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1. 1. TOPIC 3:Supply and DemandAnalysis
2. 2. THE ELASTICITY OF DEMAND Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d P ric e e la s tic ity o f d e m a n d = P e rc e n ta g e c h a n g e in p ric e
3. 3. THE ELASTICITY OF DEMAND Themidpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.
4. 4. THE ELASTICITY OF DEMAND Inelastic Demand  Quantity demanded does not respond strongly to price changes. Elastic Demand  Quantity demanded responds strongly to changes in price. Unit Elastic  Quantity demanded changes by the same percentage as the price. Perfectly Inelastic  Quantity demanded does not respond to price changes. Perfectly Elastic  Quantity demanded changes infinitely with any change in price.
5. 5. THE DETERMINANTS OF PRICEELASTICITY OF DEMAND Substitutability: The larger the number of substitute goods that are available, the greater the price elasticity of demand. Proportion of income: The higher the price of a good relative to consumers’ incomes, the greater the price elasticity of demand. Luxuries versus Necessities: The more that a good is considered to be a “luxury” rather than a “necessity”, the greater the price elasticity of demand. Definition of market: the more narrowly defined the market, the greater the price elasticity of demand. Time: Product demand is more elastic the longer the time period under consideration.
6. 6. TOTAL REVENUE Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q
7. 7. ELASTICITY OF A LINEAR DEMANDCURVE
8. 8. INCOME ELASTICITY OF DEMAND Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.
9. 9. INCOME ELASTICITY OF DEMAND Normal goods: Those goods that have positive income elasticity of demand.  Higher income raises the quantity demanded for normal goods. Inferior goods: Those goods that have negative income elasticity of demand.  Higher income lower the quantity demanded for inferior goods.
10. 10. INCOME ELASTICITY OF DEMAND Goods consumers regard as necessities tend to be income inelastic  Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic.  Examples include sports cars, furs, and expensive foods.
11. 11. CROSS-PRICE ELASTICITY OFDEMAND Cross-price elasticity of demand is a measure of how much the quantity demanded of one good responds to a change in the price of another good. It is computed as the percentage change in quantity demanded of the first good (X) divided by the percentage change in the price of the second good (Y).
12. 12. CROSS-PRICE ELASTICITY OFDEMAND Substitute goods: If the cross price elasticity of demand is positive then X and Y are substitute goods  The larger the cross elasticity coefficient the greater the substitutability between the two goods Complementary goods: If the cross price elasticity of demand is positive then X and Y are complementary goods  The larger the cross elasticity coefficient the greater the complementarity between the two goods Independent goods: If the cross price elasticity of demand is zero then X and Y are unrelated
13. 13. THE ELASTICITY OF SUPPLY Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. P e rc e n ta g e c h a n g e in q u a n tity s u p p lie d P ric e e la s tic ity o f s u p p ly = P e rc e n ta g e c h a n g e in p ric e
14. 14. PRICE ELASTICITY OF SUPPLY Elastic supply: The price-elasticity coefficient is greater than 1. Inelastic supply: The price-elasticity coefficient is less than 1. Unit elastic supply: The price-elasticity coefficient is 1. Perfectly inelastic supply: The price- elasticity coefficient is zero. Perfectly elastic supply: The price- elasticity coefficient is infinite.
15. 15. DETERMINANTS OF PRICEELASTICITY OF SUPPLY Ability of sellers to change the amount of the good they produce  Beach-front land is inelastic.  Books, cars, or manufactured goods are elastic. Time period.  Supply is more elastic in the long run.
16. 16. APPLICATIONS OF SUPPLY,DEMAND, AND ELASTICITY Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?
17. 17. FIGURE 1. AN INCREASE IN SUPPLY IN THEMARKET FOR WHEAT Price of Wheat 1. When demand is inelastic, 2. . . . leads an increase in supply . . . to a large fall S1 in price . . . S2 \$3 2 Demand 0 100 110 Quantity of Wheat 3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from \$300 to \$220. Copyright©2003 Southwestern/Thomson Learning
18. 18. SUPPLY, DEMAND, ANDGOVERNMENT POLICIES In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. One of the roles of economists is to use their theories to assist in the development of policies.
19. 19. CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors.  Price Ceiling  A legal maximum on the price at which a good can be sold  Price Floor  A legal minimum on the price at which a good can be sold.
20. 20. PRICE CEILING Twooutcomes are possible when the government imposes a price ceiling:  The price ceiling is not binding if set above the equilibrium price.  The price ceiling is binding if set below the equilibrium price, leading to a shortage.
21. 21. FIGURE 2. A MARKET WITH A PRICE CEILING (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply \$4 Price ceiling 3 Equilibrium price Demand 0 100 Quantity of Equilibrium Ice-Cream quantity Cones
22. 22. FIGURE 2. A MARKET WITH A PRICE CEILING (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Equilibrium price \$3 2 Price Shortage ceiling Demand 0 75 125 Quantity of Quantity Quantity Ice-Cream supplied demanded Cones Copyright©2003 Southwestern/Thomson Learning
23. 23. CONSEQUENCES OF PRICE CEILING Effects of Price Ceilings A binding price ceiling creates  shortages because QD > QS.  Example: Gasoline shortage of the 1970s  nonprice rationing problem  Examples: Long lines, discrimination by sellers  black markets
24. 24. CASE STUDY: LINES AT THE GASPUMP In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline. What was responsible for the long gas lines? • Economists blame government regulations that limited the price oil companies could charge for gasoline.
25. 25. FIGURE 3. THE MARKET FOR GASOLINE WITH APRICE CEILING (a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Supply, S11. Initially,the priceceilingis notbinding . . . Price ceiling P1 Demand 0 Q1 Quantity of Gasoline Copyright©2003 Southwestern/Thomson Learning
26. 26. FIGURE 3. THE MARKET FOR GASOLINE WITH APRICE CEILING (b) The Price Ceiling on Gasoline Is Binding Price of S2 Gasoline 2. . . . but when supply falls . . . S1 P2 Price ceiling P1 3. . . . the price 4. . . . ceiling becomes resulting binding . . . in a shortage. Demand 0 QS QD Q1 Quantity of Gasoline Copyright©2003 Southwestern/Thomson Learning
27. 27. CASE STUDY: RENT CONTROL INTHE SHORT RUN AND LONG RUN Rent controls are ceilings placed on the rents that landlords may charge their tenants. The goal of rent control policy is to help the poor by making housing more affordable. One economist called rent control “the best way to destroy a city, other than bombing.”
28. 28. FIGURE 4. RENT CONTROL IN THE SHORT RUNAND IN THE LONG RUN (a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Supply Controlled rent Shortage Demand 0 Quantity of Apartments Copyright©2003 Southwestern/Thomson Learning
29. 29. FIGURE 4. RENT CONTROL IN THE SHORT RUNAND IN THE LONG RUN (b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Supply Controlled rent Shortage Demand 0 Quantity of Apartments Copyright©2003 Southwestern/Thomson Learning
30. 30. PRICE FLOOR When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus.
31. 31. FIGURE 5. A MARKET WITH A PRICE FLOOR (a) A Price Floor That Is Not Binding Price of Ice-Cream Cone Supply Equilibrium price \$3 Price floor 2 Demand 0 100 Quantity of Equilibrium Ice-Cream quantity Cones Copyright©2003 Southwestern/Thomson Learning
32. 32. FIGURE 5. A MARKET WITH A PRICE FLOOR (b) A Price Floor That Is Binding Price of Ice-Cream Cone Supply Surplus \$4 Price floor 3 Equilibrium price Demand 0 80 120 Quantity of Quantity Quantity Ice-Cream demanded supplied Cones Copyright©2003 Southwestern/Thomson Learning
33. 33. CONSEQUENCES OF PRICE FLOORA binding price floor causes  a surplus because QS > QD.  nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.  Examples: The minimum wage, agricultural price supports
34. 34. THE MINIMUM WAGE LAW An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
35. 35. FIGURE 6. HOW THE MINIMUM WAGE AFFECTSTHE LABOR MARKET Wage Labor Labor surplus Supply (unemployment) Minimum wage Labor demand 0 Quantity Quantity Quantity of demanded supplied Labor Copyright©2003 Southwestern/Thomson Learning
36. 36. TAXES Governments levy taxes to raise revenue for public projects. Tax incidence is the manner in which the burden of a tax is shared among participants in a market. Tax incidence is the study of who bears the burden of a tax.
37. 37. FIGURE 7. A TAX ON BUYERS Price of Ice-Cream Price Cone Supply, S1buyers pay \$3.30 Equilibrium without tax Tax (\$0.50) Price 3.00 A tax on buyerswithout 2.80 shifts the demand tax curve downward by the size of Price Equilibrium the tax (\$0.50). sellers with tax receive D1 D2 0 90 100 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning
38. 38. FIGURE 8. A TAX ON SELLERS Price of Ice-Cream A tax on sellers Price Cone Equilibrium S2 shifts the supplybuyers with tax curve upward pay by the amount of \$3.30 S1 Tax (\$0.50) the tax (\$0.50). Price 3.00without 2.80 Equilibrium without tax tax Price sellersreceive Demand, D1 0 90 100 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning
39. 39. THE EFFECT OF TAXES Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.  In what proportions is the burden of the tax divided?  How do the effects of taxes on sellers compare to those levied on buyers?  The answers to these questions depend on the elasticity of demand and the elasticity of supply.
40. 40. FIGURE 9. HOW THE BURDEN OF A TAX IS DIVIDED (a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . .Price buyers pay Supply Tax 2. . . . the incidence of thePrice without tax tax falls more heavily on Price sellers consumers . . . receive 3. . . . than Demand on producers. 0 Quantity Copyright©2003 Southwestern/Thomson Learning
41. 41. FIGURE 9. HOW THE BURDEN OF A TAX IS DIVIDED (b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply . . .Price buyers pay SupplyPrice without tax 3. . . . than on consumers. Tax 2. . . . the Demand Price sellers incidence of receive the tax falls more heavily on producers . . . 0 Quantity Copyright©2003 Southwestern/Thomson Learning
42. 42. ELASTICITY AND TAX INCIDENCE So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic.
43. 43. WELFARE ECONOMICS Welfare economics is the study of how the allocation of resources affects economic well- being. Buyers and sellers receive benefits from taking part in the market. Consumer surplus measures economic welfare from the buyer’s side. Producer surplus measures economic welfare from the seller’s side.
44. 44. CONSUMER SURPLUS Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service. Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.
45. 45. EXAMPLE
46. 46. THE DEMAND SCHEDULE AND THEDEMAND CURVE
47. 47. CONSUMER SURPLUS The area below the demand curve and above the price measures the consumer surplus in the market.
48. 48. PRODUCER SURPLUS Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the benefit to sellers participating in a market.
49. 49. EXAMPLE
50. 50. THE SUPPLY SCHEDULE AND THESUPPLY CURVE
51. 51. PRODUCER SURPLUS The area below the price and above the supply curve measures the producer surplus in a market.
52. 52. MARKET EFFICIENCY CS = Value to buyers – Amount paid by buyers PS = Amount received by sellers – Cost to sellers Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers
53. 53. FIGURE 7 CONSUMER AND PRODUCER SURPLUS IN THE MARKET EQUILIBRIUM Price A D Supply Consumer surplusEquilibrium E price Producer surplus Demand B C 0 Equilibrium Quantity quantity Copyright©2003 Southwestern/Thomson Learning