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SizeofChangesinMarketEquilibrium

Whatdeterminesthesizeofchangesinmarket

equilibrium?

ELASTICITY Sizeofchangeindemand(orsupply)

Thelargertheshiftindemand(orsupply),thelargertheeffect

onprice

Steepnessofthecurvethatdoesnotshift

Ifthesupplycurveshifts,thesteeperthedemandcurvethe

morethepricechangesandthelesstheamountboughtand

soldchanges

Steepnessreflectsresponsivenesstoprices

2-2

ChangesinEquilibriumforTwoExtremeSupplyCurves

ChangesinEquilibriumforTwoExtremeDemandCurves

2-3 2-4

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Steepnessofthedemandcurve

ElasticitiesofDemandandSupply

Ameasureoftheresponsivenessoftheamounts

P

demandedandsuppliedtochangesinprices

S Notthesameastheslopeofthesupplyordemand

S

curve

Slopeofthecurvedependsontheunitsusedto

measurethequantityofthegoodanditsprice

Elasticitydoesnotdependonunits(e.g.,gallons,

dozens,dollarsperpound)

Q

D2 D1

2-6

Elasticity Elasticity

Demand curves can come in different

shapes We know that quantity demanded depends on many

things

From very flat to very steep So we can ask a more general question.

Very flat demand curve: a small change in How sensitive is demand to change in any of the

price has a large effect on quantity relevant factors:

demanded - Own price

Very steep curve: even a large change in - Income

price does not affect quantity demanded too - Related prices

much - Etc.

Question: how sensitive is quantity

demanded to price changes?

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Elasticities

Two situations:

Consider the market demand for a commodity, q

Situation 1 2

Let it depend on a factor y (which might be its own

price, or the price of a related good, or income). Quantity q1 q2

y is defined as:

a 1% change in y. y = y2 y1

It is the percentage change in q divided by the

percentage change in y.

elasticity measure will always be a unit-free pure Therefore elasticity of quantity demanded

number. can be with respect to:

Elasticity of q with respect to y - own price (price-elasticity of

demand)

q y

=[ ----x100] divided by [----x100]

q y - any other price (cross price-

elasticity)

= ----x----

We will spend some time on the concept of

y q the price-elasticity of demand

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move in opposite directions, so that the elasticity p1 = Rs.10 p2 = Rs.9.00

value is negative. q1 = 100 q2 = 105

To avoid this problem, we consider the absolute

Consider finite changes in prices and quantity:

value of the elasticity.

q p e = - [q/p]x[p/q],

e = - ----x---- = - (p/q)x(q/p).

p q q = q2 - q1 = 5

p = p2 - p1 = -1

1.Pointelasticitymeasures. 2.Arcelasticitymeasure.

e = - [q/p]x[p1/q1] To get rid of this ambiguity, take an average of the

= -(-5)x(10/100) = 5/10 = .5 values:

e = - [q/p]x[p2/q2]

q [(p2 + p1)/2]

= -(-5)x(9/105) = 9/21 = 3/7

= .42 e = - ---------------------------

p [(q2 + q1)/2]

small changes in price -> not much difference

between these two.

For larger changes, the differences become = - [q/p][(p2 + p1)/(q2 + q1)]

substantial.

= 5(19/205) = .46.

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P AStraightLineDemandCurve

Consider the straight-line

demand curve AB. What is e

A at the point C? Then price-elasticity at a point C on the demand

curve = (EB/CE)(CE/OE) = EB/OE

Note: [q/p] = EB/CE, = (BC/CA)

D C

p = CE, q = OE (by property of similar triangles).

O E Q

PriceElasticityRegionsalong

aStraightLineDemandCurve If the percentage change in q > the

Observation percentage change in p, then e > 1, and

Price elasticity varies at we have elastic demand.

every point along a straight-

line demand curve

1 percentage change in p, e = 1 and we say

that demand is unit elastic.

Price

a/2 1

If the percentage change in q < the

percentage change in p, so that e < 1,

b/2 b demand is said to be inelastic.

Quantity

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PriceElasticityandthe

PriceElasticityandthe

SteepnessoftheDemandCurve

SteepnessoftheDemandCurve

What is the price elasticity of

demand when P = Rs.4?

12 12 Observation

If two demand curves have a

D1 4 1 1

D1 point in common, the steeper

4 12 2 curve must be less elastic with

6 D1

respect to price at that point

6 6

Price

Price

4 1

D2

4

4 2

4 6

D2 12 D2

4 6 12 4 6 12

Quantity Quantity

Priceelasticity Threespecialcases

If (inverse) demand curve is a horizontal straight line

Supposethatwehaveadifferentiabledemandfunction parallel to the quantity axis, then the price-elasticity

Q=Q(P). measure goes to infinity.

Thenelasticityatapoint(P*,Q*)onthedemand - demand is perfectly elastic.

curveis

E=(dQ/dP)(P*/Q*) If the (inverse) demand curve is a vertical straight line,

wheredQ/dPisevaluatedat(P*,Q*) then e = 0 and demand is said to be perfectly

Example:LetQ = p-a inelastic.

Then dQ/dP = (-a) p-a-1

E=[(-a) p-a-1][p/p-a] = a (independent of the point on An example of a demand curve that is iso-elastic (has

the demand curve) the same elasticity everywhere) is q = p-a.

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P P

D

D D

Basic needs, minimum

requirements, absolute

necessities.

0 Q 0 D Q

Rangeofelasticities

0_______________1________________+

PerfectlyUnitPerfectly

InelasticElasticityElastic

DemandDemand

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Factors affecting price elasticity:

1. Availability of substitutes

Larger the availability of close substitutes, the more

elastic will demand be. 4. Time period of adjustment-flexibility over the

long run

2. Demand will be more elastic when buyers of the Larger the time period, the higher the elasticity of

product regard it as a discretionary purchase rather demand.

than as a necessity Suppose petrol prices go up

Short run demand falls somewhat because

3. If buyers are wealthy and the item accounts for a motorists drive less

very small part of the total expenditure, then In the long run, people switch to smaller,

demand will be less elastic more fuel-efficient cars quantity demanded of

petrol goes down by a larger amount

Salt 0.1

Matches 0.1

Airline travel, short-run 0.1 Whatdoyouthink?

Petrol, short-run 0.2

Willincreasingthemarketpricealwaysincrease

Tobacco products, short-run 0.45

totalrevenue?

Residential natural gas, long-run 0.5

Physician services 0.6

Movies 0.9 Application:

Housing, owner occupied, long-run 1.2 Could reducing the supply of illegal drugs

Restaurant meals 2.3 cause an increase in drug-related burglaries?

Airline travel, long-run 2.4

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Patrols on the Market for Illicit Drugs revenue

Total Expenditure = P x Q

S Rs.2500 = Rs.50 x 50

TR = pq

S Rs.3200 = Rs.80 x 40

dTR = d(pq) = pdq + qdp

S = qdp(1 e)

80

Consider what happens if price is lowered, so that

P(Rs./ounce)

S

50 dp < 0.

D

40 50 dTR = 0 if 1 = e

Q(1,000s of ounces/day)

dTR < 0 if e < 1

The cross-price elasticity of the commodity x with

respect to the price p of y is defined as

em = (q/M)(M/q)

exy = (x/p)(p/x)

In the case of a normal good, em > 0, while for an

inferior good, it is < 0.

If this is positive, x and y are said to be substitutes

(Coke and Pepsi), while if this is negative, the

If 0 < em < 1, then the good is called a necessity,

commodities are said to be complements (tea and

otherwise it is a luxury. sugar).

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CalculatingthePrice

ElasticityofSupplyGraphically

Price Elasticity of Supply

Suppose that q now refers to quantity supplied. A 4 1212 4 1 S

the price p is defined as 5

P

es = (q/p)(p/q)

A

4

Q

Price

Since supply curves are upward-sloping, this B 5 15 15 5 1

expression will be non-negative no need to put a

negative sign in front of the expression

0 12 15

Quantity

the price elasticity of supply will vary from point Application - Farming

to point.

Supposethatuniversityagronomistsdiscoveranew

For example : P = 10 + 2Qs wheathybridthatismoreproductivethanexisting

varieties.

Two points on the line are (Qs = 1, P = 12, and Whathappenstowheatfarmers?

Qs = 2, P = 14) Thediscoveryofthenewwheathybridaffectsthe

supplycurve itshiftstotheright.

Show that the price elasticities at these two Thedemandcurveremainsthesame

points are different.

10

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What happens to the total revenue received by the

Price of wheat

D farmers?

S

S Q rises but P falls

The demand for basic foodstuffs such as wheat is

usually inelastic, for these items are relatively

inexpensive and have few good substitutes

Hence fall in P is substantial while rise in Q is small

S Revenue to all wheat farmers taken together falls

S D

Quantity of wheat

Certain agricultural programs try to help farmers by

If farmers are made worse off by the discovery of inducing them not to plant crops on all their land

the new hybrid, why do they adopt it? The purpose is to reduce the supply of farm products

Each farmer is a small part of the market and thereby raise prices

For any price, it makes sense for each farmer to With inelastic demand, farmers as a whole receive

greater revenue

adopt the hybrid

No single farmer, by himself, would have found it

But when they all do it, the supply curve shifts and profitable to leave some land fallow

together, they are worse off

11

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Wheatexportallowedtofreestoragespace

PriceSupport 3July2012

Anotherwayforthegovernmenttohelpthefarmersis

byhavingasupportprice,atwhichpricethe

governmentstandspreparedtobuyanyamount Facedwithaseverespaceconstraintinthecountrys

suppliedbythefarmers overflowinggranaries,thegovernmenttodaycleared

Overtime,thismayleadtothegrowthofbuffer exportoftwomilliontonsofwheatfromitsbuffer

stockthatisexpectedtoclearstoragespacefornew

stocks

crops.

Willperishifjuststockpiled

Somecanbeusedforemploymentgeneration ThiswasapprovedbytheCabinetCommitteeon

programmes,ormeetingfoodrequirementsinalean EconomicAffairs.Informedsourcessaidafterthe

year CCEA meetingthatexportwithafloorpriceof$228

(aboutRs12,400)perton.

Whattodowiththerest?

Atpresent,thegovernmentisgrapplingwiththe

problemofstoragecapacity. TAXES

India,theworldssecondlargestproducerofwheat,

hadharvestedarecord90.23milliontonsin201112 Governmentslevytaxestoraiserevenuefor

cropyear(JulyJune),leadingtoarecordprocurement publicprojects,topayforwagesandsalaries

ofnearly38milliontonssofarthisyear. inthepublicsector,topayinterestondebt,

Itsgodowns areoverflowingwitharecord82million etc..

tonsofriceandwheatagainstthestoringcapacityof

only64milliontons.

Theexportoftwomilliontonswouldinvolveanoutgo

ofRs 1,263crore.

12

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Taxes Taxes

Aspecifictax isafixedrupeeamountthat Instudyingtheeffectsoftaxesitsimportant

mustbepaidoneachunitboughtorpaid todistinguishbetweentheamounta

Anadvaloremtax isataxthatisstatedas consumerpaysforagoodandtheamounta

apercentageofthegoodsprice firmreceives

Theincidenceofataxindicateshow UsePb fortheamountaconsumerpays,Ps

muchofthetaxburdenisbornebyvarious fortheamountafirmreceives

marketparticipants IfthetaxisTperunit,thenPs =Pb T

15-49

TheBurdenofaTax EffectsofaSpecificTax

ConsidertheeffectofaspecifictaxofTrupeesper

literpaidbygasstationsontheirsalesofgasoline Shiftingthesupplycurveisonewayto

Graphically,therearethreewaystodeterminethe determineaspecifictaxseffects

taxseffect:

ShiftthesupplycurveupbyT Demandcurveremainsunchanged

ShiftthedemandcurvedownbyT Foranypricepaidbyconsumers,firms

Useawedgebetweentheamountsconsumers nowreceivelessthanwhenthereisnotax

payandfirmsreceive Wontbewillingtosupplyasmuchas

Allthreemethodsyieldthesameresults before

Makesnodifferencewhetherthetaxisleviedon SupplycurvewiththetaxisadistanceT

consumersorproducers

abovetheoriginalsupplycurve

15-51 15-52

13

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EffectsofaSpecificTax ShiftingtheSupply

EffectsofaSpecificTax Curve

Newequilibriumpricepaidby ST

consumersispriceatwhichthe Increase in S

per Gallon Po + T

B

cross Pb T

Amountboughtandsoldfalls Po

Ps = Pb - T

A

Pricepaidbyconsumersrises;price Decrease in

Firms Receipts

receivedbyfirmsfalls per Gallon

D

Inacompetitivemarkettheburdenofa QT Qo

taxissharedbyconsumersandfirms Gallons of Gas per Month

15-54

Cases

Incidenceofataxdependsontheshapesofthe

demandandsupplycurves

Ingeneral,themoreelasticisdemandandless

elasticissupply,themoreofthetaxisborneby

firms

Firmscannotpassonthetaxtotheconsumers

becausethelatteraresensitivetopricechanges

Consumersbearthelargershareofthetax

whendemandislesselasticthansupply

15-55 15-56

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EffectsofaSpecificTax Shiftingthe

DemandCurve

Lineardemandandsupply

LetQd =a bpb

andQs =c+dps

Also,ps=pb t

Equilibriumrequires

a bpb=c+dps

Thena

b(ps+t)=c+dps

Solvingfortheequilibriumpriceps*,weget

ps*=(a c bt)/(d+b)

15-57

15

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