Chapter 3.

DEMAND, SUPPLY, AND

MARKET EQUILIBRIUM (Part 2)

Economics 11- UPLB

Prepared by T.B.Paris, Jr. 11/28/07
 Elasticity Concepts
Meaning of elasticity: If Y=f(X), elasticity
measures the responsiveness of Y due
to changes in X.
A given change in X brings about a
change in Y. The elasticity measure
attempts to compare the relative change in
Y with to the relative change in X.
Mathematical formulation: %Y Y / Y

%X X / X
 Elasticity Values
The elasticity values (in absolute terms) can range from zero to
infinity; each with definite interpretations.

0 Perfectly inelastic
1 Inelastic
1 Unit elastic
1 Elastic
Perfectly elastic
 3 Demand Elasticity Concepts
Weshall study 3 demand elasticity
concepts:
Own price elasticity : responsiveness of
quantity demanded of a good to changes in
own-price.
Cross price elasticity responsiveness of
quantity demanded of good A to changes in
price of good B (substitute or complement)
Income elasticity responsiveness of quantity
demanded of a good due to changes in
income.
 Own-Price Elasticity
Ownprice elasticity of demand ()
measure of responsiveness of quantity
demanded to changes in price

% inQ
d
% in P
 Two ways of measuring elasticity

Point elasticity elasticity is measured

for a single point
More precise since elasticity changes at every
point on demand curve
Can be obtained if demand function is known
Arcelasticity computed for two points
along a demand curve
Done if we have limited number of
observations
 Point Elasticity
P
%Qd Qd / Q Qd P

%P P / P P Q
slope P/Q
Price

P1 A

0 Q1 Q

Quantity
 Arc Elasticity

P
Q2 Q1 P2 P1

Q2 Q1 P2 P1
Diff Q Diff P

Sum Q Sum P
Price

P1 A

B
P2

0 Q1 Q2 Q

Quantity
 Arc Elasticity: Example

P
200-100 30-20

200+100 30+20

100 10 1 5
5 / 3 1.66
Price

A
300 50 3 1
30

B
20

0 100 200 Q

Quantity
 Elasticity Along a Linear Demand Curve

Elasticity goes down as

P you move down along a
D linear demand curve.
The upper half is elastic,
Elastic the lower half is inelastic.

P1 At the mid-point of the

demand curve, elasticity is
Unit Elastic
unitary.
Price

P
Inelastic

D
0 Q1 Q Q
Quantity
 Geometric derivation of
%Q Q / Q Q P
P
%P P / P P Q
A
DC BD DC

BD OD OD
BC

AB
E B
Price

O D C
Q
Quantity
 Geometric derivation of
BC

AB
P P

A A

C C
0 Q 0 Q

Elastic at B Inelastic at B
Demand function: Qd = 20 - 2P
Price Quantity Slope Elasticity
10 0 -2
9 2 -2 -9.00
8 4 -2 -4.00
7 6 -2 -2.33
6 8 -2 -1.50
5 10 -2 -1.00
4 12 -2 -0.67
3 14 -2 -0.43
2 16 -2 -0.25
1 18 -2 -0.11
0 20 -2 0.00
 Special Case:
Perfectly Inelastic Demand Curve:

P D
A vertical demand curve
implies that any change in price
will not lead to a change in
quantity demanded.
Price

%Qd 0
0
%P

0
Q

Quantity
 Special Case:
Perfectly Elastic Demand Curve:
A horizontal demand curve
P implies that a very small change
in price will lead to an infinitely
large change in quantity
demanded.

D
Price

%Qd

%P 0

0
Q

Quantity
 Elasticity and Total Revenue
Total revenue (from the point of view of a
seller) is equal to the quantity sold
multiplied by the price.
TR = P x Q
It is of interest to the seller what happens
to his TR if he raises or lowers his price,
knowing that if he does, consumers will
adjust their purchases.
What happens to TR when price increases?

Answer: it depends on the elasticity of demand

% Q

% P

Elastic TR decreases
P Q
Unitary TR unchanged
P Q
Inelastic TR increases
P Q
What happens to TR when price decreases?

Answer: it depends on the elasticity of demand

% Q

% P

Elastic TR increases
P Q
Unitary TR unchanged
P Q
Inelastic TR decreases
P Q
 Determinants of price elasticity of
demand

(1) the availability of good substitutes for the

commodity
more substitutes, more elastic
(2) the number of uses the good can be put into
more uses, more elastic
(3) the price of the good relative to the consumer's
purchasing power
if good takes a larger share of budget, likely to be more
elastic
(4) the time frame under consideration
longer period of time, more elastic
(5) location along the demand curve.
recall ideas on elasticity and the linear demand curve
 Cross Price Elasticity of
Demand
Definition:
responsiveness of quantity
demand of a good to changes in price of
other goods.
%Qdx
Formula: exy
%Py

Sign: + for substitutes,

- for complements
 Income Elasticity of Demand
Definition:
responsiveness of quantity
demanded of a good to changes in income

% Qdx
Formula: xI
% I

Sign: + for normal goods

- for inferior goods
 Some Applications
Minimum Price Policy floor prices to
protect producers (price support) or
workers (minimum wage)
Maximum Price Policy price ceilings to
protect consumers (fares, rice price, LPG
price, etc.
Tax Incidence who bears the burden
when tax is imposed on the producer?
 Minimum price policies
prices cannot go below a specified
price
E.g. price support for agricultural
commodities, minimum wages
floor price is usually set above the
equilibrium price and it causes a
surplus
 Floor Price
(minimum price policy)

Examples:
P
Minimum wages,
price support for
S rice farmers
surplus

Pf To be effective, a floor price

(Pf) must be set above the
equilibrium price(P*)
P*
Price

D
0 Q1 Q* Q
Quantity
 Maximum price policy
(price ceiling)
price cannot be set above a specified
price
Example: maximum fares allowed
public transport operators
Usually set below the equilibrium price
and causes a shortage
 Price Ceiling
(maximum price policy)

P
Examples:
S
Price control of
rice, rents, LPG

Pf
To be effective, a price
P* ceiling (Pf) must be set
Price

below the equilibrium

price(P*)
Pc

shortage
D
0 Q1 Q* Q
Quantity
 Tax incidence
Concerned with effects of government
tax policies on consumption and
production.
The tax could either be a specific or
excise tax or an ad valorem tax.
specific tax or excise tax tax per unit of
the product
ad valorem tax tax as percentage of the
selling price.
 Tax incidence
Question: Who bears the greater
portion of tax? Is it the consumer or the
producer?
Supply and demand analysis of a
specific tax:
the tax is likely to be paid for by producers
and consumers
the tax is likely to raise the equilibrium
price, but by an amount less than the tax.
 Tax Incidence

P
S1

S0
P0+ t
tax
P1+ t
Price

P0

P1

D
0 Q1 Q2 Q0 Q

Quantity
 Tax Incidence
D
P
S1

S0
P0+ t
tax
Price

P0 If demand is Perfectly
Inelastic : all of the
tax is passed on to
consumers.

0 Q0 Q

Quantity
 Tax Incidence: Perfectly Elastic Demand

P
S1

S0

tax
Price

D
P0
If demand is Perfectly
Elastic : all of the tax
burden is borne by the
producer.

0 Q1 Q0 Q

Quantity
 Consumer Surplus
P

S1
Consumer surplus:
difference between
what a consumer is
Price

willing to pay and

P1
what he actually pays
for the good.

0 Q1 Q

Quantity
 Consumer Surplus
P

S1
S2

When market price

Price

P1 decreases, consumer
surplus becomes
bigger
P2

0 Q1 Q2 Q

Quantity
 Producer Surplus
P

S1
Producer surplus:
difference between what a
producer receives (market
Price

price) and the amount that will

P1
motivate him to supply the
product (marginal costs must
be recovered).

0 Q1 Q

Quantity
 End
Chapter 3