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Elasticity

Effects of government policy on


demand and supply

What will we discuss?


The price elasticity of demand
its meaning, determinants and calculation
its relationship with total revenue
The meaning and calculation of other elasticities
income elasticity of demand, cross-price elasticity of

demand, price elasticity of supply

Applications of elasticity analysis:


Can good news for farming be bad news for farmers?

The effects government policies on demand and

supply:
Price ceiling, Price floor, Taxes
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Elasticity

What is the price elasticity of


demand?
Price elasticity of demand is the percentage

change in quantity demanded, resulting


from a one per cent change in the price.
Suppose the price elasticity of demand for eggs =

- 0.5, it means that

What determines it?


Availability of close substitutes: e.g., salt vs. Mars

bar
Necessity vs. luxuries: emergency doctor visits vs.
overseas holidays
Definition of the market: food vs. ice cream
Time horizon: quantity demanded changes less in
a week than over a few years

(
Q

Q
)
/
[
(
Q

Q
)
/
2
]
2
1
2
1
P
r
ic
e
E
la
s
t
ic
y
o
fD
e
m
a
n
d
=
P
P
Example: If the price of an ice cream cone increases from $2.00
to $2.20 and the amount you buy falls from 10 to 8 cones, then
your elasticity of demand would be calculated as:

(8 10)
22 percent
(8 10) / 2

2.3
(2.20 2.00)
9.5 percent
(2.00 2.20) / 2
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Ranges of elasticity
In terms of absolute values
E=0, perfectly inelastic
E>1, elastic
E=1, unit elastic
E<1 inelastic
E=
, perfectly elastic

Perfectly inelastic demand

Inelastic demand

Unit elastic demand

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Elastic demand

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Perfectly elastic demand

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Price elasticities for consumption


groups

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Elasticity and total revenue


If demand is elastic, an increase in the price

leads to a decrease in total revenue.


Why?

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Elastic demand and total revenue


Price

Price

$5
$4
Demand

Demand
Revenue = $200

50

Quantity

Revenue = $100

20

Quantity

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Elasticity and total revenue


If demand is inelastic, an increase in the price

leads to a increase in total revenue.


Why?

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Elasticity and total revenue: Inelastic


demand

Price

Price

$3
Revenue = $240
$1
0

Revenue = $100

Demand
100

Quantity 0

Demand
80

Quantity
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Income elasticity of demand


Income elasticity of demand measures how

much the quantity demanded of a good


responds to a change in consumers income.
Income elasticity is
positive for normal goods; e.g., holidays
negative for inferior goods; e.g., second hand

furniture
Income Elasticity of Demand =

Percentage Change in
Quantity Demanded
Percentage Change
in Income

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Income Elasticities for Consumption


Groups 2003

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Cross-price elasticity of demand


Measures how the quantity demanded of one

good changes as the price of another good


changes.
It is
positive for substitutes: pumpkins and butternut
negative for complements: movies and pop corn
Percentage Change in
Quantity Demanded of good 1
Cross - price Elasticity of Demand
Percentage Change
in price of good 2

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Price elasticity of supply


Price elasticity of supply is the percentage

change in quantity supplied resulting from a 1


percent change in price.
Percentage Change in
Quantity Supplied
Elasticity of Supply =
Percentage Change
in Price

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Factors affecting price elasticity of


supply
Sellers flexibility to change
The supply of beachfront housing vs. the supply of ice-

cream

Time period under consideration


In general, supply is more elastic in the long run than in

the short run

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Application of elasticity
People buy greeting cards and roses throughout

the year. As Valentines Day approaches,


however, cards and roses become necessities. The
demand for both products jump and we expect
the prices of both products to jump. The price of
roses, however, always increases more sharply
than the price of greeting cards. Why?

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Application of elasticity
Can good news for farming be bad news for

farmers?
What happens to wheat farmers and the market

for wheat if scientists discover a new wheat


hybrid that is more productive than existing
varieties?

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A simple approach to the question


Examine how the event affects demand

and/or supply
Use the supply-and-demand diagram to see
how the market equilibrium changes.

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Price of
wheat

1 When demand is inelastic,


an increase in supply...
S1
S2

2 ...leads $3
to a large
fall in
2
price...

Demand
0

100 110 Quantity of wheat


3 ...and a proportionately smaller
increase in quantity sold. As a result,
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revenue falls from $300 to $220.

Question
Should farmers welcome new technologies?

Do they have an incentive to innovate?

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Effects of government policy on


demand and supply

Price ceiling
A price ceiling is a legally established

maximum price at which a good can be sold


A price ceiling is binding (effective) only if it is

set below the equilibrium price.

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A price ceiling that is binding

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How to deal with shortages?


Non-market rationing
First come, first served: queuing for goods
Seller discrimination: reserve goods for friends,

preferred customers
Government ration: e.g., bureaucratic discretion on
priorities; coupons
Evading the price control: black market

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Example: Rent control


What happens in the short run? What

happens in the long run?

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Price floor
A price floor is a legally established minimum

price at which a good can be sold


A price floor is binding (effective) only if it is
set above the equilibrium price.

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A price floor that is binding

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Taxes
Governments levy taxes to fund their

operations.
Taxes result in changes in the market
equilibrium price and quantity.
Taxes on buyers (e.g. GST) and taxes on
sellers (e.g. excise tax) are equivalent.

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Price of
ice-cream
cone
Price
buyers
pay
$3.30
Price
3.00
2.80
without
tax

Equilibrium
with tax
S

Tax ($0.50)

Equilibrium without tax

Price
sellers
receive

90 100

Quantity of
ice-cream cones

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Tax Incidence and Elasticity


How is the burden of the tax divided between

buyers and seller?


It depends on the elasticity of demand and the

elasticity of supply.

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Elastic supply, inelastic demand

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Impact of taxes: summary


In general, taxes discourage any activity that

is taxed.
A taxes on buyers or sellers of a good result in
buyers paying a higher price
Sellers receiving a lower price
The quantity of the good sold is smaller.

The tax burden falls more heavily on the side

of the market that is less elastic.

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References
Gans, J., King, S., Stonecash, R., Byford, M., Libich, J. &

Mankiw, N. G. (2015). Principles of Economics (6th ed.):


Gengage Learning. Chapters 5, 6.

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