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CHAPTER 18 EXTENSIONS OF DEMAND AND SUPPLY

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Title: 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
ELASTICITY
  • 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

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
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 gt 1
  • Inelastic Demand
  • Percentage change in price produces a smaller
    percentage change in quantity demanded
  • Ed lt 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
Price Elasticity of Demand
  • Extreme Cases

Perfectly Inelastic Demand
D1
Perfectly Inelastic Demand (Ed 0)
Perfectly Elastic Demand
D2
Perfectly Elastic Demand (Ed 8)
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
The Total Revenue Test
  • Total Revenue (TR)
  • TR P x Q
  • Elastic Demand

a
b
D1
16
The Total Revenue Test
  • Total Revenue (TR)
  • TR P x Q
  • Inelastic Demand

c
d
D2
17
The Total Revenue Test
  • Total Revenue (TR)
  • TR P x Q
  • Unit-Elastic

e
f
D3
18
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 Ine
lastic Inelastic
Graphically
19
Price Elasticity and the Total-Revenue Curve
Elastic Ed gt 1
Unit Elastic Ed 1
Inelastic Ed lt 1
D
Elastic Ed gt 1
Unit Elastic Ed 1
TR
Inelastic Ed lt 1
20
ELASTIC DEMAND REVENUE
  • Elastic Demandamount 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 Demandlower 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

DEMAND SCHEDULE DEMAND SCHEDULE DEMAND SCHEDULE
Price per Pound Number of Pounds Demanded Total Receipts
.80 .70 .60 .50 .40 .30 .20 .10 1,250 1,500 2,000 2,500 3,000 4,000 5,000 6,000 1,000 1,050 1,200 1,250 1,200 1,200 1,000 600
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 products 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 goods 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
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
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
Price Elasticity of Supply
Percentage Change in Quantity Supplied of Product
X
Es
Percentage Change in Price of Product X
Inelastic Supply
Es lt 1
Short Run Resources Not Easily Shifted to
Alternative Uses
Ss
Lower Price Impact
Ps
P0
D1
D2
Q0
Qs
34
Price Elasticity of Supply
Percentage Change in Quantity Supplied of Product
X
Es
Percentage Change in Price of Product X
Elastic Supply
Es gt 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 gt 0
  • Quantity demanded of W changes in the same
    direction as change in price of Z
  • Substitutes
  • Negative
  • Exy lt 0
  • Quantity demanded of X changes in opposite
    direction as change in price of Y
  • Complements
  • Income Elasticity
  • Positive
  • Ei gt 0
  • Quantity demanded of the product changes in the
    same direction as change in income
  • Normal Good
  • Negative
  • Ei lt 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
  • MBMC or marginal benefit equals marginal cost
  • Maximum willingness to payminimum acceptable
    price
  • Combined consumer and producer surplus is at a
    maximum

51
Efficiency
S
Consumer Surplus
Equilibrium Price 8
P1
Price (Per Bag)
Producer Surplus
D
Q1
Quantity (Bags)
52
Efficiency Losses or Deadweight Losses
  • Reductions of combined consumer and producer
    surplus associated with underproduction or
    overproduction of a product

53
Dead Weight Losses
S
Efficiency
Losses
P1
Price (Per Bag)
D
Q3
Q1
Q2
Quantity (Bags)
54
Cross Elasticity of Demand
Percentage Change in Quantity Demanded of Product
X
Exy
Percentage Change in Price of Product Y
  • Substitute Goods Positive Sign
  • Complementary Goods- Negative Sign
  • Independent Goods Zero or Near-Zero Value

55
Income Elasticity of Demand
Percentage Change in Quantity Demanded
Ei
Percentage Change in Income
  • Normal Goods Positive Sign
  • Inferior Goods- Negative Sign
  • Insights into the Economy

56
Consumer and Producer Surplus
  • Efficiency Revisited

Efficiency Losses (Deadweight Losses)
S
Efficiency
Losses
P1
Price (Per Bag)
D
Q3
Q1
Q2
Quantity (Bags)
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