CHAPTER 18 EXTENSIONS OF DEMAND AND SUPPLY

1. CHAPTER 18 EXTENSIONS OF DEMAND AND SUPPLY AP ECONOMICS

2. Law of Demand • Consumers will buy more of a product when its price declines and less when its price increases. • How much more or less will they buy? • The amount varies from product to product and over different price ranges for the same product and it can vary over time.

3. A BUSINESS CONTEMPLATING A PRICE HIKE, WILL WANT TO KNOW • How will consumers respond • Will they remain loyal and thus increase the revenue of a business • Will they “defect en masse” to other sellers and thus revenue will decrease

4. PRICE ELASTICITY OF DEMAND • Responsiveness of consumers to a price change • Examples: • Restaurants • Toothpaste • Extent (Degree) to which changes in price cause changes in the quantity demanded • Two types: • Elastic • Inelastic • Can help businesses determine pricing policies to increase revenues

5. ELASTIC Change in price causes a relatively large change in the quantity demanded Things that are luxuries Things that have substitutes Large amount of income Ex: Mercedes or Lexus INELASTIC Change in price causes a relatively small change in the quantity demanded Things that are necessities Small amount of income Ex: Salt or Soap ELASTICITY

6. Price-Elasticity Coefficient and Formula • Measure degree of price elasticity or inelasticity of demand with • Coefficient = Ed Percentage Change in Quantity Demanded of Product X Ed = Percentage Change in Price of Product X

7. Restated Price Elasticy Coefficient Change in Quantity Demanded of X Ed = Original Quantity Demanded of X Change in Price of X ÷ Original Price of X

8. Change in Quantity Change in Price Ed = ÷ Sum of Quantities/2 Sum of Prices/2 Average Midpoint Formula

9. Why use percentages? • Two reasons • The choice of units will arbitrarily affect our impression of buyer responsiveness Ex: If a bag of popcorn at a game is reduced from $3 to $2 and consumers increase their purchases from 60 to 100 bags, it will tell us that consumers are quite sensitive to price changes and therefore that demand is elastic • We can compare consumer responsiveness to changes in the prices of different products

10. Interpretation of Ed • Elastic Demand • Percentage change in price results in a larger percentage change in quantity demanded • Ed > 1 • Inelastic Demand • Percentage change in price produces a smaller percentage change in quantity demanded • Ed < 1 • Unit Elasticity • Percentage change in price and percentage change in quantity demanded are the same • Ed = 1 • Perfectly Inelastic • Price change results in no changer in the quantity demanded • Ed is zero • Perfectly Elastic • Small price reduction causes buyers to increase their purchases from zero to all they can obtain • Ed is infinite

11. P 0 Q P 0 Q Price Elasticity of Demand Perfectly Inelastic Demand Extreme Cases D1 Perfectly Inelastic Demand (Ed = 0) Perfectly Elastic Demand D2 Perfectly Elastic Demand (Ed = ∞)

12. TOTAL REVENUE TEST • Total revenue is also called total receipts test • To calculate Total Revenue • Price X Quantity Sold • See Page 344--Chart at bottom of page • Changes in Total Receipts can determine elasticity • If TR changes in the opposite direction of the price, demand is elastic • If TR changes in the same direction as price, demand is inelastic • If TR does not change when price changes, demand is unit-elastic

13. Inelastic Demand and TR • If demand is inelastic, a price decrease will reduce total revenue • If demand is inelastic, a price increase will increase total revenue • See graph on Page 343 in book

14. Elastic Demand and TR • If demand is elastic, a decrease in price will increase total revenue • If demand is elastic, a price increase will reduce total revenue • See graph on Page 343 in book

15. W 18.2 P $3 2 1 Q 0 10 20 30 40 The Total Revenue Test • Total Revenue (TR) TR = P x Q Elastic Demand a b D1

16. W 18.2 P $4 3 2 1 Q 0 10 20 The Total Revenue Test • Total Revenue (TR) TR = P x Q Inelastic Demand c d D2

17. W 18.2 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

18. G 18.1 ] ] ] ] ] ] ] ] ] ] ] ] ] ] Elasticity on a Linear Demand Curve Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test (1) Total Quantity of Tickets Demanded Per Week, Thousands (3) Elasticity Coefficient (Ed) (4) Total Revenue (1) X (2) (5) Total-Revenue Test (2) Price Per Ticket 1 2 3 4 5 6 7 8 8 7 6 5 4 3 2 1 $8,000 14,000 18,000 20,000 20,000 18,000 14,000 8,000 5.00 2.60 1.57 1.00 0.64 0.38 0.20 Elastic Elastic Elastic Unit Elastic Inelastic Inelastic Inelastic Graphically…

19. $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

20. ELASTIC DEMAND REVENUE • Elastic Demand—amount consumers will buy will go up when the price is lowered causing an increase in sales at the lower price and a large increase in total receipts. Higher prices will mean lower total receipts because the quantity demanded goes down sharply.

21. INELASTIC DEMAND REVENUE • Inelastic Demand—lower prices will mean a smaller increase in the quantity demanded and increased sales would not be enough for total receipts to rise. Total revenue will actually increase when prices are raised.

22. DETERMINANTS OF DEMAND ELASTICITY • Can the purchase be delayed? • Delayed: elastic • Cannot be Delayed: inelastic • Are adequate substitutes available? • Many substitutes: elastic • Few substitutes: inelastic

23. DETERMINANTS CONTINUED • Does the purchase use a large portion of income? • Large portion of income: elastic • Small portion of income: inelastic • Specific vs. General Market? • Gas a particular gas station sells or gas in general

24. UNIT ELASTIC • Unit Elastic--Total revenues neither increase nor decrease • See graph on Page 345 in book

25. Price Elasticity of Supply • If producers are relatively responsive to price changes, supply is elastic. • If producers are relatively insensitive to price changes, supply is inelastic.

26. ELASTICITY OF SUPPLY • The degree to which price changes affect the quantity supplied • A product’s supply can be either • Elastic • Inelastic

27. ELASTIC SUPPLY • Exists when a small change in price causes a major change in the quantity supplied • Products with elastic supply usually can be made: quickly, inexpensively, and using a few, readily available resources • Suppliers can change the production rates of such goods easily in order to meet changing consumer demand • Examples: Sports teams’ souvenirs, such as T-shirts, posters, and hats

28. INELASTIC SUPPLY • Exists when a change in a good’s price has little impact on the quantity supplied. A product usually has an inelastic supply if production requires a great deal of time, money, and resources that are not readily available. • SUPPLIERS cannot easily change the production rates of such goods in order to meet changing consumer demand. • Examples: Gold, fine art, or space shuttles.

29. Measure the Degree of Price Elasticity or Inelasticity • Es • Equation Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X

30. Price Elasticity of Supply • Depends on how easily and therefore quickly producers can shift resources between alternative uses. • The longer the time, the greater the resource “shiftability.” • The longer a firm has to adjust to a price change, the greater elasticity of supply

31. O 18.2 P Q Price Elasticity of Supply Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X Es = 0 Perfectly Inelastic Supply X X Unit Elastic Supply Es = 1 Market Period: Not Enough Time to Shift Resources Sm Pm Greatest Price Impact P0 D1 D2 Q0

32. O 18.2 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 Greatest Price Impact Pm P0 D1 D2 Q0

33. O 18.2 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

34. O 18.2 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

35. Market Period • Period that occurs when the time immediately after a change in market price is too short for producers to respond with a change in quantity supplied • Ex. • Truckload of tomatoes need a full growing season • Producers of goods that can be inexpensively stored, there may be no market period at all.

36. Short Run • A period of time too short to change plant capacity, but long enough to use fixed plant more or less intensively • Result is a somewhat greater output in response to a presumed increase in demand • Greater output is reflected in a more elastic supply of tomatoes • Equilibrium price is therefore lower in the short run than in the market period

37. Long Run • A time period long enough for firms to adjust their plant sizes and for new firms to enter (or existing firms to leave) the industry. • There is not a total revenue test for supply • Supply shows a positive or direct relationship between price and amount supplied • Supply curve is upsloping • Regardless of the degree of elasticity or inelasticity, price and total revenue always move together

38. Examples of Price Elasticity of Supply • Antiques (inelastic) • Reproductions (elastic) • Gold (inelastic)

39. Cross Elasticity of Demand • Measures how sensitive consumer purchases of one product (X) are to a change in price of some other product (Y) • Exy • Equation Percentage Change in Quantity Demanded of Product X Exy = Percentage Change in Price of Product Y

40. Cross Elasticity • Helps us to more fully understand substitutes and complementary goods • Substitute Goods • Cross elasticity is positive • Sales of X move in the same direction as a change in the price of Y, then X and Y are substitute goods • Ex: • Evian and Dasani • The larger the positive cross-elasticity coefficient, the greater is the substitutability between the two products • Complementary Goods • Cross elasticity is negative • X and Y go together • Increase in the price of one decreases the demand for the other • The larger the negative cross-elasticity coefficient, the greater is the complementarity between the two goods

41. Independent Goods • A zero or near-zero cross elasticity suggests that the two products being considered are unrelated or independent goods. • Ex: walnuts and plums • A change in the price of walnuts does not have an effect on purchases of plums

42. Application of Cross Elasticity • Degree of substitutability of products measured by cross-elasticity co-efficient is important to businesses and government • Used to test the sale of one product a company makes against another product • Governments use this for proposed mergers and whether or not they violate anti-trust laws

43. Income Elasticity of Demand • Measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good • Explains the expansion and contraction (recession) of the economy • Ei • Equation Percentage Change in Quantity Demanded Ei = Percentage Change in Income

44. Normal Goods versus Inferior Goods • Normal Goods • Income elasticity co-efficient is positive • More of them are demanded as income rises • Also called superior goods • Value of Ei varies greatly among normal goods • Inferior Goods • Income elasticity co-efficient is negative • Less of them are demanded as income rises

45. Cross and Income Elasticity of Demand • Cross Elasticity • Positive • Ewz > 0 • Quantity demanded of W changes in the same direction as change in price of Z • Substitutes • Negative • Exy < 0 • Quantity demanded of X changes in opposite direction as change in price of Y • Complements • Income Elasticity • Positive • Ei > 0 • Quantity demanded of the product changes in the same direction as change in income • Normal Good • Negative • Ei < 0 • Quantity demanded of the product changes in opposite direction as change in income • Inferior

46. Consumer Surplus • The difference between maximum price a consumer is willing to pay for a product and actual price • The utility surplus arises because all consumers pay the equilibrium price even though many would be willing to pay more than that price for the product • Demand Curve • Consumer surplus and price are inversely related (negative) • Higher prices reduce consumer surplus and lower prices increase consumer surplus

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

48. Producer Surplus • The difference between the actual price a producer receives and the minimum acceptable price • Sellers receive a producer surplus in most markets because most sellers are willing to accept a lower than equilibrium price in order to sell the product • Supply Curve • Equilibrium price and amount of producer surplus are directly related (positive) • Lower prices reduce producer surplus and higher prices increase producer surplus

49. Producer Surplus S Equilibrium Price = $8 P1 Price (Per Bag) Producer Surplus Quantity (Bags)

50. Efficiency • Bring supply and demand together • Bring consumer surplus and producer surplus together • Productive efficiency is achieved because competition forces producers to use the best techniques and combinations of resources in growing and selling products • Allocative efficiency is achieved because the correct quantity of output is produced relative to other goods and services • MB=MC or marginal benefit equals marginal cost • Maximum willingness to pay=minimum acceptable price • Combined consumer and producer surplus is at a maximum