Econ 101:

Microeconomics
Chapter 4:
Working with Supply and
Demand: Part 2

Total Revenue and Total Expenditure

In

the market for a particular good:

Total revenue (TR) is the amount of money

sellers take in.

Total expenditure (TE) is the amount of money
buyers pay out.
Assuming no excise tax:
TR=TE =p x Q = Price x Quantity

Elasticity and Total Revenue

When

p and Q change as the result of

movement along a demand curve, what is
the relationship between changes in price
and changes in TR?

When p increases, Q decreases, so it is not clear,

without more information, how TR is affected.

When p and Q are both changing, percentage
change in their product is (approximately) the sum
of their individual percentage changes.
Need information about elasticity of demand.

Elasticity and Total Revenue

Case 1:

Suppose demand is inelastic ( %Q %p ) and

price increases (quantity decreases).

TR = TE = p x Q

Big increase in p combined with small decrease

in Q

TR = TE increases as the result

Elasticity and Total Revenue

This is easy to remember by visualizing a
demand curve close to the limiting case of
perfectly inelastic:

p
p2

For a demand curve that is close to perfectly

inelastic, its obvious that TR=TE rectangle
gets bigger when price increases.

p1

Q2 Q1

Elasticity and Total Revenue

Case 2:

Suppose demand is elastic (%Q %p ) and price

increases (quantity decreases).

TR = TE = p x Q

Small increase in p combined with big decrease

in Q

TR = TE decreases as the result

Elasticity and Total Revenue

Once

again, visualizing a demand curve

close to the limiting case of perfectly elastic:
p
For a demand curve that is close to perfectly
elastic, its obvious that TR=TE rectangle
gets smaller when price increases.

p2
p1

Q2

Q1

Elasticity and Total Revenue

Lets summarize the results in the table:

Perfectly inelastic
Inelastic
Unit Elastic

Increases

Decreases

TR = TE
TR = TE

TR = TE
TR = TE

No change in TR = TE

Elastic

TR = TE

TR = TE

Perfectly Elastic

Cant talk about price changes

Determinants
of the Elasticity of Demand

Availability of Substitutes:

Demand is more elastic:

Demand is less elastic

If close substitutes are easy to find and buyers can cut back on
purchases of the good in question
If close substitutes are difficult to find and buyers can not cut back on
purchases of the good in question

Narrowness of Market:

More narrowly we define a good, easier it is to find

substitutes

More elastic is demand for the good

Harder it is to find substitutes and the less elastic is demand for the
good

More broadly we define a good

Different things are assumed constant when we use a narrow

definition compared with a broader definition

Determinants
of the Elasticity of Demand

Necessities vs. Luxuries

The more necessary we regard an item, the harder it is to

find a substitute

Expect it to be less price elastic

Expect it to be more price elastic

The less necessary (luxurious) we regard an item, the

easier it is to find a substitute

Time Horizon

Short-run elasticity

Measured a short time after a price change

Measured a year or more after a price change

Therefore, demand tends to be more elastic in the long run than in the
short run

Long-run elasticity
Usually easier to find substitutes for an item in the long run
than in the short run

Determinants
of the Elasticity of Demand

Importance in the Buyers Budget

The more of their total budgets that households spend on

an item

The more elastic is demand for that item

The less of their total budgets that households spend on an

item

The less elastic is demand for that item

Other Elasticities in Economics

Elasticity is a general concept. Whenever we have

one variable (X) that depends on another variable
(Y) we can use elasticity to provide unit-free
measure of the degree of responsiveness of X to
changes in Y.

Elasticities are always ratios of percentage changes.

Income Elasticity of Demand

Percentage change in quantity demanded divided by

the percentage change in income

With all other influences on demandincluding the price of

the goodremaining constant

% change in Quantity Demanded

% Change in Income

Interpret this number as percentage increase in

quantity demanded for each 1% rise in income

Income Elasticity of Demand

Income elasticities vs. price elasticities of

demand

Price elasticity of demand

Measures effect of change in price of good

Assumes that other influences on demand, including income,

remain unchanged

Income elasticity

Measures effect on demand we would observe if income

changed and all other influences on demandincluding
price of the goodremained the same

Instead of letting price vary and holding income

constant, now we are letting income vary and
holding price constant

Income Elasticity of Demand

Another

difference between price and

income elasticity of demand

Price elasticity measures sensitivity of demand

to price as we move along a demand curve from

one point to another
Income elasticity tells us relative shift in demand
curveincrease in quantity demanded at a
given price

While

a price elasticity is virtually always

negative income elasticity can be positive
or negative

Income Elasticity of Demand

Economic necessity

Economic luxury

Good with an income elasticity of demand between 0 and 1

Good with an income elasticity of demand greater than 1

An implication follows from these definitions

As income rises, proportion of income spent on economic

necessities will fall

While proportion of income spent on economic luxuries will rise

But, it is important to remember that economic

necessities and luxuries are categorized by actual
consumer behavior

Not by our judgment of a goods importance to human survival

Cross-Price Elasticity of Demand

Cross-price elasticity of demand

Percentage change in quantity demanded of one good caused by a 1%

change in price of another good

While all other influences on demand remain unchanged

E XZ

% Change in Quantity of Good (X) Demanded

% Change in Price of Good (Z)

While the sign of the cross-price elasticity helps us

distinguish substitutes and complements among related
goods
Its size tells us how closely the two goods are related
A large absolute value for EXZ suggests that the two goods are close
substitutes or complements
While a small value suggests a weaker relationship

Price Elasticity of Supply

Percentage change in quantity of a good

supplied that is caused by a 1% change in the
price of the good

With all other influences on supply held constant

ES

% Change in Quantity Supplied

% Change in Price

Price Elasticity of Supply

When do we expect supply to be price elastic,

and when do we expect it to be price inelastic?

Ease with which suppliers can find profitable activities

that are alternatives to producing the good in question

Supply will tend to be more elastic when suppliers can

switch to producing alternate goods more easily

When can we expect suppliers to have easy alternatives?

Depends on
Nature of the good itself
Narrowness of the market definitionespecially
geographic narrowness
Time horizonlonger we wait after a price change,
greater the supply response to a price change

Price Elasticity of Supply

Extreme

cases of supply elasticity

Perfectly inelastic supply curve is a vertical

line

Many markets display almost completely inelastic

supply curves over very short periods of time

Perfectly elastic supply curve is a horizontal

line

Excise Tax

A tax on a particular good or service is called an

excise tax

Shifts market supply curve upward by amount of tax

For each quantity supplied, the new, higher curve tells us

firms gross price, and the original, lower curve tells us
the net price

Who really pays excise taxes?

Buyers and sellers share in the payment of an excise

tax

Called tax shifting

Process that causes some of tax collected from one side of

market (sellers) to be paid by other side of market (buyers)

Tax and Demand Elasticity

In

most cases excise tax will be shared

by both buyer and seller

For a given supply curve, the more elastic is

demand, the more of an excise tax is paid by

sellers
The more inelastic is demand, the more of the
tax is paid by buyers

Tax Incidence and Supply Elasticity

Although

there are extreme cases of

supply elasticity, in general the following
is true

For a given demand curve, the more elastic is

supply, the more of an excise tax is paid by

buyers
The more inelastic is supply, the more of the
tax is paid by sellers