Chapter 5
Applications of Supply and Demand
1. Elasticity of Demand (Ed)
Measures the responsiveness of Qd to a change in price.
How much does Qd change (%) when P changes (%)?
We can use a formula to calculate Ed:
Ed =
Qd
Qd avg
divided by
P
Pavg
If Ed > 1 then we say the price elasticity of demand is ELASTIC
If Ed < 1 then we say the price elasticity of demand is INELASTIC
If Ed = 1 then we say the price elasticity of demand is UNITARY
2. The Total Revenue Method
Total Revenue (TR) = Price (P) x Quantity (Q)
By calculating TR before and after a P change, we can determine the price elasticity of
demand for a good, in that price range.
The Total Revenue Rule:
If P and TR move in the same direction, then Ed is INELASTIC
If P and TR move in the opposite direction, then Ed is ELASTIC
If P changes and TR remains the same, then Ed is UNITARY
3. Factors Affecting Demand Elasticity
AVAILABILITY OF SUBSTITUTES
o Goods that have substitutes tend to be
more elastic than goods that do not.
NATURE OF THE ITEM
o Goods that are necessities tend to be more inelastic than goods considered
to be luxuries.
FRACTION OF INCOME SPENT
o The greater the proportion of income spent on a good, the more elastic it is.
AMOUNT OF TIME AVAILABLE
o Over time goods become more elastic
because substitutes will be developed
for them.
4. Elasticity of Supply (Es)
Measures the responsiveness of quantity supplied (Qs) to a rise or fall in price.
The same formula used for demand can be used here:
Es =
Qs
Qs avg
divided by
P
Pavg
If Es > 1 then we say the price elasticity of supply is ELASTIC
If Es < 1 then we say the price elasticity of supply is INELASTIC
If Es = 1 then we say the price elasticity of supply is UNITARY
NOTE:
The Total Revenue Method CANNOT be used with supply. Can you explain
why?
There is, however, a short cut to help determine Es
5. Factors Affecting Supply Elasticity
TIME
o The longer the time period the seller has increase production, the more elastic
supply is.
o Typically, in the short term, supply is INELASTIC and in the long term, supply is
ELASTIC.
EASE OF STORAGE
o When the price of a good drops, the seller can try to sell it at the new price OR
place it in storage (inventory) and wait for the price to go back up.
o The easier it is to store something for prolonged periods of time, the more
ELASTIC is the supply.
COST FACTORS
o Increasing output (supply) may be very costly, depending on the industry.
o Supply is more elastic for industries that have lower input expenses. i.e. it is
easier to increase the production of CD’s compared to that of automobiles.
6. Government Intervention in The Markets
For the most part, the governments of modern industrialized countries allow markets to
operate relatively freely. There are times, however, when the government feels it is
necessary to intervene (and they are usually wrong).
We will look at three examples:
1. If the government believes the price of a good is too high for consumers to afford, a
price ceiling will be imposed.
2. If the government believes the price of a good is too low for sellers to make a profit, a
price floor will be imposed.
3. If the government must intervene in the market for social or environmental reasons, a
subsidy or quota will be introduced.
A. PRICE CEILINGS (To help consumers)
If the ceiling price is set below equilibrium, a shortage will be the result. i.e. rent
controls
Another problem that may arise is the creation of an illegal or black market for the
good in question.
A final problem is that product quality may be affected as sellers try to reduce costs
to regain profits lost by the imposed lower price.
B. FLOOR PRICES (To help Sellers)
A floor price set above equilibrium will create a surplus
i.e. Minimum wage
This creates the problem of what to do with the surplus. The government is usually
forced to buy the surplus and dispose of it by either selling it on the world market,
donating it to countries in need or turning it into some form of non-perishable good that
can be stored.
Consumers will be forced to pay higher prices for the product and receive less for their
money. This will create problems if the consumers can find a cheaper substitute or do
without the product.
C. SUBSIDIES and QUOTAS
A subsidy is a grant of money made to a particular industry by the government.
o This will cause the supply to increase in the amount of the subsidy.
o It will benefit buyers with lower prices and sellers with extra revenue.
o Tax dollars are used to pay for this.
o Some see this as a barrier to trade. i.e. unfair advantage
A quota is a restriction placed on the amount of a product individual producers are
allowed to make.
o They are controlled by marketing boards e.g. milk
o Raises farmer incomes and increases price of goods.
o Works because food has inelastic demand.
Price Ceilings:
Total Shortage
Natural Shortage
Derived Shortage
S
D
$1 000
E
Price Ceiling = Shortage
$750
Can’t go above
the ceiling!
2 000
3 000
2 000
5 000
#
7 000
Natural Equilibrium is 5 000 units at $1 000
With the artificial price ceiling of $750:
Natural shortage of 2 000 + Derived shortage of 2 000 = Total shortage of 4 000
Price Floors:
Total Surplus
Derived Surplus
Natural Surplus
S
D
Can’t go below
the floor!
$10
$5.00
E
Price Floor = Surplus = Quota
20
30
10
50
70
#
Natural Equilibrium is 50 units at $5.00
With the artificial price floor of $10.00:
Natural surplus of 20 + Derived surplus of 10 = Total surplus of 70