Econ 101:
Microeconomics
Chapter 4:
Working with Supply and
Demand: Part 2
Total Revenue and Total Expenditure

In the market for a particular good:
• Total revenue (TR) is the amount of money
sellers take in.
• Total expenditure (TE) is the amount of money
buyers pay out.
• Assuming no excise tax:
TR=TE =p x Q = Price x Quantity
Elasticity and Total Revenue

When p and Q change as the result of
movement along a demand curve, what is
the relationship between changes in price
and changes in TR?
• When p increases, Q decreases, so it is not clear,
•
•
without more information, how TR is affected.
When p and Q are both changing, percentage
change in their product is (approximately) the sum
of their individual percentage changes.
Need information about elasticity of demand.
Elasticity and Total Revenue

Case 1:
• Suppose demand is inelastic ( %Q  %p ) and
price increases (quantity decreases).
TR = TE = p x Q
• Big increase in p combined with small decrease
in Q
TR = TE increases as the result
Elasticity and Total Revenue

This is easy to remember by visualizing a
demand curve close to the limiting case of
perfectly inelastic:
p
p2
For a demand curve that is close to perfectly
inelastic, it’s obvious that TR=TE rectangle
gets bigger when price increases.
p1
Q2 Q1
Q
Elasticity and Total Revenue

Case 2:
• Suppose demand is elastic (%Q  %p ) and price
increases (quantity decreases).
TR = TE = p x Q
•
Small increase in p combined with big decrease
in Q
TR = TE decreases as the result
Elasticity and Total Revenue

Once again, visualizing a demand curve
close to the limiting case of perfectly elastic:
p
For a demand curve that is close to perfectly
elastic, it’s obvious that TR=TE rectangle
gets smaller when price increases.
p2
p1
Q2
Q1
Q
Elasticity and Total Revenue

Lets summarize the results in the table:
Perfectly inelastic
Inelastic
Unit Elastic
Increases
Decreases
TR = TE
TR = TE
TR = TE
TR = TE
No change in TR = TE
Elastic
TR = TE
TR = TE
Perfectly Elastic
Can’t talk about price changes
Determinants
of the Elasticity of Demand

Availability of Substitutes:
•
•

Demand is more elastic:
•
If close substitutes are easy to find and buyers can cut back on
purchases of the good in question
Demand is less elastic
•
If close substitutes are difficult to find and buyers can not cut back on
purchases of the good in question
Narrowness of Market:
•
•
•
More narrowly we define a good, easier it is to find
substitutes
•
More elastic is demand for the good
More broadly we define a good
•
Harder it is to find substitutes and the less elastic is demand for the
good
Different things are assumed constant when we use a narrow
definition compared with a broader definition
Determinants
of the Elasticity of Demand

Necessities vs. Luxuries
•
•

The more “necessary” we regard an item, the harder it is to
find a substitute
•
Expect it to be less price elastic
•
Expect it to be more price elastic
The less “necessary” (luxurious) we regard an item, the
easier it is to find a substitute
Time Horizon
• Short-run elasticity
• Measured a short time after a price change
• Long-run elasticity
• Measured a year or more after a price change
• Usually easier to find substitutes for an item in the long run
than in the short run
•
Therefore, demand tends to be more elastic in the long run than in the
short run
Determinants
of the Elasticity of Demand

Importance in the Buyers Budget
•
•
The more of their total budgets that households spend on
an item
•
The more elastic is demand for that item
The less of their total budgets that households spend on an
item
•
The less elastic is demand for that item
Other Elasticities in Economics

Elasticity is a general concept. Whenever we
have one variable (X) that depends on
another variable (Y) we can use elasticity to
provide unit-free measure of the degree of
responsiveness of X to changes in Y.

Elasticities are always ratios of percentage
changes.
Income Elasticity of Demand

Percentage change in quantity demanded divided by
the percentage change in income
•
With all other influences on demand—including the price of
the good—remaining constant
E
Y

% change in Quantity Demanded
% Change in Income
• Interpret this number as percentage increase in
quantity demanded for each 1% rise in income
Income Elasticity of Demand

Income elasticities vs. price elasticities of
demand
•
Price elasticity of demand
• Measures effect of change in price of good
•
•
Assumes that other influences on demand, including
income, remain unchanged
Income elasticity
• Measures effect on demand we would observe if income
changed and all other influences on demand—including
price of the good—remained the same

Instead of letting price vary and holding income
constant, now we are letting income vary and
holding price constant
Income Elasticity of Demand

Another difference between price and
income elasticity of demand
• Price elasticity measures sensitivity of
•

demand to price as we move along a demand
curve from one point to another
Income elasticity tells us relative shift in
demand curve—increase in quantity
demanded at a given price
While a price elasticity is virtually always
negative income elasticity can be
positive or negative
Income Elasticity of Demand



Economic necessity
•
Good with an income elasticity of demand between 0 and 1
Economic luxury
•
Good with an income elasticity of demand greater than 1
An implication follows from these definitions
•
As income rises, proportion of income spent on economic
necessities will fall
•

While proportion of income spent on economic luxuries will rise
But, it is important to remember that economic
necessities and luxuries are categorized by actual
consumer behavior
•
Not by our judgment of a good’s importance to human survival
Cross-Price Elasticity of Demand

Cross-price elasticity of demand
•
Percentage change in quantity demanded of one good
caused by a 1% change in price of another good
•
While all other influences on demand remain unchanged
E XZ 
% Change in Quantity of Good (X) Demanded
% Change in Price of Good (Z)
• While the sign of the cross-price elasticity helps us
distinguish substitutes and complements among related
goods
• Its size tells us how closely the two goods are related
– A large absolute value for EXZ suggests that the two goods are close
substitutes or complements
– While a small value suggests a weaker relationship
Price Elasticity of Supply

Percentage change in quantity of a good
supplied that is caused by a 1% change in the
price of the good
•
With all other influences on supply held constant
ES 
% Change in Quantity Supplied
% Change in Price
Price Elasticity of Supply

When do we expect supply to be price elastic,
and when do we expect it to be price inelastic?
•
Ease with which suppliers can find profitable activities
that are alternatives to producing the good in question
• Supply will tend to be more elastic when suppliers can
switch to producing alternate goods more easily
•
When can we expect suppliers to have easy alternatives?
Depends on
• Nature of the good itself
• Narrowness of the market definition—especially
geographic narrowness
• Time horizon—longer we wait after a price change,
greater the supply response to a price change
Price Elasticity of Supply

Extreme cases of supply elasticity
• Perfectly inelastic supply curve is a vertical
line
• Many markets display almost completely inelastic
supply curves over very short periods of time
• Perfectly elastic supply curve is a horizontal
line
Excise Tax

A tax on a particular good or service is called an
excise tax
•
Shifts market supply curve upward by amount of tax
• For each quantity supplied, the new, higher curve tells us
firms’ gross price, and the original, lower curve tells us the
net price

Who really pays excise taxes?
•
Buyers and sellers share in the payment of an excise
tax
• Called tax shifting
•
Process that causes some of tax collected from one side of
market (sellers) to be paid by other side of market (buyers)
Tax and Demand Elasticity

In most cases excise tax will be shared
by both buyer and seller
• For a given supply curve, the more elastic is
•
demand, the more of an excise tax is paid by
sellers
The more inelastic is demand, the more of the
tax is paid by buyers
Tax Incidence and Supply Elasticity

Although there are extreme cases of
supply elasticity, in general the following
is true
• For a given demand curve, the more elastic is
•
supply, the more of an excise tax is paid by
buyers
The more inelastic is supply, the more of the
tax is paid by sellers