6/30/2017

SizeofChangesinMarketEquilibrium
Whatdeterminesthesizeofchangesinmarket
equilibrium?
ELASTICITY Sizeofchangeindemand(orsupply)
Thelargertheshiftindemand(orsupply),thelargertheeffect
onprice
Steepnessofthecurvethatdoesnotshift
Ifthesupplycurveshifts,thesteeperthedemandcurvethe
morethepricechangesandthelesstheamountboughtand
soldchanges
Steepnessreflectsresponsivenesstoprices

2-2

ChangesinEquilibriumforTwoExtremeSupplyCurves
ChangesinEquilibriumforTwoExtremeDemandCurves

2-3 2-4

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Steepnessofthedemandcurve
ElasticitiesofDemandandSupply
Ameasureoftheresponsivenessoftheamounts
P
demandedandsuppliedtochangesinprices
S Notthesameastheslopeofthesupplyordemand
S
curve
Slopeofthecurvedependsontheunitsusedto
measurethequantityofthegoodanditsprice
Elasticitydoesnotdependonunits(e.g.,gallons,
dozens,dollarsperpound)
Q
D2 D1

Reference: Read More Online 2.3 (p829)

2-6

Elasticity Elasticity
Demand curves can come in different
shapes We know that quantity demanded depends on many
things
From very flat to very steep So we can ask a more general question.
Very flat demand curve: a small change in How sensitive is demand to change in any of the
price has a large effect on quantity relevant factors:
demanded - Own price
Very steep curve: even a large change in - Income
price does not affect quantity demanded too - Related prices
much - Etc.
Question: how sensitive is quantity
demanded to price changes?

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Elasticities
Two situations:
Consider the market demand for a commodity, q
Situation 1 2
Let it depend on a factor y (which might be its own
price, or the price of a related good, or income). Quantity q1 q2

Then the elasticity of demand for q with respect to Y y1 y2

y is defined as:

the percentage change in q that results from Let q = q2 q1

a 1% change in y. y = y2 y1
It is the percentage change in q divided by the
percentage change in y.

Since percentage changes are pure numbers, the

elasticity measure will always be a unit-free pure
number.
Elasticity of q with respect to y
q y
=[ ----x100] divided by [----x100]
q y
Therefore elasticity of quantity demanded
can be with respect to:
- own price (price-elasticity of
demand)
- any other price (cross price-
elasticity)

q y - income (income elasticity)

= ----x----
We will spend some time on the concept of
y q the price-elasticity of demand

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Price Elasticity of Demand Calculation of elasticity

For downward sloping curves, prices and quantities Situation 1 Situation 2

move in opposite directions, so that the elasticity p1 = Rs.10 p2 = Rs.9.00
value is negative. q1 = 100 q2 = 105
To avoid this problem, we consider the absolute
Consider finite changes in prices and quantity:
value of the elasticity.

q p e = - [q/p]x[p/q],
e = - ----x---- = - (p/q)x(q/p).
p q q = q2 - q1 = 5

p = p2 - p1 = -1

1.Pointelasticitymeasures. 2.Arcelasticitymeasure.
e = - [q/p]x[p1/q1] To get rid of this ambiguity, take an average of the
= -(-5)x(10/100) = 5/10 = .5 values:

e = - [q/p]x[p2/q2]
q [(p2 + p1)/2]
= -(-5)x(9/105) = 9/21 = 3/7
= .42 e = - ---------------------------
p [(q2 + q1)/2]
small changes in price -> not much difference
between these two.
For larger changes, the differences become = - [q/p][(p2 + p1)/(q2 + q1)]
substantial.
= 5(19/205) = .46.

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P AStraightLineDemandCurve
Consider the straight-line
demand curve AB. What is e
A at the point C? Then price-elasticity at a point C on the demand
curve = (EB/CE)(CE/OE) = EB/OE
Note: [q/p] = EB/CE, = (BC/CA)
D C
p = CE, q = OE (by property of similar triangles).

At the mid-point of the demand curve, e = 1.

All points above this have elasticity greater than 1.

B Demand at all points below the mid-point is inelastic.

O E Q

PriceElasticityRegionsalong
aStraightLineDemandCurve If the percentage change in q > the
Observation percentage change in p, then e > 1, and
Price elasticity varies at we have elastic demand.
every point along a straight-
line demand curve

a 1 If the percentage change in q = the

1 percentage change in p, e = 1 and we say
that demand is unit elastic.
Price

a/2 1
If the percentage change in q < the
percentage change in p, so that e < 1,
b/2 b demand is said to be inelastic.
Quantity

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PriceElasticityandthe
PriceElasticityandthe
SteepnessoftheDemandCurve
SteepnessoftheDemandCurve
What is the price elasticity of
demand when P = Rs.4?
12 12 Observation
If two demand curves have a

D1 4 1 1
D1 point in common, the steeper
4 12 2 curve must be less elastic with
6 D1
respect to price at that point
6 6
Price

Price

4 1
D2
4
4 2
4 6
D2 12 D2

4 6 12 4 6 12

Quantity Quantity

Priceelasticity Threespecialcases
If (inverse) demand curve is a horizontal straight line
Supposethatwehaveadifferentiabledemandfunction parallel to the quantity axis, then the price-elasticity
Q=Q(P). measure goes to infinity.
Thenelasticityatapoint(P*,Q*)onthedemand - demand is perfectly elastic.
curveis
E=(dQ/dP)(P*/Q*) If the (inverse) demand curve is a vertical straight line,
wheredQ/dPisevaluatedat(P*,Q*) then e = 0 and demand is said to be perfectly
Example:LetQ = p-a inelastic.
Then dQ/dP = (-a) p-a-1
E=[(-a) p-a-1][p/p-a] = a (independent of the point on An example of a demand curve that is iso-elastic (has
the demand curve) the same elasticity everywhere) is q = p-a.

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Perfectly Elastic Demand Curve Perfectly Inelastic Demand Curve

P P
D

D D
Basic needs, minimum
requirements, absolute
necessities.

0 Q 0 D Q

Rangeofelasticities

0_______________1________________+
PerfectlyUnitPerfectly
InelasticElasticityElastic
DemandDemand

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Factors affecting price elasticity:

1. Availability of substitutes
Larger the availability of close substitutes, the more
elastic will demand be.
2. Demand will be more elastic when buyers of the
product regard it as a discretionary purchase rather
than as a necessity
3. If buyers are wealthy and the item accounts for a
very small part of the total expenditure, then
demand will be less elastic
Factors affecting price elasticity:
4. Time period of adjustment-flexibility over the
long run
Larger the time period, the higher the elasticity of
demand.
Suppose petrol prices go up
Short run demand falls somewhat because
motorists drive less
In the long run, people switch to smaller,
more fuel-efficient cars quantity demanded of
petrol goes down by a larger amount

Some elasticity values ElasticityandTotalRevenue

Salt 0.1
Matches 0.1
Airline travel, short-run 0.1 Whatdoyouthink?
Petrol, short-run 0.2
Willincreasingthemarketpricealwaysincrease
Tobacco products, short-run 0.45
totalrevenue?
Residential natural gas, long-run 0.5
Physician services 0.6
Movies 0.9 Application:
Housing, owner occupied, long-run 1.2 Could reducing the supply of illegal drugs
Restaurant meals 2.3 cause an increase in drug-related burglaries?
Airline travel, long-run 2.4

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The Effect of Extra Border Relationship between elasticity and total

Patrols on the Market for Illicit Drugs revenue
Total Expenditure = P x Q
S Rs.2500 = Rs.50 x 50
TR = pq
S Rs.3200 = Rs.80 x 40
dTR = d(pq) = pdq + qdp
S = qdp(1 e)
80
Consider what happens if price is lowered, so that
P(Rs./ounce)

S
50 dp < 0.

dTR > 0 if 1 e < 0, i.e. e > 1

D
40 50 dTR = 0 if 1 = e
Q(1,000s of ounces/day)
dTR < 0 if e < 1

Income-elasticity of Demand Cross-price Elasticity of Demand

The cross-price elasticity of the commodity x with
respect to the price p of y is defined as
em = (q/M)(M/q)

exy = (x/p)(p/x)
In the case of a normal good, em > 0, while for an
inferior good, it is < 0.
If this is positive, x and y are said to be substitutes
(Coke and Pepsi), while if this is negative, the
If 0 < em < 1, then the good is called a necessity,
commodities are said to be complements (tea and
otherwise it is a luxury. sugar).

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CalculatingthePrice
ElasticityofSupplyGraphically
Price Elasticity of Supply
Suppose that q now refers to quantity supplied. A 4 1212 4 1 S

The price elasticity of the supply of q with respect to Qs = AP B

the price p is defined as 5
P
es = (q/p)(p/q)
A
4
Q

Price
Since supply curves are upward-sloping, this B 5 15 15 5 1
expression will be non-negative no need to put a
negative sign in front of the expression

0 12 15
Quantity

In general, even for straight line supply curves,

the price elasticity of supply will vary from point Application - Farming
to point.
Supposethatuniversityagronomistsdiscoveranew
For example : P = 10 + 2Qs wheathybridthatismoreproductivethanexisting
varieties.
Two points on the line are (Qs = 1, P = 12, and Whathappenstowheatfarmers?
Qs = 2, P = 14) Thediscoveryofthenewwheathybridaffectsthe
supplycurve itshiftstotheright.
Show that the price elasticities at these two Thedemandcurveremainsthesame
points are different.

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Application - Farming Application - Farming

What happens to the total revenue received by the
Price of wheat
D farmers?
S
S Q rises but P falls
The demand for basic foodstuffs such as wheat is
usually inelastic, for these items are relatively
inexpensive and have few good substitutes
Hence fall in P is substantial while rise in Q is small
S Revenue to all wheat farmers taken together falls
S D
Quantity of wheat

Application - Farming Application - Farming

If farmers are made worse off by the discovery of
the new hybrid, why do they adopt it?
Each farmer is a small part of the market
For any price, it makes sense for each farmer to
adopt the hybrid
But when they all do it, the supply curve shifts and
together, they are worse off
Certain agricultural programs try to help farmers by
inducing them not to plant crops on all their land
The purpose is to reduce the supply of farm products
and thereby raise prices
With inelastic demand, farmers as a whole receive
greater revenue
No single farmer, by himself, would have found it
profitable to leave some land fallow

11

PriceSupport
Anotherwayforthegovernmenttohelpthefarmersis
byhavingasupportprice,atwhichpricethe
governmentstandspreparedtobuyanyamount
suppliedbythefarmers
Overtime,thismayleadtothegrowthofbuffer
stocks
Willperishifjuststockpiled
Somecanbeusedforemploymentgeneration
programmes,ormeetingfoodrequirementsinalean
year
Whattodowiththerest?
Atpresent,thegovernmentisgrapplingwiththe
problemofstoragecapacity.
India,theworldssecondlargestproducerofwheat,
hadharvestedarecord90.23milliontonsin201112
cropyear(JulyJune),leadingtoarecordprocurement
ofnearly38milliontonssofarthisyear.
Itsgodowns areoverflowingwitharecord82million
tonsofriceandwheatagainstthestoringcapacityof
only64milliontons.
Theexportoftwomilliontonswouldinvolveanoutgo
ofRs 1,263crore.
6/30/2017
Wheatexportallowedtofreestoragespace
3July2012
Facedwithaseverespaceconstraintinthecountrys
overflowinggranaries,thegovernmenttodaycleared
exportoftwomilliontonsofwheatfromitsbuffer
stockthatisexpectedtoclearstoragespacefornew
crops.
ThiswasapprovedbytheCabinetCommitteeon
EconomicAffairs.Informedsourcessaidafterthe
CCEA meetingthatexportwithafloorpriceof$228
(aboutRs12,400)perton.
TAXES
Governmentslevytaxestoraiserevenuefor
publicprojects,topayforwagesandsalaries
inthepublicsector,topayinterestondebt,
etc..
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Taxes
Aspecifictax isafixedrupeeamountthat
mustbepaidoneachunitboughtorpaid
Anadvaloremtax isataxthatisstatedas
apercentageofthegoodsprice
Theincidenceofataxindicateshow
muchofthetaxburdenisbornebyvarious
marketparticipants
Taxes
Instudyingtheeffectsoftaxesitsimportant
todistinguishbetweentheamounta
consumerpaysforagoodandtheamounta
firmreceives
UsePb fortheamountaconsumerpays,Ps
fortheamountafirmreceives
IfthetaxisTperunit,thenPs =Pb T

15-49

TheBurdenofaTax
ConsidertheeffectofaspecifictaxofTrupeesper
literpaidbygasstationsontheirsalesofgasoline
Graphically,therearethreewaystodeterminethe
taxseffect:
ShiftthesupplycurveupbyT
ShiftthedemandcurvedownbyT
Useawedgebetweentheamountsconsumers
payandfirmsreceive
Allthreemethodsyieldthesameresults
Makesnodifferencewhetherthetaxisleviedon
consumersorproducers
EffectsofaSpecificTax
Shiftingthesupplycurveisonewayto
determineaspecifictaxseffects
Demandcurveremainsunchanged
Foranypricepaidbyconsumers,firms
nowreceivelessthanwhenthereisnotax
Wontbewillingtosupplyasmuchas
before
SupplycurvewiththetaxisadistanceT
abovetheoriginalsupplycurve

15-51 15-52

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EffectsofaSpecificTax ShiftingtheSupply
EffectsofaSpecificTax Curve
Newequilibriumpricepaidby ST

Price Paid by Consumers ($/gallon)

consumersispriceatwhichthe Increase in S

demandcurveandnewsupplycurve Consumer Cost

per Gallon Po + T
B

cross Pb T

Amountboughtandsoldfalls Po
Ps = Pb - T
A

Pricepaidbyconsumersrises;price Decrease in
Firms Receipts
receivedbyfirmsfalls per Gallon
D

Inacompetitivemarkettheburdenofa QT Qo
taxissharedbyconsumersandfirms Gallons of Gas per Month

15-54

TaxIncidence IncidenceofaSpecificTax TwoSpecial

Cases
Incidenceofataxdependsontheshapesofthe
demandandsupplycurves
Ingeneral,themoreelasticisdemandandless
elasticissupply,themoreofthetaxisborneby
firms
Firmscannotpassonthetaxtotheconsumers
becausethelatteraresensitivetopricechanges
Consumersbearthelargershareofthetax
whendemandislesselasticthansupply

15-55 15-56

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EffectsofaSpecificTax Shiftingthe
DemandCurve
Lineardemandandsupply
LetQd =a bpb
andQs =c+dps
Also,ps=pb t
Equilibriumrequires
a bpb=c+dps
Thena
b(ps+t)=c+dps
Solvingfortheequilibriumpriceps*,weget
ps*=(a c bt)/(d+b)
15-57

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