Introduction to Microeconomics

BUSI 1083

Yorkville University
Ontario Campus

Unit 3: Elasticity

Textbook Chapter 4 : Elasticity

1 Chapter 5: Price Controls and Market Efficiency
 Chapter Outline/Learning Objectives
Section Learning Objectives
After studying this chapter, you will be able to

4.1 Price Elasticity 1. explain what price elasticity of demand is and how
of Demand it is measured.
2. explain the relationship between total expenditure
and price elasticity of demand.
4.2 Price Elasticity 3. explain what price elasticity of supply is and how
of Supply it is measured.

4.3 Elasticity Matters for 4. see how elasticity of demand and supply determine the
Excise Taxes effects of an excise tax.

4.4 Other Demand 5. measure the income elasticity of demand and be able
Elasticities to distinguish between normal and inferior goods.
6. measure cross elasticity of demand and be able to
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distinguish between substitute and complement goods.
 4.1 Price Elasticity of Demand
• Demand is elastic when quantity demanded is
quite responsive to changes in price.
• When quantity demanded is relatively
unresponsive to changes in price, demand is
inelastic.
• The more elastic is demand, the less the change
in equilibrium price and the greater the change in
equilibrium quantity resulting from any given
shift in the supply curve.

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Fig. 4-1(i) The Effects of a Supply Shift (relatively elastic demand)

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Fig. 4-1(ii) The Effects of a Supply Shift (relatively inelastic demand)

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 The Measurement of Price Elasticity
• Elasticity (Greek letter eta:) is defined as:
Percentage change in quantity demanded
 =
Percentage change in price

 Q / Qave
 =
 p / pave

where pave and Qave are the average price and average quantity.

A demand curve has a negative slope, so the percentage changes in

price and quantity have opposite signs. Although demand elasticity is
a negative number we ignore the negative sign and report the
elasticity
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of demand as a positive number.
A Numerical Example of Price Elasticity
Product Original New Average Original New Average
Price Price Price Quantity Quantity Quantity
Pair of
fuzzy $9.00 $8.00 $8.50 2000 3000 2500
slippers

= (3 000 – 2 000)/(3 000 + 2 000)/2

(8 - 9)/(8 + 9)/2

(1 000)/(2 500)
= (1)/(8.5)

0.4
= 0.1176 = 3.40
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 Fig. 4-2 Elasticity Along a Linear Demand Curve

A negatively sloped linear demand curve has a constant slope but

does not have constant elasticity.
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 Fig. 4-3 Three Demand Curves with Constant Elasticity

D1 shows perfectly
inelastic demand

D2 shows perfectly
elastic demand

D3 shows unit elastic

demand

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What Determines Elasticity of Demand?

• Availability of Substitutes
• Products with close substitutes tend to have
elastic demands; products with no close
substitutes tend to have inelastic demands.
• Narrowly defined products have more elastic
demands than do more broadly defined products.

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What Determines Elasticity of Demand?
• Short Run and Long Run
• The response to a price change, and therefore the
measured price elasticity of demand will tend to be
greater the longer the time span.
• A short-run demand curve shows the immediate
response of quantity demanded to a change in price.
• A long-run demand curve shows the response of
quantity demanded to a change in price after enough
time has passed to develop or switch to substitute
products.

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Fig. 4-4 Short-Run and Long-Run Equilibrium Following an Increase
in Supply

• The changes depend on

the time that

consumers have to
respond.

• In the long run,

demand
is more elastic.

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 Elasticity and Total Expenditure
• Total expenditure = Price X Quantity
• How does total expenditure change when the price falls?
• When price falls, quantity demanded increases.
• If demand is elastic, the quantity change dominates and
total revenue rises.
• If demand is inelastic, the price change dominates and
total revenue falls.
• If demand is unit elastic, the percentage change in
quantity demanded equals the percentage change in
price and total revenue remains unchanged.

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 Fig. 4-5 Total Expenditure and Quantity Demanded

• When demand is elastic,

total revenue increases
when price falls.
• When demand is
inelastic,
total revenue decreases
when price falls.
• Total revenue reaches a
maximum when demand
is unit elastic.

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 4.2 Price Elasticity of Supply
• Price elasticity of supply is a measure of the
responsiveness of quantity supplied to a change
in the product’s own price.
• It is denoted by s and is defined as:
Percentage change in quantity supplied
S =
Percentage change in price

S =  Q / Qave
 p / pave

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 Fig. 4-6 Computing Price Elasticity of Supply

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 Determinants of Supply Elasticity
• Ease of Substitution
• If the price of a product rises, how much more can be
produced profitably depends on how easy it is for
producers to shift from the production of other products
to the one whose price has risen.

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 Determinants of Supply Elasticity
• Short Run and Long Run
• The short-run supply curve shows the immediate
response of quantity supplied to a change in price given
producers’ current capacity to produce the good.
• The long-run supply curve shows the response of
quantity supplied to a change in price after enough time
has passed to allow producers to adjust their productive
capacity.

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 Fig. 4-7 Short-Run and Long-Run Equilibrium Following an
Increase in Demand

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 4.3 Elasticity Matters for Excise Taxes
Fig. 4-8 The Effect of a Gasoline Excise Tax

• An excise tax
raises the price
paid by
consumers but
reduces the price
received by
producers.

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 4.3 Elasticity Matters for Excise Taxes
• An excise tax is a tax on the sale of a particular
product.
• Who actually bears the burden of this tax?
• The question of who bears the burden of a tax is
called the question of tax incidence.
• The burden of an excise tax is distributed
between consumers and sellers in a manner that
depends on the relative elasticities of supply and
demand.

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 Fig. 4-9 Elasticity and the Incidence of an Excise Tax

With an excise tax, the price paid by the consumer is pc and the price
received by the seller is ps. The consumer price and the seller price
differ
22 by the amount of the tax, t.
 4.4 Other Demand Elasticities
• Income Elasticity of Demand

Y = Percentage change in quantity demanded

Percentage change in income

If Y > 0, the good is a normal good.

If Y < 0, the good is an inferior good.

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 Normal Goods
• If income elasticity is positive but less than one, demand
is income inelastic.
• If income elasticity is positive and greater than one,
demand is income elastic.
• Products for which the income elasticity of demand is
positive but less than 1 are necessities.
• Products for which the income elasticity of demand is
positive and greater than 1 are luxuries.
• The more necessary an item is in the consumption
pattern of consumers, the lower is its income elasticity.

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 Cross Elasticity of Demand
Percentage change in quantity demanded of good X
XY =
Percentage change in price of good Y

If XY > 0, then X and Y are substitutes.

If XY < 0, then X and Y are complements.

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 Cross Elasticity of Demand
• The change in the price of good Y causes the
demand curve for good X to shift.
• If X and Y are substitutes, an increase in the price
of Y leads to an increase in the demand for X. The
demand curve for X shifts rightward.
• If X and Y are complements, an increase in the
price of Y leads to a decrease in the demand for
X. The demand curve for X shifts leftward.

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 Chapter Outline/Learning Objectives
Section Learning Objectives
After studying this chapter, you will be able to

5.1 Government- 1. describe how the presence of legislated price ceilings and
Controlled Prices price floors affect equilibrium price and quantity.

5.2 Rent Controls: 2. compare the short-run and long-run effects of legislated
A Case Study of rent controls.
Price Ceilings

5.3 An Introduction 3. describe the relationship between economic surplus and

to Market Efficiency the efficiency of a market.
4. explain why government interventions that cause prices to
deviate from their market-clearing levels tend to be
inefficient for society as a whole.

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 5.1 Government-Controlled
Prices
• Disequilibrium Prices
• Voluntary market transactions require both a willing buyer
and a willing seller.

• If the quantity demanded is less than quantity supplied,

demand will determine the amount actually exchanged.

• If the quantity demanded exceeds quantity supplied,

supply will determine the amount actually exchanged.

• In disequilibrium, the quantity exchanged is determined

by the lesser of quantity demanded and quantity supplied.
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 Fig. 5-1 The Determination of Quantity Exchanged in
Disequilibrium

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 Price Floors
Fig. 5-2 A Binding Price Floor
• A price floor is the
minimum
permissible price
that can be charged
for a particular
good or service.

• A binding price
floor leads to
excess supply.

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 Price Floors
• A minimum wage is an example of a price floor in the labour
market.
• In a competitive labour market, a binding minimum wage reduces
the level of employment and increases the quantity of labour
services employed.
• Unemployment increases.

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 Price Floors
• The owners of firms are made worse off since they are now
required to pay a higher wage than before the minimum age was
imposed.
• Some workers gain because they keep their jobs and they earn a
higher wage rate.
• Other workers lose because they lose their jobs as a result of the
wage increase.

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 Price Ceilings
• Free markets with flexible prices eliminate excess demand by
allowing prices to rise.
• A price ceiling is the maximum price at which certain goods and
services may be legally exchanged.
• With a binding price ceiling some other method of allocation must
be adopted.
• First-come, first-served results in buyers waiting hours to get into
the store, only to find that supplies are exhausted before they are
served.
• A binding price ceiling usually gives rise to a black market.
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 Black Markets
Fig. 5-3 A Price Ceiling and Black-Market Pricing
• A black market is a
situation in which
products are sold
at prices that
violate a legal
price control.

• Profit can be made

by buying at the
controlled price
and selling at the
(illegal) black-
market price.
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 Price Ceilings
Three common goals that governments have when imposing price
ceilings are:
• To restrict production
• To keep specific prices down
• To satisfy notions of equity in the consumption of a product
that is temporarily in short supply

To the extent that binding price ceilings give rise to a black

market, it is likely that the government’s objectives motivating
the imposition of the price ceiling will be thwarted.

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 An Introduction to Market Efficiency

• The imposition of a controlled price generates

benefits for some individuals and costs for others.
• Does a policy of legislated minimum wages make
society as a whole better off because it helps
workers more than it harms firms?
• Economists use the concept of market efficiency
to address such questions.

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 Demand as "Value" and Supply as "Cost"

• The market demand curve for any product shows, for

each possible price, how much of that product
consumers want to purchase.
• We can turn it around by starting with any given quantity
and asking about the price.
• The demand curve tells us the highest price that
consumers are willing to pay for a given unit.
• For each unit of a product, the price on the market
demand curve shows the value to consumers from
consuming that unit.
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 Demand as "Value" and Supply as "Cost"

• The market supply curve for any product shows how

much producers want to sell at each possible price.
• We can turn it around by starting with any given quantity
and asking about the price.
• The supply curve tells us the lowest price that producers
are willing to accept for a given unit.
• For each unit of a product, the price on the market curve
supply shows the lowest acceptable price to firms for
selling that unit. This lowest acceptable price reflects the
additional cost to firms from producing that unit.
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 Reinterpreting the Demand Curve
Fig. 5-5(i) Reinterpreting the Demand Curve for Pizza

• For each pizza, the price

on the demand curve
shows the value
consumers receive from
consuming that pizza.

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 Reinterpreting the Demand Curve
Fig. 5-5(ii) Reinterpreting the Supply Curve for Pizza

• For each pizza, the

price on the supply
curve shows the
additional cost to
firms of producing
that pizza.

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Economic Surplus and Market Efficiency
Fig. 5-6 Economic Surplus in the Pizza Market

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Economic Surplus and Market Efficiency

• Economic surplus—the
area below the demand
curve and above the supply
curve—is maximized at the
free-market equilibrium
quantity. Total economic
surplus is maximized.

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 Fig. 5-7 Market Inefficiency with Price Controls

• Production falls from Q0

to Q1.
• With a free market, each
unit of output from Q0 to
Q1 generates economic
surplus.
• The purple area shows
the deadweight loss,
which is the overall loss
of economic surplus to
society of the binding
price floor.
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 Fig. 5-7 Market Inefficiency with Price Controls

• Production falls from Q0 to

Q2.
• With a free market, each
unit of output from Q0 to Q2
generates economic
surplus.
• The purple area shows the
deadweight loss, which is
the overall loss of economic
surplus to society of the
binding price floor.
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 One Final Application: Output Quotas
Fig. 5-8 The Inefficiency of Output Quotas

• An output quota restricts

output to Q1.
• The shaded area shows
the reduction in overall
economic surplus—the
deadweight loss—created
by the quota system.

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 Learning Activity
• Elasticity
• Work with your teams to identify three of the products each
one of you is consuming.
• Identify those products that you use the most.
• By discussing identify what you think their price elasticity of
demand is and what this means for your consumption.
• Are there any substitutes?
• Take notes and write all these on a piece of paper with your
names that you then need to submit to your instructor.

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