Before beginning chapter 4 . . .

1
Before beginning chapter 4 . . .
Lets review basic supply and demand.
2
Example Graph these curves
Widget Demand and Supply
Price Quantity Quantity
Demanded Supplied 20 0 100 15 10
60 10 30 30 5 90 10
3
You try it yourself
Widgets
P
20
15
10
5
Q
10 20 30 40 50 60 70 80
90 100
4
Answer
Widgets
P
20
15
10
5
Q
10 20 30 40 50 60 70 80
90 100
5
At market equilibrium
10
Price is ____________ Quantity is __________
30
6
Now suppose . . .
that the government sets a 5 cap on the price of
widgets. (A price ceiling.) There would be a
______________ of widgets. (shortage or
surplus?) Copy the previous graph and show the
effect of a 5.00 price ceiling.
shortage
7
graph
P
20
15
shortage
10
5
Q
10 20 30 40 50 60 70 80
90 100
8
Now suppose . . .
that the government sets a 15 minimum on the
price of widgets. (A price floor.) There would
be a ______________ of widgets. (shortage or
surplus?) Copy the previous graph and show the
effect of a 15.00 price floor.
surplus
9
Answer
Widgets
P
20
surplus
15
10
5
Q
10 20 30 40 50 60 70 80
90 100
10
Shifting Supply On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p. Now show the
effect of an increase in Supply.
P
S
D
Q
11
Shifting Supply On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p. Now show the
effect of an increase in Supply.
P
S
Price down Quantity up
S
p
p
D
Q
q
q
12
Shifting Supply On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p. Now show the
effect of a decrease in Supply.
P
S
D
Q
13
Shifting Supply On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p). Now show the
effect of a decrease in Supply.
S
P
S
price up quantity down
p
p
D
Q
q
q
14
Shifting Demand On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p. Now show the
effect of an increase in Demand.
P
S
D
Q
15
Shifting Demand On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p). Now show the
effect of an increase in Demand.
P
S
price up quantity up
p
p
D
D
Q
q
q
16
Shifting Demand On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p. Now show the
effect of a decrease in Demand.
P
S
D
Q
17
Shifting Demand On the graph below find
equilibrium priceand quantity (draw lines to the
axes and label points q and p). Now show the
effect of a decrease in Demand.
P
S
price down quantity down
p
p
D
D
Q
q
q
18
What factors . . .
make demand shift? make supply shift?
population, income, prices of other goods,
changes in tastes and preferences
technology, input costs, regulations, special
factors
19
Some word problems
Some word problems give an event and then ask for
the outcome in terms of price and demand of a
product. Work these problems in 2 steps.
First figure out what curve has shifted in which
direction (e.g. Supply increase, supply decrease,
demand increase or demand decrease) and then,
given this change, you can figure out the change
on price and quantity.
20
Example
The price of oats decreases. What will happen in
the market for rye, a close substitute? What
curve shifts in the rye market? And what
follows that shift?
Demand for rye decreases.
Price and quantity both fall when demand
decreases.
21
ECON 2020 Dr Duffy

• Chapter 4

22
SECTION A
ELASTICITY OF DEMAND AND SUPPLY
23
To Provide Better Analyses
We need to know how much supply and demand
respond to changes in price.
Example If the price of apples increases by
10, how many fewer apples will consumers buy?

24
Price Elasticity of Demand
The price elasticity of demand measures how much
the quantity demanded of a good changes when its
own price changes.
It is the percentage change in quantity demanded
divided by the percentage change in price.
25
Calculating Elasticities
Change in quantity demanded
_________________________
ED

Change in price
If a 1 increase in price causes a 5 decrease in
quantity demanded, what is the elasticity of
demand?
26
Calculating Elasticities, continued
Change in quantity demanded
_________________________
ED

Change in price
5
ED
____

5
1
(By convention, the minus sign is dropped on the
ED.)
27
More Examples
A 10 decrease in price causes a 5 increase in
quantity demanded.
10
5
_____
(1/2)
0.50
28
Price-Elastic Demand
Demand is said to be price elastic if a 1
change in price causes a greater than 1 change
in quantity demanded.
If demand is price elastic, ED is greater than
1.0.
29
Price-Inelastic Demand
Demand is said to be price inelastic if a 1
change in price causes less than a 1 change in
quantity demanded.
If demand is price inelastic, ED is less than
1.0.
30
Unit-Elastic Demand
When percent change in price equals percent
change in quantity demanded we have unit-elastic
demand.
ED 1.0
31
Finding the Elasticity of Demand
Given two points on the demand curve, we can
calculate the elasticity on the arc of the curve
between them. This method is called the "arc
method."
32
Calculating Elasticity of Demand Example Elastic
Demand
Price rises from 90 to 110 Quantity demand falls
from 240 to 160 units.
P
B
A
D
Q
33
Elastic Demand Example, continued
How much has price increased?
110-90 20
To find the percentage change, divide the
absolute increase (20) by the midpoint of the old
and new prices, 100.
Price increased 20
34
Elastic Demand Example, continued
How much has quantity demanded decreased?
240-160 80
To find the percentage change, divide the
absolute decrease (80) by the midpoint of the old
and new quantities, 200.
Quantity decreased 40.
35
Elastic Demand Example, continued
ED
40/20 2.

Note that the minus sign is dropped for the
decrease in quantity. By convention,
elasticity of demand is reported as a
positive number.

36
Calculating Elasticity of DemandExample 2,
Inelastic Demand.
As price falls from 12.00 to 8.00 per unit, the
quantity demanded increases from 95 to 105 units.
37
Percent Change in Price
change
12 - 8
_________
40
100
(12 8)/2
midpoint
38
Percent Change in Quantity Demanded
change
105 - 95
_______
100
10
(10595)/2
midpoint
39
Putting together the elasticity
10
_____
ED
0.25
40
40
Caution!
If the demand curve is a straight line, the
elasticity of demand does not stay constant along
the length of the line!
41
Why not?
Changes


P
__
Q/ Q
?
K
ED --------- P/ P



Q
?
Changes
?Q
----
A Constant, K

? P
42
Example


Q ?Q P ?P Q P ED 0
6 10 2 5 5 5
10 4 10 2 15 3
1 20 2 10 2 25 1
0.2 30 0
43
Elasticity along a straight line
Above the mid-point, ED gt1
.
At the mid-point, ED 1
Below the mid-point, ED lt 1
44
P
?Q/ ?P 8/4 2
4
Q
8
45
P
?Q/ ?P 8/4 2
4
midpoint
-
2
Q
8
4
46
P
?Q/ ?P 8/4 2
4
2
__
-
1
ED 2
4
2
Q
8
4
47
P
?Q/ ?P 8/4 2
4
3
__
ED 2
3
2
3
Q
8
2
48
P
?Q/ ?P 8/4 2
4

1 6
ED 2
0.33
1
Q
8
4
6
49
Along a straight line
Elasticity at a point is equal to the ratio of
the line segments below and above that point.
A
BC
B
.
----
ED
AB
at point B
C
50
The Proof
The proof relies on the geometric concept of
similar triangles. The proof is available from
me on request.
51
Point elasticity on a curve
Draw a tangent line to the curve at the point of
interest. Here, point B.
A
BC
.
B
.
----
ED
AB
at point B
C
52
Extremes of Elasticity
D
Perfectly Inelastic Demand
P
D
Perfectly elastic demand
Q
53
Factors affecting elasticity

• Availability of substitutes
• Importance of items
• Time span
• Tastes and preferences
• Incomes
• Addictions, if applicable

54
Elasticity and Revenue
Total Revenue is QxP, price times quantity sold.
What happens to total revenue as we move along a
demand curve?
55
When demand is elastic
Total revenue increases as the price falls, when
demand is elastic.
Remember On a straight line demand curve,
demand is elastic above the midpoint.
56
P
Total Revenue PxQ
P
TR
Q
Q
57
P
Total Revenue PxQ
midpoint
P
TR
Q
Q
58
Compare the areas of the two revenue boxes. The
aqua area is shared by both. The green area is
larger than the light blue. TRgt TR
P
TR
Revenue increased as price fell!
TR
Q
59
When demand is inelastic
Total revenue decreases as the price decreases,
when demand is inelastic.
Remember On a straight line demand curve,
demand is inelastic below the midpoint.
60
P
Total Revenue PxQ
P
TR
Q
Q
61
Compare the areas of the two revenue boxes. The
brown area is shared by both. The green area is
larger than the purple. TRgt TR
P

Total revenue falls as price falls!
TR
TR
TR
Q
62
Application to Airline travel
inelastic
Business travelers have an __________ demand for
travel.
elastic
Vacation travelers have an _________ demand
for travel.
63
Airline fares
Airlines could increase revenue by raising fares
for business travelers (inelastic demand) and
lowering them for vacation travelers (elastic
demand).
How can they keep the two markets separate?
64
The Paradox of the Bumper Harvest
The demand for basic food stuffs tends to be
inelastic. The increase in supply caused by a
good harvest tends to lower price relatively
heavily. Hence the percentage change in price
is larger than the percentage change in quantity,
and total revenue falls.
65
Basic food stuff market
S
S
Because demand is inelastic, price falls a lot
when quantity increases a little.
p1
D
p2
q1 q2
66
Basic food stuff market
S
S
p1
D
p2
q1 q2
67
To Sum UP
Change in quantity demanded
_________________________
ED

Change in price
If change in quantity demanded is greater than
change in price, then demand is elastic and TR
is increased when price falls, or decreased
when price rises.


68
To Sum UP
Change in quantity demanded
_________________________
ED

Change in price
If change in quantity demanded is less than
change in price, then demand is inelastic and TR
is decreased when price falls, or increased
when price rises.


69
Elasticity of Supply
Change in quantity supplied
_________________________
Es

Change in price
If change in quantity supplied is less than
change in price, then supply is inelastic. ES lt
1


70
Elasticity of Supply
Change in quantity supplied
_________________________
Es

Change in price
If change in quantity supplied is greater than
change in price, then supply is elastic. ES gt
1


71
Factors affecting Elasticity of Supply

• Ease with which production can be expanded.
• Time horizon.
• Whether or not there are alternative uses for
  inputs.

72
Consider
Consider a perishable product, such as cucumbers,
that has a several month growing season. In the
short run, the supply is nearly fixed. In the
longer run, supply responds to price changes.
73
Special cases
ES1
ES 0
ES ?
74
When Supply is a Straight Line

• Supply is inelastic if it crosses the horizontal
  axis.
• Supply is elastic if it crosses the vertical
  axis.
• It has unitary elasticity if it goes through the
  origin.

75
ES lt 1
P
ES1
ES gt 1
Q
76
Unlike demand, a straight line supply curve will
not switch from elastic to inelastic as one moves
along it.
77
Looking at Total Revenue
A question of interest to policy makers is what
happens to total revenue if supply shifts. When
demand shifts, we know that total revenue will
move in the same direction. Why?
78
Total Revenue
Total Revenue PQ When demand increases, total
revenue always increases because both p and
q increase. Similarly, when demand decreases,
total revenue always decreases.
79
When supply shifts
When supply increases, q increases and p
decreases. The effect on total revenue will
depend on which change is proportionally
the largest. When supply decreases, q
decreases and p increases. Relative size of the
changes determines impact on total revenue.
80
A closer look
Supply increases. P falls, Q increases. Total
revenue PQ. If the percentage increase in
Q is bigger than the percentage decrease in
price, total revenue will increase. If the
percentage decrease in P is greater than the
percentage increase in Q, total revenue will
fall.
81
A closer look, continued
Supply increases. P falls, Q increases. Total
revenue PQ. If the percentage increase in
Q is bigger than the percentage decrease in
price, total revenue will increase. If the
percentage decrease in P is greater than the
percentage increase in Q, total revenue will
fall.
82
Remember When demand is elastic . . .
. . Total Revenue increases as the price falls.
83
P
Total Revenue PxQ
P
TR
Q
Q
84
P
Total Revenue PxQ
midpoint
P
TR
Q
Q
85
Compare the areas of the two revenue boxes. The
aqua area is shared by both. The green area is
larger than the light blue. TRgt TR
P
TR
Revenue increased as price fell!
TR
Q
86
When demand is inelastic
Total revenue decreases as the price decreases,
when demand is inelastic.
Remember On a straight line demand curve,
demand is inelastic below the midpoint.
87
P
Total Revenue PxQ
P
TR
Q
Q
88
Compare the areas of the two revenue boxes. The
brown area is shared by both. The green area is
larger than the purple. TRgt TR
P

Total revenue falls as price falls!
TR
TR
TR
Q
89
The Paradox of the Bumper Harvest
The demand for basic food stuffs tends to be
inelastic. The increase in supply caused by a
good harvest tends to lower price relatively
heavily. Hence the percentage change in price
is larger than the percentage change in quantity,
and total revenue falls.
90
Supply increase caused by good weather
S
S
Total Revenue falls because demand is inelastic.
D
91
Supply Reduction Policies in Agriculture
At times, some governments have attempted to
help farmers by curbing agricultural output.
Why?
92
Supply Reduction Policies in Agriculture
S
S
Because demand is inelastic, TR increases as
supply contracts.
D
93
Using Elasticities
If we know something about the demand elasticity
in the market, we can get more information about
the impact of a supply shift.
94
Consider this Example
Suppose the elasticity of demand for new homes is
1.5. If supply decreases to the point where
the number of new homes sold dropped by 30, what
would be the effect on price and total sales
revenue?
95
Impact on Price
Calculate the magnitude of the change in price.
ED 1.5. That means that a 1 change in price
is associated with a 1.5 decrease in quantity
demanded. A 30 decrease in quantity would thus
be associated with a 20 increase in price.
30 20
--------- 1.5
96
Impact on Sales Revenue
Revenue is the product of quantity and price. If
price is up 20 and quantity is down 30, the net
effect will be a decrease in total
revenue, because the fall in quantity is
relatively larger than the increase in price.
97
Graph for Total Revenue Effect on Home Example
S
Total revenue before the supply decrease is area
pq. After the shift it is pq. Area pq
is bigger.
S
p
p
D
q
q
98
Another example
The elasticity of demand for grapes is 0.5. If
supply of grapes falls so that the new quantity
in the market is 20 less than before, calculate
the effect on total revenue.
99
Grapes Price Impact
Price will increase by 40. 20 40
________
0.5
Increase in price is proportionately larger
than decrease in quantity, so TR will rise after
the supply decreased.
100
The Economics of Addiction
Would the demand for an addictive substance be
elastic or inelastic?
101
Demand for Addictive Items
Among current addicts, demand is highly
inelastic. Potential users -- e.g. those who
have not yet used the addictive substance but
are considering doing so -- will have a more
elastic demand.
102
Restricting supply of an addictive substance
If supply of an addictive substance
is restricted, price may increase substantially.
Total dollar sales (pq) may thus increase
sharply after an interdiction program for an
illegal drug.
103
Example problem
Assume the elasticity of demand for heroin is 0.1
among group of addicts in a particular
geographic area. If supply is cut in half
because of interdiction efforts what will
happen to price and total revenue?
104
Price Impact
If Ed 0.1, a 50 decrease in quantity will
result in 0.1
50 X
X 500
A 500 increase means the new price is 6 times
the old price. (A quantity that used to cost 10
now costs 60.)
105
Total Revenue Impact
Quantity in the market is cut in half. Price is
6 times higher than before. .506 3. Sales,
in dollars have tripled.
What do you think will happen to property crime
and the rate of muggings? (Many addicts have
little money of their own.)
106
Perspective users and casual users
Those who have not yet started using an illegal
drug and casual users (those who have tried it
but are not yet addicted) are much more price
responsive. Use among this population will thus
be cut heavily by the increase in price
associated with interdiction. Total sales to a
non-addicted population will thus fall.
107
Elastic Demand Example
If the population of illegal drug users in a
given area has an elastic demand (e.g.
experimenters), then cutting quantity will cause
TR to the sellers to fall. If Ed 2.0, a 50 cut
in quantity will make price rise by 25. The net
impact is a decrease in TR.
108
Decreasing Supply -- Edgt1
If we decrease supply and demand is elastic,
price will rise by only a little bit. TR will
fall. If we increase supply and demand is
elastic, price will fall only a little bit. TR
will increase.
109
Decreasing Supply -- Edlt1
If we decrease supply and demand is inelastic,
price will rise by a lot. TR will increase. If
we increase supply and demand is inelastic,
price will fall a lot. TR will decrease.
110
Increasing price
If we increase price, TR rises when demand is
inelastic. If we increase price, TR falls when
demand is elastic.
111
Decreasing price
If we decrease price, TR falls when demand is
inelastic. If we decrease price, TR rises when
demand is elastic.
112
Relationships
If demand is elastic, TR moves in the
SAME direction as quantity. If quantity
increases, so will TR if Edgt1. If demand is
inelastic, TR moves in the OPPOSITE direction as
quantity. If quantity increases TR will fall if
EDlt1.
113
Relationships, part 2
If demand is inelastic, TR moves in the
SAME direction as price. If price increases, so
will TR if Edlt1. If demand is elastic, TR moves
in the OPPOSITE direction as price. If price
increases TR will fall if EDgt1.
114
Elasticity and Policy Making
Knowing the elasticity of supply and demand is
important to policy-makers. If the government
intervenes in a market. Consider for example,
minimum wage, which is an example of a
government-set price floor. A price floor will
cause a surplus.
115
Price Floors
When the government sets a price floor, quantity
demand will decrease and quantity supplied will
increase. A higher price makes consumers buy
less. A higher price makes suppliers produce
more.
116
A Price Floor Example, Minimum Wage
S
Minimum wage decreases employment from e to e'
Wmin
W
D
D
labor
e
e'
117
Decrease in Employment
Although the government sets minimum wage,
employers decide how many people to employ.
When the wage rate goes up, they employ fewer
people and employment falls. Demand for minimum
wage workers is generally believed to be highly
inelastic, so the total earnings of the workers
go up, although some will be without jobs.
118
Measuring Unemployment
Unemployment is measured in the same way as any
other surplus. It is the difference between the
quantity willingly supplied at a price (or wage
rate) and the quantity demanded at that price
(or wage rate). Unemployment is thus not the
same as the decrease in employment, which
involved only the movement along the demand
curve.
119
A Price Floor Example, Minimum Wage
S
Unemployment measures surplus workers.
U
Wmin
W
D
D
labor
e
ed
es
120
Minimum Wage

• Most studies indicate that a 10 increase in
  minimum wage results in a 1-3 decrease in
  employment of teens, in the short run.
• Adult employment is not much affected.
• The total incomes of low-wage workers will
  increase with minimum wage increases, but some
  people (teenagers who lose employment
  opportunities) are worse off.

121
It is also worth keeping in mind that in the days
before minimum wage legislation existed in the
U.S., the unemployment rate was not 0.
In fact, at times it was quite high.
122
The Minimum Wage Controversy
There is no right answer, from an economic
perspective, as to whether or not the government
"should" increase the minimum wage. People will
make their decisions based on how important the
various concerns are to them.
123
Price Controls
If a price is set below the market equilibrium,
there is a shortage. More people want the
commodity than can purchase it at the
controlled price.
124
Price ceiling
.
market equilibrium
E
Ceiling price
shortage
125
When a ceiling price is in place
When price is set below equilibrium, what
mechanism serves to allocate the commodity?
Normally, time. People queue up to buy the
commodity. Those who cannot or will not wait in
long lines will not be able to buy it.
126
1970s gasoline shortage

• Long lines for gasoline at pumps
• Gasoline theft from cars
• Secondary market where people who could wait in
  line would do so and then charge more than pump
  price.

127
Coupon rationing
The government can issue coupons as a means of
rationing. Under such a system, a consumer must
have a coupon to be allowed to purchase a
rationed commodity at the ceiling price.
This system was used for some items during WWII.
128
Coupon rationing
Coupon rationing solves the problem of long
lines, but incentives to cheat abound. Some
goods will end up sold under the table.
129
Effect of a Sales Tax
Sometimes the government puts a tax on specific
commodities such as gasoline, tobacco, and
alcohol. Policy analysts will want to know
How will the tax affect the market price
and quantity? Who will end up paying for the
tax, the producers or the consumers?
130
Impact of a Sales Tax, Example
In this market, with no tax, 1,000 items are sold
at 2.00 each.
S
2.00
D
1,000
131
Impact of a Sales Tax, Example
The government now asks the producers to pay a
1.00 tax on every item sold, which
will cause a decrease in supply. For
the firm to sell the original
1,000 units, the price would
have to be 3.00
S
S
3.00
2.00
1,000
132
Impact of a Sales Tax, Example
But consumers would not be willing to buy
1,000 units at a price of 3.00.
The market will find a new
equilibrium price somewhere
between 2.00 and 3.00, and
a new equilibrium
quantity less than 1,000.
S
S
3.00
2.00
D
1,000
133
The new equilibrium price
In this case, lets say that the new
equilibrium price is 2.80. Of this selling
price, the producers get 1.80 (2.80 minus the
1.00 tax.) The 1.00 tax is the difference
between producer and consumer prices. Thus 0.80
of the tax is paid by consumers in higher
consumer prices and 0.20 is paid by producers
in terms of lower producer prices.
134
General Rules on Tax Shifting
When demand is less elastic than supply, the
consumers pay the greater share of the sales
tax. When demand is more elastic than
supply, producers pay the greater share of
the sales tax.
135
Our Example with a more elastic demand

With this demand curve, final price would be
2.40. Consumers pay .40 of tax, producers
pay .60.
S
S
3.00
2.00
D
1,000
136
Subsidies
Sometimes the government subsidizes production of
a product. A subsidy given to producers shifts
the supply curve out.
137
Who benefits from a subsidy?
S
S
Pg
The yellow dotted line is the value of the
subsidy per unit of supply.
P
P
D
q
q
138
Who benefits from a subsidy?
Output expands Consumer price falls. Benefit is
shared.
S
S
p1
p2
D
D
139
The Importance of ED
When demand is elastic, more of the subsidy goes
to producers. When demand is inelastic,
consumers receive most of the benefit.
Why?
140
This Material is Difficult
Most students need to go over this material
several times to understand it. The book has
additional examples that will help. Homework 2
will have problems over this material.