Economics: Foundations and Models Chapter 6 Notes: Elasticity: The Responsiveness of Demand and Supply
- How much will the quantity demanded change as a result of a price increase or decrease? - Elasticity – measure of how much of the economic variable responds to changes in another economic variable.
- Ex: The responsiveness of the quantity demanded of a good to changes in its price is called price elasticity of demand.
- Price elasticity of supply: responsiveness of quantity supplied of a good to changes in its price.
6.1 The Price Elasticity of Demand and its Measurement
- the Law of demand tells firms only that the demand curves for their products slope downward
- Price Elasticity of Demand: measure of the responsiveness of the quantity demanded to a change in price
- Unit-Elastic Demand: percentage change in quantity demanded is equal to the percentage change in price
Measuring the Price Elasticity of Demand
- Can use slope of demand curve to measure price elasticity
o Drawback: measurement of slope is sensitive to the units chosen for quantity and price
o Solution: use percentage change – not dependent on units We also discuss several other topics like Whose idea is antithesis?
- (PED) Price Elasticity of demand = (Percentage change in quantity
demanded)/(Percentage change in price)
o *Price elasticity of demand is NOT the same as demand curve’s slope o PED for a price cut: Negative & Percentage in Quantity demanded will be positive
o PED for a price increase: Positive & Percentage in Quantity demanded will be negative
o ???? PED is always negative; Compare using absolute values
Elastic Demand and Inelastic Demand
- Elastic: percentage change in the quantity demanded is greater than the percentage change in price ???? Price Elasticity is Greater than 1
- Inelastic: quantity demanded is less than the percentage change in price ???? Price Elasticity is Less than 1
- Ensure that we have only one value of the price elasticity of demand between the same two points on demand curve If you want to learn more check out What do people learn through social learning theory?
- Uses the average of initial and initial quantities and prices.
- Price Elasticity of Demand= ((Q2-Q1)/((Q1+Q2)/2)) / ((P2-P1)/((P1+P2)/2)) When Demand Curves Intersect, The Flatter Curve is More Elastic
- Use the absolute value of the slope
- Smaller slope (in absolute value) is the flatter slope ???? The more elastic slope Polar Cases of Perfectly Elastic and Perfectly Inelastic Demand Don't forget about the age old question of What are the most common complex carbohydrates?
- Perfectly Inelastic Demand
o Demand curve is vertical
o Quantity demanded is unresponsive to price
o Price Elasticity of Demand = 0
- Perfectly Elastic:
o Demand curve is horizontal
o Quantity demanded is infinitely responsive to price
o Price elasticity of demand = infinity
- If demand is … Then the absolute value of Price elasticity is …
o Elastic … Greater than 1
o Inelastic … less than 1
o Unit Elastic … Equal to 1
o Perfectly Elastic … equal to infinity (horizontal)
o Perfectly In elastic … equal to 0 (vertical)
6.2 The Determinants of the Price Elasticity of Demand
- Key determinants of price elasticity of Demand
o The availability of close substitutes to the good If you want to learn more check out How does modern society treat individualism?
▪ Are there alternatives? How easy is it to access?
▪ If a product has more substitutes available, it will have more elastic
▪ If a product has fewer substitutes available, it will have less elastic
▪ The more time that passes the more elastic the demand for a product We also discuss several other topics like Where do statutes come from?
o Whether the good is a luxury or necessity If you want to learn more check out What are examples of statutory laws?
▪ Demand curve for Luxury: more elastic
▪ Demand curve for Necessity: Less elastic
o Definition of the market
▪ Narrowly defined market: consumers have more substitutes available. ▪ More narrowly a market is defined, the more elastic the demand will be. o Share of the good in the consumer’s budget
▪ Goods that take only a small fraction of budget have less elastic demand than goods that take a large fraction
• Table salt: small fraction ???? Price increase = demand won’t change
• House/car: large fraction ???? Price increase = decrease in demand
▪ The demand for a good will be more elastic the larger the share of the good in the average consumer’s budget
6.3 The relationship between Price Elasticity of Demand and Total Revenue - Total Revenue: amount of funds received from selling a good or service
o Price per unit * Number of units sold = Total Rev. ???? Rectangular area of the graph
o Demand: Inelastic: Price and total revenue move in the same direction (increase, increase)
o Demand: elastic: Price and total revenue are inverse (increase, decrease) o Demand: Unit Elastic: small change in price is exactly offset by a proportional change in quantity demanded ???? revenue is unaffected
Elasticity and Revenue with a Linear Demand Curve
- Elasticity is not constant at every point
- If demand is… then… Because
o Elastic… Increase in price reduces revenue … decrease in quantity demanded is proportionally greater than the increase in price
o Elastic … decrease in price increases revenue … increase in quantity demanded is proportionally greater than the decrease in price
o Inelastic … an increase in price increases revenue … decrease in quantity demanded is proportionally smaller than the increase in price
o Inelastic … a decrease in price reduces revenue … increase in quantity demanded is proportionally smaller than the decrease in price
o Unit elastic… increase in price does not affect revenue… the decrease in quantity demanded is proportionally the same as the increase in price
o Unit elastic… a decrease in price does not affect the revenue … the increase in quantity demanded is proportionally the same as the decrease in price.
Estimating Price Elasticity of Demand
- Firm must know the demand curve for its product.
- Well established: historical data
- New: market experiments.
6.4 Other Demand Elasticities
- Elasticity allows us to quantify the responsiveness of economic variables - Cross Price Elasticity of Demand
o = Percent change in quantity demanded divided by the percent change in price of another good
o Positive = Good is a substitute
▪ Increase in price of substitute leads to an increase in quantity demanded o Negative = Good is a complement
▪ Increase in price of a complement leads to a decrease in quantity
o Zero = Goods are unrelated
- Income Elasticity of Demand
o Measures responsiveness of the quantity demanded to change in income o = percent change in quantity demanded / percent change in income
o Necessity: quantity demanded is not very responsive to change in income o Inferior: Quantity demanded falls when the income increases
o Luxury: quantity demanded increases when income increases
o If the income elasticity of demand is… then the good is…
▪ Positive but less than 1… normal and a necessity
▪ Positive and Greater than 1… normal and a luxury
▪ Negative … inferior good
Using Elasticity to analyze the Disappearing Family Farm
- Food production is growing rapidly, farms/farmers dwindling
- Productivity measures the ability of firms to produce goods and services with a given amount of economic input.
o U.S. agriculture is growing rapidly
- Increase in wheat production ???? Decrease in prices
o Demand is inelastic
o Income elasticity of the demand is low
The Price Elasticity of Supply and its measurement
- Elasticity can measure the responsiveness of firms to a change in price - Law of supply: price of product increase, quantity supplied increases
Measuring the Price Elasticity of Supply
- Price Elasticity of Supply
o Responsiveness of the quantity supplied to a change in price
- = Percentage change in quantity supplied / Percentage change in price - B/c Supply curves are positive, the price elasticity of supply will be positive - Less than one: Supply is inelastic
- Greater than one: Elastic
- Equal to one: Unit elastic
Determinants of the Price Elasticity of Supply
- Depends on the ability and willingness of firms to alter the quantity the produce as price increases
- Time: harder to increase during a short period of time (inelastic) but if more time is given it will become elastic
o Exception: goods that require resources that are fixed supply ex: Wine Why are Oil Prices So unstable?
- When supply is inelastic an increase in demand can cause a large increase in price - Heavily influenced by OPEC
- Low price Elasticities of oil supply and demand ???? oil fluctuates
- Long run: the elasticity of supply is much higher than in the short run
Polar cases of Perfectly Elastic and Perfectly Inelastic Supply
- Perfectly inelastic: If a supply curve is a vertical line
o quantity supplied is unresponsive to the price
o price elasticity of supply = 0
- Perfectly Elastic: Supply curve is a horizontal line
o Quantity supplied is infinitely responsive to the price
o Elasticity of supply equals infinity
o Small increase in price can cause a large increase in quantity supplied - Summary:
o If Supply is… then the value of price elasticity is…
▪ Elastic … greater than 1
▪ Inelastic … less than 1
▪ Unit elastic ... equal to 1
▪ Perfectly elastic … equal to infinity
▪ Perfectly inelastic … equal to 0
Using Price Elasticity of Supply to Predict Changes in Price
- With inelastic supply, an increase in demand causes a large increase in price - With elastic supply, an increase in demand causes a smaller increase in price.
Economics 1011 Foundations and Models Ch. 4 Notes – Economic Efficiency, Government Price Setting and Taxes
Hubbard & O’Brien – Micro Economics
This week’s Quiz: Ch. 4.1 – 4.3
Price Ceiling: Legally determined maximum price that sellers may charge. Price Floor: Legally determined minimum price that sellers may receive.
- In a competitive Market: price adjusts so that Quantity demanded equals quantity supplied.
o In other words: Equilibrium = every consumer willing to pay the market price is able to buy as much of the product as the consumer wants & every firm that accepts market price can sell as much as it wants
- Government also intervenes through taxes
- Government influence (floor, ceiling, tax)
- Consumer/producer surplus and deadweight loss = concepts to analyze economic effects of price ceilings/floors/taxes
4.1 Consumer Surplus and Producer Surplus
- Consumer Surplus: dollar benefit consumers gain from buying in a particular market. - Producer Surplus: dollar benefit from selling
- Economic Surplus: sum of consumer + producer surplus
- Consumer Surplus
o Demand curves show the willingness of consumers to purchase a product at different prices.
o Consumers are willing to purchase up to the point where the marginal benefit is equal to price
o Marginal Benefit: additional benefit to consumer from consuming one more unit of a good/service
o Total consumer surplus in a market is equal to the area below the demand curve and above the market price.
- Producer Surplus
o Shown on supply curves – Willingness of firms to supply a product at different prices
o An additional unit will be supplied if they receive a price equal to the additional cost of producing that unit
o Marginal cost: additional cost to a firm of producing one more unit of a good/service
o Producer Surplus: Difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives.
o Total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price
- What consumer surplus and producer surplus measure
o Consumer surplus measures the net benefit to consumers (not the total benefit) o Producer Surplus measures the net benefit received by producers
4.2 - The Efficiency of Competitive Markets
- Competitive market: market with many buyers and sellers
- Advantage of market system: results in efficient economic outcomes
- Marginal Benefit Equals Marginal Cost in Competitive Equilibrium
o Economically efficient: product produced where the marginal benefit to buyers is greater than or equal to the marginal cost of production
o Equilibrium in a competitive market results in the the economically efficient level of output, at which marginal benefit equals marginal cost
- Economic Surplus
o Economic Surplus: sum of consumer surplus and producer surplus.
o In a perfectly competitive market, economic surplus is at a maximum when market is in equilibrium.
- Deadweight Loss
o Deadweight loss: reduction in economic surplus resulting from a market not being in competitive equilibrium.
▪ From “missing” goods
- Economic Surplus and Economic Efficiency
o Measures the benefit to society from the production of a particular good/service o Economic efficiency can be characterized as : Equilibrium in a competitive market resulting in the greatest amount of economic surplus/total net benefit to society from the production of a good/service
o Anything that obstructs competitive equilibrium, reduces economic efficiency o Economic Efficiency: Market outcome where marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum.
4.3 – Government Intervention in the Market: Price Floors and Price Ceilings - As previously noted: the government can intervene with price floors and ceilings and taxes
- To affect the market
o Price floors must be above the equilibrium price
o Price ceilings must be below equilibrium price
o Else: will not be binding
- Price Floors: Government Policy in Agricultural Markets:
o Federal governments farm programs have often resulted in large surpluses of agricultural products
- Price Floors in Labor Markets: The Debate over Minimum Wage Policy o Minimum wage = price floor
▪ Way of raising the incomes of low-skilled workers
▪ Results in fewer jobs
▪ Large costs on small businesses
o Results: The quantity of labor supplied will increase and the demand will decrease leading to a surplus of workers unable to find jobs
o Will cause a deadweight loss
▪ Earned income tax credit:
• Reduces the amount of tax that low-income wage earners would
otherwise pay to the federal government.
- Price Ceilings: Government Rent Control Policy in Housing Markets o Support for price floors typically comes from sellers
o For setting ceilings from consumers
o Rent control is a price ceiling ???? reduces economic efficiency
- Black Markets and Peer-to-Peer Sites
o Ways around the controls: Black Markets: which buying/selling take place at prices that violate government price regulations
o The sharing economy also has the potential to improve economic efficiency and make available to consumer goods at lower prices.
- The Results of Government Price controls: Winners, Losers, and Inefficiency o With rent control:
▪ Winners: people paying less for rent; land lords if they break the law and charge above the legal maximum provided that their rate is higher than the competitive equilibrium rents would be.
▪ Land lords who abide by the law
▪ Renters who can’t find apartments to rent at the controlled price
o Reduces economic efficiency because fewer apartments are rented than would be rented in a competitive market (dead weight loss)
- Positive and Normative Analysis of Price Ceilings and Price Floors: o Competitive markets have played in raising the average person’s standards of living
o Government intervention has the potential to reduce the ability of the market system to produce similar increases in living standards in the future.
o Positive analysis: WHAT IS
o Normative: WHAT SHOULD BE
o Analysis of rent control and fed farm program is positive analysis.
o Whether these programs are desirable or undesirable is normative
4.4 – The Economic Impact of Taxes
- Public finance: analyzing taxes
- The Effect of taxes on Economic Efficiency
o government taxes????less of the good/service will be produced and consumed. o Equilibrium will fall
o Reduces BOTH consumer and producer surplus
o Excess burden: the deadweight loss from taxes
o Tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.
- Tax Incidence: Who actually Pays a tax?
o Tax Incidence: The actual division of the burden of tax between buyers and sellers
o The incidence of a tax does not depend on whether the government collects a tax from the consumers or producers
- Is the Burden of the Social Security Tax Really Shared Equally between Workers and Firms?
o Requiring workers and employers to each pay half the tax does NOT mean that the burden of the tax is shared equally.