Chapter 4: Working with Supply and Demand: Part 2 Econ 101: Microeconomics.

Chapter 4:

Working with Supply and Demand: Part 2

Econ 101: Microeconomics

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.


Case 1: • Suppose demand is inelastic ( ) 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

% %Q p


This is easy to remember by visualizing a demand curve close to the limiting case of perfectly inelastic:

p

Q

p2

p1

Q1Q2

For a demand curve that is close to perfectly inelastic, it’s obvious that TR=TE rectangle gets bigger when price increases.


Case 2: • Suppose demand is elastic ( ) 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

% %Q p


Once again, visualizing a demand curve close to the limiting case of perfectly elastic:

p

Q2

p2p1

Q1 Q

For a demand curve that is close to perfectly elastic, it’s obvious that TR=TE rectangle gets smaller when price increases.


Lets summarize the results in the table:

Increases Decreases

Perfectly inelastic TR = TE TR = TE

Inelastic TR = TE TR = TE

Unit Elastic 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


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

• The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute

• Expect it to be more price elastic

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


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

• Interpret this number as percentage increase in quantity demanded for each 1% rise in income

Income in Change %

DemandedQuantity in change %EY


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


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

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

XZ

% Change in Quantity of Good (X) Demanded

% Change in Price of Good (Z)E

• 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

Price in Change %

SuppliedQuantity in Change %ES


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


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

Chapter 4: Working with Supply and Demand: Part 2 Econ 101: Microeconomics.

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Transcript of Chapter 4: Working with Supply and Demand: Part 2 Econ 101: Microeconomics.