Demand and Supply Chapter 6 (McConnell and Brue)

Chapter 2 (Pindyck)

Lecture 4

The Supply and Demand Functions

The supply curve is the relationship between the quantity supplied and the price

Qs = Qs (P) This implies that supply is a function of price The demand curve shows how much of a

good consumers are willing to buy as the price per unit changes

Qd = Qd (P)

Revisiting Substitute and Complementary goods

Goods are substitutes when an increase in the price of one leads to an increase in the quantity demanded of the other. E.g. Coke and Pepsi, Copper and Aluminium etc

Goods are complements when an increase in the price of one leads to a decrease in the qty. demanded of the other. E.g. automobiles and gas!

Price Elasticity of Demand Law of Demand The responsiveness of consumers to a price

change is measured by a product’s price elasticity of demand

If consumers are very sensitive to a price change (e.g. luxury goods) then we say that consumers have an elastic demand for that particular good

Inelastic demand

Price Elasticity Coefficient & Formulaεd = % ∆ in qty. dmd of X % ∆ in price of X % change in X = change in qty dmd of X * 100 original qty. dmd of X % change in price = change in price of X *100 original price of X Get rid of *100 as they cancel out

Price Elasticity Coefficient & Formula – alternate formula

εd = ∆ in Q * P ∆ in P Q Point elasticity - when you consider a

particular point on the demand curve or the supply curve.

*But what happens when you calculate εd

over a range of prices?

ARC ELASTICITY- USING AVERAGES

Mid-point formula (Alternate name)εd = ∆ in qty. dmd of X ÷ ∆ in price sum of qtys/2 sum of prices/2 This formula simply averages out the two

prices and two quantities as the reference points for computing the percentages

The solution eliminates up-verses-down problem

Linear Demand Curve (point Elasticity)

εd = ∆ in Q * P ∆ in P Q As we move along the demand curve, (∆Q/∆P)

may change, and the P and Q will always change along the curve.

Therefore the price elasticity of Demand must be measured at a particular point on the demand

curve and εd will generally change along the curve See Graph – 2.11 (Pindyck – pg 33)

Q = a – bP general form Example : Q = 8 - 2P Here ∆Q/∆P = -2 (it is constant) for a linear

demand curve Slope = ∆ in y-axis ∆ in x-axis Hence slope = ∆P/∆Q But since for elasticity we use ∆Q/∆P hence

∆Q/∆P= 1/slope But ratio : P/Q falls along the curve,

therefore εd is falling!

Price Elasticity of Demand Using percentages :

if absolute changes were used, then the choice of units would affect results (using dollars Vs pennies).

Percentages make it easier to compare consumer responsiveness across goods

Ignore minus sign of elasticity, as its always –ve for demand. Absolute values are used (Eg. -4 Vs -2: which is bigger ? )

Interpreting εd Elastic demand: when the % change in quantity

demanded is greater than the % change in price.

εd > 1 Inelastic demand: when the % change in qty.

demanded is less than the % change in price

εd < 1

Unit Elasticity : when the % change in qty. demanded is the same as the % change in price εd = 1

Perfectly Inelastic: A price change results in NO change in the qty. demanded. It’s a horizontal line εd = 0

Perfectly Elastic : where a small reduction in price causes demand to change from 0 to all they can obtain εd = infinity

Special Cases

D

D

Q0 0 Q

Perfectly elastic demand Perfectly inelastic demand

Income Elasticity of Demand Demand for most goods usually rises when

aggregate income rises. The income elasticity of demand is the %

change in the qty demanded Q, resulting for a 1% increase in income I

εi = ∆ in Q * i ∆ in i Q

Income Elasticity Normal Goods: income elasticity is positive,

meaning that more of them are demanded as income rises. Such goods are called normal or superior goods

Inferior Goods: Negative income elasticity coefficient, implies that consumers decrease their purchases of inferior goods as income rises

Cross-price Elasticity of Demand The demand for some goods is also

affected by the prices of other goods. A cross-price elasticity of demand refers to

the % change in the qty. demanded for a good that results from a 1% increase in the price of another good

εi = ∆ in Qb * Pm ∆ in Pm Qb

Cross-price Elasticity Cross-price elasticity of substitutes is

Positive : a rise in price of margarine makes butter cheaper relative to margarine, leading to an increase in qty. dmd. of butter

C-P elasticity of complements is Negative: they are used together, an increase in price of one tends to push down the consumption of the other!

Independent Goods A zero or near zero cross-elasticity

suggests that the two products being considered are unrelated or independent goods

Eg. Books and grapes !

Supply Elasticityεs = % ∆ in qty. supplied of X % ∆ in price of X The price elasticity of supply is the

percentage change in the qty. supplied resulting from a 1% increase in price.

εs is usually positive because a higher price gives producers an incentive to increase output

Supply Elasticity The degree of price elasticity of supply

depends on how easily producers can shift resources between alternate uses. The easier it is to shift resources towards the production of the good, the more elastic it’s supply

Elasticity of Demand & Supply

Chap 2-The Basics of Demand & Supply - Pindyck

Lecture 5

Total Revenue Elasticity of Demand is important for firms

with regards to changes in total revenue and thus profits (TR – TC)

TR is the total amount the seller receives from the sale of a product in a particular time period TR = P * Q

TOTAL REVENUE TEST

TR and Price change in opposite direction when Demand is Elastic If demand is elastic, a decrease in price

will increase total revenue The decrease in revenue from decline in

price received per unit is more than compensated by the increase in additional units at lower price. GRAPH- pg 343 (Ch.18)

An increase in price causes TR to decline

TR and Price change in same direction when Demand is Inelastic If demand is inelastic, a decrease in price

will reduce total revenue The increase in sales from a price decline

will not fully offset the decline in revenue per unit, and TR will decline.

GRAPH- pg 343 (Ch.18) An increase in price causes TR to increase

TR stays constant with Price changes when Demand is Unit elastic If demand is unit elastic, a

decrease/increase in price leaves total revenue constant

The loss in revenue from a lower price is exactly offset by the gain in revenue from the accompanying increase in sales

GRAPH- pg 343 (Ch.18)

Price Elasticity and the Total Revenue Curve Figure 18.3 , pg 345 Chap 18

Determinants of PED Substitutability – the more the substitutes

available, the more elastic the demand. The elasticity of demand depends on how narrowly the product is defined – (Reebok Vs Shoes)

Proportion of Income – the higher the price of a good relative to consumers’ incomes, the greater the PED (low priced items such as pencils Vs cars or houses)

Luxury Vs Necessities – luxury goods have more elastic demands compared to necessity goods (electricity vs jewellery)

Time – product demand is more elastic the longer the time period under consideration (SR demand for petrol is more inelastic than it’s LR demand)

Salt ? GO OVER “APPLICATIONS OF PRICE

ELASTICITY OF DEMAND” in chapter 18