Advanced Topics
Elasticity and Equilibrium Price
Changes
Changes in Equilibrium
• When events cause a supply or demand
curve to shift, the equilibrium price will
shift. But how much?
• Knowledge of elasticities can provide the
answer to this question.
Quantitative Changes Equilibrium
Effects
Negative Supply Shock
• Negative supply shock like embargo on
Iranian oil would raise prices and reduce
quantity of oil available.
– But how much? Clearly depends on the
supply
Equilibrium Change in Price
• A 1% shift out in the demand curve leads to a
change in equilibrium price.
1
%
S
D
e e
• A 1% shift out in the supply curve leads to a
1
change in equilibrium price.
%
S
D
e e
Example 1
• Elasticity of demand for oil is eD = -.061
and elasticity of supply is eS = .04. World
oil demand goes up by 1%. How much
does the price change?
• Answer:
1
1
1
1 S D % 
%
%  9.90%
e e
.04  .061
.101
Example 2
• What would happen to oil prices for GeoPolitical reasons there were a shut-down
of Iranian oil production and there was an
inward shift in the oil supply curve of
4.9%?
A shift in the supply schedule
(Spreadsheet)
A 4.9% shift in the supply schedule
30
35
40
45
50
55
60
65
70
75
80
85
90
95
100
105
Supply
29893.38
30078.28
30239.36
30382.16
30510.48
30627.02
30733.8
30832.36
30923.89
31009.35
31089.51
31164.99
31236.32
31303.95
31368.24
31429.56
Supply'
28428.61
28604.44
28757.63
28893.44
29015.46
29126.29
29227.84
29321.57
29408.62
29489.89
29566.12
29637.9
29705.74
29770.06
29831.2
29889.51
Demand
31867.11
31568.86
31312.77
31088.6
30889.43
30710.37
30547.8
30399.01
30261.9
30134.8
30016.4
29905.6
29801.51
29703.39
29610.59
29522.57
At the new supply curve
there is excess demand for
oil.
• Excess demand will
induce additional supply
and cut back in demand.
What is the new
equilibrium?
Example 3
• The cross price elasticity of bacon with
respect to eggs is -.2.
• The elasticity of demand for bacon is -.5.
The elasticity of supply for bacon is .5.
• The price of eggs goes up by 1%. What
happens to the price of bacon?
Example
• What would the oil price change be in the
long run, if world income went up
permanently by 10% and no shift in supply
curve?
Excise Tax
Own Price Elasticity Matters as
well.
• A less important effect is that the
steepness of the demand curve will also
impact the size of a demand shift.
• The steepness of the supply curve will
impact the size of a supply shift.
Steeper (less elastic) demand curve means that a demand shift
. price and quantity.
will have a bigger impact on both
D2’
P
P2**
2
1
P1**
0
P*
D2
Q* Q1** Q2**
D1
D1’
Q
Steeper (less elastic) supply curve means that a supply shift will
. and bigger impact on price.
have a stronger impact on quantity
P
S1’
P1**
S1
S2’
S2
1
2
P2**
P*
0
D
Q1**
Q2**
Q*
Q
Gains from Trade
Advanced Topic
Market System
• A free market allows people to sell goods that
they value relatively little to buyers who value
them more.
• A price can be obtained between buyers and
sellers valuations at which they can both benefit.
• You own shares of stock that you think are
worth $5 and someone else thinks are worth $9
per share. If you sell them at $7 both the buyer
and the seller are happy.
Demand Curves are Valuation
Curves
• To measure the benefits of the market,
economists invert the meaning of the demand
curve.
• Standard definition of the demand curve: how
many units of Q will buyers want at price P.
• Inverted definition: What is the maximum price
that buyers are willing to pay to buy the Qth unit
of the good.
• Implication: What is the value that the consumer
places on the Qth good.
Demand curve
P
.
P1D
Maximum that the
buyer on the fence
will pay to for Q1th
good is P1
D
Q1
Q
Supply Curves are Valuation
Curves
• To measure the benefits of the market,
economists invert the meaning of the supply
curve.
• Standard definition of the supply curve: how
many units of Q will sellers want at price P.
• Inverted definition: What is the minimum price
that sellers are willing to accept for the Qth unit
of the good.
• Implication: What is the value that the seller
places on the Qth good.
Supply curve
.
P
S
P1S
Maximum that the
buyer on the fence
will pay to for Q1th
good is P1
Q1
Q
Equilibrium Price
• Price will be between the value that the seller
places on the Qth good and what the buyer
places on the same good.
• Both buyer and seller benefit.
• We can calculate exactly how much each
benefits by comparing the value they place on
the good vs. either the price they pay for it or sell
it for.
• The gains from trade on the final good Q* is zero.
Gains from Trade of selling Q1 is [P1D – P1S].
.
Buyers Benefit is [P1D – P*]. Sellers benefit is [P*- P1S].
P
S
P1D
P*
P1S
D
Q1
Q
Surplus
• The sum total of gains from trade is the
sum of the benefits from each good.
• This sum of gains of trade, called surplus,
can be divided into two parts…consumer
surplus and producer surplus.
Sum of the benefits from all goods.
.
P
S
Q1
Q
Represented as a triangle
.
P
S
Q1
Q
Triangle can be split into two triangles, total consumer benefit
.
and total producer benefit.
P
S
Consumer
P*
Surplus
Producer
Surplus
Q1
Q