1

Supply & Demand

Elasticity & Government Set Prices

Chapter 7

2

Price Elasticity of Demand

Measured by the responsiveness of consumers to a price change.

Formula:

% change in quantity demanded

% change in price

3

Elimination of Minus Sign

Price and quantity have an inverse relationship

When using the elasticity formula, it will be a negative number.

Ignore the minus sign to avoid any ambiguity

4

Elastic Demand

Demand is elastic if % change in price results in a larger % change in quantity demanded

Formula results in a number greater than 1

5

Inelastic Demand

Demand is inelastic if % change in price produces a smaller % change in demand

Formula results in a number less than 1

6

Unit Elastic Demand

% change in price and % change in demand are the same

Formula equals 1

7

Extreme Cases

Perfectly inelastic- price change results in no change in quantity demanded

Perfectly elastic- small price reductions cause buyers to increase their purchases from zero to all they can obtain

8

Midpoint Formula

Change in quantity ÷ change in price

Sum of quantities sum of prices

9

Quantity Price Total Revenue(Price X Qty)

Elasticity E, I, or U

1 8 $ --- ---

2 7

3 6

4 5

5 4

6 3

7 2

8 1

10

Total-Revenue Test

Total revenue- total amount sellers receive from sale of a product

Price X Quantity sold

Total revenue test looks at what happens to total revenue when product price changes

11

Summary

Absolute Value

Demand Is:

Description

Impact on TR of a Price

increase

Impact on TR of a Price

decrease

>1 Elastic

Qd changes by a larger %

than does price

TR decreases

TR increases

=1 Unit Elastic Qd changes by the same % as price

TR is unchanged

TR is unchanged

<1 Inelastic Qd changes by a smaller % than price

TR increases TR decreases

12

Price Elasticity & Total Revenue Curve

Comparison of curves D and TR shows relationship between elasticity and total revenue

13

Determinants of Price Elasticity of Demand Substitutability

Proportion of Income

Luxuries vs. Necessities

Time

14

Price Elasticity of Supply

If producers are responsive to a price change, supply is elastic & vice versa

Formula:

% change in quantity supplied

% change in price

15

Cross Elasticity of Demand

Measures how sensitive consumer purchases of one product are to a change in price of some other product

Formula

% change in qty demanded for product x

% change in price of product y

16

Income Elasticity of Demand

Formula

% change in quantity demanded

% change in income

Measures the responsiveness of consumers to changes in income and the impact it has on demand

17

Government Set Prices

Price ceiling- maximum legal price a seller may charge

Rationale – enable consumers to obtain an “essential” product that they could not afford at equilibrium.

18

Black Markets

Products are bought and sold at prices above the legal limits.

Buyers are willing to pay more than the ceiling price which allows companies to make more profits.

19

Price Floors & Surpluses

Minimum prices fixed by the government. A price at or above the price floor is legal.

Examples include farm products that are already sold at low prices. Government raises the price to assist farmers to earn higher incomes.