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CHAPTER 4 CHAPTER 4 EXTENSIONS OF EXTENSIONS OF DEMAND AND DEMAND AND
SUPPLY ANALYSIS SUPPLY ANALYSIS AND THE EFFICIENCY AND THE EFFICIENCY
OF MARKETSOF MARKETS
Part Two: Microeconomics Part Two: Microeconomics of Product Marketsof Product Markets
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4 2
In this chapter you will learn:In this chapter you will learn:
4.1 About price elasticity of demand and how it can be applied
4.2 The usefulness of the total revenue test for price elasticity of demand
4.3 About price elasticity of supply and how it can be applied
4.4 About cross elasticity of demand and income elasticity of demand
4.5 To apply the concept of elasticity to various real-world situations
4.6 About consumer surplus, producer surplus, and efficiency losses
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1 3
Price Elasticity of DemandPrice Elasticity of Demand
THE LAW OF DEMAND SAYS…• An increase in price causes a
decrease in quantity demanded (and vice-versa)
• But HOW MUCH does quantity demanded change in response to a change in price?
• Elasticity gives us a measure of RESPONSIVENESS
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1 4
Price Elasticity of DemandPrice Elasticity of Demand
• When QD responds STRONGLY to a change in P, demand is ELASTIC
• When QD responds WEAKLY to a change in P, demand is INELASTIC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1 5
X productof price inchange %X productof demanded quantity inchange %
Ed
Calculate the average:Calculate the average:• If the quantity demanded increased
from 4 to 5 units• %ΔQd = ΔQd/Q0 = ¼ x 100 = 25%
The Price Elasticity Coefficient and The Price Elasticity Coefficient and FormulaFormula
• If the price dropped $5 to $4• %ΔP = ΔP/P0 = 1/5 x 100 = 20%
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1 6
Price Elasticity of DemandPrice Elasticity of Demand
•Average price and quantity–avoids confusion about start and end points
100X prices/2ofsum
priceinchange /2quantities ofsum
quantity inchange Ed
12/)54(
1
2/)54(
1
2/)(2/)( 1010
PP
P
QEd
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.1 7
The Price Elasticity Coefficient and The Price Elasticity Coefficient and FormulaFormula
• Price elasticity of demand:– Use of Percentages– Elimination of the Minus Sign
• Interpretation of Ed:– Elastic Demand– Inelastic Demand– Unit Elasticity– Extreme Cases
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 8
The Total-Revenue TestThe Total-Revenue Test
• Total revenue (TR)– TR = P x Q
• TR and Ed are related– If TR changes in the opposite
direction from price, demand is elastic
– If TR changes in the same direction from price, demand is inelastic
– If TR does not change when price changes, demand is unit elastic
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 9
PP
DDPP22
PP11
QQ22QQ11
Quantity is very responsive to a change in price
Elastic DemandElastic Demand
When P changes from P1 to P2, TR increases
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 10
Quantity is NOT very responsive to a change in price
PP
DD
PP22
PP11
QQ22QQ11QQ
Inelastic DemandInelastic Demand
When P changes from P1 to P2, TR decreases
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 11
% change in quantity is equal to % change in price
PP
DD
PP22
PP11
QQ22QQ11QQ
Unit ElasticUnit Elastic
When P changes from P1 to P2, TR does not change
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 12
Price Elasticity along a Linear Price Elasticity along a Linear Demand CurveDemand Curve
• For all straight-line and most other demand curves– demand is more elastic toward the
upper left– demand is less elastic toward the
lower right
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 13
The Total-Revenue TestThe Total-Revenue Test
• TR = P X Q• What happens to total revenue
when product price changes?
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 14
Table 4-1Table 4-1EEdd and Total Revenue and Total Revenue
Qd P Ed TR
1 8 8,000
2 7 14,000
3 6 18,000
4 5 20,000
5 4 20,000
6 3 18,000
7 2 14,000
8 1 8,000
5.005.00
2.602.60
1.571.57
1.001.00
0.640.64
0.380.38
0.200.20
ELASTIC ELASTIC DEMAND:DEMAND:when price when price decreases, decreases,
total total revenue revenue
increasesincreases
ELASTIC ELASTIC DEMAND:DEMAND:when price when price decreases, decreases,
total total revenue revenue
increasesincreases
INELASTIC INELASTIC DEMAND:DEMAND:when price when price decreases, decreases,
total total revenue revenue
decreasesdecreases
INELASTIC INELASTIC DEMAND:DEMAND:when price when price decreases, decreases,
total total revenue revenue
decreasesdecreases
UNIT UNIT ELASTIC ELASTIC DEMAND:DEMAND:when price when price decreases, decreases,
total total revenue revenue stays the stays the
samesame
UNIT UNIT ELASTIC ELASTIC DEMAND:DEMAND:when price when price decreases, decreases,
total total revenue revenue stays the stays the
samesame
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 15
Figure 4-3
0123456789
0 1 2 3 4 5 6 7 8 9
Quantity demanded(thousands)
Pric
e
02468
10121416182022
0 1 2 3 4 5 6 7 8 9
Quantity demanded (thousands)
Tota
l rev
enue
($
thou
sand
s)
DD
TR
Elastic UnitElastic
Inelastic
TR
Incr
ease
s
TR Decreases
MaxTR
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 16
Determinants of EDeterminants of Edd
• Substitutability• Proportion of Income• Luxuries versus Necessities• Time
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.2 17
Applications of EApplications of Edd
• Large Crop Yields• Sales Taxes• Decriminalization of Illegal
Drugs• Minimum Wage
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3 18
EEss==
Percentage change in quantityPercentage change in quantitysupplied of product Xsupplied of product X
Percentage change in Percentage change in the price of product Xthe price of product X
Price Elasticity of SupplyPrice Elasticity of Supply
The main determinant of EThe main determinant of Ess is the is the
amount of time producers have for amount of time producers have for responding to a change in product responding to a change in product priceprice
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3 19
Immediate Market PeriodImmediate Market Period
PPoo
PP
DD11
QQoo
An increase in demand without enough time to change supply causes...
SSmm
Figure 4-4 Time and the Elasticity of Figure 4-4 Time and the Elasticity of SupplySupply
PPmm
DD22
A Large Increase in Price -
Perfect Inelastic Supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3 20
Short RunShort Run
PPoo
PP
DD11
An increase in An increase in demand with demand with some supply some supply responseresponse will will cause...cause...
SSss
PPmm
QQoo
Time and the Elasticity of SupplyTime and the Elasticity of Supply
PPss
DD22
QQss
An Increase in Price -
More elastic Supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3 21
Long RunLong Run
PPoo
PP
DD11
An increase in An increase in demand in the demand in the long run allows a long run allows a greater supply greater supply response....response....SSLL
PPmm
QQoo
Time and the Elasticity of SupplyTime and the Elasticity of Supply
PPLL
DD11
QQLL
DD22
A small Increase in Price -
More elastic Supply
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.3 22
Applications of Price Elasticity of Applications of Price Elasticity of SupplySupply
• Antiques and Reproductions• Volatile Gold Prices
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.4 23
EExy xy ==
Percentage change in quantityPercentage change in quantitydemanded of demanded of product Xproduct X
Percentage change in Percentage change in the price ofthe price of product Y product Y
• Substitute Goods- positive sign
• Complementary Goods- negative sign
• Independent Goods- near zero
Cross Elasticity of DemandCross Elasticity of Demand
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.4 24
Cross Elasticity of DemandCross Elasticity of Demand
Applications• Coca-Cola vs. Sprite• Assessing competition
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.4 25
EEi i ==
Percentage change inPercentage change inquantity demanded quantity demanded
Percentage changePercentage changein incomein income
• Normal Goods- positive sign
• Inferior Goods
- negative sign
• Insights
Income Elasticity of DemandIncome Elasticity of Demand
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 26
Figure 4-5
0
2
4
6
8
10
12
14
0 5 10 15 20 25
Quantity
Price
Figure 4-5 The Incidence of a Figure 4-5 The Incidence of a TaxTax
• Tax of $2 per unit• S shifts up $2• Equilibrium price
rises to $9• Consumer’s
burden is the amount of the price increase = $1
• Firm’s burden = tax-consumer’s burden =$2 - $1 = $1
$$22
$9$9
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 27
Figure 4-6 Figure 4-6 Demand Elasticity and the Incidence Demand Elasticity and the Incidence
of a Taxof a Tax
DD
SSSS
Tax incidence and elastic demandTax incidence and elastic demand
PP11
QQ11
SS
QQ00
PP00
PPaa
TA
XProducer bears most of the tax burden
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 28
Demand Elasticity and the Incidence Demand Elasticity and the Incidence of a Taxof a Tax
DD
SSSS
Tax incidence and inelastic demandTax incidence and inelastic demand
PP11
QQ11
SS
QQ00
PP00
PPaa
TA
XConsumer bears most of the tax burden
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 29
Figure 4-7Figure 4-7Supply Elasticity and the Incidence of Supply Elasticity and the Incidence of
a Taxa Tax
DD
SSSS
Tax incidence and elastic supplyTax incidence and elastic supply
PP11
QQ11
SS
QQ00
PP00
PPaa
TA
X
Consumer bears most of the tax burden
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 30
Supply Elasticity and the Incidence of Supply Elasticity and the Incidence of a Taxa Tax
DD
SSSS
Tax incidence and inelastic supplyTax incidence and inelastic supply
PP11
QQ11
SS
QQ00
PP00
PPaa
TA
XProducer bears most of the tax burden
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 31
The Economics of Agricultural Price The Economics of Agricultural Price Supports Supports
• Net income stabilization• Supply management programs:
– dairy, poultry products, and eggs– Canadian Wheat Board
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 32
Offers to PurchaseOffers to Purchase
• Surplus Output– misallocation of resources– higher taxes
• Loss to Consumers– higher prices– higher taxes
• Gain to Farmers
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 33
D
D S
S
PPee
The result of imposing a floor (support) priceis a...
PP
QQQQee
PPSS Support priceSupport price
Figure 4-8 Price Supports and Supply Figure 4-8 Price Supports and Supply Restriction – Offers to PurchaseRestriction – Offers to Purchase
SURPLUSSURPLUS
Government Government must must
purchase purchase this amountthis amount
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 34
Deficiency PaymentsDeficiency Payments
• Subsidies to make up the difference between the market price and government-supported price
• Elasticity of supply & demand– effect of elasticity the same as that
of a sales tax
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 35
D S
S
PPee
At price PS, farmersIncrease output from Qe to QS
PP
QQQQee
PPSS
QQss
PP00
D
Figure 4-8 Figure 4-8 Deficiency PaymentsDeficiency Payments
Government must pay Government must pay farmers this amountfarmers this amount
S
S
Supplycurve (consumer)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 36
ComparisonComparison
• Farmers benefit equally from offers to purchase and deficiency payments
• Consumers prefer deficiency payments, because of lower prices
• When subsidies are taken into account, total payments by the public are identical
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 37
Resource OverallocationResource Overallocation
• Both approaches encourage overallocation of resources to agriculture
• Efficiency loss
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 38
Supply RestrictionsSupply Restrictions
• Crop restrictions• Quotas• With highly price-elastic supply,
offers to purchase or deficiency payments result in surpluses higher than original quantity demanded
• Supply restriction is the only option
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.5 39
D
PPee
PPrr
QQee QQrrQQff
PP
SURPLUSSURPLUS
D
S
Sf
Figure 4-8 Figure 4-8 Supply RestrictionsSupply Restrictions
Sf
All costs All costs are are
borne by borne by con-con-
sumerssumers
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 40
Consumer and Producer SurplusConsumer and Producer Surplus
• Consumer surplus– is the benefit surplus received by a
consumer or consumers in a market
– is the difference between the maximum price a consumer is willing to pay for a product and the actual price
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 41
Figure 4-9Figure 4-9Consumer SurplusConsumer Surplus
PP
DD
Equilibrium Price = $8
ConsumerSurplus
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 42
Table 4-5 Consumer SurplusTable 4-5 Consumer Surplus
Person Maximum price willing to pay
Actual Price Consumer surplus
Bob 13 8
Barb 12 8
Bill 11 8
Bart 10 8
Brent 9 8
Betty 8 8
Person Maximum price willing to pay
Actual Price Consumer surplus
Bob 13 8 5
Barb 12 8 4
Bill 11 8 3
Bart 10 8 2
Brent 9 8 1
Betty 8 8 0
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 43
Figure 4-10Figure 4-10Producer SurplusProducer Surplus
PP
SS
Equilibrium Price = $8
Pro
du
cer
Surp
lus
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 44
Table 4-6 Producer SurplusTable 4-6 Producer Surplus
Person Maximum acceptable price
Actual Price Consumer surplus
Carlos 3 8
Courtney
4 8
Chuck 5 8
Cindy 6 8
Craig 7 8
Chad 8 8
Person Actual Price Producer surplus
8 5
8 4
8 3
8 2
8 1
8 0
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 45
Figure 4-11Figure 4-11Efficiency RevisitedEfficiency Revisited
PP
SS
Equilibrium Price = $8
DD
ConsumerSurplus
ProducerSurplus
Productive Efficiency is achieved since CS and PS are maximized
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4.6 46
Figure 4-12Figure 4-12Efficiency Losses (or Deadweight Efficiency Losses (or Deadweight
Losses)Losses)PP
SS
Equilibrium Price = $8
DD
Quantity levels less than efficiency quantity create efficiency losses
EfficiencyLosses
©2007 McGraw-Hill Ryerson Ltd.
Chapter 4 47
Chapter SummaryChapter Summary
4.1 Price Elasticity of Demand 4.2 The Total-Revenue Test 4.3 Price Elasticity of Supply 4.4 Cross Elasticity and Income
Elasticity of Demand 4.5 Elasticity and Real-World
Applications- Excise Tax- The Economics of Agricultural Price Supports
4.6 Consumer and Producer Surplus
