ECON 351 Elasticity of Demand & Supply Week 4.1 September 17, 2013.

ECON 351Elasticity of Demand & Supply

Week 4.1

September 17, 2013

Review

• Markets are the interaction of buyers and sellers.

• Focus on buyers and sellers separately.

• Ceteris paribus: look at one thing at a time; All other things held equal.

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10

Demand x

Demand shows the amounts purchased at alternative prices (horizontal distances at each price)

Qtyx /T

Dx

Dx

Demand for X

Supply Curve$Price

$10

8

6

4

2

2 4 6 8 10 12 14 16 Qty x/ T

$Price

$ 4

3

2.50

2.00

1.50

1.00

.50

.25

100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T

Demand

Supply

Surplus at this $ Price

$Price

$ 4

3

2.50

2.00

1.50

1.00

.50

.25

100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T

Demand

Supply

Shortage at this $ Price

$Price

4

3

2.50

2.00

1.50

PePe 1.00

.50

.25

100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T QeQe

Demand Supply

Market EquilibriumMarket Equilibrium

Qty D = Qty S

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SupplyDemand

Dx

Pe

Qe

Total Revenue = P X Q

$6x5 = $30

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SupplyDo

Do

Sx

Effects of Increase in Demand on Price and Quantity

Increases Price and Quantity

Pe

Qe

D1

D1

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Demand

DxS0

Effects of an Increase in Supply on Price and Quantity

Price decreases and Quantity increases

Pe

Qe

S0

S1

S1

What causes an increase in price?

Increase in Demand or Decrease in Supply

$ P

S2

$ P

Q/T

D1

Q2Q1 Q1

P2

P1Demand

S1

Q2

P1

P2

D2

Supply

Q/T

(if you know quantity increased) (if you know quantity decreased)

What causes an decrease in price?

Decrease in Demand or

Increase in Supply

$ P

S2

$ P

Q/T

D1

Q2 Q1Q1

P2

P1

Demand

S1

Q2

P1

P2D2

Supply

Q/T

(if you know quantity decreased) (if you know quantity increased)

$ P x

109 8 7 6 5 43 2 1

Qtyx /T

Supply

D3

Sx

Market Demand Determines Price

P1

Q2

D2

D1

Q1 Q3

P3

P2

A B

PxPx

Qx/T Qx/T

P0

Q0

P0

Q0

Slope of Supply Shows responsiveness of quantity to a change

in Price

P1

Q1

P1

Q1

Slope Shows Responsiveness of Quantity to a Change in Price

A B

Px Px

Qx/T Qx/T

P0 P0

Dx

Dx

Q0Q1 Q0

P1P1

Q1

A B

PxPx

Qx/T Qx/T

P0

Q0

P0

Q0

Problems using Slope as a measure of responsiveness: Slope depends on the units of measure on the vertical and horizontal axis.

P1

Q1

P1

Q1

Price Elasticity: a Measure of responsiveness of Quantity to a Change in Price

Ed = % Δ Qd

% Δ Price

Es = % Qs

% Price

Computing the Point Price Elasticity of demand

Ed = % Δ Qd

% Δ P

% Δ Qd = (Δ Qd/ Q0)

% Δ P = (Δ P/ P0)

Ed = (Δ Qd/ Q0)

(Δ P/ P0)

Problem with measures of Point Elasticity:

• Evaluate elasticity between two points on the demand curve

• Point A: Price = $4 Quantity = 120

• Point B: Price = $6 Quantity = 80

• From A to B: Ed = (-33% / 50%) = -.66

• From B to A: Ed= (50% / -33%) = -1.5

• Measuring from either endpoint (P0, Q0) gives different estimates

Arc or midpoint price elasticityInstead of using one end of the price, quantity change as the reference point, use the midpoint.

Ed = (Δ Qd/( (Q1 + Q2)/2 ) / (Δ P/)/ ( (P1 + P2)/2 )

Ed= (- 40/100) / ($2/$5) = - 40% / 40% = -1

By using the midpoint formulation the answer will be the same for a price increase or a price decrease and is therefore an unbiased measure of the responsiveness of quantity to a change in price.

Measures of Elasticity

• Demand is ElasticElastic : %Δ Qd > %Δ P;

ie |Ed| >1. A decrease in Price an increase in Total Revenue.

• Demand is Unitary ElasticUnitary Elastic: %ΔQd = %ΔP;

ie |Ed| = 1. A Change in price no change in Total Revenue.

• Demand is InelasticInelastic: %ΔQd < %ΔP;i.e. |Ed| < 1. An increase in Price an increase in Total Revenue.

Elasticity varies on a straight line demand curve

$Price

Qty/T

Demand

Ed > 1

Ed < 1

Ed = 1

Elasticity, Price Change & Total Revenue

$Px $PxElastic (upper half)

Inelastic(lower half)

Q1Qty/T

P0

P1

Q0

P1

P0

Q0Q1

Increased Demand with elastic Supply$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Sx

Dx

Dx

Sx

Pe

Qe

Dx`

Qe`

Pe`

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SxDx

Dx

Sx

Pe

Qe

Dx’

Qe’

Pe’

Increased Demand , Inelastic Supply

Decrease in Supply, Elastic Demand$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SxDx

Dx

Sx’

Pe

QeQe`

Pe`

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SxDx

Dx

Sx’

Pe

QeQe’

Pe’

Decrease in Supply, Inelastic Demand

Determinants of Price Elasticity of Demand

• Number & Closeness of Substitutes.

• Information about price change and availability of substitutes.

• Percentage of Income Spent on good.

• Period of time: Second Law of DemandSecond Law of Demand: Demand is more elastic over a longer period of time.

Factors creating increased elasticity over time

1. More information about price change and substitutes (Beef & Chicken)

2. More substitutes over time (More Hybrids)

3. Increased opportunity to change the complementary basket of goods (Buy a car with higher MPG. Move closer to work.)

Other Elasticity's

A Measure of responsiveness of Quantity to a Change in some other factor

Income Elasticity: Measure of responsiveness of Quantity to a Change in Income

• EdI = % Δ Qd

% Δ income

• Normal Goods: Positive

• Clothing: .95: 10% income → 9.5%

• Stereo: 2.72: 10% income → 27.2%

• Increase may be Quantity or Quality

• Inferior Goods: Negative

Cross Price Elasticity: Measure of responsiveness of Quantity to a Change Price of other good

• Exy = % Δ Qx

% Δ Py

• Substitutes: Positive

• Complements: Negative

Uses of Cross Price Elasticity

• Magnitude of cross price elasticity reflects closeness of substitutes or complements

• Able to identify your closest competitors

• Courts use cross-price to measure monopoly power

Transaction Costs of Exchange

• Information Costs– Search Costs– Quality Identification Cost

• Negotiating Costs: Cost of agreeing on what and how much will be exchanged

• Transportation Costs: Cost of moving goods between parties

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