Chapter 3
Market behaviour:
elasticity, tax and price
controls
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Learning objectives
1. Introduce the concept of price elasticity of demand
and discuss its determinants.
2. Relate price elasticity of demand to the changes in
total revenue that result from a change in market
price.
3. Introduce the concept of the elasticity of supply and
its relationship to time.
4. Define the cross-price and income elasticities of
demand.
5. Survey some applications of supply and demand
analysis—in particular, the role of price controls, and
taxes on goods.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Price elasticity of demand
• The price elasticity of demand is the measure of the
responsiveness of the quantity demanded to a
change in the price of a product.
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Price elasticity is . . .
P
As price increases from
P1 to P2, quantity decreases
from Q1 to Q2
P2
P1
D
Q2 Q1
Q
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Price elasticity is . . . (cont.)
P
As price decreases from
P1 to P2, quantity increases
from Q1 to Q2
P1
P2
D
Q1 Q2
Q
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Price elasticity is . . . (cont.)
P
But what percentage did
price change and what
percentage did quantity
change?
P2
P1
D
Q2 Q1 Q
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Elasticity formula for product X
Ed
Ed
the percentage change in quantity demanded of X
=
the percentage change in price of X
change in quantity
=
original quantity
demanded
÷
change in price
original price
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Price elasticity of demand
• Uses percentages not absolute values
– Choice of units
– Product comparison
• Ignore the minus sign
– The absolute value of the coefficient is what is important
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Price elasticity of demand (cont.)
• Elastic demand
– A given percentage change in price results in a larger
percentage change in quantity demanded:
Ed > 1
• Inelastic demand
– A given percentage change in price results in a relatively
smaller percentage change in quantity demanded:
Ed < 1
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Price elasticity of demand (cont.)
• Unit elasticity
– A given percentage change in price results in an equal
percentage change in quantity demanded:
Ed = 1
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Perfectly inelastic demand
P
D1
Perfectly
inelastic
demand
Q
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Perfectly elastic demand
P
D1
Perfectly
price inelastic
demand
D2
Perfectly
price elastic
demand
Q
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Midpoints formula
Ed =
Change in
quantity
Sum of
quantities/2

Change in
price
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Sum of
prices/2
3- 13
Total revenue test
• Elastic demand
– A change in price will cause total revenue to change in
the opposite direction.
• Inelastic demand
– A change in price will cause total revenue to change in
the same direction.
• Unit elasticity
– A change in price leaves total revenue unchanged.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Price (per unit)
Price
elasticity of
demand and
revenue
5
4
Ed > 1
3
2
1
Total revenue
0 2 4 6 8 10 12 14 16
20
16
TR
12
8
4
0
2 4 6 8 10 12 14 16
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Units of X (thousands per week)
3- 15
Price (per unit)
Price
elasticity of
demand and
revenue
5
4
Ed > 1
3
Ed = 1
2
1
Total revenue
0 2 4 6 8 10 12 14 16
20
16
TR
12
8
4
0
2 4 6 8 10 12 14 16
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
Units of X (thousands per week)
3- 16
Price (per unit)
Price
elasticity of
demand and
revenue
5
4
Ed > 1
3
Ed = 1
Ed < 1
2
1
Total revenue
0 2 4 6 8 10 12 14 16
20
16
TR
12
8
4
0
2 4 6 8 10 12 14 16
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Units of X (thousands per week)
3- 17
Determinants of price elasticity of
demand
• Substitutability
– Goods with substitutes have a greater elasticity of demand.
• Proportion of income
– The higher the price of a good relative to the budget, the
higher will be the elasticity.
• Luxuries versus necessities
– Luxuries have higher elasticity, while necessities tend to be
inelastic.
• Time
– The longer the time period under consideration, the greater
will be the elasticity.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Price elasticity of supply
Percentage change in quantity
supplied of product X
Es =
Percentage change in
the price of product X
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Market period and elasticity
of supply
• Market period:
– a period of time in which producers are unable to
change the quantity produced in response to a
change in its price.
• The supply curve is inelastic in the immediate
market period, and more elastic in the short run
period.
• Supply elasticity is greater in the long run when
all adjustments to factors of production can be
made.
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Price elasticity of supply (cont.)
P
D2
Sm
D1
Immediate market
period
Pm
Po
D2
D1
Qo
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Q
3- 21
Price elasticity of supply (cont.)
P
Ss
Short run
Ps
Po
D2
D1
Qo Qs
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Q
3- 22
Price elasticity of supply (cont.)
P
Long run
SL
PL
Po
S′L
D2
D1
Qo QLQ′L
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Q
3- 23
Cross elasticity of demand
Exy =
Percentage change in quantity
demanded of good X
Percentage change in
the price of good Y
• Substitute goods—positive sign
• Complementary goods—negative sign
• Independent goods—zero or near-zero value
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Income elasticity of demand
Ei =
Percentage change in
quantity demanded
Percentage change
in income
• Normal goods—positive sign
• Inferior goods—negative sign
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Price ceilings and shortages
• Price ceiling is the maximum legal price a seller may
charge for a product or service. Price ceilings result
in shortages:
–
–
–
–
wartime price controls
rationing problem
black market
rent controls.
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Price ceilings and shortages (cont.)
P
D
S
The result of
imposing a
legal price
ceiling is a ...
P
Pc
S
D
Qs Qe Qd
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Q
3- 27
Price ceilings and shortages (cont.)
P
D
S
… a surplus
P
Pc
Legal price ceiling
S
Shortage
D
Qs Qe Qd
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Q
3- 28
Price supports and surpluses
• Price support or ‘price floor’ is a minimum price fixed
by government, above equilibrium prices.
– Minimum wage legislation
– Agricultural support prices
• Price support results in surpluses.
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Price supports and surpluses (cont.)
P
D
S
Surplus
Ps
Legal price
support
Pe
S
D
Qd
Q
Q
Qs
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Elasticity and tax incidence
• Elasticity of demand and supply determines who
bears the burden of sales or excise tax, called the
incidence of a tax.
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Incidence of a sales tax
P
Price ($ per bottle)
5
4
3
2
D
S
1
0
Q
5 10 15 20 25 30 35 40
Quantity demanded (thousands of bottles/month)
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Incidence of a sales tax (cont.)
P
Tax $1
Price ($ per bottle)
5
4
3
S1
2
S
D
1
0
Q
5 10 15 20 25 30 35 40
Quantity demanded (thousands of bottles/month)
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Incidence of a sales tax (cont.)
P
Price ($ per bottle)
5
Tax $1
Consumer’s tax
incidence
4
Producer’s tax
incidence
3
2
S1
S
D
1
0
Q
5 10 15 20 25 30 35 40
Quantity demanded (thousands of bottles/month)
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Elastic demand and incidence
P
Tax $1
Consumer’s tax
incidence
Price ($ per bottle)
5
4
3
S1
2
D
S
Producer’s tax
incidence
1
0
Q
5 10 15 20 25 30 35 40
Quantity demanded (thousands of bottles/month)
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Inelastic demand and incidence
P
Tax $1
Consumer’s tax
incidence
Price ($ per bottle)
5
4
Producer’s tax
incidence
3
S1
2
1
0
S
D
Q
5 10 15 20 25 30 35 40
Quantity demanded (thousands of bottles/month)
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Next chapter
The costs of production
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