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Ch 18.
Extensions of Demand &
Supply
A.
Price elasticity of demand –
responsiveness (sensitivity) of
consumers to a price change ($ Δ).
LAW OF DEMAND:
 $ =  Purchases
 $ =  Purchases
Three ideas:
 Price elasticity
 Cross elasticity – buying response of consumers of one product
when the price of another product changes.
 Income elasticity – the buying response of consumers when their
income changes.
B.
Price-elasticity Coefficient & Formula
Economists measure the degree of price elasticity or
inelasticity of demand with the coefficient Ed, defined as:
Ed =
C.
percentage change in quantity
demanded of product X
percentage change in price
of product X
Quantity demanded = Qd
Midpoint formula – simplest solution:
Ed =
Δ in Q
sum of Q / 2
√
Δ in $
sum of prices / 2
-- % are better than absolute amounts; eliminate the minus sign for clarification.
-- Use the Midpoint Formula for the Popcorn simulation.
D.

Interpretations of Ed
Elastic demand – % Δ in price results in a larger % Δ in
Qd (Ed > 1),
Ex: A 2%  in $  4%  in Qd
Ed = .04 = 2 (demand is elastic)
.02
● Inelastic demand – % Δ in $ results in a smaller % Δ in Qd
(Ed < 1),
Ex: A 2%  in $  1%  in Qd
Ed = .01 = .5 (demand is inelastic)
.02

Unit elasticity – % Δ in $ and the resulting
% Δ in Qd are the same (Ed = 1),
Ex: A 2%  in $  2%  in Qd
Ed = .02 = 1 (unit elasticity)
.02
● Perfectly inelastic (rare) – coefficient is
zero due to consumers being unresponsive to a $
Δ.
E.
VERTICAL
F.
Perfectly inelastic – a $ Δ results in no Δ
in demand.
Perfectly elastic – infinite coefficient (∞).
HORIZONTAL
**Important for Popcorn simulation**
Perfectly Inelastic
has relatively little
“quantity stretch”
Perfectly Elastic
has considerable
“quantity stretch”
Price Elasticity of Demand
 Why Use Percentages?
 Elimination of the Minus Sign
 Interpretations of Ed
Elastic Demand
Ed =
.04
.02
=2
.01
.02
= .5
.02
.02
=1
Inelastic Demand
Ed =
Unit Elasticity
Ed =
The Total Revenue Test
Total Revenue (TR)
TR = P x Q
Elastic Demand
P
$3
2 X 10 (a) = 20
1 X 40 (b) = 40
Pt ‘b’ is greater
a
2
b
1
Ed (Midpoint formula) =
Δ in Q
Δ in $
sum of Q/2 √ sum of $/2
D1
0
10
20
30
40
Q
The Total Revenue Test
Total
Revenue (TR)
TR = P x Q
Inelastic Demand
P
c
$4
4 X 10 (c) = 40
1 X 20 (d) = 20
Pt ‘c’ is greater
3
2
d
Ed (Midpoint formula) =
Δ in Q
Δ in $
sum of Q/2 √ sum of $/2
1
D2
0
10
20
Q
The Total Revenue Test
Total
Revenue (TR)
TR = P x Q
Unit-Elastic
P
e
$3
2
f
1
D3
0
10
20
30
Q



Midpoint Formula – finding
Δ in quantity
√
Δ in $
the price elasticity coefficient. Ed =
sum of quantities/2
sum of price/2
Is the demand for tickets
elastic or inelastic?
Using data from the $5 - $4 price range:
Try using averages of two
tickets and two quantities as
the reference point.
Ed = 1 √
1 = 1
9/2
9/2
G.
Total Revenue (TR) – total amount the
seller receives from the sale of product
in particular time period.
$  & TR  = D is elastic.
$  & TR is unchanged = D is unit-elastic.
$  & TR  = D in inelastic
-- Firms want to know the effect of price changes on total revenue and thus
profits (total revenue minus total costs).
-- ‘Total-revenue test’ looks at what happens to TR when product $ Δ.
-- Graph: Lowering the tix price from $8 to $5 (elastic range) increased TR.
-- Lowering price from $4 to $1 (inelastic range) lowered TR.
Graphical Analysis
Relationship
between price
elasticity of demand
for movie tickets.
 Demand curve D is
based on table 20.1.
 More price elastic
between $5-8 price
range of D than
between $4-1 range.

Price
Price Elasticity and the Total-Revenue Curve
$8 a
7
b
6
c
5
d
4
e
3
f
2
g
1
Elastic
Ed > 1
Unit Elastic
Ed = 1
Inelastic
Ed < 1
h
D
0 1 2 3 4 5 6 7 8
Total Revenue
(Thousands of Dollars)
Quantity Demanded
$20
18
16
14
12
10
8
6
4
2
Elastic
Ed > 1
Unit Elastic
Ed = 1
TR
0 1 2 3 4 5 6 7 8
Quantity Demanded
Inelastic
Ed < 1
Determinants of Price
Elasticity of Demand


Substitutability
Proportion of Income
● Luxuries v. Necessities
● Time
Applications of Price
Elasticity of Demand
Large crop yields
 Excise tax Typical examples of excise duties are taxes on gasoline,
tobacco and alcohol (sometimes referred to as sin taxes).
 Decriminalize illegal drugs
 Minimum wage ($8/CA, $7.25/Fed)

H.
Price elasticity of Supply – if producers
are relatively responsive to $ Δ = supply
is elastic; if not = inelastic.
Es =
% Δ in quantity
supply of product X
% Δ in $ of product X
OR
An increase in the $ of a good from $4 to $6
increases the quantity supplied from 10 units
to 14 units. The % Δ in $ would be 2/5, or
40%, and the % Δ in quantity would be 4/12,
or 33%:
.33
Es = .40 = .83
-- The degree of price elasticity of supply depends on how easily (how quickly)
producers can shift resources between alternative uses.
-- Faster shift =  elasticity of supply; Slower response =  inelasticity.
I.
Market period
-- Market period: period that occurs when the time immediately after a Δ in
market price is too short for producers to respond w/ a Δ in quantity supplied.
-- Ex: a tomato farmer only has one truck full of tomatoes to sell; line is vertical
(perfectly inelastic) due to not having time to respond to change in demand
(D1 to D2).
-- P0 to Pm determines which buyers get the fixed quantity supplied.
Price Elasticity of Supply
Es =
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
Unit Elastic Supply
Es = 1
Market Period:
Not Enough Time to Shift Resources
P
Greatest
Price
Impact
Sm
Pm
P0
D1 D2
Q0
Q
1.
2.
Short run
Long run
-- Short run – period of time too short to change plant capacity but long
enough to use fixed plant more or less inexpensively (fixed land/farm
machinery, but can use more labor/fertilizer) for more output (more elastic).
-- Long run – time period long enough for firms to adjust their plant sizes &
for new firms to enter (or existing to leave) the industry (still more elastic).
-- There is no total-revenue test for elasticity of supply.
-- Supply shows a positive (direct relationship) between $ & amount supplied.
Price Elasticity of Supply
Es =
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
Inelastic Supply
Es < 1
Short Run:
Resources Not Easily Shifted to Alternative Uses
P
Lower
Price
Impact
Ss
Ps
P0
D1 D2
Q0 Qs
Q
Price Elasticity of Supply
Es =
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
Elastic Supply
Es > 1
Long Run:
Resources Easily Shifted to Alternative Uses
P
Sl
Least
Price
Impact
Pl
P0
D1 D2
Q0 Ql
Q
J.
Cross elasticity of demand – measures
how sensitive customers purchases are
to 2 products.
% Δ in Qd of product X
Exy = % Δ in Qd of product Y
1.
2.
3.
Substitute goods
Complimentary goods
Independent goods
-- One product is X, the other is Y.
-- The cross-price elasticity allows us to quantify/understand substitute and
complimentary goods (Ch 3).
K.
Income elasticity of demand – measures
degree consumers respond to Δ in their
incomes by buying more/less of a good.
% Δ in Qd
Ei = % Δ in I
1.
2.
Normal goods
Inferior goods
-- For most goods, income-elasticity coefficient Ei is positive (more are
demanded as income rises); called normal or superior goods.
-- Inferior goods have a negative income-elasticity (more $ = lower sales).
-- Insights: we do not eat more when our income rises, we eat better!
-- When income declines, food purchases stay same but buy fewer electronics.
Cross Elasticity of Demand
Exy =
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product Y
Goods – Positive Sign
 Complementary Goods- Negative
 Substitute
Sign
 Independent
Goods – Zero or
Near-Zero Value
Income Elasticity of Demand
Percentage Change in Quantity
Demanded
Ei =
 Normal
Percentage Change in Income
Goods –
Positive Sign
 Inferior
Goods -
Negative Sign
 Insights
into the Economy
Consumer and Producer Surplus
Consumer Surplus
Price (Per Bag)
Consumer
Surplus
Equilibrium
Price = $8
P1
D
Q1
Quantity (Bags)
Consumer and Producer Surplus
Efficiency Revisited
Efficiency Losses (Deadweight Losses)
S
Price (Per Bag)
Efficiency
Losses
P1
D
Q2
Q1
Q3
Quantity (Bags)
Ch. 22