Further topics in Supply and Demand

Introduction to 2
y Three further topics to round up the supply and
Microeconomics demand model:
1
1
1. The concept of elasticity.
elasticity
LECTURE 4 2. Introduction to welfare economics
MORE ON DEMAND & SUPPLY
1. The
Th conceptst off consumer surplusl and d
producer surplus.
DR NICHOLAS VASILAKOS

Elasticity--Responsiveness
y p of Demand or Supply
pp y Responsiveness
p of demand to p
price changes
g
3 4

y In
I some problems
bl it is
i iimportant
t t tto k
know h
how responsive
i supply
l y How can we measure responsiveness?
or demand is to changes in price (or other determinants).
y Why not use the slope of the demand curve (will
y For example,
p , let’s sayy you
y are running
g the municipal
p bus service
and it is making a loss. You desperately need to increase
concentrate on demand – similar considerations
revenue. apply to supply)?
{ One of your advisors tells you that you need to increase prices. “OK,
OK, he y We could do,
do and that might give us the information
says, you will lose a few customers, but the higher bus fares paid by the
remaining customers will more than offset this reduction in revenues.” we need.
{ Another of your advisors suggests exactly the opposite. “Cut
Cut fares
fares”,, she y There is problem with using slope
slope, however
however.
says, “and you will attract so many new travellers that your revenue will
increase even though each is paying a bit less per journey.” y Surely, in next diagram the right hand side demand
y Who is right? curve shows greater responsiveness of demand to a
y The answer depends on how responsive demand for bus journeys price change.
is to a change in the price per journey
 Sl
Slope d
depends
d on units
it off measurementt El ti it measure iis unit-free
Elasticity it f
5 6
y The demand for petrol: these two demand curves could be identical;
they look different because of the units chosen. y To
T get around
d the
h problem
bl off choice
h i off units
i we d
define
fi the
h
(£/gallon)
own-price elasticity of demand as:
P P (£/litre)
percentage change in quantity of Q demanded
H
percentage change in price
'Q Q 'Q P
'P P 'P Q
'Q
note that because is negative (demand curve slopes downwards)
'P
D2
D1 the
h sign
i off the
h own price
i elasticity
l i i off demand
d d is
i negative.
i
Q Q
(gallons) (litres)

Different elasticities along a straight-line demand curve

Elasticityy along
g a linear demand curve 10
PHd = (1 / slope) x P/Q
7
n
8 (1 / slope) is constant
P = 50/10 = 5
=- ((demand infinitelyy elastic)) m But P/Q varies:
6
at n, P/Q = 8/10
< -1 (demand elastic)
P at m, P/Q = 6/20
l P/Q = 4/30
atlt l,
= -1 (demand unit elastic) 4
l Demand
> -1 (demand inelastic) k
2
=0
0 (d
(demand
d zero elastic)
l i )
Q
a/2 a
0
0 10 20 30 40 50
Q
 Question for you: calculate the point elasticity
Elasticityy and total revenue (expenditure)
p
50
PHd = (1 / slope) x P/Q
10

y The revenue from sales of the good (or, equivalently,

r
the total expenditure on the good) is:
30 TR=P.Q
P
y How does total revenue change when P changes?
D

y As in our example of bus fares, the answer clearly

depends
p on how responsive
p demand is to the p
price
change.

0 40 100
Q

Elastic demand between two points

Price change
g and total revenue-diagrammatically
g y
11
Expenditure falls
P
A is the gain in revenue due
as price rises
to price increase

P(£)
P2
B is the loss of revenue due b
A quantity
tit reduction
d ti 5
P1 a
4
I
Increase in
i revenue = A-B
AB
D
C B

D
Demand
d
Q
Q2 Q1
0 10 20
Q (millions of units per period of time)
 Inelastic demand between two points

Price change and total revenue-

revenue a useful formula
Expenditure rises
14
as price rises
y The preceding analysis can be encapsulated in a simple
c formula:
8

P(£) 'TR
Q (1  H )
'P
a
4
y Remembering  is negative
negative, this means that when
demand is elastic (inelastic) a price increase will
decrease ((increase)) revenue. i.e. the LHS is negative
g
D (positive).

0 15 20
Q (millions of units per period of time)

Market supply and demand

S
Summary off elasticity-revenue
l ti it relationship
l ti hi S2
15
S1

Effect on total revenue of:

|| b
(absolute
 P2

Price
value) Demand is: Price
Price increase
decrease
c
P3
<-1 ||>1 elastic – + a

P1
D '
= -1 ||=1 Unit elastic unchanged unchanged

D
>-1 ||<1 inelastic + –
O Q3 Q2 Q1
Quantity
 Totally inelastic demand (PD = 0) Infinitely elastic demand (PD = f)
P P
D

a b
P2 b P1 D

P1 a

O Q1 O Q1 Q2
Q Q

Unit elastic demand (PD = –1)

P Other Elasticity Measures
20
Expenditure stays the
same as price changes y Elasticity
El i i iis a generall measure off responsiveness.
i
y Here are some other examples:
a
20 y XY= cross-price
i elasticity
l i i off d
demand
d between
b goods
d X
and Y. It is the % change in demand for X divided by %
change in price of Y (what sign would you expect XY to
take?).
y QM= income (M) elasticity of demand
demand. It is the %
b change in demand divided by % change in income.
8 Again, think about the sign.
D
y = price elasticity of supply. It is the % change in
quantity supplied divided by % change in price.
O 40 100 Q
 What
W at determines
dete es eelasticity
ast c ty o
of de
demand?
a d? Evaluating
g welfare and welfare changes
g
21 22
y We have seen that the market model using supply and
y In a broad
b d sense, “tastes”
“ ” or ““preferences”
f ” demand curves enables us to analyse equilibrium and how
y Existence of close substitutes equilibrium changes when an exogenous variable changes.
{ where they exist demand more elastic than in absence of close
y But our model can do somethingg else as well:
substitutes. { Demand curves tell us how much consumers benefit from a market
and how their welfare is affected by changes in the market (i.e.
{ Definition of the good is relevant here; the demand for tennis changes in equilibrium price and quantity).
racquets
t iis lless elastic
l ti ththan th
the d
demand
d ffor Sl
Slazenger ttennis
i { Similarly supply curves tell us how much producers benefit from a
racquets. market and how their welfare is affected by changes in equilibrium
price and quantity.
y Time y To understand these benefits and welfare changes we
{ For many goods demand is more elastic the longer the time period introduce two new concepts:
considered. { Consumer surplus.
{ But this not a “law”;
law ; for some goods demand may be more elastic in { Producer surplus.
p
the short run. y These will prove to be useful in evaluating (changes in)
government economic policy.

Willingness
g to p
payy and the demand curve Consumer welfare,, WTP and the demand curve.
23 24

y Willingness
Willi to pay (WTP) is
i the
h maximum
i a y Consumer net welfare from a good is the willingness
consumer would be prepared to pay for a good or to pay for a good minus what the consumer actually
service. pays.
pays
y If market price exceeds WTP consumer will not
purchase. y At the margin (for the marginal unit of consumption)
{ Will do so if WTP>price. WTP and d price
i willill b
be equall or very nearly
l so.
{ Is indifferent between purchasing and not purchasing where y But for all previous units purchased (intra-marginal
WTP price.
WTP=price.
units)
i ) WTP>price.
WTP i
y Marginal WTP is the willingness to pay for the
marginal unit, i.e. the marginal value the consumer y Summing up the excess of WTP over price for all
d i
derives from
f th
the llastt or marginal
i l unit
it off output.
t t units purchased gives us a measure we call consumer
y So the consumer’s demand curve represents (at surplus.
any given quantity) the consumer’s
consumer s marginal WTP.
WTP
 Consumer surplus diagrammatically
Consumer surplus at the level of the market
26
P Willingness
g to pay
p y for the first unit
e y Previous few slides have implicitly analysed
aecd=total WTP for Q* units
abcd=total amount actually paid for Q* units
consumer surplus for an individual consumer.
bec= consumer surplus y But
B t exactly
tl the
th same conceptt applies
li att th
the llevell off
the market.
CS
y Market consumer surplus is the sum of all
P* (market price) b c consumers’ valuations, as shown by the area under
the
h market
k demand
d d curve, minus
i the
h totall
Willingness to pay
expenditure by consumers in the market.
D
for the marginal unit y The next diagram shows how we measure the benefit
d
a
1
Q to consumers of a fall in the market price.
Q*
Q

25

Using CS to measure the benefit of a fall in price Producer surplus

P 27 28
y Producer surplus
p is the excess of the total revenue
received by a supplier from the sale of a good over and
above the minimum amount necessary to supply the
amount sold.
sold
y The supply curve shows the marginal willingness to
a supply,
pp y, i.e. the p
price it must receive to supply
pp y the
P1
marginal unit.
b y But intra-marginal units would have been supplied at
P2 c
a lower price.
price
y The sum of the excess of the market price over the
D
marginal supply price for Q up to Q* Q is producer
Q
surplus (PS).
Q1 Q2
 Producer surplus
p diagrammatically
g y Producer surplus
p at level of market
29 30

P
aecd=total WTS for Q*
units y This
Thi simply
i l applies
li ththe same conceptt att th
the llevell off
abcd=total revenue actually received for Q* units
bec= producer surplus the market.
S
y It is
i the
h diff
difference between
b totall revenue off all
ll
P b c producers in the market and the sum of all
*
PS
Price at which first unit would producers’
d ’ marginal
i l supply
l prices
i as shown
h b
by th
the
be supplied area under the market supply curve.
Price at which Q*th unit would y The
h next di
diagram shows
h h
how we measure the h b benefit
fi
e be supplied to producers of an increase in the market price.
d Q
a 1
Q*

Gain in p
producer surplus
p when p
price increases A measure of society’s
y welfare.
31 32

P
y Measuring
M i society’s
i t ’ welfare
lf a complex
l iissue.
S
y Recent research has attempted not to use money
measures butb to measure happiness
h i di
directly.
l
P2=$30 Supply curve:
P=10+0.8Q
P 10+0.8Q
y A simple monetary measure in our framework is CS
b c
+ PS , i.e. the sum of benefits to consumers and to
P1=$20
producers.
a
y Implicit assumption: wellbeing of consumers and of
producers equally important.
Q
Q1=12.5 Q2=25
 Welfare loss from producing less than competitive output
Competitive markets maximise
33
this measure of welfare 34

P P c+e is the deadweight loss

from restricting output from Q* to Q1

S
a S
P1
CS
b c
P* P*
d e
PS
f
D
D

Q Q
Q* Q1 Q*
The sum of CS and PS is maximised at P*, Q* c+e is the deadweight loss of producing Q1<Q*

Application:
pp quantityy controls
q
35

y A new chemical cleaning solution is introduced to

the market. Initially, demand is QD = 1,000 – 2P and
supply is QS = 100+P (Q is quantity and P is price).
{ Determine the equilibrium price and quantity.
{ The government then decides that no more than 300 units of
this product should be sold per period, and imposes a quota at
that level. How does this quota affect the equilibrium price and
quantity?
q y Show the solution using g a graph
g p and calculate the
numerical answer.
{ How does the introduction of the quota affect the welfare of
consumers and producers?
{ How would your answer have changed had the quota been set
at 500?