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Lecture#2(2) Lecture#2(2) Presentation Transcript

  • Lecture #2: Supply and Demand Browning and Zupan Chapter 2 ECON306 Alexander Schibuola
  • OUTLINE: SUPPLY AND DEMAND
    • DEMAND
    • SUPPLY
    • EQUILIBRIUM
    • CHANGES IN SUPPLY AND DEMAND
    • PRICE CONTROLS
    • ELASTICITIES
  • 1. DEMAND: The Demand Curve
    • The Demand Curve
      • Is a schedule showing the quantity demanded (Q d ) for a good, Q, for different prices (P)
      • -It shows the present price and present quantity demanded (as opposed to future price and future quantity demanded)
      • -Keep in mind in reality all we see is one price and one quantity over a given time, the other values we don’t see are hypothetical
    • Law of Demand
      • The lower the price of a good the larger the quantity demanded.
      • Corollary: The higher the price, the smaller the quantity demanded
    • Demand vs. Quantity Demanded
      • -“Demand” depicts the Q d for different P
      • -“Quantity demanded” depicts how much Q d for one particular P
    • Shifts in Demand
      • A demand curve shift (change in demand) shows that Q d changes for all P
  • 1. DEMAND: The Demand Curve
    • Left-side: Demand schedule;
    • P = price
    • Q d = quantity demanded
    • Right-side: Demand curve
    D P Q d 7 0 6 0 5 100 4 200 3 300 2 400 1 500 7 6 5 1 2 3 4 100 200 300 400 600 500 700 0 1. Demand curve is a schedule of prices and quantities 2. Law of Demand—at lower P, Q d is greater 100 200 0 300 100 200 0 400 300 100 200 0 500 400 300 100 200 0 600 500 400 300 100 200 0 700 600 500 400 300 100 200 0 Underlying algebra: D: P = 6 – (1/100)*Q d , or Q d = 600 –100P P Q
  • 1. DEMAND: The Demand Curve
    • Left-side: Demand schedule;
    • P = price
    • Q d = quantity demanded
    • Right-side: Demand curve
    D P Q d 7 0 6 0 5 100 4 200 3 300 2 400 1 500 7 6 5 1 2 3 4 100 200 300 400 600 500 700 0 D’ (Q d )’ 100 200 300 400 500 600 700 3. Change in quantity demanded when we move along a given demand curve 4. Shift in demand = change in demand There’s been a change in Q d for all prices Underlying algebra: D: P = 6 – (1/100)*Q d , or Q d = 600 –100P D’: P= 8 – (1/100)*Q d , or Q d = 800 – 100P P Q
  • 1. DEMAND: The Demand Curve
    • When drawing a given demand curve we assume the following factors are constant (a.k.a. ceteris paribus):
      • Income
      • Prices of related goods
      • Tastes and preferences
      • The number of buyers
      • Expected future price
    • If one of these factors changes, the entire demand curve shifts…
  • 1. DEMAND: The Demand Curve
    • Why changes in demand (i.e., demand curve shifts)?
    • Changes in income
      • An increase in income will cause demand to increase (shifts right) if the good is a normal good
      • What is a normal good ? It’s a good for which consumption increases when income rises
      • An increase in income will cause demand to decrease (shifts left) if the good is an inferior good
      • What is an inferior good ? It’s a good for which consumption decreases when income rises
  • 1. DEMAND: The Demand Curve
    • Why changes in demand (i.e., demand curve shifts)?
    • 2. Changes in the prices of related goods
      • An increase in the price of a complement will cause demand to decrease (shifts left)
      • What are complements ? Goods that tend to be consumed together, so consumption of tends to rise or fall together
      • An increase the price of a substitute will cause demand to increase (shifts right)
      • What is a substitutes ? Two goods that can replace one another in consumption
  • 1. DEMAND: The Demand Curve
    • Why changes in demand (i.e., demand curve shifts)?
    • 3. Changes in the tastes and preferences
      • Tastes and preferences are the feelings of consumers about the desirability of different goods
      • If preferences for a good increase demand will increase (shifts right)
  • 1. DEMAND: The Demand Curve
    • Why changes in demand (i.e., demand curve shifts)?
    • 4. Changes in the number of buyers
      • If more people try to buy a good, they bid up prices
      • If the number of buyers increases demand increases (shifts right)
  • 1. DEMAND: The Demand Curve
    • Why changes in demand (i.e., demand curve shifts)?
    • 5. Changes in expected future price
      • If the expected future price of a good rises today, buyers would want to buy more today when it’s relatively cheaper
      • If the expected future price increases demand increases (shifts right)
      • in the present
  • 1. DEMAND: The Demand Curve
    • Other notes…
    • The demand curve is downward sloping for two possible reasons:
    • (1) A given individual buys more as a good’s price falls
    • (2) The number of people who buy a good rises as price falls
    • Two aspects are not necessarily mutually exclusive on a given demand curve
    • Willingness-to-pay (WTP)—the value, one attaches to a good (independent of its price)
    • Demand curve shows the maximum value attached to the q th good
    • a.k.a. (Buyer’s) reservation price —the highest price one is willing-to-pay
    • The difference between an individual’s reservation price and the market price (the price actually paid) is that consumer’s surplus
  • 1. DEMAND: The Demand Curve
    • Other notes…
    • Suppose we’re talking about the demand for 8 apartments, one buyer per good
    • Person 1—R 1 =$1000
    • Person 2—R 2 = $900
    • Person 3—R 3 = $800
    • Person 8—R 8 = $300
    • Person 9—R 9 = $200
    • Person 10—R 10 =$100
    CS i = R i – P* 1000-300=700 900-300 = 600 800-300 = 500 … 300-300 = 0 200-300 =-100 100-300 =-200 D S Q P P* Scale of P-axis in hundreds, e.g., 5 = $500 700 600 500 400 Graphically: The total consumer surplus is measured by the area underneath the demand curve and between the market price, P* 300 200 100 CS tot = 700 + 600 + … + 100 + 0 = $2800 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 1. DEMAND: The Demand Curve
    • Other notes…
    • Why account for consumer surplus?
    • Most of the goods you will ever purchase come at a considerable bargain…
    • Person 3 with R = $800 gets an apartment she values at $800 for only $300
    • Person 10 (with R = $100) opts not to rent the apartment because his wealth decreases by $200 (= 100 – 300)
    • The opportunity cost is too high. P10 prefers to not live there and to spend his $300 elsewhere…if the price falls to $100 he will reconsider
    • We’ll return to this concept of consumer surplus in another lecture…
  • 2. SUPPLY: The Supply Curve
    • The Supply Curve
      • Is a schedule showing the quantity supplied (Q s ) for a good, Q for different prices (P)
      • -It shows the present price and present quantity supplied (as opposed to future price and future quantity supplied)
      • -Keep in mind in reality all we see is one price and one quantity over a given time, the other values we don’t see are hypothetical
    • Law of Supply
      • The higher the price of a good the larger the quantity supplied
      • Corollary: The lower the price, the smaller the quantity supplied
    • Supply vs. Quantity Supplied
      • “ Supply” depicts the Q s for different P
      • “ Quantity supplied” depicts how much Q s for one particular P
    • Shifts in Supply
      • A supply curve shift (change in supply) shows that Q s changes for all P
  • 1. SUPPLY: The Supply Curve
    • Left-side: Supply schedule;
    • P = price
    • Q s = quantity supplied
    • Right-side: Supply curve
    S P Q s 6 600 5 500 4 400 3 300 2 200 1 100 7 6 5 1 2 3 4 100 200 300 400 600 500 700 0 1. Supply curve is a schedule of prices and quantities 2. Law of Supply—at higher P, Q s is greater Underlying algebra: S: P = 0 + (1/100)*Q s , or Q s = 0 + 100P P Q
  • 2. SUPPLY: The Supply Curve
    • Left-side: Supply schedule;
    • P = price
    • Q s = quantity supplied
    • Right-side: Supply curve
    S P Q s 6 600 5 500 4 400 3 300 2 200 1 100 7 6 5 1 2 3 4 100 200 300 400 600 500 700 0 S’ (Q s )’ 800 700 600 500 400 300 3. Change in quantity supplied when we move along a given supply curve 4. Shift in supply = change in supply There’s been a change in Q s for all prices Underlying algebra: S: P = 0 + (1/100)*Q s , or Q s = 0 + 100P S’: P= -1+(1/100)*Q s , or Q s = -100 + 100P P Q
  • 2. SUPPLY: The Supply Curve
    • When drawing a given supply curve we assume the following factors are constant (a.k.a. ceteris paribus):
      • Prices of inputs
      • State of technological knowledge
      • Price of alternative outputs
      • Number of sellers
      • Expected future price
    • If one of these factors changes the entire supply curve shifts.
  • 2. SUPPLY: The Supply Curve
    • Why changes in supply (i.e., supply curve shifts)?
    • 1. Changes in the prices of inputs
      • To produce an output (i.e., to produce a certain “quantity supplied”, producers use inputs:
      • Inputs are labor (L) and capital (K)
      • When producers combine these inputs (L and K) we get outputs, if the price of the inputs decreases (making it cheaper to employ more inputs, supply increases
  • 2. SUPPLY: The Supply Curve
    • Why changes in supply (i.e., supply curve shifts)?
    • 2. Changes in the state of technological knowledge
      • An improvement in the state of technological knowledge increases supply (supply curve shifts right), it makes production cheaper
  • 2. SUPPLY: The Supply Curve
    • Why changes in supply (i.e., supply curve shifts)?
    • 3. Changes in the price of alternative outputs
      • If producers can produce an alternative to Q, let’s call it R, and the price of R falls relative to the price of Q, producers will increase the supply of Q.
      • Why? Because it’s Q’s price is now relatively higher, making it relatively more profitable to produce
  • 2. SUPPLY: The Supply Curve
    • Why changes in supply (i.e., supply curve shifts)?
    • 4. Changes in the number of sellers
      • If more sellers (or producers or firms, etc.) enter a market, they must outbid each other by lowering prices to sell the greater supply
      • As a result an increase in the number of sellers leads the supply to increase (shifts right)
  • 2. SUPPLY: The Supply Curve
    • Why changes in supply (i.e., supply curve shifts)?
    • 5. Changes in the expected future price
      • If the expected future price of a good falls, suppliers will want to sell more today when it’s present price is relatively higher
      • As a result an increase the supply to increase (shifts right)
  • 2. SUPPLY: The Supply Curve
    • Other notes…
    • The supply curve is upward sloping for two possible reasons:
    • (1) A given individual sells more as a good’s price rises
    • (2) The number of people who sell a good rises as price rises
    • These two aspects are not necessarily mutually exclusive
    • Willingness-to-sell (WTS)—the value, one attaches to a good (independent of its price)
    • Supply curve shows the minimum values sellers attach to the q th good
    • a.k.a. (Seller’s) reservation price —the lowest price one is willing-to-sell
    • The difference between a the market price and the seller’s reservation price is the producer’s surplus
  • 2. SUPPLY: The Supply Curve
    • Other notes…
    • Suppose we’re talking about the supply of apartments, one seller per good
    • Person 1—R 1 = $100
    • Person 2—R 2 = $200
    • Person 3—R 3 = $300
    • Person 8—R 8 = $800
    • Person 9—R 9 = $900
    • Person 10—R 10 =$1000
    P* – R i = PS i 800-100 = 700 800-200 = 600 800-300 = 500 … 800-800 = 0 800-900 = -100 800-1000 = -200 D S Q P P* Scale of P-axis in hundreds, e.g., 5 = $500 Graphically: The total producer surplus is measured by the area underneath the market price, P* and between the supply curve PS tot = 700 + 600 + … + 100 + 0 = $2800 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 700 600 500 400 300 200 100
  • 2. SUPPLY: The Supply Curve
    • Other notes…
    • Why account for producer surplus?
    • Most of the goods you will ever sell are a bargain to part with…
    • Person 1 with R = $100 gives up an apartment he values at $100 for $800
    • Person 9 (with R = $900) opts not to rent out the apartment because her wealth decreases by $100 (= 800 – 900)
    • The opportunity cost is too high, you’d only rent it out for a minimum additional $800
    • We’ll return to this concept of producer surplus in another lecture…
  • 2. SUPPLY: The Supply Curve
    • Other notes…
    • Demand-side: Buyers, Consumers, Demanders
    • Supply-side: Sellers, Producers (or firms), Suppliers
    • Terms buyers and sellers somewhat misleading…
    • In an exchange there is neither really a buyer or seller per se, only traders…
    • Do you buy coffee from Starbucks with your money? OR
    • Does you Starbucks buy money from you with their coffee?
    • From another angle:
    • Does Starbucks sell coffee for your money? OR
    • Do you sell your money for coffee?
  • 2. SUMMARY I
    • Demand increases (shifts right) if…
      • Income increases and the good demanded is a normal good
      • Income decreases and the good demanded is an inferior good
      • The price of a complement decreases
      • The price of a substitute increases
      • Tastes and preferences for the good increases
      • The number of buyers increases
      • The expected future price of the good increases
    • Supply increases (shifts right) if…
      • The price of inputs decreases
      • The state of technological knowledge improves
      • The price of alternative outputs decreases
      • The number of sellers increases
      • The expected future price decreases
  • 2. SUMMARY II
    • Demand decreases (shifts left) if…
      • Income decreases and the good demanded is a normal good
      • Income increases and the good demanded is an inferior good
      • The price of a complement increases
      • The price of a substitute decreases
      • Tastes and preferences for the good decreases
      • The number of buyers decreases
      • The expected future price of the good decreases
    • Supply decreases (shifts left) if…
      • The price of inputs increases
      • The state of technological knowledge regresses
      • The price of alternative outputs increases
      • The number of sellers decreases
      • The expected future price increases
  • 3. Equilibrium
    • Equilibrium, (Q*, P*)
      • Quantity Supplied = Quantity Demanded
        • No one wants to make any more trades
        • Exists at the price, P* that equates the quantity supplied with quantity demanded ceteris paribus
    • Disequilibrium
      • Q s ≠ Q d (P ≠ P*)
      • Shortages:
      • (Q d > Q s because P < P*)
      • Surpluses:
      • (Q s > Q d because P > P*)
    D S Q P P* Q* 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 3. Equilibrium: Disequilibrium
      • Shortages (Q s < Q d because P < P*)
      • At P = $3:
      • Consumers want to buy 6000g (Q d = 6000)
      • Producers want to sell 2000g (Q s = 2000)
    D S Q P P Q s Q d XD Figure: Market for gasoline Q in thousands, i.e., 2 = 2000 gallons P is price per gallon P = $3/gallon Buyers want more than sellers are willing to supply at P = 3 Their inventories are depleted faster than they can be replaced Sellers start to raise prices: Q d decreases and Q s increases Process continues until Q d = Q s Shortage exists if there is an excess demand (XD) for goods P* 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 3. Equilibrium: Disequilibrium
      • Surpluses (Q s > Q d because P > P*)
      • At P = $7:
      • Consumers want to buy 2000g (Q d = 2000)
      • Producers want to sell 6000g (Q s = 6000)
    D S Q P P Q d Q s XS Figure: Market for gasoline Q in thousands, i.e., 2 = 2000 gallons P is price per gallon P = $3/gallon Buyers want less than sellers are willing to supply at P = 7 Their inventories accumulate more than they can be sold Sellers start to decrease prices: Q s decreases and Q d increases Process continues until Q d = Q s Surplus exists if there is an excess supply (XS) of goods P* 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • Suppose there is an unexpected increase in demand…
    • Buyers want more across all prices
    • Initial equilibrium (P 1 , Q 1 )
    • Temporary disequilibrium
      • Q d > Q s  shortage (XD)
      • Sellers raise price
      • Higher price leads Q s to increase
      • Higher price leads Q d to decrease
      • Continues until:
    • New equilibrium (P 2 , Q 2 )
    D S Q P P 1 Q 1 D’ a b c Q d Q 2 P 2 Q s 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • Suppose there is an unexpected decrease in demand…
    • Buyers want less across all prices
    • Initial equilibrium (P 1 , Q 1 )
    • Temporary disequilibrium
      • Q d < Q s  surplus (XS)
      • Sellers decrease price
      • Lower price leads Q s to decrease
      • Lower price leads Q d to increase
      • Continues until:
    • New equilibrium (P 2 , Q 2 )
    D S Q P P 1 Q 1 D’ a b c Q d Q 2 P 2 Q s 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • Suppose there is an unexpected increase in supply…
    • Sellers want to sell more across all prices
    • Initial equilibrium (P 1 , Q 1 )
    • Temporary disequilibrium
      • Q s > Q d  surplus (XS)
      • Sellers decrease price
      • Lower price leads Q s to decrease
      • Lower price leads Q d to increase
      • Continues until:
    • New equilibrium (P 2 , Q 2 )
    D S Q P P 1 Q d a b c Q s Q 2 P 2 S’ Q 1 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • Suppose there is an unexpected decrease in supply…
    • Sellers want to sell less across all prices
    • Initial equilibrium (P 1 , Q 1 )
    • Temporary disequilibrium
      • Q s < Q d  shortage (XD)
      • Sellers increase price
      • Higher price leads Q s to increase
      • Higher price leads Q d to decrease
      • Continues until:
    • New equilibrium (P 2 , Q 2 )
    D S Q P P 1 Q d a b c Q s Q 2 P 2 S’ Q 1 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • In practice we will generally take the short-route:
    • Suppose (again) that there’s a decrease in supply…
    • Initial equilibrium (P 1 , Q 1 )
    • New equilibrium (P 2 , Q 2 )
    D S Q P P 1 Q 1 a b Q 2 P 2 S’ Rather than go through the dynamic transition from one equilibrium to another we just jump from one equilibrium to another HOW THIS GRAPH IS READ: A decrease in supply (shifts left) leads to a decrease in the quantity demanded . Equilibrium price (P*) increases and equilibrium quantity (Q*) decreases. 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • In reality all we observe are P and Q
    • Suppose we look at monthly gasoline prices and quantity
    • Point 0—Initial equilibrium (P 0 , Q 0 )
    D S Q P P 0 Q 0 0 d c b a Suppose next month, we observe that: a: P a > P 0 and Q a > Q 0 b: P b < P 0 and Q b > Q 0 c: P c < P 0 and Q c < Q 0 d: P d > P 0 and Q d < Q 0 We can infer whether supply or demand changes dominated the market over time A: Demand Increase A: Supply Increase A: Supply Decrease A: Demand Decrease e 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 4. CHANGES IN SUPPLY AND DEMAND
    • No shortages of economic illiteracy…
    • You will frequently read/hear something like this in the news:
    • “ Increased demand is causing shortages in the market for X”
    • Generally incorrect…true only if price does not increase
    • An increased demand does not produce shortages but a higher price…if price does not increase then a prolonged shortage is possible
    • But why would prices not increase?
  • 5. PRICE CONTOLS
    • Frequently politicians attack “price-gouging” and want to impose price controls to benefit an interest group
    • E.g., New York mayoral candidate who complained that, “The Rent is too Damn High!”
    • Price ceiling —a legislated maximum price for a good
    • (Some times known as a rent control)
    • Price floor —a legislated minimum price for a good
    • These are instances in which there are good intentions but bad outcomes… (unintended consequences)
  • 5. PRICE CONTOLS
    • Can the law be effectively enforced?
    • If NO:
    • -Furnish the apartment and charge for using furniture
    • -Make tenant responsible for maintenance cost
    • -Charge a non-refundable deposit
    • -Accept bribes (monetary or non-monetary)
    • -Engage in discrimination
    • P* and Q* still prevail albeit in a less transparent manner
    D S Q P P c Q* XD New York apartment market Q in millions P in hundreds per month P c = price ceiling P* Q c 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 5. PRICE CONTOLS
    • Can the law be effectively enforced?
    • If YES:
    • Q* will fall to Q c
    • Produces a shortage, at P c 6 million apartments are demanded, but only 2 million are made available
    • 2 million people will get an apartment, the other 4 million will not get an apartment in NYC
    • Rather than produce apartments for housing—space will be used for offices or stores instead
    D S Q P P c Q* XD New York apartment market Q in millions P in hundreds per month P c = price ceiling P* Q c 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 5. PRICE CONTOLS
    • Who is harmed?
    • Obviously landlords are worse-off—they started to rent expecting P* but end up with P c
    • Less obvious:
    • Shortages
    • Quality degradation
    • Enforcement costs
    • Misallocated resources
    D S Q P P c Q* XD New York apartment market: Q in millions P in hundreds per month P c = price ceiling P* Q c Who benefits? -Landlords not in NYC -People who do manage to find a rent-controlled apartment 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
  • 5. PRICE CONTOLS
    • Surplus 
    • Q s > Q d
     Shortage Q d > Q s
  • 6. ELASTICITIES
    • Qualitative answers not enough; need something more quantitative…
    • Elasticity—measures how responsive Q d (or Q s ) is to a change in a determinant (e.g., price, income, etc.)
    • Definition and Calculation
      • Price elasticity of demand
      • Income elasticity of demand
      • Cross-price elasticity
      • Price elasticity of supply
    • Application and Interpretation
  • 6. ELASTICITIES: (1) Definition and Calculation: (A) Price Elasticity of Demand
    • Price Elasticity of Demand —measures how responsive the quantity demanded of a good is to a change in its price
    • Formally it measures the percentage change in quantity demanded relative to the percentage change in price
  • 6. ELASTICITIES: (1) Definition and Calculation: (A) Price Elasticity of Demand
    • Calculation of Point Elasticity Formula : For small changes in Q d and P
    • Step 1: Find percentage change in Q d
    • [(Q d1 – Q d0 )/Q d0 ]*100 = (% change in Q)
    • Step 2: Find percentage change in P
    • [(P 1 – P 0 )/P 0 ]*100 = (% change in P)
    • Step 3: Divide percentage change in Q d by percentage change in P
    • (% change in Q d )/(% change in P) = η
    • Here’s the formula in the most reduced form:
    • η = ( Δ Q d / Δ P)*(P 0 /Q d0 ),
    • Where Δ (delta) indicates “change in,” e.g., Δ Q d = Q d1 – Q d0
  • 6. ELASTICITIES: (1) Definition and Calculation: (A) Price Elasticity of Demand
    • Calculation of Arc Elasticity Formula : For large changes in Q d and P
    • Step 1: Find averaged percentage change in Q d
    • {(Q d1 – Q d0 )/[0.5*(Q d1 + Q d0 ]}*100 = (% change in Q)
    • Step 2: Find averaged percentage change in P
    • {(P 1 – P 0 )/[0.5*(P 1 + P 0 ]}*100 = (% change in P)
    • Step 3: Divide averaged % change in Q by averaged % change in P
    • (% change in Q d )/(% change in P) = η ( η is eta)
    • Here’s the formula in the most reduced form:
    • η = {(Q d1 – Q d0 )/[0.5*(Q d1 + Q d0 ]} / {(P 1 – P 0 )/[0.5*(P 1 + P 0 ]}
    • Where Δ (delta) indicates “change in,” e.g., Δ Q d = Q d1 – Q d0
  • 6. ELASTICITIES: (1) Definition and Calculation: (A) Price Elasticity of Demand
    • When you estimate the price elasticity of demand you have three qualitative results:
    • NOTE: When calculating the price elasticity of demand, η will be negative (because of the First Law of Demand). In context, we generally speak of elasticity as a positive number so we analyze the absolute value of n, | η |:
    • (a) If | η | > 1  demand is elastic
    • (b) If | η | = 1  demand is unit elastic
    • (c) If | η | < 1  demand is inelastic
    • We’ll return to the interpretation of η
  • 6. ELASTICITIES: (1) Definition and Calculation: (A) Price Elasticity of Demand
    • Other notes on Price Elasticity of Demand:
    • It varies between goods, and this depends on:
    • The number of substitutes and/or the degree to which substitutes are close
    • The time period over which demand is analyzed
    • In particular demand will be more elastic, if:
    • (1) There are many substitutes and/or close substitutes
    • (2) The time period analyzed is of longer duration
  • 6. ELASTICITIES: (1) Definition and Calculation: (B) Income Elasticity of Demand
    • Income Elasticity of Demand —measures how responsive the quantity demanded of a good is to a change in income
    • Formally it measures the percentage change in quantity demanded relative to the percentage change in income
  • 6. ELASTICITIES: (1) Definition and Calculation: (B) Income Elasticity of Demand
    • Calculation of Income Elasticity Formula : For changes in Q d and I
    • Step 1: Find percentage change in Q d
    • [(Q d1 – Q d0 )/Q d0 ]*100 = (% change in Q)
    • Step 2: Find percentage change in income, I
    • [(I 1 – I 0 )/I 0 ]*100 = (% change in I)
    • Step 3: Divide percentage change in Q by percentage change in I
    • (% change in Q d )/(% change in I) = Φ , ( Φ is phi)
    • Here’s the formula in the most reduced form:
    • Φ = ( Δ Q d / Δ I)*(I 0 /Q d0 ),
    • Where Δ (delta) indicates “change in,” e.g., Δ Q d = Q d1 – Q d0
  • 6. ELASTICITIES: (1) Definition and Calculation: (B) Income Elasticity of Demand
    • When you estimate the income elasticity of demand you have two qualitative results:
    • (a) If Φ ≥ 0  it’s a normal good
    • (b) If Φ < 0  it’s an inferior good
    • We’ll return to the interpretation of Φ
  • 6. ELASTICITIES: (1) Definition and Calculation: (C) Cross-Price Elasticity of Demand
    • Cross-Price Elasticity of Demand —measures how responsive the quantity demanded of a good is to a change in the price of a related good
    • Formally it is measures the percentage change in quantity demanded relative to a percentage change in the price of a related good
  • 6. ELASTICITIES: (1) Definition and Calculation: (C) Cross-Price Elasticity of Demand
    • Calculation of Cross-Price Elasticity Formula : For changes in Q d and P R
    • Step 1: Find percentage change in Q d
    • [(Q d1 – Q d0 )/Q d0 ]*100 = (% change in Q)
    • Step 2: Find percentage change in the price of the related good, P R
    • [(P R1 – P R0 )/P R0 ]*100 = (% change in P R )
    • Step 3: Divide percentage change in Q by percentage change in P R
    • (% change in Q d )/(% change in P R ) = Χ ( Χ is chi)
    • Here’s the formula in the most reduced form:
    • Χ = ( Δ Q d / Δ P R )*(P R0 /Q d0 ),
    • Where Δ (delta) indicates “change in,” e.g., Δ Q d = Q d1 – Q d0
  • 6. ELASTICITIES: (1) Definition and Calculation: (C) Cross-Price Elasticity of Demand
    • When you estimate the income elasticity of demand you have three qualitative results:
    • (a) If Χ > 0  it’s a substitute to good R
    • (b) If Χ < 0  it’s a complement to good R
    • (c) If Χ = 0  R is not a related good
    • We’ll return to this the interpretation of Χ
  • 6. ELASTICITIES: (1) Definition and Calculation: (D) Price Elasticity of Supply
    • Price Elasticity of Supply —measures how responsive the quantity supplied of a good is to a change in the good’s price
    • Formally it is measures the percentage change in quantity supplied relative to a percentage change in the price
  • 6. ELASTICITIES: (1) Definition and Calculation: (D) Price Elasticity of Supply
    • Calculation of Price Elasticity of Supply Formula : For changes in Q s and P
    • Step 1: Find percentage change in Q s
    • [(Q s1 – Q s0 )/Q s0 ]*100 = (% change in Q)
    • Step 2: Find percentage change in the price of the related good, P
    • [(P 1 – P 0 )/P 0 ]*100 = (% change in P)
    • Step 3: Divide percentage change in Q s by percentage change in P
    • (% change in Q s )/(% change in P ) = ε ( ε is epsilon)
    • Here’s the formula in the most reduced form:
    • ε = ( Δ Q s / Δ P)*(P 0 /Q s0 ),
    • Where Δ (delta) indicates “change in,” e.g., Δ Q s = Q s1 – Q s0
  • 6. ELASTICITIES: (1) Definition and Calculation: (D) Price Elasticity of Supply
    • When you estimate the income elasticity of demand you have five qualitative results:
    • (a) If ε = ∞  supply curve is horizontal
    • (b) If ε > 1  supply is elastic
    • (c) If ε = 1  supply is unit elastic
    • (d) If ε < 1  supply is inelastic
    • (c) If ε = 0  supply curve is vertical
    • We’ll return to the interpretation of ε
  • 6. ELASTICITIES: (2) Application & Interpretation: (A) Price Elasticity of Demand
    • Calculation of Point Elasticity Formula :
    • For small changes in Q d and P
    • η = ( Δ Q d / Δ P)*(P 0 /Q d0 ),
    • = [(102 – 100)/(9.9 – 10.0)] * [10.0/100]
    • = [2/(-0.1)] * [0.1]
    • = -2.0, | η | = 2.0 > 1  demand is elastic
    • Read as: a 1 % decrease in price leads to a 2 % increase in Q d
    • or rather, +2%/-1% = -2.0
    9.9 10.0 P t 102 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (A) Price Elasticity of Demand
    • Calculation of Point Elasticity Formula :
    • For small changes in Q d and P
    • η = ( Δ Q d / Δ P)*(P 0 /Q d0 ),
    • = [(101 – 100)/(9.8 – 10.0)] * [10.0/100]
    • = [1/(-0.2)] * [0.1]
    • = -0.5, | η | = 0.5 < 1  demand is inelastic
    • Read as: a 2 % increase in price leads to a 1 % decrease in Q d
    • or rather, -1%/+2% = -0.5
    9.8 10.0 P t 101 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (A) Price Elasticity of Demand
    • Calculation of Point Elasticity Formula :
    • For small changes in Q d and P
    • η = ( Δ Q d / Δ P)*(P 0 /Q d0 ),
    • = [(99 – 100)/(10.1 – 10.0)] * [10.0/100]
    • = [-1/(0.1) * [0.1]
    • = -1.0, | η | = 1.0 = 1  demand is unit elastic
    • Read as: a 1 % increase in price leads to a 1 % decrease in Q d
    • or rather, -1%/+1% = -1.0
    10.1 10.0 P t 99 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (B) Income Elasticity of Demand
    • Calculation of Income Elasticity of Demand :
    • For small changes in Q d and I
    • Φ = ( Δ Q d / Δ I)*(I 0 /Q d0 ),
    • = [(101 – 100)/(101 – 100)] * [100.0/100]
    • = [1/(1)] * [1]
    • = 1.0, Φ = 1.0 > 0  normal good
    • Read as: a 1 % increase in income, I , leads to a 1 % increase in Q d
    • or rather, 1%/1% = 1.0
    101.0 100.0 I t 101 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (B) Income Elasticity of Demand
    • Calculation of Income Elasticity of Demand :
    • For small changes in Q d and I
    • Φ = ( Δ Q d / Δ I)*(I 0 /Q d0 ),
    • = [(99 – 100)/(101 – 100)] * [100.0/100]
    • = [-1/(1)] * (1)]
    • = -1.0, Φ = -1.0 < 0  inferior good
    • Read as: a 1 % increase in income, I , leads to a 1 % decrease in Q d
    • or rather, -1%/+1% = -1.0
    101.0 100.0 I t 99 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (C) Cross-Price Elasticity of Demand
    • Calculation of Cross-Price Elasticity of Demand :
    • For small changes in Q d and P R
    • Φ = ( Δ Q d / Δ P R )*(P R0 /Q 0 ),
    • = [(101 – 100)/(5.1 – 5.0)] * [5.0/100]
    • = [1/(0.1)] * [0.05]
    • = +0.5, Φ = 0.5 > 0  R is a substitute for Q
    • Read as: a 2 % increase in the P R , leads to a 1 % increase in Q d
    • or rather, +1%/+2% = 0.5
    5.1 5.0 P Rt 101 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (C) Cross-Price Elasticity of Demand
    • Calculation of Cross-Price Elasticity of Demand :
    • For small changes in Q d and P R
    • Φ = ( Δ Q d / Δ P R )*(P R0 /Q 0 ),
    • = [(101 – 100)/(4.9 – 5.0)] * [5.0/100]
    • = [1/(-0.1)] * [0.05]
    • = -0.5, Φ = -0.5 < 0  R is a complement to Q
    • Read as: a 2 % decrease in P R , leads to a 1 % increase in Q d
    • or rather, +0.5%/-1% = 0.5
    4.9 5.0 P Rt 101 100 Q dt t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (D) Price Elasticity of Supply
    • Calculation of Price Elasticity of Supply :
    • For small changes in Q s and P
    • ε = ( Δ Q s / Δ P)*(P 0 /Q s0 ),
    • = [(102 – 100)/(10.1 – 10.0)] * [10.0/100]
    • = [2/(0.1)] * [0.1]
    • = 2.0, ε = 2.0 > 1.0  supply is elastic
    • Read as: a 1 % increase in the price, leads to a 2 % increase in Q s
    • or rather, 2%/1% = 2.0
    10.1 10.0 P Rt 102 100 Q st t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (D) Price Elasticity of Supply
    • Calculation of Price Elasticity of Supply :
    • For small changes in Q s and P
    • ε = ( Δ Q s / Δ P)*(P 0 /Q s0 ),
    • = [(101 – 100)/(10.2 – 10.0)] * [10.0/100]
    • = [1/(0.2)] * [0.1]
    • = 0.5, ε = 0.5 < 1  supply is inelastic
    • Read as: a 2% increase in the price, leads to a 1 % increase in Q s
    • or rather, 1%/2% = 0.5
    10.2 10.0 P Rt 101 100 Q st t = 1 t = 0 Given:
  • 6. ELASTICITIES: (2) Application & Interpretation: (D) Price Elasticity of Supply
    • Calculation of Price Elasticity of Supply :
    • For small changes in Q s and P
    • ε = ( Δ Q s / Δ P)*(P 0 /Q s0 ),
    • = [(101 – 100)/(10.1 – 10.0)] * [10.0/100]
    • = [1/(0.1)] * [0.1]
    • = 1.0, ε = 1.0 = 1  supply is unit elastic
    • Read as: a 1 % increase in the price, leads to a 1 % increase in Q s
    • or rather, 1%/1% = 1.0
    10.1 10.0 P Rt 101 100 Q st t = 1 t = 0 Given:
  • 6. ELASTICITIES: SUMMARY
    • Price elasticity of demand
    • Q d increases ___% if price , P decreases by ___%
    • (B) Income elasticity of demand
    • Q d changes ___% if income , I increases by ___%
    • (C) Cross-price elasticity of demand
    • Q d changes ___% if the price of a related good , P R increases by ___%
    • (D) Price elasticity of supply
    • Q s increases ___% if price , P increase by ___%
  • 6. ELASTICITIES: SUMMARY II
    • Price elasticity of demand, η
    • Q d increases ___% if price , P decreases by ___%
    • Suppose elasticity is 1.0…
    • A 1% decrease in price leads to a 1% increase in Q d .
    • Price elasticity of demand is unit elastic (1.0 = 1).
    • Suppose elasticity is (1/4)…
    • A 1% decrease in price leads to a 0.25% increase in Q d .
    • (Or) A 4% increase in price leads to a 1% decrease in Q d .
    • Price elasticity of demand is inelastic ((1/4) < 1).
    • Suppose elasticity is (3/2)…
  • 6. ELASTICITIES: SUMMARY II
    • (B) Income elasticity of demand, Φ
    • Q d changes ___ % if income , I increases by ___%
    • Suppose elasticity is 1.0…
    • A 1% increase in income leads to a 1% increase in Q d .
    • Is the good normal or inferior? (Depends whether: Φ > 0 or Φ is < 0)
    • Suppose elasticity is (-3/4)…
    • A 1% increase in income leads to a 0.75% decrease in Q d .
    • (Or) A 4% decrease in income leads to a 3% increase in Q d .
    • Is the good normal or inferior?
  • 6. ELASTICITIES: SUMMARY II
    • (C) Cross-price elasticity of demand, Χ
    • Q d changes ___% if the price of a related good , P R increases by ___%
    • Suppose elasticity is (5/2)…
    • A 1% increase in P R leads to a 2.5% increase in Q d .
    • (Or) A 2% increase in P R leads to a 5% increase in Q d .
    • Are the goods complements or substitutes?
    • Suppose elasticity is (-1/2)…
    • A 1% increase in P R leads to a 0.5% decrease in Q d .
    • (Or) What’s another way this could be read as?
    • Are the goods complements or substitutes?
    • Suppose elasticity is 0…
    • NOTE: P R = Price of related good.
  • 6. ELASTICITIES: SUMMARY II
    • (D) Price elasticity of supply , ε
    • Q s increases ___% if price , P increase by ___%
    • Suppose elasticity is (6/3)…
    • A 1% increase in P leads to a 2% increase in Q s .
    • (Or) A 10% increase in P leads to a 20% increase in Q s .
    • Is supply elastic, inelastic, or unit elastic?
    • Suppose elasticity is (0.8)…
    • A 1% increase in P leads to a 0.8% increase in Q s .
    • (Or) What’s another way this could be read as?
    • Is supply elastic, inelastic, or unit elastic?