Demand and Supply Applications

Chapter 4

Chapter 5Elasticity

The Price System: Rationing and Allocating

ResourcesPrices perform two major roles in market

systems: rationing the available goods and

services, and determining which goods and services

are produced and how they're produced.

price rationing The process by which the market system allocates goods and services to consumers when quantity

demanded exceeds quantity supplied.

The Price System: Rationing and Allocating

Resources

The Market for WheatFires in Russia in the summer of

2010 caused a shift in the world's supply of wheat to the left,

causing theprice to increase from $160 per millions of metric tons to $247.

The equilibrium moved from C to B.

The adjustment of price is the rationing mechanism in free markets.

Price rationing means that whenever there is a need to ration a good —that is, when a shortage exists — in a

free market, the price of the good will rise until quantity

supplied equals quantity demanded — that is, until the market clears.

The Price System: Rationing and Allocating

Resources

Constraints on the Market and Alternative Rationing

Mechanismsprice ceiling A maximum price that sellers may charge for

a good, usually set by government.In 1974, a ceiling price of $0.57 cents per gallon of leaded regular gasoline

was imposed. If the price had been set by the interaction of supply and demand instead, it would have

increased to approximately $1.50 per gallon.

At $0.57 per gallon, the quantity demanded exceeded the quantity

supplied. Because the price system was not allowed to function, an alternative

rationing system had to be found to distribute the available supply of

gasoline.

favored customers

Those who receive special treatment

fromdealers during

situations of excess demand.

ration coupons Tickets or coupons

that entitle individuals to

purchase a certain amount of a given product per month.

Non-price Rationing Mechanismsqueuing

Waiting in line as a means of distributing goods and services:

a nonprice rationing mechanism.

black market A market in which illegal trading takes place at

market-determined prices.

Price changes resulting from shifts of demand in output markets cause profits to rise or fall.

Profits attract capital; losses lead to disinvestment. Higher wages attract labor and encourage workers to acquire skills. At the core of the system, supply,

demand, and prices in input and output markets determine the allocation of resources and the

ultimate combinations of things produced.

Prices and the Allocation of Resources

At a world price of $18, domestic production is 7.7 million barrels per

day and the total quantity of oil demanded in the United States is 13.6 million barrels per day. The difference is total imports (5.9

million barrels per day).

tariff a tax on imported goods

If the government levies a 33 1/3 percent tax on imports, the price of

a barrel of oil rises to $24. The quantity demanded falls to 12.2

million barrels per day. At the same time, the quantity supplied by

domestic producers increases to 9.0 million barrels per day and the quantity imported falls to 3.2

million barrels per day.

Supply and Demand Analysis: An Oil Import Fee

Supply and Demand and Market Efficiency

consumer surplus The difference between the maximum amount

a person is willing to pay for a good and its current market price.

producer surplus The difference between the current market price and the full cost of production for the

firm.

Supply and Demand and Market Efficiency

Consumer Surplus

As illustrated in Figure (a), some consumers are willing to pay as much as $9.00 each for unit. Since the market price is just $5, they receive a consumer surplus of $4 for each unit that they consume.

Others are willing to pay something less than $9 and receive a slightly smaller surplus.

Since the market price of units is just $5, the area of the shaded triangle in Figure (b) is equal to total consumer surplus.

Supply and Demand and Market Efficiency

Producer Surplus

As illustrated in Figure (a), some producers are willing to produce units for a price of $1 each. Since they are paid $5, they earn a

producer surplus equal to $4. Other producers are willing to supply units at a price of $2; they receive a producer surplus equal to $3.

Since the market price of units is $5, the area of the shaded triangle in Figure (b) is equal to total producer surplus.

Supply and Demand and Market Efficiency

Competitive Markets Maximize the Sum of Producer and Consumer Surplus

Total Producer and Consumer SurplusTotal producer and consumer surplus is greatest where supply and

demand curves intersect at equilibrium.

Supply and Demand and Market Efficiency

Competitive Markets Maximize the Sum of Producer and Consumer Surplus

deadweight loss The net loss of producer and consumer surplus

from underproduction or overproduction.

Supply and Demand and Market Efficiency

Competitive Markets Maximize the Sum of Producer and Consumer Surplus

Deadweight loss from underproduction

Deadweight loss from overproduction

Concept of ElasticityElasticity is used to describe the behavior

of buyers and sellers in the market.

Elasticity A general concept used to quantify the response in one variable when another

variable changes.

Elasticity is a measure of the quantity demanded or

supplied to one of its determinants.

%elasticity of with respect to %AA BB

Price Elasticity of Demand

price elasticity of demand The ratio of the percentage of change in quantity demanded to the percentage of

change in price; measures the responsiveness of quantity demanded to changes in price.

Price Elasticity of DemandTypes of Elasticity

if the result is > 1, demand is said to be elastic if the result is < 1, demand is said to be

inelastic if the result is = 1, demand is said to be

unitary elastic if the result is = 0, demand is said to be

perfectly inelasticTABLE : Hypothetical Demand Elasticities for Four Products

Product

% Change In Price(% DP)

% ChangeIn Quantity Demanded

(% DQD)Elasticity

(% DQD ÷ %DP)Insulin +10% 0% .0 Perfectly

inelasticBasic telephone

service+10% -1% -.1 Inelastic

Beef +10% -10% -1.0 Unitarily elasticBananas +10% -30% -3.0 Elastic

Types of ElasticityElastic Demand

Quantity demanded responds strongly to changes in price.

Price elasticity of demand is greater than one.

Types of ElasticityInelastic Demand

Quantity demanded does not respond strongly to price changes.

Price elasticity of demand is less than one.

Types of ElasticityUnit Elastic

Quantity demanded changes by the same percentage as the price.

Types of ElasticityPerfectly Inelastic

Quantity demanded does not respond to price changes.

Types of ElasticityPerfectly Elastic

Quantity demanded changes infinitely with any change in price.

Slope and ElasticityThe value of the slope of the demand curve and the

value of elasticity are not the same.

Unlike the value of the slope, the value of elasticity is a

useful measure of responsiveness.

Calculating the Price Elasticity of Demand

Calculating Percentage ChangesTo calculate percentage change in price using the initial value as

the base, the following formula is used:

To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used:

Calculating the Price Elasticity of Demand

Calculating Percentage Changes

Calculating the Price Elasticity of Demand

Midpoint Formula

The midpoint method gives us the same price elasticity of

demand between two points regardless of the direction of

change.

Elasticity and Total RevenueIn any market, P x Q is total revenue (TR) received by

producers:

When price (P) declines, quantity demanded (QD) increases. The two factors, P and QD move in opposite directions:

TR = P x Qtotal revenue = price x

quantity

Effects of price changes on quantity demanded:

and

D

D

QP

QP

Elasticity and Total RevenueTotal revenue

is the amount paid by buyers and received by sellers of a good.

Elasticity and Total RevenueBecause total revenue is the product of P and Q,

whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded.

If the percentage decline in quantity demanded following a price increase is larger than the percentage

increase in price, total revenue will fall.

Effects of price increase ona product with inelastic demand: x D TRQP

Effects of price increase ona product with inelastic demand: x D TRQP

How Total Revenue Changes When Price Changes: Inelastic Demand

How Total Revenue Changes When Price Changes: Elastic Demand

Elasticity and Total Revenue

The opposite is true for a price cut. When demand is elastic, a cut in price increases total

revenues:

When demand is inelastic, a cut in price reduces total revenues:

effect of price cut on a productwith elastic demand: x D TRQP

effect of price cut on a productwith inelastic demand: x D TRQP

Elasticity and Total RevenueSummary

The Determinants of Demand Elasticity

Availability of SubstitutesPerhaps the most obvious factor affecting demand elasticity is the availability of substitutes.The Importance of Being UnimportantWhen an item represents a relatively small part of our total budget, we tend to pay little attention to its price.The Time DimensionThe elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods.

Other Important Elasticitiesincome elasticity of demand

A measure of the responsiveness of demand to changes in income.

cross-price elasticity of demand A measure of the response of the quantity of one

good demanded to a change in the price of another good.

incomein change %demandedquantity in change % demand of elasticity income

XY

of pricein change %demanded ofquantity in change % demand of elasticity price-cross

Other Important ElasticitiesElasticity Of Supply

elasticity of supply A measure of the response of quantity of a good

supplied to a change in price of that good. Likely to be positive in output markets.

elasticity of labor supply A measure of the

response of labor supplied to a change in the price of labor.

rate wagein the change %suppliedlabor ofquantity in change % supply labor of elasticity

% change in quantity suppliedelasticity of supply % change in price