Chapter 3' DEMAND, SUPPLY, AND MARKET EQUILIBRIUM Part 2

1
Chapter 3. DEMAND, SUPPLY, AND MARKET EQUILIBRIUM
(Part 2)

• Economics 11- UPLB
• Prepared by T.B.Paris, Jr. 11/28/07

2
Elasticity Concepts

• Meaning of elasticity If Yf(X), elasticity
  measures the responsiveness of Y due to changes
  in X.
• A given change in X brings about a change in Y.
  The elasticity measure attempts to compare the
  relative change in Y with to the relative change
  in X.
• Mathematical formulation

3
Elasticity Values
The elasticity values (in absolute terms) can
range from zero to infinity each with definite
interpretations.
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3 Demand Elasticity Concepts

• We shall study 3 demand elasticity concepts
• Own price elasticity responsiveness of quantity
  demanded of a good to changes in own-price.
• Cross price elasticity responsiveness of
  quantity demanded of good A to changes in price
  of good B (substitute or complement)
• Income elasticity responsiveness of quantity
  demanded of a good due to changes in income.

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Own-Price Elasticity

• Own price elasticity of demand (e) measure of
  responsiveness of quantity demanded to changes in
  price

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Two ways of measuring elasticity

• Point elasticity ? elasticity is measured for a
  single point
• More precise since elasticity changes at every
  point on demand curve
• Can be obtained if demand function is known
• Arc elasticity ? computed for two points along a
  demand curve
• Done if we have limited number of observations

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Point Elasticity
P
Price
A
P1
D
Q
0
Q1
Quantity
8
Arc Elasticity
P
Price
A
P1
B
P2
D
Q
Q2
0
Q1
Quantity
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Arc Elasticity Example
P
Price
A
30
B
20
D
Q
200
0
100
Quantity
10
Elasticity Along a Linear Demand Curve

• Elasticity goes down as you move down along a
  linear demand curve.
• The upper half is elastic, the lower half is
  inelastic.
• At the mid-point of the demand curve, elasticity
  is unitary.

P
D
Elastic
Price
P1
Unit Elastic
P
Inelastic
D
Q
Q1
0
Q
Quantity
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Geometric derivation of e
P
A
Price
B
E
O
D
C
Q
Quantity
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Geometric derivation of e
P
P
A
A
B
B
C
C
Q
Q
0
0
Elastic at B
Inelastic at B
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Demand function Qd 20 - 2P
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Special Case

• Perfectly Inelastic Demand Curve

D
P

• A vertical demand curve implies that any
  change in price will not lead to a change in
  quantity demanded.

Price
Q
0
Quantity
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Special Case

• Perfectly Elastic Demand Curve

• A horizontal demand curve implies that a very
  small change in price will lead to an infinitely
  large change in quantity demanded.

P
Price
D
Q
0
Quantity
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Elasticity and Total Revenue

• Total revenue (from the point of view of a
  seller) is equal to the quantity sold multiplied
  by the price.
• TR P x Q
• It is of interest to the seller what happens to
  his TR if he raises or lowers his price, knowing
  that if he does, consumers will adjust their
  purchases.

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What happens to TR when price increases?

• Answer it depends on the elasticity of demand

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What happens to TR when price decreases?

• Answer it depends on the elasticity of demand

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Determinants of price elasticity of demand

• (1) the availability of good substitutes for the
  commodity
• ? more substitutes, more elastic
• (2) the number of uses the good can be put into
• ? more uses, more elastic
• (3) the price of the good relative to the
  consumer's purchasing power
• ? if good takes a larger share of budget, likely
  to be more elastic
• (4) the time frame under consideration
• ? longer period of time, more elastic
• (5) location along the demand curve.
• ? recall ideas on elasticity and the linear
  demand curve

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Cross Price Elasticity of Demand

• Definition responsiveness of quantity demand of
  a good to changes in price of other goods.
• Formula
• Sign for substitutes, - for
  complements

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Income Elasticity of Demand

• Definition responsiveness of quantity demanded
  of a good to changes in income
• Formula
• Sign for normal goods
• - for inferior goods

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Some Applications

• Minimum Price Policy floor prices to protect
  producers (price support) or workers (minimum
  wage)
• Maximum Price Policy price ceilings to protect
  consumers (fares, rice price, LPG price, etc.
• Tax Incidence who bears the burden when tax is
  imposed on the producer?

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Minimum price policies

• prices cannot go below a specified price
• E.g. price support for agricultural commodities,
  minimum wages
• floor price is usually set above the equilibrium
  price and it causes a surplus

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Floor Price(minimum price policy)
Examples Minimum wages, price support for rice
farmers
P
S
surplus
Price
Pf
To be effective, a floor price (Pf) must be set
above the equilibrium price(P)
P
D
Q
Q1
0
Q
Quantity
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Maximum price policy (price ceiling)

• price cannot be set above a specified price
• Example maximum fares allowed public transport
  operators
• Usually set below the equilibrium price and
  causes a shortage

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Price Ceiling(maximum price policy)
P
Examples Price control of rice, rents, LPG
S
Price
Pf
To be effective, a price ceiling (Pf) must be set
below the equilibrium price(P)
P
Pc
shortage
D
Q
Q1
0
Q
Quantity
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Tax incidence

• Concerned with effects of government tax policies
  on consumption and production.
• The tax could either be a specific or excise tax
  or an ad valorem tax.
• specific tax or excise tax ? tax per unit of the
  product
• ad valorem tax ? tax as percentage of the
  selling price.

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Tax incidence

• Question Who bears the greater portion of tax?
  Is it the consumer or the producer?
• Supply and demand analysis of a specific tax
• the tax is likely to be paid for by producers and
  consumers
• the tax is likely to raise the equilibrium price,
  but by an amount less than the tax.

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Tax Incidence
P
S1
S0
P0 t
Price
tax
P1 t
P0
P1
D
Q
Q0
0
Q2
Q1
Quantity
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Tax Incidence
D
P
S1
S0
P0 t
Price
tax
If demand is Perfectly Inelastic all of the
tax is passed on to consumers.
P0
Q
Q0
0
Quantity
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Tax Incidence Perfectly Elastic Demand
P
S1
S0
Price
tax
D
P0
If demand is Perfectly Elastic all of the tax
burden is borne by the producer.
Q
Q0
0
Q1
Quantity
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Consumer Surplus
P
S1
Consumer surplus difference between what a
consumer is willing to pay and what he actually
pays for the good.
Price
P1
D
Q
0
Q1
Quantity
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Consumer Surplus
P
S1
S2
S2
S2
S2
S2
S2
S2
Price
When market price decreases, consumer surplus
becomes bigger
P1
P2
P2
P2
P2
P2
D
Q
0
Q1
Q2
Q2
Quantity
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Producer Surplus
P
S1
Producer surplus difference between what a
producer receives (market price) and the amount
that will motivate him to supply the product
(marginal costs must be recovered).
Price
P1
D
Q
0
Q1
Quantity
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End

• Chapter 3