CHAPTER 2

DEMAND AND SUPPLY

0
LEARNING OBJECTIVES:
By the end of this chapter, students should
understand:
▪ what determines the demand and supply
▪ distinguish between a shift of a demand
curve and a movement along a demand
curve
▪ distinguish between a shift of a supply curve
and a movement along a supply curve
▪ how supply and demand together set the
price of a good and the quantity sold.
▪ the key role of prices in allocating scarce
1
resources in market economies.
A market is a group of
buyers and sellers of a
particular good or
service

2
◦ Can be highly organized
◦ Can be less organized
Market: any institution,
mechanism, or arrangement
which facilitates exchange.

@Ki
Markets and Competition euMi
nh.M
Sc2
2
MARKETS

▪ The terms supply and demand refer to the

behavior of people as they interact with
one another in markets
▪ Buyers determine
▪ Sellers determine

3
I. DEMAND

▪ Demand is the various amount of a product that

consumers are willing and able to purchase at
each of a series of possible prices during a
specified period of time.

▪ The Quantity demanded is the particular

quantity that is demanded at a particular price.
The term “quantity demanded” makes sense only
in relation to a particular price
4
Demand
▪ Law of demand: the claim that the quantity
demanded of a good when the price of the good
other things equal.
▪ Other things equal: this assumes that when there are
a number of different factors that determine
something, only one is changing and all of the
others are held constant. Thus, in this case, price is
changing but any other determinants of demand are
assumed to be unchanging

5
The Demand Schedule
Price
▪ Demand schedule: of
Quantity
a table that shows the of cookies
cooki
demanded
relationship between the es
price of a good and the $0.00 16
quantity demanded 1.00 14
2.00 12
▪ Example:
3.00 10
Helen’s demand for cookies.
4.00 8
▪ Notice that Helen’s 5.00 6
preferences obey the 6.00 4
law of demand.
6
 Helen’s Demand Schedule & Curve
Price
Price of Quantity
of
Cookie of cookies
cooki
$6.00 s demanded
es
$5.00 $0.00 16
1.00 14
$4.00
2.00 12
$3.00 3.00 10
$2.00 4.00 8
5.00 6
$1.00
6.00 4
$0.00
Quantity
0 5 10 15 of
7
cookies
8

I. DEMAND

▪ Demand function:

QD = f(P)
Linear: QD = a.P + b (a < 0)

 Ex: QD = -2P + 180

8
Market Demand versus Individual Demand
▪ The quantity demanded in the market is the sum of the
quantities demanded by all buyers at each price.
▪ Suppose Helen and Ken are the only two buyers in
the cookies market. (Qd = quantity demanded)
Price Helen’s Qd Ken’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 The Market Demand Curve for cookies

Qd
P P
(Market)
$6.00
$0.00 24
$5.00 1.00 21
$4.00 2.00 18
3.00 15
$3.00
4.00 12
$2.00 5.00 9
$1.00 6.00 6
$0.00 Q
0 5 10 15 20 25
10
Demand Curve Shifters
▪ The demand curve shows how price affects
quantity demanded, other things being equal.
▪ These “other things” are non-price determinants
of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price).
▪ Changes in non-price determinants shift the D
curve to either the right or the left

11
Demand Curve Shifters: # of Buyers
▪ Increase in # of buyers

▪ An ……………..in the number of buyers in a

market for a product will ……………… the
demand for the product

12
 Demand Curve Shifters: # of Buyers

P Suppose the number

$6.00 of buyers increases.
Then, at each P,
$5.00
Qd will increase
$4.00 (by 5 in this example).
$3.00
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30
13
Demand Curve Shifters: Income
▪ Demand for a normal good:
▪ is positively related to income.

.
Demand for an inferior good”
▪ is negatively related to income.

14
Demand Curve Shifters: Prices of
Related Goods
▪ Two goods are substitutes if
an increase in the price of one
causes an increase in demand for the other.

▪ The price of one of the product increase -> quantity

demanded of substitute goods will increase at all
prices -> the demand curve will shift to the right.

15
Demand Curve Shifters: Prices of
Related Goods
▪ Example: pizza and hamburgers.
An increase in the price of pizza
increases demand for hamburgers,
shifting hamburger demand curve to the right.

▪ Other examples: Coke and Pepsi,

laptops and desktop computers,
CDs and music downloads
16
Demand Curve Shifters: Prices of
Related Goods
▪ Two goods are complements if
an increase in the price of one
causes a fall in demand for the other.
▪ Example: computers and software.
If price of computers rises,
people buy fewer computers,
and therefore less software.
Software demand curve shifts left.
▪ Other examples: college tuition and textbooks,
bagels and cream cheese, eggs and bacon
17
Demand Curve Shifters: Tastes
▪ Anything that causes a shift in tastes toward a
good will ………

▪ Example:
The Atkins diet became popular in the ’90s,
caused an increase in demand for eggs,
shifted the egg demand curve to the right.

18
Demand Curve Shifters: Expectations
▪ Expectations affect consumers’ buying decisions.
▪ Examples:
▪ If people expect their incomes to rise,
their demand for meals at expensive
restaurants may increase now.
▪ If the economy sours and people worry about
their future job security, demand for new autos
may fall now.

19
Summary: Variables That Influence Buyers
Variable A change in this variable…

Price …causes a movement

along the D curve
# of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
20
 ACTIVE LEARNING 1
Demand Curve
Draw a demand curve for music downloads.
What happens to it in each of
the following scenarios? Why?

A. The price of iPods

falls
B. The price of music
downloads falls
C. The price of CDs falls

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Supply
▪ Supply is the willingness and ability of
producers to produce a quantity of a good or
service at a given price in a given time period.
▪ The quantity supplied of any good is the
amount that sellers are willing and able to sell at
a particular price.
▪ Law of supply: the claim that the quantity
supplied of a good rises when the price of the
good rises, other things equal

22
The Supply Schedule
Price Quantity
▪ Supply schedule:
of of lattes
A table that shows the lattes supplied
relationship between the $0.00 0
price of a good and the 1.00 3
quantity supplied. 2.00 6
▪ Example: 3.00 9
Starbucks’ supply of lattes. 4.00 12
5.00 15
▪ Notice that Starbucks’ 6.00 18
supply schedule obeys the
law of supply.
23
Starbucks’ Supply Schedule & Curve
Price Quantity
P of of lattes
$6.00 lattes supplied
$0.00 0
$5.00
1.00 3
$4.00 2.00 6
3.00 9
$3.00
4.00 12
$2.00 5.00 15
$1.00 6.00 18
Q
$0.00
0 5 10 15
24
Market Supply versus Individual Supply
▪ The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
▪ Suppose Starbucks and Jitters are the only two
sellers in this market. (Qs = quantity supplied)
Price Starbucks Jitters Market Qs
$0.00 0 0 =
1.00 3 2 =
2.00 6 4 =
3.00 9 6 =
4.00 12 8 =
5.00 15 10 =
6.00 18 12 =
 The Market Supply Curve
QS
P
(Market)
P
$0.00 0
$6.00
1.00 5
$5.00
2.00 10
$4.00 3.00 15
$3.00 4.00 20
5.00 25
$2.00
6.00 30
$1.00

$0.00 Q
0 5 10 15 20 25 30 35
26
Supply Curve Shifters
▪ The supply curve shows how price affects
quantity supplied, other things being equal.
▪ These “other things” are non-price determinants
of supply.
▪ Changes in them shift the S curve…

27
Supply Curve Shifters: Input Prices
▪ Examples of input prices:
wages, prices of raw materials.
▪ A …………..in input prices makes production
more …………………..at each output price,
so firms supply a ………………...quantity at
each price, and the S curve shifts to the
………………….

28
 Supply Curve Shifters: Input Prices

P Suppose the
$6.00 price of milk falls.
At each price,
$5.00
the quantity of
$4.00 lattes supplied
will increase
$3.00
(by 5 in this
$2.00 example).
$1.00

$0.00 Q
0 5 10 15 20 25 30 35
29
Supply Curve Shifters: Technology
▪ Technology determines how much inputs are
required to produce a unit of output.
▪ A cost-saving technological improvement has
the same effect as a fall in input prices,
shifts S curve to the right.

30
Supply Curve Shifters: # of Sellers
▪ An increase in the number of sellers increases
the quantity supplied at each price,
shifts S curve to the right.

31
Supply Curve Shifters: Expectations
▪ Example:
▪ Events in the Middle East lead to expectations
of higher oil prices.
▪ In response, owners of Texas oilfields reduce
supply now, save some inventory to sell later at
the higher price.
▪ S curve shifts left.
▪ In general, sellers may adjust supply* when their
expectations of future prices change.
(*If good not perishable)

32
Summary: Variables that Influence Sellers

Variable A change in this variable…

Price …causes a movement
along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve

33
 ACTIVE LEARNING 2
Supply Curve
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the
price of the services they provide.
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 Supply and Demand Together

P Equilibrium:
$6.00 D S
P has reached
$5.00 the level where
$4.00 quantity supplied
$3.00
equals
quantity demanded
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
35
 Equilibrium price:
the price that equates quantity supplied
with quantity demanded
P
$6.00 D S
P QD QS
$5.00 $0 24 0
$4.00 1 21 5
2 18 10
$3.00
3 15 15
$2.00 4 12 20
$1.00 5 9 25
$0.00 6 6 30
Q
0 5 10 15 20 25 30 35
36
 Equilibrium quantity:
the quantity supplied and quantity demanded
at the equilibrium price
P
$6.00 D S
P QD QS
$5.00 $0 24 0
$4.00 1 21 5
2 18 10
$3.00
3 15 15
$2.00 4 12 20
$1.00 5 9 25
$0.00 6 6 30
Q
0 5 10 15 20 25 30 35
37
 Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P Example:
$6.00 D S
If P = $5,
$5.00 then
$4.00 QD = lattes
$3.00 and
QS = lattes
$2.00
resulting in a
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
38
 Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00 D S Facing a …….
sellers try to ……………..
$5.00 sales by ………….. price.
$4.00 This causes
$3.00 QD to and QS to ….…
$2.00 …which …………..
the ……………...
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
39
 Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Example:
If P = $1,
$5.00
then
$4.00 QD = … lattes
$3.00 and
QS = lattes
$2.00
resulting in a
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
40
 Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Facing a shortage,
sellers ………..the price,
$5.00
causing QD to …….
$4.00 and QS to ………..,
$3.00 …which …………..
the shortage.
$2.00
$1.00

$0.00 Q
0 5 10 15 20 25 30 35
41
Three Steps to Analyzing Changes in Eq’m

To determine the effects of any event,

1. Decide whether event shifts S curve,

D curve, or both.
2. Decide in which direction curve shifts.

3. Use supply—demand diagram to see

how the shift changes eq’m P and Q.

42
EXAMPLE: The Market for Hybrid Cars

P
price of
S1
hybrid cars

P1

D1
Q
Q1
quantity of
hybrid cars
43
EXAMPLE 1: A Shift in Demand
EVENT TO BE
ANALYZED: P
Increase in price of gas. S1
STEP 1: P2

because
STEP 2: price of gas P1
affects demand for
hybrids.
because
STEP 3: high gas
S curve
price doeshybrids
makes not D1
.
shift,
more because
attractiveprice Q
of gas does not cars. Q1 Q2
relative to other
affect cost of
producing hybrids.
44
EXAMPLE 1: A Shift in Demand

Notice: P
.
S1
P2

P1

D1
Q
Q1 Q2

45
Terms for Shift vs. Movement Along Curve
▪ Change in supply:

▪ Change in the quantity supplied:

▪ Change in demand:

▪ Change in the quantity demanded:

46
EXAMPLE 2: A Shift in Supply
EVENT: New technology
reduces cost of P
producing hybrid cars. S1
STEP 1:

because
STEP 2: event affects P1
cost of production.
P2
D curve does
because event not
STEPbecause
shift, 3:
reduces cost, D1
production technology
makes production Q
is not profitable
one of theat Q1 Q2
more
factors thatprice.
any given affect
demand.
47
EXAMPLE 3: A Shift in Both Supply
EVENTS:
and Demand
Price of gas rises AND P
new technology reduces S1
production costs
STEP 1: P2
P1
STEP 2:

STEP 3: D1
Q
Q1 Q2

48
EXAMPLE 3: A Shift in Both Supply
EVENTS:
and Demand
price of gas rises AND P
new technology reduces S1
production costs

STEP 3, cont.
P1
.
P2

D1
Q
Q1 Q2

49
 ACTIVE LEARNING 3
Shifts in supply and demand
Use the three-step method to analyze the effects of
each event on the equilibrium price and quantity of
music downloads.
Event A: A fall in the price of CDs
Event B: Sellers of music downloads negotiate a
reduction in the royalties they must pay
for each song they sell.
Event C: Events A and B both occur.

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50
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SU MMA RY

• A competitive market has many buyers and

sellers, each of whom has little or no influence
on the market price.
• Economists use the supply and demand model
to analyze competitive markets.
• The downward-sloping demand curve reflects
the law of demand, which states that the quantity
buyers demand of a good depends negatively
on the good’s price.

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51
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SU MMA RY

• Besides price, demand depends on buyers’ incomes,

tastes, expectations, the prices of substitutes and
complements, and number of buyers.
If one of these factors changes, the D curve shifts.
• The upward-sloping supply curve reflects the Law of
Supply, which states that the quantity sellers supply
depends positively on the good’s price.
• Other determinants of supply include input prices,
technology, expectations, and the # of sellers.
Changes in these factors shift the S curve.

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52
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SU MMA RY

• The intersection of S and D curves determines

the market equilibrium. At the equilibrium price,
quantity supplied equals quantity demanded.
• If the market price is above equilibrium,
a surplus results, which causes the price to fall.
If the market price is below equilibrium,
a shortage results, causing the price to rise.

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53
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SU MMA RY

• We can use the supply-demand diagram to

analyze the effects of any event on a market:
First, determine whether the event shifts one or
both curves. Second, determine the direction of
the shifts. Third, compare the new equilibrium to
the initial one.
• In market economies, prices are the signals that
guide economic decisions and allocate scarce
resources.

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54
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Elasticity and its Application

55
LEARNING OBJECTIVES:

By the end of this chapter, students should

understand:
Ø the meaning of the elasticity of demand.
Ø what determines the elasticity of demand.
Ø the meaning of the elasticity of supply.
Ø what determines the elasticity of supply.
Ø the concept of elasticity in three very
different markets (the market for wheat, the
market for oil, and the market for illegal drugs).

56
 A scenario…
You design websites for local businesses.
You charge $200 per website,
and currently sell 12 websites per month.
Your costs are rising
(including the opportunity cost of your time),
so you consider raising the price to $250.
The law of demand says that you won’t sell as
many websites if you raise your price.
How many fewer websites? How much will your
revenue fall, or might it increase?

57
I. Elasticity

▪ Basic idea:
Elasticity measures how much one variable
responds to changes in another variable.
▪ One type of elasticity measures how much
demand for your websites will fall if you
raise your price.
▪ Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
58
59

I. THE ELASTICITY

- Price elasticity of demand

- Income elasticity of demand

- Cross-price elasticity of demand

- Price elasticity of supply

59
1.1 Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P

▪ Price elasticity of demand measures how much the

quantity demanded Qd responds to a change in the
price of that good. P.

▪ Loosely speaking, it measures the price-sensitivity of

buyers’ demand.

60
1.1 Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P
P
Example:
P rises
Price elasticity by 10%
P2
of demand P1
equals D
Q
Q2 Q1
Q falls
by 15%
61
1.1 Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions,
P2
which would make price
elasticity negative. P1
We will drop the minus sign D
and report all price Q
elasticities as Q2 Q1
positive numbers.

62
63

1.1 Price Elasticity of Demand

EP  (%Q)/(%P)

63
Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200 the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

64
Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending on
your websites where you start.
P
From A to B,
B P rises ……., Q falls ……..,
$250
A elasticity =
$200
From B to A,
D
P falls ………., Q rises …….,
Q elasticity =
8 12

65
Calculating Percentage Changes
▪ So, we instead use the midpoint method:

end value – start value

x 100%
midpoint
▪ The midpoint is the number halfway between the
start and end values, the average of those values.
▪ It doesn’t matter which value you use as the start
and which as the end—you get the same answer
either way!

66
THE ELASTICITY OF DEMAND

▪ The midpoint formula is preferable when

calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the change.

67
Calculating Percentage Changes
▪ Using the midpoint method, the % change
in P equals

▪ The % change in Q equals

▪ The price elasticity of demand equals

68
 ACTIVE LEARNING 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Variety of Demand Curves

▪ The price elasticity of demand is closely

related to the slope of the demand curve.
▪ Rule of thumb:
The flatter the curve, the bigger the
elasticity.
The steeper the curve, the smaller the
elasticity.
▪ Five different classifications of D curves.…

70
▪ Inelastic Demand
▪ Quantity demanded does not respond strongly to
price changes.
▪ Elastic Demand
▪ Quantity demanded responds strongly to changes
in price.
▪ Unit Elastic
▪ Quantity demanded changes by the same
percentage as the price.
▪ Perfectly Inelastic
▪ Quantity demanded does not respond to price
changes.
▪ Perfectly Elastic
▪ Quantity demanded changes infinitely with any
change in price.
71
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q
= = =
of demand % change in P

D curve: P
D

P1
Consumers’
price sensitivity: P2

P falls Q
Elasticity: by 10% Q1
Q changes
by …..
72
“Inelastic demand”
Price elasticity % change in Q
= = <1
of demand % change in P

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2

Q rises less
than 10%
73
“Unit elastic demand”
Price elasticity % change in Q
= = =
of demand % change in P

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2

Q rises by 10%

74
“Elastic demand”
Price elasticity % change in Q
= =
of demand % change in P

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
Q rises more
than 10%
75
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q
= =
of demand % change in P

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2

Q changes
by any %
76
A few elasticities from the real world

Eggs 0.1
Healthcare 0.2
Rice 0.5
Housing 0.7
Beef 1.6
Restaurant meals 2.3
Mountain Dew 4.4

77
1.1 Price elasticity of demand

▪ Total revenue is the amount paid by buyers

and received by sellers of a good.

▪ Computed as the price of the good times

the quantity sold.

TR = P x Q

78
Price Elasticity and Total
Revenue
▪ Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
▪ A price increase has two effects on revenue:
▪ Higher P means more revenue on each unit
you sell.
▪ But you sell fewer units (lower Q),
due to law of demand.
▪ Which of these two effects is bigger?
It depends on the price elasticity of demand.
79
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
▪ The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
…………………………….
80
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
▪ The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
▪ In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
81
 ACTIVE LEARNING 2
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?

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82
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P

▪ Price elasticity of supply measures how much

Qs responds to a change in P.
▪ Loosely speaking, it measures sellers’
price-sensitivity.
▪ Again, use the midpoint method to compute the
percentage changes.

83
Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
84
The Variety of Supply Curves
▪ The slope of the supply curve is closely related
to price elasticity of supply.
▪ Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
▪ Five different classifications…

85
“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
86
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
87
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
88
“Elastic”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
89
“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
90
 ACTIVE LEARNING 3
Elasticity and changes in equilibrium
▪ The supply of beachfront property is inelastic.
The supply of new cars is elastic.
▪ Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
▪ For which product will P change the most?
▪ For which product will Q change the most?

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91
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Other Elasticities
▪ Income elasticity of demand: measures the
response of Qd to a change in consumer income

Income elasticity Percent change in Qd

=
of demand Percent change in income

▪ Recall from Chapter 4: An increase in income

causes an increase in demand for a normal good.
▪ Hence, for normal goods, income elasticity > 0.
▪ For inferior goods, income elasticity < 0.

92
Other Elasticities
▪ Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
▪ For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an
increase in demand for chicken)
▪ For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)
93
Cross-Price Elasticities in the News
“As Gas Costs Soar, Buyers Flock to Small Cars”
-New York Times, 5/2/2008
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008
“Gas prices knock bicycle sales, repairs into higher gear”
-Associated Press, 5/11/2008
“Camel demand soars in India”
(as a substitute for “gas-guzzling tractors”)
-Financial Times, 5/2/2008
“High gas prices drive farmer to switch to mules”
-Associated Press, 5/21/2008
94
 SU MMA RY

• Elasticity measures the responsiveness of

Qd or Qs to one of its determinants.
• Price elasticity of demand equals percentage
change in Qd divided by percentage change in P.
When it’s less than one, demand is “inelastic.”
When greater than one, demand is “elastic.”
• When demand is inelastic, total revenue rises
when price rises. When demand is elastic, total
revenue falls when price rises.

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 SU MMA RY

• Demand is less elastic: in the short run;

for necessities; for broadly defined goods;
and for goods with few close substitutes.
• Price elasticity of supply equals percentage
change in Qs divided by percentage change in P.
When it’s less than one, supply is “inelastic.”
When greater than one, supply is “elastic.”
• Price elasticity of supply is greater in the long run
than in the short run.

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 SU MMA RY

• The income elasticity of demand measures how

much quantity demanded responds to changes
in buyers’ incomes.
• The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.

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Government Polcies

98
In this chapter,
look for the answers to these questions:
• What are price ceilings and price floors?
What are some examples of each?
• How do price ceilings and price floors affect
market outcomes?
• How do taxes affect market outcomes?
How do the effects depend on whether
the tax is imposed on buyers or sellers?
• What is the incidence of a tax?
What determines the incidence?
99
 Government Policies That Alter the
Private Market Outcome
▪ Price controls
▪ Price ceiling:

▪ Price floor:

▪ Taxes
▪ The govt can make buyers or sellers pay a
specific amount on each unit.

We will use the supply/demand model to see

how each policy affects the market outcome
(the price buyers pay, the price sellers receive,
and eq’m quantity).
Taxes
▪ The govt levies taxes on many goods & services
to raise revenue to pay for national defense,
public schools, etc.
▪ The govt can make buyers or sellers pay the tax.
▪ The tax can be a % of the good’s price,
or a specific amount for each unit sold.
▪ For simplicity, we analyze per-unit taxes only.

101
EXAMPLE 3: The Market for Pizza

Eq’m
w/o tax P
S1

$10.00

D1

Q
500

102
 A Tax on Sellers
The tax effectively raises Effects of a $1.50 per
sellers’ costs by unit tax on sellers
P S2
$1.50 per pizza. $11.50
Tax S1
Sellers will supply
500 pizzas
$10.00
only if
P rises to $11.50,
to compensate for
this cost increase. D1

Hence, a tax on sellers shifts the Q

S curve up by the amount of the tax. 500

103
 A Tax on Sellers
New eq’m: Effects of a $1.50 per
unit tax on sellers
Q = 450 P S2
Buyers pay S1
PB = $11.00 PB = $11.00
Tax
Sellers $10.00
receive PS = $9.50
PS = $9.50
D1
Difference
between them
= $1.50 = tax Q
450 500

104
 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P
It’s easier
for sellers
PB S
than buyers
Buyers’ share
to leave the
of tax burden
Tax market.
Price if no tax So buyers
Sellers’ share
bear most of
PS
of tax burden the burden
of the tax.
D
Q

105
 Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
It’s easier
P
S for buyers
Buyers’ share than sellers
of tax burden PB to leave the
market.
Price if no tax
Tax Sellers bear
Sellers’ share most of the
of tax burden PS burden of
D the tax.
Q

106
CONCLUSION: Government Policies and the
Allocation of Resources
▪ Each of the policies in this chapter affects the
allocation of society’s resources.
▪ Example 1: A tax on pizza reduces eq’m Q.
With less production of pizza, resources
(workers, ovens, cheese) will become available
to other industries.
▪ Example 2: A binding minimum wage causes
a surplus of workers, a waste of resources.
▪ So, it’s important for policymakers to apply such
policies very carefully.
107
 SU MMA RY

• A price ceiling is a legal maximum on the price of

a good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage.
• A price floor is a legal minimum on the price of a
good. An example is the minimum wage. If the
price floor is above the eq’m price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.

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 SU MMA RY

• A tax on a good places a wedge between the

price buyers pay and the price sellers receive,
and causes the eq’m quantity to fall, whether the
tax is imposed on buyers or sellers.
• The incidence of a tax is the division of the
burden of the tax between buyers and sellers,
and does not depend on whether the tax is
imposed on buyers or sellers.
• The incidence of the tax depends on the price
elasticities of supply and demand.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.