Elasticity of Demand Chapter 5. Slope of Demand Curves Demand curves do not all have the same slope Slope indicates response of buyers to a change in.

Elasticity of Demand Chapter 5

Slope of Demand Curves Demand curves do not all have the same slope Slope indicates response of buyers to a change in price D1D1 D1D1 D1D1 Price 10% => Qty Demanded ? (how much?) Which demand curve is most sensitive to price changes?

ELASTICITY OF DEMAND Price elasticity of demand: how much quantity demanded of a good responds to a change in price Responsiveness is measured in percentage terms:

Determinants of Elasticity of Demand Availability of Close Substitutes Necessities versus Luxuries Proportion of Income Time Horizon

Demand is more elastic: the larger the number of close substitutes if the good is a luxury Good is a larger percent of budget the longer the time period

Price Elastic or Price Inelastic? Soda Heart Surgery Table Salt Gasoline Price Inelastic No real substitutes Price Inelastic Necessity & No real substitutes, Short time period Price Elastic Many substitutes Price Inelastic Small proportion of income, no good substitute

Computing Price Elasticity of Demand Example: –If the price of an ice cream cone increases from $2.00 to $2.20 –The quantity bought falls from 10 to 8 cones:

Variety of Demand Curves Inelastic Demand –Quantity demanded does not respond strongly to price changes. –Price elasticity of demand is less than 1 Elastic Demand –Quantity demanded responds strongly to changes in price. –Price elasticity of demand is greater than 1

Computing Price Elasticity of Demand Demand is Price Elastic or Greater than 1---(use absolute values) $5 4 Demand Quantity 100050 Price

The Variety of Demand Curves Perfectly Inelastic –Quantity demanded does not respond to price changes Perfectly Elastic –Quantity demanded changes infinitely with price change Unit Elastic –Quantity demanded changes by the same percentage as price

The Variety of Demand Curves Price elasticity of demand is closely related to the slope of the demand curve. But it is not the same thing as the slope!

Perfectly Inelastic (a) Perfectly Inelastic Demand: Elasticity Equals 0 $5 4 Quantity Demand 100 0 1. An increase in price... 2.... leaves the quantity demanded unchanged. Price

Perfectly Elastic (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.

Inelastic Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Quantity 0 $5 90 Demand 1. A 22% increase in price... Price 2.... leads to an 11% decrease in quantity demanded. 4 100

Unit Elastic Demand 2.... leads to a 22% decrease in quantity demanded. (c) Unit Elastic Demand: Elasticity Equals 1 Quantity 4 100 0 Price $5 80 1. A 22% increase in price... Demand

Elastic Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Demand Quantity 4 100 0 Price $5 50 1. A 22% increase in price... 2.... leads to a 67% decrease in quantity demanded.

Elasticity & Total Revenue Chapter 5

Total Revenue Total revenue is not profit It is the total amount of money received by a business Total Revenue = Price & Quantity Sold Coffee Shop: Price coffee: $2/cup Qty Sold: 500 per day Total Revenue = $2 * 500 = $1,000 Profit = TR – all expenses

Total Revenue Demand Quantity Q P 0 Price P × Q = $400 ( total revenue) $4 100 When the price is $4, consumers demand 100 units, and spend $400 on this good.

Elasticity and Total Revenue Inelastic demand curve: Elastic demand curve in price => a smaller % in Qty demanded = > TR in price => a greater % in Qty demanded = > TR

Total Revenue & Inelastic Demand Demand Quantity 0 Price Total Revenue = $100 Quantity 0 Price Total Revenue = $240 Demand $1 100 $3 80 An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240

Total Revenue & Elastic Demand Demand Quantity 0 Price Total Revenue = $200 $4 50 Demand Quantity 0 Price Total Revenue = $100 $5 20 An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies!

D1D1 D1D1 Which demand curve is inelastic? Elastic demand curves tend to flat (horizontal) Inelastic demand curves tend to be steep (vertical) Linear demand curves: 1) Have a constant slope 2) Do not have constant elasticity 3) Have both elastic & inelastic ranges 4) SLOPE is constant------ELASTICITY changes

Elasticity of Linear Demand Curves Demand curves have both elastic & inelastic ranges Points with high price & low quantity demand is elastic Points with low price & high quantity demand is inelastic

0 2 6 4 10 8 12 14 2 1 4 3 5 6 $7 Elastic Range: Elasticity > 1 Inelastic Range: Elasticity < 1 Price Quantity Linear Demand Curve Elasticity Price from $4 to $5 => TR from $24 to $20. Price from $2 to $3 => TR from $20 to $24

Price increases leads to: Total Revenue rising in inelastic ranges Total Revenue falling in elastic ranges Total Revenue staying constant in unit elastic

Income Elasticity of Demand Income elasticity of demand- how much quantity demanded responds to a change in consumers’ income – E I = % change in Qty Demanded % change in income Normal Goods have positive Income elasticity Income elastic: E I >1 (considered a luxury) Income inelastic: 1 > E I > 0 (considered a necessity) Inferior Goods: E I < 0 (negative income elasticity)

Cross-price elasticity of demand How much quantity demanded of one good responds to a change in price of another good Substitutes have positive cross-price elasticity E a,b > 0 Complements have negative cross-price elasticity E a,b < 0 2 good of pricein %change 1good of demandedquantityin %change demand of elasticity price-Cross 

Summary Elastic demand curves are flat Inelastic demand curves are steep Slope is constant, Elasticity is not Linear demand curves have inelastic & elastic ranges Total Revenue => Prices elastic goods Firms can maximize total revenue by calculating the elasticity of demand of their product

Taxes & Market Equilibrium Chapter 6

How Taxes on Buyers (and Sellers) Affect Market Outcomes When a good is taxed, the quantity sold is smaller Buyers and sellers both share the tax burden Types of Taxes: –Sales Tax: tax on most goods –Excise Tax: taxes on specific goods (ex: cigarettes, gasoline, etc…) Why tax? –To raise Government Revenue or –To decrease consumption of a good (cigarettes)

Elasticity & Tax Incidence Tax incidence is the study of who bears the burden of a tax Taxes result in a change in market equilibrium Buyers pay more & sellers receive less –regardless of whom the tax is levied on

Example: Tax on Buyers Government places a tax on ice cream of.50 cents Does the tax shift the supply or demand curve? Supply Curve is not affected –Determinant of supply did not change (TINE & TP) Demand Curve will shift left –Price of substitute good in effect fell (remember TIPSEN)

Tax on Buyers Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $3.30 90 New Equilibrium with tax 2.80 3.00 100

Tax on Sellers 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). 3.00 100 $3.30 90 TINE & TP Taxes are a Determinant of supply

Elasticity and Tax Incidence In what proportions is the burden of the tax divided? How do the effects of taxes on sellers compare to those levied on buyers? It depends on the elasticity of demand & the elasticity of supply.

Supply more elastic than demand Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand 2.... the incidence of the tax falls more heavily on consumers... 1. When supply is more elastic than demand... Price without tax 3.... than on producers.

Demand more elastic than supply Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand 3.... than on consumers. 1. When demand is more elastic than supply... Price without tax 2.... the incidence of the tax falls more heavily on producers...

So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic.

The incidence of a tax does not depend on whether the tax is levied on buyers or sellers It depends on the price elasticities of supply and demand. The burden falls on the side of the market that is less elastic Incidence of Tax Summary

Welfare Economics Chapter 7: Consumer Surplus

Consumers, Producers & Efficiency of Markets Market equilibrium reflects the way markets allocate scarce resources Whether the market allocation is desirable can be addressed by welfare economics Welfare economics is the study of how the allocation of resources affects economic well-being

Welfare Economics Equilibrium- results in maximum total welfare for consumers & producers Consumer surplus measures economic welfare from the buyer’s side Producer surplus measures economic welfare from the seller’s side

CONSUMER SURPLUS Willingness to pay- the maximum amount that a buyer will pay for a good It measures how much the buyer values the good or service Consumer surplus- the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it

Demand Schedule & the Demand Curve The market demand curve depicts the various quantities that buyers would be willing to purchase at different prices. Consumers value goods differently

Demand Curve Price of Album 0Quantity of Albums Demand 1234 $100 John’s willingness to pay 80 Paul’s willingness to pay 70 George’s willingness to pay 50 Ringo’s willingness to pay

Equilibrium Price = $80 (a) Price = $80 Price of Album 50 70 80 0 $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20) John was willing to pay $100 But he only had to pay $80 John is better off by $20

Equilibrium Price = $70 (b) Price = $70 Price of Album 50 70 80 0 $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10) The area below the demand curve & above the price measures the consumer surplus in the market. Notice that as price falls, consumer surplus rises

Equilibrium Price & Consumer Surplus Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C This triangle represents the “welfare” of consumers

Price falls from P 1 to P 2 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 As Price falls, area below Demand curve increases, so Consumer Surplus increases

What Does Consumer Surplus Measure? Amount buyers are willing to pay Amount buyers actually pay Welfare of Buyers: Consumer Surplus! - = Total Welfare = Consumer Surplus + Producer Surplus

Welfare Economics Part II Chapter 7: Producer Surplus

PRODUCER SURPLUS Producer surplus = the amount a seller is paid for a good minus the seller’s marginal cost It measures the benefit to sellers participating in a market Just as consumer surplus is related to the demand curve, producer surplus is related to the supply curve

Supply Schedule & Supply Curve

Equilibrium Price = $600 Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (a) Price = $600 Supply Grandma’s producer surplus ($100) Price Received = $600 Marginal Cost = $500 Producer Surplus = $100

Equilibrium Price = $800 Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply

Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1 The area below price & above supply curve = producer surplus

Quantity (b) Producer Surplus at PriceP 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 As Price Producer Surplus

EFFICIENCY vs. EQUITY Efficiency = resource allocation which maximizes the total surplus received by all members of society Equity = the fairness of the distribution of well-being among the various buyers and sellers –Equity is not addressed in free markets Free markets naturally (invisible hand) maximize efficiency by maximizing total welfare (consumer surplus + producer surplus)

Consumer Surplus = Value to buyers – Amount paid by buyers Producer Surplus = Amount received by sellers – Cost to sellers Total Surplus (welfare) = Consumer Surplus + Producer Surplus Therefore: Total Surplus = Value to buyers – Cost to sellers Total Welfare

Market Equilibrium Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E = Total Welfare

Evaluating Free Market Equilibrium Free markets allocate the supply of goods to buyers who value them most highly (willingness to pay) Free markets allocate the demand for goods to sellers who can produce goods at least cost Free markets produce the quantity of goods that maximizes the sum of consumer & producer surplus (Total Welfare/Surplus)

Efficiency of Equilibrium Quantity 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

Worksheet: Lesson 1, Activity 9 Please complete side 2 of the Consumer/Producer Surplus worksheet