Any price above the equilibrium causes an excess supply and any price below the equilibrium causes a shortage.
The market if uncontrolled will automatically arrive at the equilibrium price at which supply equals demand.
Any shift in demand and supply curves will result in a new equilibrium
Comparison of equilibrium is called comparative -statics
A decrease in supply creates a shortage at P 0 . Quantity demanded is greater than quantity supplied. Price will begin to rise.
The lower total supply is rationed to those who are willing and able to pay the higher price.
Alternative Price- Control Mechanisms
A price ceiling is a maximum price that sellers may charge for a good, usually set by government .
Example: rent control
A price floor is a price above equilibrium price that the buyers have to pay.
Example : agricultural support price, minimum wages
Elasticity: A measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable.
By converting each of these changes into percentages, the elasticity measure does not depend on the units in which we measure the variables.
Sensitivity of the quantity demanded to price is called: price elasticity of demand :
To get the average elasticity between two points on a demand curve we take the average of the two end points (for both price and quantity) and use it as the initial value:
Own Price Elasticity of Demand
Own price elasticity: A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good; the percentage change in quantity demanded divided by the percentage change in the price of the good.
Elastic demand: Demand is elastic if the absolute value of the own price elasticity is greater than 1.
Types of elasticities
elastic : the quantity demanded changes more than in proportion to a change in price
inelastic : the quantity demanded changes less than in proportion to a change in price
Elasticity and slope Price Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
Slope of the Demand Curve
P is the change in price. ( P<0)
Q is the change in quantity.
slope = P/ Q
Price Quantity Demand Q Q + Q Q P P+ P P
Elasticity and slope
Elastic demand : Demand is elastic if the absolute value of own price elasticity is greater than 1.
Inelastic demand: Demand is inelastic if the absolute value of the own price elasticity is less than 1.
Unitary elastic demand: Demand is unitary elastic if the absolute value of the own price elasticity is equal to 1.
Perfectly elastic demand : e= infinity
Perfectly inelastic demand : e = 0
Linear Demand Curve:
Qty E = infinity e=lower segment/upper segment E=0 E=1
Determinants of Elasticity
Number and closeness of substitutes – the greater the number of substitutes, the more elastic
The proportion of income taken up by the product – the smaller the proportion the more inelastic
Price of the product- lower the price, lower the elasticity
Luxury or Necessity - for example, addictive drugs
Time period – the longer the time under consideration the more elastic a good is likely to be
Cross-price elasticity: A measure of the responsiveness of the demand for a good to changes in the price of a related good; the percentage change in the quantity demanded of one good divided by the percentage change in the price of a related good.
The cross-price elasticity is positive whenever goods are substitutes.
The cross-price elasticity is negative whenever goods are complements.
Cross-price elasticity of demand
how quantity of one good changes as price of another good increases
Income elasticity of demand
Income elasticity: A measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income.
The income elasticity is positive whenever the good is a normal good.
The income elasticity is negative whenever the good is an inferior good.
Factors affecting Income elasticity :
Nature of the good:
inferior goods have negative income elasticity
Normal goods have positive income elasticity
Luxury goods have income elasticity greater than one
Necessary goods have income elasticity less than one
The own advertising elasticity of demand for good X defines the percentage change in the consumption of X that results from a given percentage change in advertising spent on X.
Elasticity and Total Revenue
If demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in total revenue.
If demand is inelastic, an increase (decrease) in price will lead to an increase (decrease) in total revenue.
Total revenue is maximized at the point where demand is unitary elastic.