The Model

© Playconomics, LHS 1
 Shift in demand : numerical example

• Assume : original equation for demand is P = 88 - Qd

equation for supply is P = 0.1 Qs

At equilibrium : Qs = Qd
Therefore 88 - Qd = 0.1 Qs
Therefore 88 = 1.1Q therefore Q = 80
Substitute to find Price : P = 88 - 80 = 8

2
Diagram : positive consumption
externality

3
 What is new equilibrium
• Assume the product has a per unit positive externality of $5.5
• New equation for demand is: P = 88-Qd + 5.5
• The equation for supply is : P = 0.1Qs

• What is the optimum equilibrium P and Q

• At equilibrium : Qs = Qd
• Therefore 93.5-Qd = 0.1 Qs
• Therefore 93.5 = 1.1Q therefore Q = 85
• Substitute to find Price : Pd = 93.5 – 85= 8.5
• Substitute to find Price : Ps = 0.1 x 85 = 8.5

4
 Diagram : positive consumption externality
If Government gives a Subsidy to the Consumer, what out of pocket expense will they pay ?

Answer : the price $8.5 – government assistance $5.5 = $3

5
 What is new equilibrium
• Assume the product has a per unit positive externality of $5.5
• GOVERNMENT GIVES THE PRODUCER A SUBSIDY of $5.5
• New equation for demand is: P = 88-Qd
• The equation for supply is : P = 0.1Qs -5.5 …………Why ?

• What is the optimum equilibrium P and Q ?

• At equilibrium : Qs = Qd
• Therefore 88-Qd = 0.1 Qs -5.5
• Therefore 93.5 = 1.1Q therefore Q = 85
• Substitute to find Price : Pd = 88 – 85= 3
• Substitute to find Price : Ps = (0.1 x 85) -5.5 = 3

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Diagram

7
The Model : Shifts in Supply

© Playconomics, LHS 8
 Equilibrium Output and Price ?

• Assume : equation for demand is P = 60 -0.2Qd

equation for supply is P = 0.2 Qs

At equilibrium : Qs = Qd
Therefore 60 -0.2Qd = 0.2 Qs
Therefore 60 = 0.4Q therefore Q = 150
Substitute to find Price : P = 60 – 0. 2 (150) = 30

9
 Decrease in Supply : New Equilibrium

• Assume a negative externality of $10

• Decrease in Supply
• New equation for supply is : P = 0.2 Qs + 10………...why ?
• Equation for demand is : P = 60 -0.2Qd

• At equilibrium : Qs = Qd
• Therefore 60 -0.2Qd = 0.2 Qs + 10
• Therefore 50 = 0.4Q therefore Q = 125
• Substitute to find Price : P = 60 – 0. 2 (125) = 35

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Diagram

11
Use the information below to answer
Question below
The demand curve for paper clips is given by
the equation:
Qd = 36 -2P

What is the Output when P is 12 ?

What is the consumer surplus ?

Diagram
Use the information below to answer
Question below
The demand curve for paper clips is given by
the equation:
P = 36 -2Q
P = Qs

What is the price P and Q at equilibrium ?

3Q =36
Q = 12
P = Qs=12
P= 36-(2x12)=12
Diagram
 Consumer and Producer Surplus
• Consumer Surplus = ½ (24 x12 ) = 144

• Producer Surplus = ½ (12 x 12) = 72

• Total Surplus = 144 + 72 = 216

Ceiling price:
P = 36 -2Qd
P = Qs

Assume a price ceiling at $6

Draw the diagram
What is the Qd and Qs ?
6 = 36- (2x Qd ) …………Qd =15 Qs = P= 6
What is the new consumer surplus ?
At Qs 6 the reservation price is 36 – (2x6) =24
Surplus is 6(24-6) + ½ (12 x 6) = 144
What is the new producer surplus ?
½ (6 x 6) = 18
What is the dead weight loss ?
½ (24-6) x 6 = 54
 Diagram

CS 144 + PS 18 + DWL 54 = 216

 Price Elasticity of Demand

Definition:
The Price Elasticity of demand represents the
percentage change in the quantity demanded
resulting from a very small percentage change in
price. It also measures the responsiveness of the
demand to changes in price.

© Playconomics, LHS 19
Price Elasticity of Demand
ElasticityA = (1/slope) x (PA/QA)
ElasticityA = (ΔQ/QA) / (ΔP/PA)

ElasticityA < 0 … Why? P  Q

P  Q
(Convention:
When we report the elasticity we
always use its absolute value)

© Playconomics, LHS 20
 Price Elasticity
Where Q is the original quantity and P is the
original price.

ΔQ Q
Price elasticity   
ΔP P
 Price Elasticity
• Example
– Originally
• Price (P) = $100
• Quantity (Q) = 20
– New
• Price (P) = $105
• Quantity (Q) = 15

5 20 25
   5 : Elastic
5 100 5
Calculating price elasticity of demand

Figure 4.3 Calculating price elasticity of demand at “A”

The price elasticity of demand at point A is given by (P/Q) × (1/slope) =

(8/3) × (1/4) = 2/3.

vertical intercept 20
slope   4
horizontal intercept 5
8 1 8 2
A  x  
3 4 12 3
  
 4  1  1
D1     
 4  12  2
 6
 
 4  1 
D2     2
 4  6 
 12 
 Price Elasticity of Demand

Definition:
Elastic Demand: Demand is elastic when the price
elasticity of demand is greater than 1.
Unit Elastic Demand: Demand is unit elastic when
the price elasticity of demand is equal to 1.
Inelastic Demand: Demand is inelastic when the
price elasticity of demand is less than 1.

© Playconomics, LHS 25
Elasticity and Expenditure
Quantity Price Total Marginal
Spending Spending
1 $10 $10 $10
2 $9 $18 $8
3 $8 $24 $6
4 $7 $28 $4
5 $6 $30 $2
6 $5 $30 $0
7 $4 $28 -$2
8 $3 $24 -$4
9 $2 $18 -$6
10 $1 $10 -$8
 Why does elasticity change along a
straight line demand curve
• Diagram
 Law of Demand
• if P  Q
• if P  Q

• but as price changes, elasticity of demand changes

– at low ranges of quantity, demand is price elastic, but as
quantity increases, demand will become price inelastic
– as demand (AR) falls, MR is falling more steeply
underneath it
Question

The absolute value of price elasticity of demand for a product is

2.0. Assume that the price for this product increases by 5 percent.
If sales before the price change were 200 units, what will sales be
after the price change, ceteris paribus?

(a) 180 units

(b) 190 units
(c) 210 units
(d) 220 units