CHAPTER 4 EXTENSIONS OF DEMAND AND SUPPLY ANALYSIS AND THE EFFICIENCY OF MARKETS

1. Part Two: Microeconomics of Product Markets CHAPTER 4 EXTENSIONS OF DEMAND AND SUPPLY ANALYSIS AND THE EFFICIENCY OF MARKETS

2. 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 Chapter 4

3. 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 Chapter 4.1

4. Price Elasticity of Demand • When QD respondsSTRONGLYto a change in P, demand isELASTIC • When QD respondsWEAKLYto a change in P, demand isINELASTIC Chapter 4.1

5. The Price Elasticity Coefficient and Formula • Calculate the average: • If the quantity demanded increased from 4 to 5 units • %ΔQd = ΔQd/Q0 = ¼ x 100 = 25% • If the price dropped $5 to $4 • %ΔP = ΔP/P0 = 1/5 x 100 = 20% Chapter 4.1

6. Price Elasticity of Demand • Average price and quantity • avoids confusion about start and end points Chapter 4.1

7. The Price Elasticity Coefficient and Formula • Price elasticity of demand: • Use of Percentages • Elimination of the Minus Sign • Interpretation of Ed: • Elastic Demand • Inelastic Demand • Unit Elasticity • Extreme Cases Chapter 4.1

8. The Total-Revenue Test • Total revenue (TR) • TR = P x Q • TR and Ed 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 Chapter 4.2

9. P1 P2 Q1 Q2 Elastic Demand Quantity is very responsive to a change in price P When P changes from P1 to P2, TR increases D Q Chapter 4.2

10. P1 P2 Q1 Q2 Inelastic Demand Quantity is NOT very responsive to a change in price P When P changes from P1 to P2, TR decreases D Q Chapter 4.2

11. P1 P2 Q1 Q2 Unit Elastic % change in quantity is equal to % change in price P When P changes from P1 to P2, TR does not change D Q Chapter 4.2

12. 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 Chapter 4.2

13. The Total-Revenue Test • TR = P X Q • What happens to total revenue when product price changes? Chapter 4.2

14. Table 4-1Ed and Total Revenue INELASTIC DEMAND: when price decreases, total revenue decreases UNIT ELASTIC DEMAND: when price decreases, total revenue stays the same 5.00 2.60 ELASTIC DEMAND: when price decreases, total revenue increases 1.57 1.00 0.64 0.38 0.20 Chapter 4.2

15. Elastic Unit Elastic Inelastic D D Max TR TR Decreases TR TR Increases Chapter 4.2

16. Determinants of Ed • Substitutability • Proportion of Income • Luxuries versus Necessities • Time Chapter 4.2

17. Applications of Ed • Large Crop Yields • Sales Taxes • Decriminalization of Illegal Drugs • Minimum Wage Chapter 4.2

18. Price Elasticity of Supply Percentage change in quantity supplied of product X Es= Percentage change in the price of product X The main determinant of Es is the amount of time producers have for responding to a change in product price Chapter 4.3

19. Figure 4-4 Time and the Elasticity of Supply Immediate Market Period P Sm A Large Increase in Price - Perfect Inelastic Supply An increase in demand without enough time to change supply causes... Pm Po D2 D1 Q Qo Chapter 4.3

20. Time and the Elasticity of Supply Short Run P Ss An increase in demand with some supply response will cause... An Increase in Price - More elastic Supply Pm Ps Po D2 D1 Q Qs Qo Chapter 4.3

21. Time and the Elasticity of Supply Long Run P An increase in demand in the long run allows a greater supply response.... D2 A small Increase in Price - More elastic Supply Pm SL PL Po D1 D1 Q QL Qo Chapter 4.3

22. Applications of Price Elasticity of Supply • Antiques and Reproductions • Volatile Gold Prices Chapter 4.3

23. Cross Elasticity of Demand Percentage change in quantity demanded of product X Exy = Percentage change in the price of product Y • Substitute Goods • - positive sign • Complementary Goods • - negative sign • Independent Goods • - near zero Chapter 4.4

24. Cross Elasticity of Demand Applications • Coca-Cola vs. Sprite • Assessing competition Chapter 4.4

25. Income Elasticity of Demand Percentage change in quantity demanded Ei = Percentage change in income • Normal Goods • - positive sign • Inferior Goods • - negative sign • Insights Chapter 4.4

26. $9 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 Chapter 4.5

27. Figure 4-6 Demand Elasticity and the Incidence of a Tax SS S TAX P1 Producer bears most of the tax burden P0 Pa D Q0 Q1 Tax incidence and elastic demand Chapter 4.5

28. Demand Elasticity and the Incidence of a Tax SS S P1 TAX Consumer bears most of the tax burden P0 Pa D Q0 Q1 Tax incidence and inelastic demand Chapter 4.5

29. Figure 4-7Supply Elasticity and the Incidence of a Tax SS S P1 TAX P0 Consumer bears most of the tax burden Pa D Q0 Q1 Tax incidence and elastic supply Chapter 4.5

30. Supply Elasticity and the Incidence of a Tax SS S TAX Producer bears most of the tax burden P1 P0 Pa D Q1 Q0 Tax incidence and inelastic supply Chapter 4.5

31. The Economics of Agricultural Price Supports • Net income stabilization • Supply management programs: • dairy, poultry products, and eggs • Canadian Wheat Board Chapter 4.5

32. Offers to Purchase • Surplus Output • misallocation of resources • higher taxes • Loss to Consumers • higher prices • higher taxes • Gain to Farmers Chapter 4.5

33. Figure 4-8 Price Supports and Supply Restriction – Offers to Purchase P The result of imposing a floor (support) price is a... D S SURPLUS PS Support price Government must purchase this amount Pe S D Q Qe Chapter 4.5

34. 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 Chapter 4.5

35. S Supply curve (consumer) S Figure 4-8 Deficiency Payments P D S At price PS, farmers Increase output from Qe to QS PS Government must pay farmers this amount Pe P0 S D Q Qe Qs Chapter 4.5

36. 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 Chapter 4.5

37. Resource Overallocation • Both approaches encourage overallocation of resources to agriculture • Efficiency loss Chapter 4.5

38. 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 Chapter 4.5

39. Figure 4-8 Supply Restrictions P Sf D SURPLUS Sf Pr All costs are borne by con-sumers Pe S D Q Qf Qr Qe Chapter 4.5

40. 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 Chapter 4.6

41. Figure 4-9Consumer Surplus P Consumer Surplus Equilibrium Price = $8 D Q Chapter 4.6

42. Table 4-5 Consumer Surplus Chapter 4.6

43. Figure 4-10Producer Surplus P S Equilibrium Price = $8 Producer Surplus Q Chapter 4.6

44. Table 4-6 Producer Surplus Chapter 4.6

45. Figure 4-11Efficiency Revisited P Productive Efficiency is achieved since CS and PS are maximized Consumer Surplus S Producer Surplus Equilibrium Price = $8 D Q Chapter 4.6

46. Figure 4-12Efficiency Losses (or Deadweight Losses) P Quantity levels less than efficiency quantity create efficiency losses S Efficiency Losses Equilibrium Price = $8 D Q Chapter 4.6

47. 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 Chapter 4