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Learning Objectives
In this chapter, you will:
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learn about the price elasticity of demand, its relation to other demand elasticities, and its impact on sellers revenues learn about the price elasticity of supply and the links between production periods and supply consider how governments use price controls to override the invisible hand of competition examine spillover costs and benefits and the ways that government addresses the issues
Price elasticity of demand shows how responsive consumers are to price changes
elastic demand:demand for which a percentage change in a products price causes a larger percentage change in quantity demanded % change in quantity demand is more than % change in price inelastic demand: demand for which a percentage change in a products price causes a smaller percentage change in quantity demanded % change in quantity demand is less than % change in price unit-elastic demand means % change in quantity demand equals % change in price
Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
3
D1
50%
D2
D4
1.60
D3
Total revenue: the total income earned from a product, calculated by multiplying the products price by its quantity demanded, (TR=P x Qd). A price change causes total revenue to change in the opposite direction when demand is elastic
Eg, Increase of price causes decrease of total revenue or decrease of price causes increase of total revenue
A price change causes total revenue to change in the same direction when demand is inelastic
A price change does not affect total revenue when demand is unit-elastic
Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
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10 000
Inelastic Demand
Unit-Elastic Demand
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portion of consumer incomes (products with smaller portions more inelastic) access to substitutes (products with more substitutes more elastic) necessities versus luxuries (more inelastic for necessities and more elastic for luxuries) time (more elastic with the passage of time)
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A numerical value for price elasticity of demand (ed) is found by taking the ratio of the changes in quantity demanded and in price, each divided by its average value. In mathematical terms: ed = Qd average Qd price average price
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A linear demand curve has a different price elasticity (ed) at every point. At high prices, the change in quantity demanded (price) is relatively large (small), giving a large ed. At low prices, the change in quantity demand (price) is relatively small (large), giving a small ed.
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ed > 1 4 3 2 ed < 1 1 ed = 1
Income Elasticity
Income elasticity (ei) is the responsiveness of a products quantity demanded to changes in consumer income. In mathematical terms: ei = Qd average Qd I average I
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Cross-Price Elasticity
Cross-price elasticity (exy) is the responsiveness of the quantity demanded of one product (x) to a change in price of another (y) In mathematical terms: exy = Qd average Qd Py average Py
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Price elasticity of supply measures the responsiveness of quantity supplied to price changes
elastic supply:supply for which a percentage change in a products price causes a larger percentage change in quantity supplied means % change in quantity supplied is more than % change in price inelastic supply:supply for which the percentage change in a products price causes a smaller percentage change in quantity supplied means % change in quantity supplied is less than % change in price
Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
17
S1
2 1 0
100%
2 1 0
20%
100 000
120000
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supply is perfectly inelastic in the immediate run Immediate run:the production period during which none of the resources required to make a product can be varied supply is either elastic or inelastic in the short run Short run: the production period during which at least one of resources required to make a product cannot be varied.
Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
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supply is perfectly elastic for a constantcost industry and very elastic for an increasing-cost industry in the long run Long run: the production period during which all resources required to make a product can be varied, and business may either enter or leave the industry Constant-cost industry: an industry that is not a major user of any single resource Increasing-cost industry: an industry that is a major user of at least one resource
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A higher price of strawberries raises production but not resource prices. As new businesses enter the industry in the long run due to a higher price of strawberries, this price is gradually pushed back down to its original level. Therefore the long-run supply curve for a constant-cost industry is perfectly elastic.
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A higher price of strawberries raises production and also resource prices. As new businesses enter the industry in the long run due to a higher price of strawberries, this price is gradually pushed back down to its lowest possible level, but this level is higher than it was originally. Therefore the long-run supply curve for an increasing-cost industry is very elastic.
Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
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Constantcost Industry
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A numerical value for price elasticity of supply (es) is found by taking the ratio of the changes in quantity supplied and in price, each divided by its average value. In mathematical terms: es = Qs average Qs price average price
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Price Controls
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they help overcome unstable agricultural prices farmers win from these supports consumers and taxpayers lose from these supports
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surplus
S
Rent Controls
they keep down prices of controlled rental accommodation some (especially middle-class) tenants win from these controls other (especially poorer) tenants lose from these controls
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shortage
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Spillover costs are the negative external effects of producing or consuming a product
adding these costs to private costs raises the supply curve the preferred outcome is at a lower quantity than in a perfectly competitive market government intervention (e.g. an excise tax) can produce the preferred outcome
Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
33
S0
S1
Spillover Costs, Excise Tax
Millions of Litres
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Spillover benefits are the positive external effects of producing or consuming a product
adding these benefits to private benefits raises the demand curve the preferred outcome is at a higher quantity than occurs in a perfectly competitive market government intervention (e.g. a consumer subsidy) can produce the preferred outcome
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D1
10 11 12 13 14
Thousands of Students
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