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SizeofChangesinMarketEquilibrium
Whatdeterminesthesizeofchangesinmarket
equilibrium?
ELASTICITY Sizeofchangeindemand(orsupply)
Thelargertheshiftindemand(orsupply),thelargertheeffect
onprice
Steepnessofthecurvethatdoesnotshift
Ifthesupplycurveshifts,thesteeperthedemandcurvethe
morethepricechangesandthelesstheamountboughtand
soldchanges
Steepnessreflectsresponsivenesstoprices

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ChangesinEquilibriumforTwoExtremeSupplyCurves
ChangesinEquilibriumforTwoExtremeDemandCurves

2-3 2-4

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Steepnessofthedemandcurve
ElasticitiesofDemandandSupply
Ameasureoftheresponsivenessoftheamounts
P
demandedandsuppliedtochangesinprices
S Notthesameastheslopeofthesupplyordemand
S
curve
Slopeofthecurvedependsontheunitsusedto
measurethequantityofthegoodanditsprice
Elasticitydoesnotdependonunits(e.g.,gallons,
dozens,dollarsperpound)
Q
D2 D1

Reference: Read More Online 2.3 (p829)


2-6

Elasticity Elasticity
Demand curves can come in different
shapes We know that quantity demanded depends on many
things
From very flat to very steep So we can ask a more general question.
Very flat demand curve: a small change in How sensitive is demand to change in any of the
price has a large effect on quantity relevant factors:
demanded - Own price
Very steep curve: even a large change in - Income
price does not affect quantity demanded too - Related prices
much - Etc.
Question: how sensitive is quantity
demanded to price changes?

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Elasticities
Two situations:
Consider the market demand for a commodity, q
Situation 1 2
Let it depend on a factor y (which might be its own
price, or the price of a related good, or income). Quantity q1 q2

Then the elasticity of demand for q with respect to Y y1 y2


y is defined as:

the percentage change in q that results from Let q = q2 q1


a 1% change in y. y = y2 y1
It is the percentage change in q divided by the
percentage change in y.

Since percentage changes are pure numbers, the


elasticity measure will always be a unit-free pure Therefore elasticity of quantity demanded
number. can be with respect to:
Elasticity of q with respect to y - own price (price-elasticity of
demand)
q y
=[ ----x100] divided by [----x100]
q y - any other price (cross price-
elasticity)

q y - income (income elasticity)


= ----x----
We will spend some time on the concept of
y q the price-elasticity of demand

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Price Elasticity of Demand Calculation of elasticity

For downward sloping curves, prices and quantities Situation 1 Situation 2


move in opposite directions, so that the elasticity p1 = Rs.10 p2 = Rs.9.00
value is negative. q1 = 100 q2 = 105
To avoid this problem, we consider the absolute
Consider finite changes in prices and quantity:
value of the elasticity.

q p e = - [q/p]x[p/q],
e = - ----x---- = - (p/q)x(q/p).
p q q = q2 - q1 = 5

p = p2 - p1 = -1

1.Pointelasticitymeasures. 2.Arcelasticitymeasure.
e = - [q/p]x[p1/q1] To get rid of this ambiguity, take an average of the
= -(-5)x(10/100) = 5/10 = .5 values:

e = - [q/p]x[p2/q2]
q [(p2 + p1)/2]
= -(-5)x(9/105) = 9/21 = 3/7
= .42 e = - ---------------------------
p [(q2 + q1)/2]
small changes in price -> not much difference
between these two.
For larger changes, the differences become = - [q/p][(p2 + p1)/(q2 + q1)]
substantial.
= 5(19/205) = .46.

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P AStraightLineDemandCurve
Consider the straight-line
demand curve AB. What is e
A at the point C? Then price-elasticity at a point C on the demand
curve = (EB/CE)(CE/OE) = EB/OE
Note: [q/p] = EB/CE, = (BC/CA)
D C
p = CE, q = OE (by property of similar triangles).

At the mid-point of the demand curve, e = 1.

All points above this have elasticity greater than 1.

B Demand at all points below the mid-point is inelastic.


O E Q

PriceElasticityRegionsalong
aStraightLineDemandCurve If the percentage change in q > the
Observation percentage change in p, then e > 1, and
Price elasticity varies at we have elastic demand.
every point along a straight-
line demand curve

a 1 If the percentage change in q = the


1 percentage change in p, e = 1 and we say
that demand is unit elastic.
Price

a/2 1
If the percentage change in q < the
percentage change in p, so that e < 1,
b/2 b demand is said to be inelastic.
Quantity

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PriceElasticityandthe
PriceElasticityandthe
SteepnessoftheDemandCurve
SteepnessoftheDemandCurve
What is the price elasticity of
demand when P = Rs.4?
12 12 Observation
If two demand curves have a

D1 4 1 1
D1 point in common, the steeper
4 12 2 curve must be less elastic with
6 D1
respect to price at that point
6 6
Price

Price

4 1
D2
4
4 2
4 6
D2 12 D2

4 6 12 4 6 12

Quantity Quantity

Priceelasticity Threespecialcases
If (inverse) demand curve is a horizontal straight line
Supposethatwehaveadifferentiabledemandfunction parallel to the quantity axis, then the price-elasticity
Q=Q(P). measure goes to infinity.
Thenelasticityatapoint(P*,Q*)onthedemand - demand is perfectly elastic.
curveis
E=(dQ/dP)(P*/Q*) If the (inverse) demand curve is a vertical straight line,
wheredQ/dPisevaluatedat(P*,Q*) then e = 0 and demand is said to be perfectly
Example:LetQ = p-a inelastic.
Then dQ/dP = (-a) p-a-1
E=[(-a) p-a-1][p/p-a] = a (independent of the point on An example of a demand curve that is iso-elastic (has
the demand curve) the same elasticity everywhere) is q = p-a.

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Perfectly Elastic Demand Curve Perfectly Inelastic Demand Curve


P P
D

D D
Basic needs, minimum
requirements, absolute
necessities.

0 Q 0 D Q

Rangeofelasticities

0_______________1________________+
PerfectlyUnitPerfectly
InelasticElasticityElastic
DemandDemand

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Factors affecting price elasticity:


Factors affecting price elasticity:
1. Availability of substitutes
Larger the availability of close substitutes, the more
elastic will demand be. 4. Time period of adjustment-flexibility over the
long run
2. Demand will be more elastic when buyers of the Larger the time period, the higher the elasticity of
product regard it as a discretionary purchase rather demand.
than as a necessity Suppose petrol prices go up
Short run demand falls somewhat because
3. If buyers are wealthy and the item accounts for a motorists drive less
very small part of the total expenditure, then In the long run, people switch to smaller,
demand will be less elastic more fuel-efficient cars quantity demanded of
petrol goes down by a larger amount

Some elasticity values ElasticityandTotalRevenue


Salt 0.1
Matches 0.1
Airline travel, short-run 0.1 Whatdoyouthink?
Petrol, short-run 0.2
Willincreasingthemarketpricealwaysincrease
Tobacco products, short-run 0.45
totalrevenue?
Residential natural gas, long-run 0.5
Physician services 0.6
Movies 0.9 Application:
Housing, owner occupied, long-run 1.2 Could reducing the supply of illegal drugs
Restaurant meals 2.3 cause an increase in drug-related burglaries?
Airline travel, long-run 2.4

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The Effect of Extra Border Relationship between elasticity and total


Patrols on the Market for Illicit Drugs revenue
Total Expenditure = P x Q
S Rs.2500 = Rs.50 x 50
TR = pq
S Rs.3200 = Rs.80 x 40
dTR = d(pq) = pdq + qdp
S = qdp(1 e)
80
Consider what happens if price is lowered, so that
P(Rs./ounce)

S
50 dp < 0.

dTR > 0 if 1 e < 0, i.e. e > 1


D
40 50 dTR = 0 if 1 = e
Q(1,000s of ounces/day)
dTR < 0 if e < 1

Income-elasticity of Demand Cross-price Elasticity of Demand


The cross-price elasticity of the commodity x with
respect to the price p of y is defined as
em = (q/M)(M/q)

exy = (x/p)(p/x)
In the case of a normal good, em > 0, while for an
inferior good, it is < 0.
If this is positive, x and y are said to be substitutes
(Coke and Pepsi), while if this is negative, the
If 0 < em < 1, then the good is called a necessity,
commodities are said to be complements (tea and
otherwise it is a luxury. sugar).

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CalculatingthePrice
ElasticityofSupplyGraphically
Price Elasticity of Supply
Suppose that q now refers to quantity supplied. A 4 1212 4 1 S

The price elasticity of the supply of q with respect to Qs = AP B


the price p is defined as 5
P
es = (q/p)(p/q)
A
4
Q

Price
Since supply curves are upward-sloping, this B 5 15 15 5 1
expression will be non-negative no need to put a
negative sign in front of the expression

0 12 15
Quantity

In general, even for straight line supply curves,


the price elasticity of supply will vary from point Application - Farming
to point.
Supposethatuniversityagronomistsdiscoveranew
For example : P = 10 + 2Qs wheathybridthatismoreproductivethanexisting
varieties.
Two points on the line are (Qs = 1, P = 12, and Whathappenstowheatfarmers?
Qs = 2, P = 14) Thediscoveryofthenewwheathybridaffectsthe
supplycurve itshiftstotheright.
Show that the price elasticities at these two Thedemandcurveremainsthesame
points are different.

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Application - Farming Application - Farming


What happens to the total revenue received by the
Price of wheat
D farmers?
S
S Q rises but P falls
The demand for basic foodstuffs such as wheat is
usually inelastic, for these items are relatively
inexpensive and have few good substitutes
Hence fall in P is substantial while rise in Q is small
S Revenue to all wheat farmers taken together falls
S D
Quantity of wheat

Application - Farming Application - Farming


Certain agricultural programs try to help farmers by
If farmers are made worse off by the discovery of inducing them not to plant crops on all their land
the new hybrid, why do they adopt it? The purpose is to reduce the supply of farm products
Each farmer is a small part of the market and thereby raise prices
For any price, it makes sense for each farmer to With inelastic demand, farmers as a whole receive
greater revenue
adopt the hybrid
No single farmer, by himself, would have found it
But when they all do it, the supply curve shifts and profitable to leave some land fallow
together, they are worse off

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Wheatexportallowedtofreestoragespace
PriceSupport 3July2012
Anotherwayforthegovernmenttohelpthefarmersis
byhavingasupportprice,atwhichpricethe
governmentstandspreparedtobuyanyamount Facedwithaseverespaceconstraintinthecountrys
suppliedbythefarmers overflowinggranaries,thegovernmenttodaycleared
Overtime,thismayleadtothegrowthofbuffer exportoftwomilliontonsofwheatfromitsbuffer
stockthatisexpectedtoclearstoragespacefornew
stocks
crops.
Willperishifjuststockpiled
Somecanbeusedforemploymentgeneration ThiswasapprovedbytheCabinetCommitteeon
programmes,ormeetingfoodrequirementsinalean EconomicAffairs.Informedsourcessaidafterthe
year CCEA meetingthatexportwithafloorpriceof$228
(aboutRs12,400)perton.
Whattodowiththerest?

Atpresent,thegovernmentisgrapplingwiththe
problemofstoragecapacity. TAXES
India,theworldssecondlargestproducerofwheat,
hadharvestedarecord90.23milliontonsin201112 Governmentslevytaxestoraiserevenuefor
cropyear(JulyJune),leadingtoarecordprocurement publicprojects,topayforwagesandsalaries
ofnearly38milliontonssofarthisyear. inthepublicsector,topayinterestondebt,
Itsgodowns areoverflowingwitharecord82million etc..
tonsofriceandwheatagainstthestoringcapacityof
only64milliontons.
Theexportoftwomilliontonswouldinvolveanoutgo
ofRs 1,263crore.

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Taxes Taxes
Aspecifictax isafixedrupeeamountthat Instudyingtheeffectsoftaxesitsimportant
mustbepaidoneachunitboughtorpaid todistinguishbetweentheamounta
Anadvaloremtax isataxthatisstatedas consumerpaysforagoodandtheamounta
apercentageofthegoodsprice firmreceives
Theincidenceofataxindicateshow UsePb fortheamountaconsumerpays,Ps
muchofthetaxburdenisbornebyvarious fortheamountafirmreceives
marketparticipants IfthetaxisTperunit,thenPs =Pb T

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TheBurdenofaTax EffectsofaSpecificTax
ConsidertheeffectofaspecifictaxofTrupeesper
literpaidbygasstationsontheirsalesofgasoline Shiftingthesupplycurveisonewayto
Graphically,therearethreewaystodeterminethe determineaspecifictaxseffects
taxseffect:
ShiftthesupplycurveupbyT Demandcurveremainsunchanged
ShiftthedemandcurvedownbyT Foranypricepaidbyconsumers,firms
Useawedgebetweentheamountsconsumers nowreceivelessthanwhenthereisnotax
payandfirmsreceive Wontbewillingtosupplyasmuchas
Allthreemethodsyieldthesameresults before
Makesnodifferencewhetherthetaxisleviedon SupplycurvewiththetaxisadistanceT
consumersorproducers
abovetheoriginalsupplycurve

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EffectsofaSpecificTax ShiftingtheSupply
EffectsofaSpecificTax Curve
Newequilibriumpricepaidby ST

Price Paid by Consumers ($/gallon)


consumersispriceatwhichthe Increase in S

demandcurveandnewsupplycurve Consumer Cost


per Gallon Po + T
B

cross Pb T

Amountboughtandsoldfalls Po
Ps = Pb - T
A

Pricepaidbyconsumersrises;price Decrease in
Firms Receipts
receivedbyfirmsfalls per Gallon
D

Inacompetitivemarkettheburdenofa QT Qo
taxissharedbyconsumersandfirms Gallons of Gas per Month

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TaxIncidence IncidenceofaSpecificTax TwoSpecial


Cases
Incidenceofataxdependsontheshapesofthe
demandandsupplycurves
Ingeneral,themoreelasticisdemandandless
elasticissupply,themoreofthetaxisborneby
firms
Firmscannotpassonthetaxtotheconsumers
becausethelatteraresensitivetopricechanges
Consumersbearthelargershareofthetax
whendemandislesselasticthansupply

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EffectsofaSpecificTax Shiftingthe
DemandCurve
Lineardemandandsupply
LetQd =a bpb
andQs =c+dps
Also,ps=pb t
Equilibriumrequires
a bpb=c+dps
Thena
b(ps+t)=c+dps
Solvingfortheequilibriumpriceps*,weget
ps*=(a c bt)/(d+b)
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