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## Elasticity of Supply & Demand

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**Elasticity of**Supply & Demand**PRICE ELASTICITY OF DEMAND**THE LAW OF DEMAND SAYS... Consumers will buy more when prices go down and less when prices go up HOW MUCH MORE OR LESS? Price Elasticity Provides an Answer**PRICE ELASTICITY OF DEMAND**Measures Responsiveness to Price Changes The percentage change in quantity P The percentage change in price .10 .20 P2 P1 Elasticity is .5 D Q Q2 Q1****Q % d % P PRICE ELASTICITY OF DEMAND Commonly Expressed as… The percentage change in quantity P The percentage change in price P2 P1 Elasticity is .5 D Q Q2 Q1**Percentage change in quantity**demanded of product X Ed = Percentage change in price of product X Change in quantity demanded of X Ed = Original quantity demanded of X Change in price of X Original price of X PRICE ELASTICITY OF DEMAND The Price-Elasticity Coefficient and Formula Or equivalently… Elimination of the Minus Sign****Elastic from 1 < X < PRICE ELASTICITY OF DEMAND Price Elasticity is... Inelastic 0 < X < 1 Typical of necessities one must have Typical of luxuries one wants Unit elastic when exactly = 1 Quantity change offsets Price change**Elastic Demand**.02 .04 .01 = 1 = .5 = 2 Ed = Ed = Ed = .02 .02 .02 Inelastic Demand Unit Elasticity PRICE ELASTICITY OF DEMAND Interpretations of Ed**PRICE ELASTICITY OF DEMAND**Extreme Cases Perfectly Inelastic Demand D1 P Ed = 0 0 Q Perfectly Elastic Demand P D2 Ed = Q 0**DETERMINANTS OF PRICE**ELASTICITY OF DEMAND • Substitutability • Proportion of Income • Luxuries versus Necessities • Time**Change in**quantity Change in price ΔQ ΔP Ed Ed = = AVG Q AVG P Sum of Quantities/2 Sum of prices/2 PRICE ELASTICITY OF DEMAND More Accurate Calculation – The Midpoint Formula**Lemonade Stand**You sell 24 glasses for $.50 each. P x Q = Total Revenue (TR) $.50 x 24 = $12 = Total Revenue -$4 = Total Cost $8 = Profit**Total Revenue**• Total Revenue (TR): The total dollars received by a firm for selling a product. • AKA Consumer Expenditures**CIRCULAR FLOW MODEL**$ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION**PRICE ELASTICITY & TOTAL REVENUE**So is total revenue When prices are low, P TR D Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... P TR D Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR D Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR D Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR D Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR Inelastic Demand D Inelastic Demand Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR Elastic Demand Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded**PRICE ELASTICITY & TOTAL REVENUE**Total revenue rises with price to a point... then declines P TR Unit Elastic Elastic Demand Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded**TOTAL REVENUE TEST**Another way to determine elasticity • P x Q = TR • P and Q move opposite each other • So how do we know what happens to TR? • If P and TR move together demand is inelastic • If Q and TR move together demand is elastic • If TR doesn’t move demand is unit elastic**%ΔQS**Es= %ΔP PRICE ELASTICITY OF SUPPLY**PRICE ELASTICITY OF SUPPLY**Immediate Market period P An increase in demand without enough time to change supply causes… Sm Po D1 Q Qo**PRICE ELASTICITY OF SUPPLY**Immediate Market period P An increase in demand without enough time to change supply causes… an increase in price Sm Pm Po D2 D1 Q Qo**PRICE ELASTICITY OF SUPPLY**Short Run P Ss An increase in demand with more elastic supply causes... Po D1 Q Qo**PRICE ELASTICITY OF SUPPLY**Short Run P Ss An increase in demand with more elastic supply causes...a smaller increase in price Ps Po D2 D1 Q Qo Qs**PRICE ELASTICITY OF SUPPLY**Long Run An increase in demand in the long run allows greater change causing... P SL Po D1 Q Qo**PRICE ELASTICITY OF SUPPLY**Long Run An increase in demand in the long run allows greater change causing... P SL PL Even more elastic response - less price increase Po D2 D1 Q QL Qo**%ΔQDX**Exy = %ΔPY CROSS PRICE ELASTICITY OF DEMAND Positive Sign Goods are Substitutes Negative Sign Goods are Complementary Zero or Near-Zero Value Goods are Unrelated**%ΔQD**Ei = %Δ Income INCOME ELASTICITY OF DEMAND Positive Sign Goods are Normal or Superior Negative Sign Goods are Inferior**PRICE CONTROLS**• Enacted when policymakers believe the market price is unfair to buyers or sellers.**CONTROLS ON PRICES**• Price Ceiling • A legal maximum on the price at which a good can be sold. • Price Floor • A legal minimum on the price at which a good can be sold.**How Price Ceilings Affect Market Outcomes**• Two possibilities: • Not binding (not effective) • Binding (effective)**Supply**$4 Price ceiling 3 Equilibrium price Demand 100 Equilibrium quantity A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones**Supply**Equilibrium price $3 2 Price ceiling Shortage Demand 75 125 Quantity Quantity supplied demanded A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones**How Price Ceilings Affect Market Outcomes**• A binding price ceiling creates • A shortage because QD > QS. • Non-price rationing • Long lines • Discrimination**CASE STUDY:Lines at the Gas Pump**• In the early 1970s the government placed a price ceiling on gas. • In 1973, OPEC raised the price of crude oil (input for gas).**Supply,**S1 1. Initially, the price ceiling is not Price ceiling binding . . . P1 Demand Q1 The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not Binding Price of Gasoline Quantity of 0 Gasoline**S2**2. . . . but when supply falls . . . S1 P2 Price ceiling 3. . . . the price P1 ceiling becomes 4. . . . binding . . . resulting in a Demand shortage. QS QD Q1 The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Price of Gasoline Quantity of 0 Gasoline**How Price Floors Affect Market Outcomes**• Two possibilities: • Not binding • Binding**Supply**Equilibrium price $3 Price floor 2 Demand 100 Equilibrium quantity A Market with a Price Floor (a) A Price Floor That Is Not Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones**Supply**Surplus $4 Price floor 3 Equilibrium price Demand 80 120 Quantity Quantity demanded supplied A Market with a Price Floor (b) A Price Floor That Is Binding Price of Ice-Cream Cone Quantity of 0 Ice-Cream Cones**How Price Floors Affect Market Outcomes**• A binding price floor causes . . . • A surplus because QS > QD. • Non-price rationing**CASE STUDY: MINIMUM WAGE**• Minimum wage laws dictate the lowest price possible for labor that any employer may pay.**Labor**Supply Equilibrium wage Labor demand Equilibrium employment How the Minimum Wage Affects the Labor Market Wage 0 Quantity of Labor**Labor**Supply Labor surplus (unemployment) Minimum wage Labor demand Quantity demanded Quantity supplied How the Minimum Wage Affects the Labor Market Wage 0 Quantity of Labor