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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
c
A A
= =
A A
Elasticity Values
0 Perfectly inelastic
1 Inelastic
1 Unit elastic
1 Elastic
Perfectly elastic
c
c
c
c
c
=
<
=
>
=
The elasticity values (in absolute terms) can range from zero to
infinity; each with definite interpretations.
3 Demand Elasticity Concepts
We shall 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
Own price elasticity of demand ()
measure of responsiveness of quantity
demanded to changes in price
%
%
inQ
d
inP
c
A
=
A
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
Arc elasticity computed for two points
along a demand curve
Done if we have limited number of
observations

Point Elasticity
0
Q

P

P
r
i
c
e

Quantity
Q
1
D

A

P
1
% /
% /
slope P/Q
d d d
Q Q Q Q P
P P P P Q
c
c
A A A
= = =
A A A
=
Arc Elasticity
Q
2
0
Q

P

P
r
i
c
e

Quantity
Q
1
D

A

P
1
P
2
B

2 1 2 1
2 1 2 1
Diff Q Diff P
Sum Q Sum P
Q Q P P
Q Q P P
c
c

=
+ +
=
Arc Elasticity: Example
200

0
Q

P

P
r
i
c
e

Quantity
100

D

A

30

20

B

200-100 30-20
200+100 30+20
100 10 1 5
5/ 3 1.66
300 50 3 1
c
c
=
= = = =
Elasticity Along a Linear Demand Curve
Unit Elastic
Elastic
Inelastic
P
P
1
Q
1
0
Q

Q

P

P
r
i
c
e

Quantity
D
D
Elasticity goes down as
you move down along a
linear demand curve.
The upper half is elastic,
the lower half is inelastic.
At the mid-point of the
demand curve, elasticity is
unitary.
Geometric derivation of
B
O
Q

D

P

P
r
i
c
e

Quantity
C
A
E
% /
% /
Q Q Q Q P
P P P P Q
DC BD DC
BD OD OD
BC
AB
c
c
c
A A A
= = =
A A A
= =
=
Geometric derivation of
BC
AB
c =
B
A
C
P
Q
0
Elastic at B
B
A
C
P
Q
0
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:
0
Q

P

P
r
i
c
e

Quantity
D

A vertical demand curve
implies that any change in price
will not lead to a change in
quantity demanded.
% 0
0
%
d
Q
P
c
A
= = =
A +
Special Case:
Perfectly Elastic Demand Curve:
0
Q

P

P
r
i
c
e

Quantity
D

A horizontal demand curve
implies that a very small change
in price will lead to an infinitely
large change in quantity
demanded.
%
% 0
d
Q
P
c
A +
= = =
A
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

Elastic
P Q
TR decreases
Unitary
P Q
TR unchanged
Inelastic
P Q
TR increases
%
%
Q
P
c
A
=
A
What happens to TR when price decreases?
Answer: it depends on the elasticity of demand
Elastic
P Q
TR increases
Unitary
P Q
TR unchanged
Inelastic
P Q
TR decreases
%
%
Q
P
c
A
=
A
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.
Formula:

Sign: + for substitutes,
- for complements

%
%
dx
xy
y
Q
e
P
A
=
A
Income Elasticity of Demand
Definition: responsiveness of quantity
demanded of a good to changes in income

Formula:

Sign: + for normal goods
- for inferior goods

%
%
dx
xI
Q
I
q
A
=
A
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)
P
f
Q
1
0
Q

Q*

P

P
r
i
c
e

Quantity
S
D
P*

surplus
To be effective, a floor price
(P
f
) must be set above the
equilibrium price(P*)
Examples:
Minimum wages,
price support for
rice farmers
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
f
Q
1
0
Q

Q*

P

P
r
i
c
e

Quantity
S
D
P*

shortage
To be effective, a price
ceiling (P
f
) must be set
below the equilibrium
price(P*)
P
c
Examples:
Price control of
rice, rents, LPG
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
Q
0
0
Q

P

P
r
i
c
e

Quantity
S
0
D
P
0
S
1
tax
P
1
P
1+ t
P
0+ t
Q
2
Q
1
Tax Incidence
Q
0
0
Q

P

P
r
i
c
e

Quantity
S
0
D
P
0
S
1
tax
P
0+ t
If demand is Perfectly
Inelastic : all of the
tax is passed on to
consumers.
Tax Incidence: Perfectly Elastic Demand
Q
0
0
Q

P

P
r
i
c
e

Quantity
S
0
D
P
0
S
1
tax
If demand is Perfectly
Elastic : all of the tax
burden is borne by the
producer.
Q
1
Consumer Surplus
0
Q

P

P
r
i
c
e

Quantity
Q
1
D

P
1
S
1
Consumer surplus:
difference between
what a consumer is
willing to pay and
what he actually pays
for the good.
Consumer Surplus
0
Q

P

P
r
i
c
e

Quantity
Q
1
D

P
1
S
1
S
2
When market price
decreases, consumer
surplus becomes
bigger
P
2
Q
2
S
2
S
2
P
2
S
2
P
2
S
2
P
2
S
2
Q
2
P
2
S
2
Producer Surplus
0
Q

P

P
r
i
c
e

Quantity
Q
1
D

P
1
S
1
Producer surplus:
difference between what a
producer receives (market
price) and the amount that will
motivate him to supply the
product (marginal costs must
be recovered).
End
Chapter 3

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