Markets in Action

Price Elasticity of Demand

Defining price elasticity of demand (PD)
responsiveness of demand to a change in price

Market supply and demand

S1

Price

a
P1

D
O Q1 Quantity

Market supply and demand

S2 S1 b
Price P2

a
P1

D
O Q2 Q1 Quantity

Market supply and demand

S2 S1 b
Price P2

a
P1

D'

D
O Q2 Q1 Quantity

Market supply and demand

S2 S1 b
Price P2

c
P3 P1

a D'

D
O Q3 Q2 Q1 Quantity

Price Elasticity of Demand

Measuring price elasticity of demand
%QD / %P use of percentage changes the sign: positive or negative? the value: greater or less than 1?

Determinants of price elasticity of demand

number and closeness of substitute goods proportion of income spent on the good the time period

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically

Total expenditure
4

P(RM)2

Consumers total expenditure = firms total revenue = RM2 x 3m = RM6m

0 1 2 3 4 Q (millions of units per period of time)

0 5

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically Effects of a price change: elastic demand

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically Effects of a price change: elastic demand

P rises: TE falls

Elastic demand between two points

Expenditure falls as price rises

P(RM) 5 4

b a D

10

20

Q (millions of units per period of time)

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically Effects of a price change: elastic demand

P rises: TE falls P falls: TE rises

Elastic demand between two points

P(RM) 5 4

b a D

10

20

Q (millions of units per period of time)

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically Effects of a price change: elastic demand

P rises: TE falls P falls: TE rises

Effects of a price change: inelastic demand

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically Effects of a price change: elastic demand

P rises: TE falls P falls: TE rises

Effects of a price change: inelastic demand

P rises: TE rises

Inelastic demand between two points

Expenditure rises as price rises
8 P(RM)

D
0 15 20

Q (millions of units per period of time)

Price Elasticity of Demand and Consumer Expenditure

Defining total consumer expenditure

TE = P Q

Illustrating TE graphically Effects of a price change: elastic demand

P rises: TE falls P falls: TE rises

Effects of a price change: inelastic demand

P rises: TE rises P falls: TE falls

Inelastic demand between two points

8 P(RM)

D
0 15 20

Q (millions of units per period of time)

Price Elasticity of Demand and Consumer Expenditure

Special cases
PD = 0

Totally inelastic demand (PD = 0)

P

P2

P1

Q1

Price Elasticity of Demand and Consumer Expenditure

Special cases
PD = 0 PD =

Infinitely elastic demand (PD = )

P

a
P1

b D

Q1

Q2

Price Elasticity of Demand and Consumer Expenditure

Special cases
PD = 0 PD = PD = 1

Unit elastic demand (PD = 1)

P

20

b
8

40

100

Price Elasticity of Demand and Consumer Expenditure

Special cases
PD = 0 PD = PD = 1

Applications to pricing decisions

Price Elasticity of Supply

Meaning of price elasticity of supply Elasticity of supply and the supply curve

Supply curves with different price elasticity of supply

P

S1

P0

Q0

Supply curves with different price elasticity of supply

P

S1 S2

P0

Q0

Supply curves with different price elasticity of supply

P

S1 S2
P1

P0

Q0

Q1

Supply curves with different price elasticity of supply

P

S1 S2
P1

P0

Q0

Q1

Q2

Price Elasticity of Supply

Measuring price elasticity of supply
%QS / %P elastic and inelastic supply

Determinants of price elasticity of supply

amount that costs rise as output increases time period

Supply in different time periods

P

P1

D1
O Q1 Q

Supply in different time periods

P

P1

D2 D1
O Q1 Q

Supply in different time periods

P

Si b

P2

P1

D2 D1
O Q1 Q

Supply in different time periods

P

Si b c

SS

P2 P3 P1

D2 D1
O Q1 Q3 Q

Supply in different time periods

P

Si b c

SS

P2 P3 P4 P1

SL d

D2 D1
O Q1 Q3 Q4 Q

Other Elasticities
Income elasticity of demand
measurement determinants
degree of necessity rate at which people are satisfied level of income

applications

Cross-price elasticity of demand

measurement determinants applications

Markets and Adjustment over Time

Short-run and long-run adjustment
short- and long-run supply curves

Response of supply to an increase in demand

P

P1

D1
O Q1 Q

Response of supply to an increase in demand

P

P1

D2 D1
O Q1 Q

Response of supply to an increase in demand

P

S short-run

b
P2 P1

D2 D1
O Q1 Q2 Q

Response of supply to an increase in demand

P

S short-run

b
P2 P3 P1

S long-run c

D2 D1
O Q1 Q2 Q3 Q

Markets and Adjustment over Time

Short-run and long-run adjustment
short- and long-run supply curves short- and long-run demand curves

Response of demand to an increase in supply

P

S1

a
P1

Q1

Response of demand to an increase in supply

P

S1 S2 a
P1

Q1

Response of demand to an increase in supply

P

S1 S2 a
P1 P2

D short-run

Q1

Q2

Response of demand to an increase in supply

P

S1 S2 a
P1 P3 P2

c b D long-run D short-run
Q2 Q3

Q1

Markets and Adjustment over Time

Price expectations and speculation
stabilising speculation

Stabilising speculation: initial price fall

P

S1

P1

D1

Stabilising speculation: initial price fall

P

S1

P1

P2

b D2

D1

Stabilising speculation: initial price fall

P

S2 S1

P1 P3

a c

P2

b D2 D3

D1

Stabilising speculation: initial price rise

P

S1

P1

D1
O Q

Stabilising speculation: initial price rise

P

S1

P2

P1

a D2 D1

Stabilising speculation: initial price rise

P

S1 S2

P2

P3 P1

c a D2 D1 D3
Q

Markets and Adjustment over Time

Price expectations and speculation
stabilising speculation destabilising speculation

Destabilising speculation: initial price fall

P

S1

P1

D1

Destabilising speculation: initial price fall

P

S1

P1 P2

a b

D1 D2
O Q

Destabilising speculation: initial price fall

P

S1 S2

P1 P2

a b

P3

c D1 D3 D2
Q

Destabilising speculation: initial price rise

P

S1

P1

D1
O Q

Destabilising speculation: initial price rise

P

S1

P2 P1

b a

D1
O

D2
Q

Destabilising speculation: initial price rise

P

S2 S1

P3

P2 P1

b a D3 D1 D2
Q

Markets and Adjustment over Time

Uncertainty and risk
defining risk and uncertainty reducing risks by holding stocks a market in information

Markets where Prices are Controlled

Minimum prices
justification effects

Minimum price: price floor

P

Pe

D
O Q

Minimum price: price floor

P

S
minimum price

surplus

Pe

D
O

Qd

Qs

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Maximum prices

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Maximum prices
justification

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Maximum prices
justification effects

Maximum price: price ceiling

P

Pe

D
O Q

Maximum price: price ceiling

P

Pe

maximum price

shortage D

Qs

Qd

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Maximum prices
justification effects dealing with resulting shortages

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Maximum prices
justification effects dealing with resulting shortages rationing

Markets where Prices are Controlled

Minimum prices
justification effects dealing with resulting surpluses

Maximum prices
justification effects dealing with resulting shortages rationing black markets