Part Two: Microeconomics
of Product Markets
CHAPTER 4
EXTENSIONS OF DEMAND
AND SUPPLY ANALYSIS AND
THE EFFICIENCY OF
MARKETS
Slides prepared by Dr. Amy Peng, Ryerson University
In this chapter you will learn:
4.1
4.2
4.3
4.4
4.5
4.6
About price elasticity of demand and how
it can be applied
The usefulness of the total revenue test
for price elasticity of demand
About price elasticity of supply and how it
can be applied
About cross elasticity of demand and
income elasticity of demand
To apply the concept of elasticity to
various real-world situations
About consumer surplus, producer
surplus, and efficiency losses
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4
2
Price Elasticity of Demand
THE LAW OF DEMAND SAYS…
• An increase in price causes a decrease
in quantity demanded (and vice-versa)
• But HOW MUCH does quantity
demanded change in response to a
change in price?
• Elasticity gives us a measure of
RESPONSIVENESS
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1
3
Price Elasticity of Demand
• When QD responds STRONGLY to a
change in P, demand is ELASTIC
• When QD responds WEAKLY to a change
in P, demand is INELASTIC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1
4
The Price Elasticity Coefficient and Formula
% change in quantity demanded of product X
Ed 
% change in price of product X
Calculate the average:
• If the quantity demanded increased
from 4 to 5 units
• %ΔQd = ΔQd/Q0 = ¼ x 100 = 25%
• If the price dropped $5 to $4
• %ΔP = ΔP/P0 = 1/5 x 100 = 20%
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1
5
Price Elasticity of Demand
•Average price and quantity
–avoids confusion about start and end points
change in quantity change in price
Ed 

X 100
sum of quantities /2 sum of prices/2
Q
P
1
1
Ed 



1
(Q0  Q1 ) / 2 ( P0  P1 ) / 2 (4  5) / 2 (4  5) / 2
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1
6
The Price Elasticity Coefficient and Formula
• Price elasticity of demand:
– Use of Percentages
– Elimination of the Minus Sign
• Interpretation of Ed:
–
–
–
–
Elastic Demand
Inelastic Demand
Unit Elasticity
Extreme Cases
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1
7
The Total-Revenue Test
• Total revenue (TR)
– TR = P x Q
• TR and Ed are related
– If TR changes in the opposite direction from
price, demand is elastic
– If TR changes in the same direction from
price, demand is inelastic
– If TR does not change when price changes,
demand is unit elastic
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
8
Elastic Demand
Quantity is very responsive to a
change in price
When P changes
from P1 to P2, TR
increases
P
P
1
P2
D
Q1
©2007 McGraw-Hill Ryerson Ltd.
Q2
Q
Chapter 4.2
9
Inelastic Demand
P
P
Quantity is NOT very
responsive to a change in
price
When P changes
from P1 to P2, TR
decreases
1
P2
D
Q1 Q2
©2007 McGraw-Hill Ryerson Ltd.
Q
Chapter 4.2
10
Unit Elastic
% change in quantity is equal
to % change in price
P
P
When P changes
from P1 to P2, TR
does not change
1
P2
D
Q1
©2007 McGraw-Hill Ryerson Ltd.
Q2
Q
Chapter 4.2
11
Price Elasticity along a Linear Demand Curve
• For all straight-line and most other
demand curves
– demand is more elastic toward the upper left
– demand is less elastic toward the lower right
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
12
The Total-Revenue Test
• TR = P X Q
• What happens to total revenue when
product price changes?
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
13
Table 4-1
Ed and Total Revenue
Qd
P
Ed
TR
1
8
5.00
8,000
2
7
2.60
14,000
3
6
4
5
5
4
1.57
1.00
18,000
20,000
20,000
3
0.64
18,000
7
2
0.38
14,000
8
1
0.20
8,000
6
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
INELASTIC
UNIT
DEMAND:
ELASTIC
when
price
DEMAND:
decreases,
ELASTIC
when
totalprice
DEMAND:
decreases,
revenue
when
price
total
decreases
decreases,
revenue
total
stays the
revenue
same
increases
14
Elastic
Price
D
Figure 4-3
Unit
Elastic
9
8
7
6
5
4
3
2
1
0
Inelastic
0
1
2
3
4
5
6
7
8
9
Total revenue ($ thousands)
Quantity demanded
(thousands)
22
20
18
16
14
12
10
8
6
4
2
0
Max
TR
0
1
2
3
4
5
TR
6
7
8
9
Quantity demanded (thousands)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
15
Determinants of Ed
•
•
•
•
Substitutability
Proportion of Income
Luxuries versus Necessities
Time
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
16
Applications of Ed
•
•
•
•
Large Crop Yields
Sales Taxes
Decriminalization of Illegal Drugs
Minimum Wage
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2
17
Price Elasticity of Supply
Percentage change in quantity
supplied of product X
Es=
Percentage change in
the price of product X
The main determinant of Es is the
amount of time producers have for
responding to a change in product
price
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3
18
Figure 4-4 Time and the Elasticity of Supply
Immediate Market Period
P
Sm
A Large Increase in Price -An increase in
Perfect Inelastic Supply demand without
enough time to
Pm
change supply
causes...
Po
D2
D1
©2007 McGraw-Hill Ryerson Ltd.
Qo
Chapter 4.3
Q
19
Time and the Elasticity of Supply
P
Short Run
An Increase in Price More elastic Supply
Pm
Ps
Ss
An increase in
demand with
some supply
response will
cause...
Po
D2
D1
©2007 McGraw-Hill Ryerson Ltd.
Q Qs
o 4.3
Chapter
Q
20
Time and the Elasticity of Supply
P
Long Run
D2
A small Increase in Price More elastic Supply
Pm
An increase in
demand in the
long run allows a
greater supply
response....
S
L
PL
Po
D1
©2007 McGraw-Hill Ryerson Ltd.
Q
o 4.3
Chapter
QL
Q
21
Applications of Price Elasticity of Supply
• Antiques and Reproductions
• Volatile Gold Prices
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3
22
Cross Elasticity of Demand
Percentage change in quantity
demanded of product X
Exy =
Percentage change in
the price of product Y
• Substitute Goods
- positive sign
• Complementary Goods
- negative sign
• Independent Goods
- near zero
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.4
23
Cross Elasticity of Demand
Applications
• Coca-Cola vs. Sprite
• Assessing competition
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.4
24
Income Elasticity of Demand
Ei =
Percentage change in
quantity demanded
Percentage change
in income
• Normal Goods
- positive sign
• Inferior Goods
- negative sign
• Insights
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.4
25
Figure 4-5 The Incidence of a Tax
Figure 4-5
14
12
$
2
10
Price
$9
8
6
4
2
0
0
5
10
15
20
25
• Tax of $2 per unit
• S shifts up $2
• Equilibrium price
rises to $9
• Consumer’s burden
is the amount of the
price increase = $1
• Firm’s burden =
tax-consumer’s
burden =$2 - $1 =
$1
Quantity
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
26
Figure 4-6
Demand Elasticity and the Incidence of a Tax
SS
TAX
P1
P0
Pa
S
Producer bears most of
the tax burden
D
Q1 Q0
Tax incidence and elastic demand
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
27
Demand Elasticity and the Incidence of a Tax
SS
TAX
P1
P0
S
Consumer bears most
of the tax burden
Pa
D
Q1 Q0
Tax incidence and inelastic demand
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
28
Figure 4-7
Supply Elasticity and the Incidence of a Tax
SS
S
TAX
P1
P0
Pa
Consumer bears most
of the tax burden
D
Q1 Q0
Tax incidence and elastic supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
29
Supply Elasticity and the Incidence of a Tax
SS
S
TAX
Producer bears most of
the tax burden
P1
P0
Pa
D
Q1 Q0
Tax incidence and inelastic supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
30
The Economics of Agricultural Price Supports
• Net income stabilization
• Supply management programs:
– dairy, poultry products, and eggs
– Canadian Wheat Board
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
31
Offers to Purchase
• Surplus Output
– misallocation of resources
– higher taxes
• Loss to Consumers
– higher prices
– higher taxes
• Gain to Farmers
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
32
Figure 4-8 Price Supports and Supply
Restriction – Offers to Purchase
The result of P
imposing a floor
(support) price
is a...
D
S
SURPLUS
PS
Support price
Pe
S
©2007 McGraw-Hill Ryerson Ltd.
Government
must
purchase
this amount
Qe
Chapter 4.5
D
Q
33
Deficiency Payments
• Subsidies to make up the difference
between the market price and
government-supported price
• Elasticity of supply & demand
– effect of elasticity the same as that of a sales
tax
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
34
Figure 4-8
Deficiency Payments
P
D
S
At price PS, farmers
Increase output
from Qe to QS
S
PS
Pe
P0
Government must pay
farmers this amount
Supply
curve
(consumer)
S
D
S
©2007 McGraw-Hill Ryerson Ltd.
Q
e
Chapter 4.5
Qs
Q
35
Comparison
• Farmers benefit equally from offers to
purchase and deficiency payments
• Consumers prefer deficiency payments,
because of lower prices
• When subsidies are taken into account,
total payments by the public are identical
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
36
Resource Overallocation
• Both approaches encourage
overallocation of resources to agriculture
• Efficiency loss
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
37
Supply Restrictions
• Crop restrictions
• Quotas
• With highly price-elastic supply, offers to
purchase or deficiency payments result in
surpluses higher than original quantity
demanded
• Supply restriction is the only option
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5
38
Figure 4-8
Supply Restrictions
P
D
Sf
SURPLUS
Sf
Pr
Pe
All costs
are
S
borne
by
consumers
©2007 McGraw-Hill Ryerson Ltd.
D
Qf ChapterQ4.5e
Qr
Q
39
Consumer and Producer Surplus
• Consumer surplus
– is the benefit surplus received by a
consumer or consumers in a market
– is the difference between the maximum price
a consumer is willing to pay for a product
and the actual price
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
40
Figure 4-9
Consumer Surplus
P
Consumer
Surplus
Equilibrium Price = $8
D
Q
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
41
Table 4-5 Consumer Surplus
Person
Maximum price
willing to pay
Actual Price
Consumer
surplus
Bob
13
8
5
Barb
12
8
4
Bill
11
8
3
Bart
10
8
2
Brent
9
8
1
Betty
8
8
0
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
42
Figure 4-10
Producer Surplus
P
S
Equilibrium Price = $8
Producer
Surplus
Q
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
43
Table 4-6 Producer Surplus
Person
Maximum
Actual Price
acceptable price
Producer
Consumer
surplus
Carlos
3
8
5
Courtney 4
8
4
Chuck
5
8
3
Cindy
6
8
2
Craig
7
8
1
Chad
8
8
0
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
44
Figure 4-11
Efficiency Revisited
P
Consumer
Surplus
Productive Efficiency is
achieved since CS and
PS are maximizedS
Equilibrium Price = $8
Producer
Surplus
D
Q
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
45
Figure 4-12
Efficiency Losses (or Deadweight Losses)
P
Quantity levels less
than efficiency quantity
create efficiency losses
S
Efficiency
Losses
Equilibrium Price = $8
D
Q
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6
46
Chapter Summary






4.1 Price Elasticity of Demand
4.2 The Total-Revenue Test
4.3 Price Elasticity of Supply
4.4 Cross Elasticity and Income Elasticity of
Demand
4.5 Elasticity and Real-World Applications
- Excise Tax
- The Economics of Agricultural Price
Supports
4.6 Consumer and Producer Surplus
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4
47