Chapter 6: Extensions of Supply, Demand, and Supply Analysis

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Chapter 6 Extensions of Supply, Demand, and
Supply Analysis
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Supply and Demand Review

1. Define the Law of Demand
2. Define the Law of Supply
3. What is the difference between a change in demand
   and a change in quantity demanded?
4. What happens if price is above equilibrium?
5. What happens if price is below equilibrium?
6. Define Consumers and Producers Surplus
7. Identify the rule for double shifts in SD
8. Explain the results of an excise tax

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THE LAW OF DEMAND SAYS...
Consumers will buy more when prices go down and
less when prices go up
HOW MUCH MORE OR LESS?
DOES IT MATTER?
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Elasticity
Elasticity shows how sensitive quantity is to a
change in price.
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4 Types of Elasticity

1. Elasticity of Demand
2. Elasticity of Supply
3. Cross-Price Elasticity (Subs or Comp)
4. Income Elasticity (Norm or Inferior)

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Total Revenue

• Total revenue total amount the seller receives
  from the sale of a product or service
• In a particular time period
• Formula
• TR P Q
• TR total revenue
• P Price
• Q quantity

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Total Revenue

• Formula
• TR P X Q
• TR total revenue
• P Price
• Q quantity
• Example
• Price is 3.50 per gallon
• Quantity 10 gallons
• 3.5 10 35 Total Revenue

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What Happens If---

• What happens to total revenue if
• Prices go up?
• Prices go down?
• We know about the Supply and Demand Curve
• Does not tell us what happens if---
• Brings us to elasticity

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Elasticity

• Measure of the responsiveness of the quantity
  demanded to a good or service
• To change in price
• When all other factors remain the same

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1. Elasticity of Demand

• Elasticity of Demand-
• Measurement of consumers responsiveness to a
  change in price.
• What will happen if price increase? How much will
  it affect Quantity Demanded
• Who cares?
• Used by firms to help determine prices and sales
• Used by the government to decide how to tax

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Elasticity of Demand

• In the previous section, supply and demand curves
  were drawn as straight lines.
• This is a simplification,
• we assuming rate of change of demand or supply
  is the same for all prices in the market.
• At some prices, a small change in price may
• cause a large change in the quantity demanded.

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This shown in the diagram as the movement from Pe
to Pe1 a small change in price which causes an
even larger percentage decrease in quantity
demanded (from Qe to Qe1.
At other prices, a large increase in price may
see a much smaller decrease in demand. This shown
in the diagram as the movement from Pe2 to Pe3 a
large change in price which causes a smaller
percentage decrease in quantity demanded (from
Qe2 to Qe3.
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Inelastic Demand
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Inelastic Demand
INelastic Quantity is INsensitive to a change
in price.

• If price increases, quantity demanded will fall a
  little
• If price decreases, quantity demanded increases a
  little.
• In other words, people will continue to buy it.

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A INELASTIC demand curve is steep! (looks like an
I)

• Examples
• Gasoline
• Milk
• Diapers

• Chewing Gum
• Medical Care
• Toilet paper

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Inelastic Demand

• If percentage change in price produces a smaller
  percentage change in quantity demanded

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Inelastic Demand

• General Characteristics of INelastic Goods
• Few Substitutes
• Necessities
• Small portion of income
• Required now, rather than later
• Elasticity coefficient less than 1

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5
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Elastic Demand
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Elastic Demand
Elastic Quantity is sensitive to a change in
price.

• If price increases, quantity demanded will fall a
  lot
• If price decreases, quantity demanded increases a
  lot.
• In other words, the amount people buy is
  sensitive to price.

An ELASTIC demand curve is flat!

• Examples
• Soda
• Boats
• Beef

• Real Estate
• Pizza
• Gold

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Elastic Demand

• General Characteristics of Elastic Goods
• Many Substitutes
• Luxuries
• Large portion of income
• Plenty of time to decide
• Elasticity coefficient greater than 1

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Price Elasticity Coefficient Formula

• Ed change in quantity demanded of product X
• change in price of product X
• Calculating change
• Change in quantity nqd iqd
• 
  initial quantity demanded
• Example Change in quantity
• 100,000 nqd - 110,000 iqd - 10,000
• -10,000 .10 or 10
• 100,000

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Price Elasticity Coefficient Formula

• Ed change in quantity demanded of product X
• change in price of product X
• Change in price New Price Initial Price
• Initial price
• New Price 4
• Initial Price 3
• 4 np - 3 ip 1 .33 or 33
• 3 ip 3

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Price Elasticity Coefficient Formula

• Ed change in quantity demanded of product X
• change in price of product X
• 10 .30 or 30
• 33

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Graph

• Graph the previous example
• Is it elastic or inelastic? WHY?
• Inelastic because change in change in quantity
  demanded is less than change in price
• Or a 33 change in price created a 10 drop in
  quantity demanded
• Calculated price elastic is lt 1 therefore price
  is inelastic

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You Solve

• Decide the price elasticity of demand for a slice
  of pizza at 2.00 by examining a price decrease
  from 2.00 to 1.50 per slice. In this case, the
  demand pizza would increase from 7 million slices
  to 10 million slices. You can use these figures
  to calculate the price elasticity of demand

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• Ed change in quantity demanded of product X
• change in price of product X
• Ed (10M 7M) 7M (DN-OO)
• (1.50 - 2.00) 2.00 (PN-OO)
• Ed .43 -1.72
• - 0.25
• Drop the negative Ed is gt 1 therefore the
  demand for pizza slices is elastic

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Negative Numbers

• If price increases by 10 and consumers respond
  by decreasing purchases by 20
• the equation computes the elasticity coefficient
  as -2.
• The result is negative because an increase in
  price (a positive number)
• leads to a decrease in purchases (a negative
  number).
• Because the law of demand says it will always be
  negative, many economists ignore the negative sign

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Elastic or Inelastic?
Beef- 1.27 Gasoline-
.20 Real Estate- 1.6 Medical Care- .31
Electricity- .13 Gold- 2.6
Elastic INelastic Elastic INelastic
INelastic Elastic
What about the demand for insulin for diabetics?


What if change in quantity demanded equals
change in price?

Perfectly INELASTIC (Coefficient 0)
Unit Elastic (Coefficient 1)
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2. Price Elasticity of Supply

• Elasticity of Supply-
• Elasticity of supply shows how sensitive
  producers are to a change in price.
• Elasticity of supply is based on time
  limitations.
• Producers need time to produce more.

• INelastic Insensitive to a change in price
  (Steep curve)
• Most goods have INelastic supply in the short-run
  
• Elastic Sensitive to a change in price (Flat
  curve)
• Most goods have elastic supply in the long-run
• Perfectly Inelastic Q doesnt change (Vertical
  line)
• Set quantity supplied

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• Elasticity of supply is influenced by a number of
  factors. These include
• the length of the production period. In the late
  1990's, demand for Australia wines overseas has
  reached all time records. Vines take three years
  to grow to a point where they yield adequate
  amounts of fruit. Increases in demand for
  Australian wine has seen prices rise (from Po to
  P1), and returns to existing grape growers are
  excellent. Those who wish to buy grapes face a
  market where supply can only increase marginally
  (from Qo to Q1), in the short term.
• However, many new stands of vines are being
  planted, and in a few years, returns to growers
  may stabilise, as supply increases. Prices will
  fall from P1 to P2 as the supply of grapes
  increases from Q1 to Q2.

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Elasticity Over Time - Supply
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Elasticity Over Time - Supply
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Elasticity Over Time - Supply
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2.Price Elasticity of Supply Over Time
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Price Elasticity of Supply Over Time

• How would you graph the supply elasticity of Gas
  over time?
• Lets see

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3. Cross-Price Elasticity of Demand

• Cross-Price elasticity shows how sensitive a
  product is to a change in price of another good
• It shows if two goods are substitutes or
  complements

change in quantity of product b
change in price of product a
P increases 20
Q decreases 15

• If coefficient is negative (shows inverse
  relationship) then the goods are complements
• If coefficient is positive (shows direct
  relationship) then the goods are substitutes

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Think

• Pizza and Burgers are elastic and substitutes of
  each other
• If the price of pizza declines
• 1. What happens to the sale of pizza?
• 2. What happens to the sale of burgers?
• 2. Soda is a compliment to pizza. What happens
  to the sale of soda?
• Lets Graph

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4. Income-Elasticity of Demand

• Income elasticity shows how sensitive a product
  is to a change in INCOME
• It shows if goods are normal or inferior

change in quantity
change in income
Income increases 20, and quantity decreases 15
then the good is a
INFERIOR GOOD

• If coefficient is negative (shows inverse
  relationship) then the good is inferior
• If coefficient is positive (shows direct
  relationship) then the good is normal
• Ex If income falls 10 and quantity falls 20

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Total Revenue Test

• Uses elasticity to show how changes in price will
  affect total revenue (TR).
• (TR Price x Quantity)
• Elastic Demand-
• Price increase causes TR to decrease
• Price decrease causes TR to increase
• Inelastic Demand-
• Price increase causes TR to increase
• Price decrease causes TR to decrease
• Unit Elastic-
• Price changes and TR remains unchanged
• Ex If demand for milk is INelastic, what will
  happen to expenditures on milk if price increases?

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Is the range between A and B, elastic, inelastic,
or unit elastic?
10 x 100 1000 Total Revenue
5 x 225 1125 Total Revenue
A
Price decreased and TR increased, so Demand is
ELASTIC
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B
125
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Total Revenue Test
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Total Revenue Test
inelastic unit elastic elastic
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Password

1. Demand
2. Substitute
3. Inferior Good
4. Elastic
5. Total Revenue Test

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Terms

1. Subsidy
2. Supply
3. Excise Tax
4. Inelastic
5. Elasticity Coefficient

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Elasticity Practice
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• Graph the following chart
• Calculate the Ed using the top set of numbers
  and prices rising

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Answers -Graph

• This is what your graph should look like

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Answers - Ed

• Ed change in quantity demanded of product X
• change in price of product X
• Change in quantity nqd iqd
• 
  initial quantity demanded
• Change in price New Price
  Initial Price
• 
  Initial price
• Ed (90 100) 100
• (2 - 1.00) 1.00
• Ed -.10 -.1
• 1
• Drop the negative Ed is lt 1 therefore the
  demand for is INelastic

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• Calculate the TR and determine if Total Revenue
  increased or decreased with a price increase
• What is gain or loss on
• price move?

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Answers

• 3 70 210
• 2 90 180
• Total Revenue increased 30

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What Happens If ---

• Graph the following chart
• Calculate the Ed using the bottom two numbers
  and prices rising

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Answers - Ed

• Ed change in quantity demanded of product X
• change in price of product X
• Change in quantity nqd iqd
• 
  initial quantity demanded
• Change in price New Price
  Initial Price
• 
  Initial price
• Ed (40 70) 70
• (4 - 3.00) 3.00
• Ed -.4285 or 42.85
  1.28
• .3333
  or 33.33
• Drop the negative Ed is gt 1 therefore the
  demand for is elastic

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Ed TR Test quiz
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Practice Problem

• See handout

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Consumer and Producer Surplus

• Consumer Surplus
• Difference between maximum price willing to pay
  and the actual price producers charge
• Think of it as a willing to pay curve

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Marginal Benefit Surplusses

• Marginal Benefit
• What you gain when you get one more unit
• Measured by what you are willing to give up
• Everyday life we say getting value for our
  money
• There is a difference between value and price

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Value vs. Price

• Value is what we get
• Price is what we pay
• Everyday idea of value is marginal benefit
• OR
• The measure of the maximum price what consumers
  are willing to pay for another unit of a good or
  service

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Pizza Sales Per Slice
2 1.5 1 .5
Consumer Surplus
Consumer surplus from 10th slice of pizza
P
Willing to pay
Market Price

Amount Paid
D
20 30 40
10
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Voluntary Exchange
In the free-market, buyers and sellers
voluntarily come together to seek mutual
benefits.
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Voluntary Exchange
In the free-market, buyers and sellers
voluntarily come together to seek mutual
benefits.
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Voluntary Exchange
In the free-market, buyers and sellers
voluntarily come together to seek mutual
benefits.
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Voluntary Exchange
In the free-market, buyers and sellers
voluntarily come together to seek mutual
benefits.
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Example of Voluntary Exchange
Ex You want to buy a truck so you go to the
local dealership. You are willing to spend up to
20,000 for a new 4x4. The seller is willing to
sell this truck for no less than 15,000. After
some negotiation you buy the truck for 18,000.
Analysis Buyer Maximum- Sellers
Minimum- Price- Consumers Surplus- Producers
Surplus-
20,000
15,000
18,000
2,000
3,000
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Voluntary Exchange Terms
Consumer Surplus is the difference between what
you are willing to pay and what you actually pay.
CS Buyers Maximum Price Producers Surplus
is the difference between the price the seller
received and how much they were willing to sell
it for. PS Price Sellers Minimum
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Pearl Exchange Activity
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Voluntary Exchange Activity
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Consumer and Producers Surplus
P

• Calculate the
• Consumer Surplus
• Producer Surplus
• Total Surplus

10 8 6 5 4 2 1
S
CS
PS
D
10
2 4 6 8
Q
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Calculating Consumer SurplusIn Dollars
Max Willing to pay Actual price (E) Calculate CS
9 5 9 5 4
8 5 8 5 3
7 5 7 5 2
6 5 6 5 1
5 5 5 5 0
Sum CS 10
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Calculating Producer SurplusIn Dollars
Min Price charged Actual price (E) Calculate PS
2 5 5 2 3
3 5 5 - 3 2
4 5 5 - 4 1
5 5 5 5 0

Sum PS 6
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Surpluses

• Could be calculated in Quantity

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Summary
Consumption Inefficiency
Production Inefficiency
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Practice Problem
Name of Consumer Price willing to pay
Matt 20
Don 15
Sarah 8
George 12
Ann 7
Q. If dinner sells for 10, what is the value of
Dons consumer surplus?
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Practice Problem
Name of Consumer Price willing to pay
Matt 20
Don 15
Sarah 8
George 12
Ann 7
Q. If dinner sells for 10, what is the value of
Dons consumer surplus?
A. Willing to pay is 15. Market price is 10.
Willing to pay (15) Actual Price (10) 5
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Practice Problem
Name of Consumer Price willing to pay
Matt 20
Don 15
Sarah 8
George 12
Ann 7
Q. If dinner sells for 11, what is the TOTAL
value of consumer surplus?
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Practice Problem
Name of Consumer Price willing to pay
Matt 20
Don 15
Sarah 8
George 12
Ann 7
Q. If dinner sells for 11, what is the TOTAL
value of consumer surplus?

• 20 11 9, 15 11 4, 12 11 1
• 9 4 1 15 consumer surplus

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• For a given linier demand curve, the value of
  consumer surplus does what as market price
  increases?

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• For a given linier demand curve, the value of
  consumer surplus does what as market price
  increases?
• Decreases as market price increases