Ch 18. Extensions of Demand & Supply

1. Ch 18.Extensions of Demand & Supply

2. A. Price elasticity of demand – responsiveness (sensitivity) of consumers to a price change ($ Δ). • LAW OF DEMAND: • $ =  Purchases  $ =  Purchases Three ideas: • Price elasticity • Cross elasticity – buying response of consumers of one product when the price of another product changes. • Income elasticity – the buying response of consumers when their income changes.

3. Economists measure the degree of price elasticity or inelasticity of demand with the coefficient Ed, defined as: percentage change in quantity Ed = demanded of product X percentage change in price of product X B. Price-elasticity Coefficient & Formula C. Midpoint formula – simplest solution: Quantity demanded = Qd **USE THIS FORMULA** Δ in QΔ in $ Ed = sum of Q / 2 √ sum of prices / 2 -- % are better than absolute amounts; eliminate the minus sign for clarification.

4. D. Interpretations of Ed • Elastic demand – % Δ in price results in a larger % Δ in Qd (Ed> 1), Ex: A 2%  in $  4%  in Qd Ed = .04 = 2 (demand is elastic) .02 ● Inelastic demand – % Δ in $ results in a smaller % Δ in Qd (Ed< 1), Ex: A 2%  in $  1%  in Qd Ed = .01 = .5 (demand is inelastic) .02

5. Unit elasticity – % Δ in $ and the resulting % Δ in Qd are the same (Ed = 1), Ex: A 2%  in $  2%  in Qd Ed = .02 = 1 (unit elasticity) .02 ● Perfectly inelastic (rare) – coefficient is zero due to consumers being unresponsive to a $ Δ.

6. E. Perfectly inelastic – a $ Δ results in no Δ in demand. F. Perfectly elastic – infinite coefficient (∞). VERTICAL Perfectly Inelastic has relatively little “quantity stretch” HORIZONTAL Perfectly Elastic has considerable “quantity stretch” **Important for Popcorn simulation**

7. .04 Ed = = 2 .02 .01 Ed = = .5 .02 .02 Ed = = 1 .02 Price Elasticity of Demand • Why Use Percentages? • Elimination of the Minus Sign • Interpretations of Ed Elastic Demand Inelastic Demand Unit Elasticity

8. P $3 2 1 Q 0 10 20 30 40 The Total Revenue Test • Total Revenue (TR) TR = P x Q Elastic Demand 2 X 10 (a) = 20 1 X 40 (b) = 40 Pt ‘b’ is greater a b D1 Ed (Midpoint formula) = Δ in QΔ in $ sum of Q/2 √ sum of $/2

9. P $4 3 2 1 Q 0 10 20 The Total Revenue Test • Total Revenue (TR) TR = P x Q Inelastic Demand c 4 X 10 (c) = 40 1 X 20 (d) = 20 Pt ‘c’ is greater d Ed (Midpoint formula) = Δ in QΔ in $ sum of Q/2 √ sum of $/2 D2

10. P $3 2 1 Q 0 10 20 30 The Total Revenue Test • Total Revenue (TR) TR = P x Q Unit-Elastic e f D3

11. Midpoint Formula – finding the price elasticity coefficient. • Is the demand for tickets elastic or inelastic? • Try using averages of two tickets and two quantities as the reference point. Ed = Δ in quantity√ Δ in $ sum of quantities/2 sum of price/2 Using data from the $5 - $4 price range: Ed = 1 √ 1 = 1 9/2 9/2

12. G. Total Revenue (TR) – total amount the seller receives from the sale of product in particular time period. **Important for Popcorn simulation** TR = price (P) X quantity (Q) $  & TR  = D is elastic. $  & TR is unchanged = D is unit-elastic. $  & TR  = D in inelastic -- Firms want to know the effect of price changes on total revenue and thus profits (total revenue minus total costs). -- ‘Total-revenue test’ looks at what happens to TR when product $ Δ. -- Graph: Lowering the tix price from $8 to $5 (elastic range) increased TR. -- Lowering price from $4 to $1 (inelastic range) lowered TR.

13. Graphical Analysis **Important for Popcorn simulation** • Relationship between price elasticity of demand for movie tickets. • Demand curve D is based on table 20.1. • More price elastic between $5-8 price range of D than between $4-1 range.

14. $8 7 6 5 4 3 2 1 a b c Price d e f g h 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 Quantity Demanded $20 18 16 14 12 10 8 6 4 2 Total Revenue (Thousands of Dollars) Quantity Demanded Price Elasticity and the Total-Revenue Curve Elastic Ed > 1 Unit Elastic Ed = 1 Inelastic Ed < 1 D Elastic Ed > 1 Unit Elastic Ed = 1 TR Inelastic Ed < 1

16. Determinants of Price Elasticity of Demand • Substitutability ● Luxuries v. Necessities • Proportion of Income ● Time

17. Applications of Price Elasticity of Demand • Large crop yields • Excise tax • Decriminalize illegal drugs • Minimum wage ($8/CA, $7.25/Fed) Typical examples of excise duties are taxes on gasoline, tobacco and alcohol (sometimes referred to as sin taxes).

18. H. Price elasticity of Supply – if producers relatively responsive to $ Δ = supply is elastic; if not = inelastic. % Δ in quantity Es =supply of product X % Δ in $ of product X OR An increase in the $ of a good from $4 to $6 increases the quantity supplied from 10 units to 14 units. The % Δ in $ would be 2/5, or 40%, and the % Δ in quantity would be 4/12, or 33%: .33 Es = .40 = .83 -- The degree of price elasticity of supply depends on how easily (how quickly) producers can shift resources between alternative uses. -- Faster shift =  elasticity of supply; Slower response =  inelasticity.

19. Market supply I. Market period Price Elasticity of Supply in Microeconomics -- Market period: period that occurs when the time immediately after a Δ in market price is too short for producers to respond w/ a Δ in quantity supplied. -- Ex: a tomato farmer only has one truck full of tomatoes to sell; line is vertical (perfectly inelastic) due to not having time to respond to change in demand (D1 to D2). -- P0 to Pm determines which buyers get the fixed quantity supplied.

20. P Q Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X Unit Elastic Supply Es = 1 Market Period: Not Enough Time to Shift Resources Sm Pm Greatest Price Impact P0 D1 D2 Q0

21. Price Elasticity of Supply in Microeconomics 1. Short run 2. Long run -- Short run – period of time too short to change plant capacity but long enough to use fixed plant more or less inexpensively (fixed land/farm machinery, but can use more labor/fertilizer) for more output (more elastic). -- Long run – time period long enough for firms to adjust their plant sizes & for new firms to enter (or existing to leave) the industry (still more elastic). -- There is no total-revenue test for elasticity of supply. -- Supply shows a positive (direct relationship) between $ & amount supplied.

22. P Q Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X Inelastic Supply Es < 1 Short Run: Resources Not Easily Shifted to Alternative Uses Ss Lower Price Impact Ps P0 D1 D2 Q0 Qs

23. P Q Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X Elastic Supply Es > 1 Long Run: Resources Easily Shifted to Alternative Uses Sl Least Price Impact Pl P0 D1 D2 Q0 Ql

24. J. Cross elasticity of demand – measures how sensitive customers purchases are to 2 products. 1. Substitute goods 2. Complimentary goods 3. Independent goods % Δ in Qd of product X Exy = % Δ in Qd of product Y -- One product is X, the other is Y. -- The cross-price elasticity allows us to quantify/understand substitute and complimentary goods (Ch 3).

25. K. Income elasticity of demand – measures degree consumers respond to Δ in their incomes by buying more/less of a good. 1. Normal goods 2. Inferior goods % Δ in Qd Ei = % Δ in I -- For most goods, income-elasticity coefficient Ei is positive (more are demanded as income rises); called normal or superior goods. -- Inferior goods have a negative income-elasticity (more $ = lower sales). -- Insights: we do not eat more when our income rises, we eat better! -- When income declines, food purchases stay same but buy fewer electronics.

27. Cross Elasticity of Demand Percentage Change in Quantity Demanded of Product X Exy = • Substitute Goods – Positive Sign • Complementary Goods- Negative Sign • Independent Goods – Zero or Near-Zero Value Percentage Change in Price of Product Y

28. Income Elasticity of Demand Percentage Change in Quantity Demanded Ei = • Normal Goods – Positive Sign • Inferior Goods- Negative Sign • Insights into the Economy Percentage Change in Income

29. Consumer and Producer Surplus Consumer Surplus Consumer Surplus Equilibrium Price = $8 P1 Price (Per Bag) D Q1 Quantity (Bags)

30. Consumer and Producer Surplus Efficiency Losses (Deadweight Losses) Efficiency Revisited S Efficiency Losses P1 Price (Per Bag) D Q3 Q2 Q1 Quantity (Bags)