitution possibilities, The more unique the resource, the more inelastic the supply.
Time frame for the supply decision, Momentary supply Long-run supply Short-run supply
- Typically, the longer producers have to adjust to a price change, the more elastic is supply.

97. Long-Run Elasticity of Demand
Elasticities can vary in the short run (when major changes cannot be made) and the long run.
-For most goods, elasticity of demand is greater in the long run (curves are “flatter”)
-People are more able to adjust to changes over time (slowly switch consumption)
-For essential durable goods (ie: Cars), long-run demand elasticity is less (curves are “steeper”)
-People can change their purchases or suppliers now, but eventually they have to buy new goods as old ones break

98. Long-Run Elasticity of Supply
Elasticities can vary in the short run (when major changes cannot be made) and the long run.
-For most goods, elasticity of supply is greater in the long run (curves are “flatter”)
-Firms are more able to adjust to changes over time (slowly switch production)
-For reusable goods (ie: Aluminum), long-run supply elasticity is less (curves are “steeper”)
-People resell their stock when prices go up, but eventually their stock runs out

99. Supply Elasticity and the Long Run (most non-durable, non-essential goods)Qe S3 P1
Price per Unit Pe
As time passes, the
supply curve rotates
to S2 and then to S3
and quantity supplied
rises first to Q1 and
then to Q2 Q1 Q2
Quantity Supplied per Period 98

100. How Long is the Long Run?
There is no set amount of time that puts a market into the long run
The long run could be a week or a year
The long run is how long a consumer or firm takes to fully adjust to a price change
Time required to make major changes
Ie) Give up Pepsi Vanilla, Build more cost efficient Pepsi factory, secure a US Pepsi Vanilla supplier
The short run is anything shorter than the long run

101. Cross Price Elasticity of Demand
We’ve seen already that demand is affected by the price of substitutes and compliments
An increase in the price of a substitute increases demand
An increase in the price of a complement decrease demand
This effect can be measured using cross price elasticity
If the cross price elasticity is zero, the good is neither a complement nor a substitute

102. Cross Price Elasticity of Demand
Percentage change in quantity demanded of X Є 
Qi,Pj
Percentage change in price of Y
Є Qi,Pj = Change in X
(X1 + X2)/2 /
Change in Price of Y
(Py1 + Py2)/2
Substitutes – Positive Cross Price Elasticity
Compliments – Negative Cross Price Elasticity 8

103. Cross Price Elasticity of Demand Example
“Recent cat attacks have prompted cat owners to buy guns for self-defense”
Originally, 2 Econ students owned a cat. After the price of guns went from $100 to $200, only 1 Econ student owned a cat.
Calculate the cross-price elasticity of demand

104. Cross-Price Elasticity
D Q = -1
X 100
%D Qi =-66%
Q Q2 (2 + 1)
= 1.5 2
-66%
ЄQ,P =
= ЄQi,Pj = = -1
66%
D P = $100
X 100
%D PJ =66%
P P2 ($100 + $200)
= $150 2
Are cats and guns substitutes or compliments?

105. Income Elasticity of Demand
Income Elasticity of demand refers to a HORIZONTAL SHIFT in the demand curve resulting from an income change
Price elasticity of demand refers to a MOVEMENT ALONG THE DEMAND CURVE in response to a price change

106. Income Elasticity of Demand
Percentage change in quantity demanded Є 
Q,I
Percentage change in income
Є Q,I= Change in Q
(Q1 + Q2)/2 /
Change in M
(M1 + M2)/2
Normal Good – Positive Shift/Elasticity
Inferior Good – Negative Shift/Elasticity 8

107. Income Elasticity of Demand Example
In New Zealand, the average family will own 4 Toyotas in their lifetime.
If average Kiwi family income rose from $140K to $160K a year, the average Kiwi family would own 2 Toyotas over their lifetime
Calculate Income Elasticity of Demand for Toyotas in New Zealand.
Are Toyotas normal or inferior goods in New Zealand?

108. Income Elasticity of Demand
D Q = -2
X 100
%D Q =-66%
Q Q2 (4 + 2)
= 3 2
-66%
ЄQ,I =
= ЄQi,Pj = = -5
13.3%
D I = $20K
X 100
%D I =13.3%
I I2 ($140K + $160K)
= $150K 2
In New Zealand, are Toyotas normal or inferior goods?
Guess which brand is the luxury car.