BEMPC 311 MANAGERIAL ECONOMICS

MODULE 3: ANALYSIS OF THE THEORY OF

DEMAND, SUPPLY, AND MARKETS
TOPIC 4: APPLICATIONS

One of the main purposes of teaching the demand and supply model in a principles class is
that the model is extremely powerful in predicting how markets work. This sections gives two of the
many possible examples of how the model is useful in analyzing market outcomes. Considered below
is the impact of a particular type of governmental market intervention, known as price controls. Price
controls refer to the government attempting to control the market price through legal intervention in
the market. Two different types of price controls, price floors and price ceilings, are defined and
analyzed separately.

PRICE CEILINGS

 Definition

A price ceiling is a maximum legal price. The name is descriptive of the effect of a maximum
legal price. Similar to a ceiling, the market price can be below the ceiling, but not above it. There
are a number of examples of price ceilings. One example is rent controlled housing. A number of
jurisdictions, usually urban areas, impose a price ceiling, often called rent controls, on housing in
an attempt to reduce the prices consumers pay for housing.

 What is an effective price ceiling?

An effective price ceiling is one that, when enforced, will cause the market to move away from
the equilibrium.

Which of all the possible ceiling prices are

effective and which ineffective? Graph 9
shows the normal, free-market equilibrium
where quantity demanded equals quantity
supplied, at a price of PE and a quantity of
QE. It also shows two other prices, one
higher than the equilibrium price (P2) and
one lower (P1).

Figure 2.19: Price Ceiling

 Which of these two prices, or both, would be effective price ceilings? The answer to this question
depends upon a clear understanding of the definitions of both an effective price ceiling and a
price ceiling itself. Recall that a price ceiling is a maximum legal price. Hence, the actual market
price can be below but not above a ceiling price. An effective price is one that when enforced
will move the market away from the equilibrium. Put together, these two concepts mean that only
ceiling prices set below the equilibrium, such as P1 in Figure 2.19, will be effective.

Ceiling prices below the equilibrium price are effective while those above are ineffective because
the market in the absence of some intervening factor will always attempt to be at the equilibrium
price. However, a ceiling price set above the equilibrium, such as at P 2, still allows the market to
be at the equilibrium. On the other hand, at P 1, even though the market attempts to be at the
higher equilibrium price of PE, the enforced ceiling price will not allow this.

 Equilibrium

Now consider the impact of only effective price ceilings. That is, consider only the impact of
ceiling prices that are set below the equilibrium price. There are three possible outcomes, all of
which are discussed in more detail below. Either the market will (1) make no change and remain
at the original equilibrium or (2) the price of the good will decrease but a shortage of the good
will develop or (3) the price of the good will actually increase.

 Enforceable price ceilings?

Which of the above three outcomes occurs depends crucially upon whether or not the
government can actually enforce the ceiling price. This is not a trivial question, either. Clearly,
the actors in the market will have an incentive to attempt to avoid the regulation and return to the
equilibrium, just as happens when the market is not in equilibrium for other reasons. For
example, one way to get around rent control laws for housing is to pay what is commonly known
as “key money.” That is a payment upfront to have the keys in an apartment changed when
changing renters. However, if the key money is substantial, then this is clearly an attempt to
avoid the price ceiling.

Thus, the analysis of the impact of the price ceiling depends crucially upon whether or not the
price ceiling can be enforced.

1. Price is Enforced
If the ceiling price equals P1 as shown by Graph 9, then the result is straightforward. At this
price in the graph, then a shortage occurs, with quantity demanded equaling Q 2 and quantity
supplied equaling Q1. While the price does fall to the ceiling price, some consumers are not
able to buy the good. That is true even of some consumers who previously were able to buy
the good at the equilibrium.

2. Ceiling Price is Not Enforced

There are actually two possible outcomes if the price ceiling cannot be enforced. In this
case, someone is being paid a price in excess of the ceiling price for the product. The
outcome depends crucially upon who gets that extra money.

a. If the extra money simply goes to the firm producing the good, then they respond as do
all firms when receiving a higher price. They increase their quantity supplied.
Likewise, consumers respond to the higher price by reducing their quantity demanded.
As a result, the market simply moves back to the original equilibrium. (Note: the
 market might not go back all the way to the original equilibrium if the cost of avoiding
the price ceiling is substantial. In that case, the equilibrium quantity will be lower.)

b. If the extra money does not go to the firm producing the good but, instead ends up
going to some third party, then quite a different outcome results. Why might this even
be a possibility? This commonly occurs because it is easier for the government to
enforce the ceiling price upon the original producers but it cannot enforce the ceiling
price on people who buy and then resell the product. This is the classic formation of a
black market.

What happens in a black market? First, because the producing firms are not receiving a
higher price, they do not change their behavior. They continue to produce at the same
level, Q1, in Figure 2.19. Hence, the crucial question is how will consumers react to the
formation of the black market. Recall that they are generally now buying the product,
not from the firm at a price of P1 but from the black marketeers.

The black marketeers will attempt to resell the good at the highest price they can in the
market. How high will consumers be willing to pay in order to ensure that they receive
the limited quantity available? The relationship between quantity and price for
consumers is given by the demand curve. Hence, when the quantity available equals
Q1, then the price in the market will equal P 2. This is commonly known as the black
market price.

• Does the Price Ceiling Improve the Position of Consumers?

The normal justification for the imposition of price ceilings is to improve the welfare of
consumers in a market where prices are considered too high by some subjective standard. Thus, it
is crucial to ask as part of our analysis, how well do price ceilings achieve their stated goal?

The results are actually not encouraging, as an examination of the results above clearly indicate.
Consider each of the three possible outcomes:

1. When the ceiling price is enforced, the price does fall in the market to whatever price is set
by the government. However, a shortage occurs in the market so that some consumers are
unable to buy at this lower price. Hence, some consumers will be better off, those who can
buy the good at the lower price. However, other consumers will be worse off, those who
cannot buy the good at all but would have at the higher price.

2. When the ceiling price is not enforced and the illegal higher price is paid to the firms
producing the good, the market does not change with the regulation. As a result, the price
ceiling does not advantage consumers. In fact, consumers may be worse off if avoiding
enforcement, as is likely, is costly to them. Furthermore, the government will be wasting
some resources in passing and attempting to enforce the regulation. Hence, there exists no
possibility of a consumer advantage and significant possibility of substantial costs.

3. When the ceiling price is not enforced and a black market forms, consumers actually end up
paying a higher price and also buy a lower quantity. For both reasons, they are worse off as
a result of the price ceiling.

PRICE FLOORS

 Definition
 A price floor is a minimum legal price. The name is descriptive of the effect of a minimum legal
price. Similar to an actual floor, the market price can be above the floor, but not below it.
Examples of price floors include the national minimum wage in the U.S. and price floors
imposed for a number of agricultural products.

 What is an effective price floor?

An effective price floor is one that, when enforced, will cause the market to move away from the
equilibrium. Which of all the possible floor prices are effective and which ineffective? In Figure
2.20, the equilibrium in the absence of any price controls will be at P E and QE. The graph also
shows a price above (P2) and one below (P1) the equilibrium price.

Which of these two prices, or both, would be

effective price floors? Again, to understand this
point, one must clearly understand the definitions
of both a price floor and of an effective price floor.
Because a price floor is a minimum legal price, the
actual price can be above, but not below, a given
price floor. Likewise, because an effective price
floor is one that forces the market away from the
actual equilibrium only prices above the
equilibrium price, such as P2 in the graph, will be
effective. If the price floor were set below the
equilibrium price, at P1 in the graph, then the
market legally can and would still choose the
equilibrium price.

Figure 2.19: Price Ceiling

 Equilibrium

Next consider only the impact of effective price floors, those that are set above the equilibrium
price. In the case of price floors, there are only two possible outcomes. Either the market will (1)
make no change and remain at the original equilibrium or (2) the price will increase but a surplus
of the good will also result.

 Enforceable Price Floors?

Which outcome will actually occur, similar to the analysis for price ceilings, depends crucially
upon whether or not the price floor can actually be enforced. Again, the actors in the market have
an incentive to avoid the floor and return to the equilibrium.

1. Floor Price is Not Enforced

If the floor price is not enforced, then there exists only one possible outcome. At the floor
price a surplus would exist so price competition by firms would force the price back to the
equilibrium, at a price of PE and a quantity of QE. Similar to the same situation for price
ceilings, there would potentially exist significant costs to the unenforceable floor price as
firms attempt to avoid the regulation.

2. Floor Price is Enforced

The situation that results is quite different if the floor price is enforced. In that case, at a
floor price of P2, then quantity demanded would only equal Q 1 while quantity supplied
would equal Q2. Hence, a surplus would occur with firms unable to sell all that they wish to
at the higher price.
 Supporting an effective price floor

Price floors are usually intended to advantage firms or, in the case of minimum wage laws,
individuals who supply labor. However, as we’ve seen above they do not necessarily work as
planned. Either they have no impact on the market, even though imposing substantial
enforcement costs, or they do increase the price while causing a surplus. In the latter case, only
those firms who can sell their product will be better off. Other firms will be worse off and may
even be forced out of business.

As a result, the government often enacts programs, known as price supports, in order to alleviate
these problems. These programs tend to involve some type of government subsidy.

1. Government subsidies
A government subsidy is when the government either pays for part of the higher price for
the good, or more commonly, buys up the extra surplus at the floor price. Such subsidies are
often called price supports because they are enacted in order to keep the price at the higher
level. For example, price support programs are common in agricultural industries where
products have price floors imposed.

What does the government do with the product that it buys up in the subsidy program?
Often, they will use the good as part of a welfare program to support poor people, perhaps
giving the good away to welfare recipients or other qualifying individuals.

• What is the effect if the price floor is not subsidized?

In this instance the surplus persists and eventually some firms will go out of business. But the
cycle will not stop there. The higher price of the good and resultant higher profits for surviving
firms will induce other firms to enter the industry, which will cause another surplus. As a result,
more firms will go out of business. This cycle could possibly continue indefinitely.

Another important point is to carefully examine the impact on other markets. Consider for
example the impact of minimum wage legislation. Suppose the minimum wage is increased,
Then the effect will be dependent upon which workers are considered. Higher skilled workers
have higher wages and, hence, are not affected by the change because the price floor is not
effective for them. It is only the lower skilled and wage workers who are affected directly. The
impact is as discussed above for these unskilled workers.

However, skilled workers are indirectly impacted by the minimum wage in the following
manner. As the wage increases for unskilled workers, they become less desirable to firms, who
reduce their employment. For skilled workers, especially those who are close substitutes for the
unskilled workers, employment increases as a result. That is, firms’ demand increases for those
skilled workers who are substitutable for the lower paid unskilled workers. As demand increases
(shifts right) this will increase both employment and wages, not for the lower skilled workers, but
for skilled workers. Thus, even though the minimum wage is unlikely to help unskilled workers,
ultimately causing unemployment for unskilled workers, it will advantage skilled workers. Of
course, the regulation is not originally intended (or is it?) to advantage skilled workers.

TOPIC 5: ELASTICITY
We now extend the concept of demand and supply by learning further about the relationship
between price and quantity (demanded and supplied). The concept of elasticity is very important
because it tells us how consumers can be sensitive (or not) to changes in price.
DEMAND AND ELASTICITY

Law of Demand states that, ceteris paribus (all else equal), as price falls, the quantity
demanded rises (& vice versa). But HOW MUCH does quantity demanded change in response to a
change in P (or is the change in QD small or large)? (which the law of demand cannot answer). The
responsiveness of quantity demanded can be measured in two ways:

1. Describe responsiveness to price changes in terms of the steepness (or slope) of the demand
curve.

Problem with this measure: depends on the units we are using to measure both the amount of the
good its price

For example: The demand curve for milk has a slope of –200 (two cases can show that slope may
be confusing to use as a measure of how sensitive/responsive Qd is with respect to a price
change, i.e., peso/dollar change)

Interpretation:
a. If Qd is in quarts: When the price of milk rises by a dollar, 200 fewer quarts of milk are sold.
b. If Qd is in gallons: When the price of milk rises by a dollar, 200 fewer quarts of milk are
sold.

From the above example, is Qd of milk more sensitive/responsive to a dollar change when it is in
quarts or in gallons?

2. Elasticity gives a better measure of responsiveness. Why? Because elasticities are “unit-free”
measures.

Elasticity – a measure of how sensitive or responsive a dependent variable is with respect to a

change in the independent variable

%∆ Y
Elasticity ℇ=
%∆ X

Where: Y = a dependent variable; X = an independent variable

 Demand Elasticities

(1) Price Elasticity of Demand

- A measure of how sensitive or responsive Qd is with respect to a 1% change in the P of a
good
- (But still keeping in mind that P and Qd are negatively related, i.e., Law of demand still
holds.)

Calculation

% ∆ Qd
ℇd =
%∆P

A numerical value derived is a coefficient; a pure # which is expressed in %.

How to derive %∆ ’s:

 Q2−Q1 Q2−Q1
Q1 Q2
1. ℇd= or ℇd=
P2−P1 P2−P1
P1 P2

The problem with this formula is that it can possibly use 2 values as a denominator
(base) for taking %∆ ’s and thus result to two possible values of price elasticity (one can
be a lesser value, the other a greater value; or 2 values can have a different elasticity
interpretation with regards to how Qd respond to P changes).

2. Mid-point Arc Elasticity Formula

To address the problem with the above-formula, a so-called mid-point arc elasticity
formula was devised, so as not to eliminate any of the values of Qd and P in calculating
the price elasticity of demand coefficient.

Q2−Q1
Average of
Q 1+ Q 2 2 quantities
2
ℇd=
P 2−P1 Average of
P 1+ P 2 2 prices

3. Alternative Formula: Point-Price Elasticity Formula

Coming from previous formula (#1):

Q2−Q1
Q1 Q2−Q1 P1 Q2−Q1 P1
ℇd= ℇd= X ℇd= X
P2−P1 Q1 P 2−P1 Q1 P 2−P1
P1
by cross-multiplying
Q −Q1 P1
ℇd= 2 X ratio of a price & quantity combination
P 2−P1 Q 1

Slope (of linear demand function: quantity function)

This formula is used to determine the price elasticity at a certain point on a demand
curve.

Illustration:

Data: Price (x) Quantity (y) Point

100 50 A
90 60 B

1. Using first formula:

 Q2−Q1 60−50
Q1 50 10/50 0.2
ℇd= ℇd= ℇd= = ℇ =−2=|2|
P2−P1 90−100 −10/100 −0.1 d
P1 100

Interpretation: For every 1% change (increase or decrease) in P, Qd changes (decrease,

increase) by 2%.

Or:

Q2−Q1 60−50
Q2 60 10/ 60 0.17
ℇd= ℇd = ℇd= = ℇ d =−1.5=|1.5|
P2−P1 90−100 −10/90 −0.11
P2 90

Interpretation: For every 1% change (increase or decrease) in P, Qd changes (decrease,

increase) by 1.5%.

We see a difference of values of the calculated estimated coefficients and these matters
because they have different interpretations (one indicates that Qd is more responsive (2)
than the other (1.5)).

Also, the elasticity from point A to point B seems different from the elasticity from
point B to point A. Getting from A to point B, the elasticity coefficient is |2| (0.2/0.1).
By contrast, going from point B to point A, the elasticity coefficient is |1.45|
(0.17/0.11). This difference arises because the percentage changes are calculated from a
different base. (To avoid this problem is to use the mid-point method for calculating
elasticities.)

2. Mid-point Arc Elasticity Formula

Q2−Q1 60−50
Q 1+ Q 2 50+60 10
2 2 55 0.18
ℇd= ℇd= ℇd = =
P 2−P1 90−100 −10 0.11
P 1+ P 2 100+90 95
2 2
ℇ d =−1.73=|1.73|

Interpretation: For every 1% change (increase or decrease) in P, Qd changes (decrease,

increase) by 1.73%.

Note: The price elasticity of demand coefficients are applicable and true only to the
given price and quantity combinations. If there are other price-quantity combinations,
expect a different value of the price elasticity coefficients.

3. Point-Price Elasticity Formula

Determine the demand function:

 60−50 10
Q−50= (P−100) Q−50= ( P−100 ) Q=−P+150
90−100 −10

(or P = 150 – Q)

Set up a Demand schedule:

Slope = –1
Table 1: Demand Schedule for Q=−P+ 150
P Qd Applying the elasticity formula ℇd
150 0 ℇ d =−1 x ¿ α
140 10 ℇ d =−1 x ¿ |14|
130 20 ℇ d =−1 x ¿ |6.5|
120 30 ℇ d =−1 x ¿ |4|
110 40 ℇ d =−1 x ¿ |2.75|
100 50 ℇ d =−1 x ¿ |2|
90 60 ℇ d =−1 x ¿ |1.5|
80 70 ℇ d =−1 x ¿ |1.14|
75 75 ℇ d =−1 x ¿ |1|
70 80 ℇ d =−1 x ¿ |0.88|
60 90 ℇ d =−1 x ¿ |0.67|
50 100 ℇ d =−1 x ¿ |0.5|
40 110 ℇ d =−1 x ¿ |0.36|
30 120 ℇ d =−1 x ¿ |0.25|
20 130 ℇ d =−1 x ¿ |0.15|
10 140 ℇ d =−1 x ¿ |0.07|
0 150 ℇ d =−1 x ¿ 0

Note: Price elasticity coefficients vary along the demand curve (while the slope is
constant).

Type of Price Elasticity of Demand

A more meaningful interpretation of the price elasticity of demand coefficient is given by

the type of elasticity (the above interpretation is only a technical interpretation, more
importantly is the type of elasticity).

Table 2: Price Elasticity of Demand Types

Type Description Coefficient*
% ∆ in Qd > % ∆ in P ℇd> 1
1. Elastic
(Qd is responsive/sensitive to P)
% ∆ in Qd = % ∆ in P ℇ d =1
2. Unitary Elastic
(Qd is neither responsive nor insensitive to P)
% ∆ in Qd > % ∆ in P ℇd< 1
3. Inelastic
(Qd is less responsive/sensitive to P)
*In absolute value

Example:

10/50 0.2
1. ℇd= = ℇ =−2=|2| Demand for the good is Elastic
−10/100 −0.1 d
 10
55 0.18
2. ℇd= = ℇ d =−1.73=|1.73| Demand for the good is Elastic
−10 0.11
95

Other (Extreme) Cases of Price Elasticity of Demand

Table 3: Extreme Cases of ℇ d

Type Description Coefficient*
At a certain P, Qd can take on different values; a
Perfectly Elastic slight decrease in P, Qd can infinitely vary, but a ℇ d =¿∞
slight increase in P, Qd can be zero
Any change in P, Qd does not change (Qd is ℇ d =0
Perfectly Inelastic
unresponsive to changes in P)

Types of Demand Curve According to the Type of Elasticity

Demand curves can also be described according to the type of elasticity:

Table 4: Variety of Demand Curves

Type of Demand Curve Description, Slope &
Curve Elasticity Coefficients
Elastic  Flatter demand curve
 Slope is a low value (but
constant)
 Elasticity coefficients
along the demand curve
are greater than one

Unitary Elastic  Demand curve lies in

between elastic and
inelastic demand curves
 Neither flat nor steep
 Elasticity coefficients
along the demand curve
are equal to one
 Type of Demand Curve Description, Slope &
Curve Elasticity Coefficients
Inelastic  Steep demand curve
 Slope is a high value (but
constant)
 Elasticity coefficients
along the demand curve
are less than one

Perfectly Elastic  Demand curve is a

horizontal line
 Slope is ∞ (demand is
expressed as Q-function)
 At a certain price,
consumers can buy any
quantity

Perfectly Inelastic  Demand curve is a

vertical line
 Slope is zero (demand is
expressed as Q-function)
 Any P change leaves Qd
unchanged

Elasticity Varies Along a Demand Curve

Price elasticity of demand coefficients can vary along a demand curve, i.e., the demand
curve is called a normal, linear demand curve.

Consider this example: Demand function: Q = –P + 150 (or P = –Q + 150)

Table 5: Demand and ℇ d
P Qd Applying the elasticity ℇd Type
formula
150 0 ℇ d =−1 x ¿ α Perfectly elastic
140 10 ℇ d =−1 x ¿ |14|
130 20 ℇ d =−1 x ¿ |6.5|
120 30 ℇ d =−1 x ¿ |4|
110 40 ℇ d =−1 x ¿ |2.75| Elastic
100 50 ℇ d =−1 x ¿ |2|
90 60 ℇ d =−1 x ¿ |1.5|
80 70 ℇ d =−1 x ¿ |1.14|
75 75 ℇ d =−1 x ¿ |1| Unitary elastic
70 80 ℇ d =−1 x ¿ |0.88|
60 90 ℇ d =−1 x ¿ |0.67|
50 100 ℇ d =−1 x ¿ |0.5|
40 110 ℇ d =−1 x ¿ |0.36| Inelastic
30 120 ℇ d =−1 x ¿ |0.25|
20 130 ℇ d =−1 x ¿ |0.15|
10 140 ℇ d =−1 x ¿ |0.07|
0 150 ℇ d =−1 x ¿ 0 Perfectly inelastic

Demand Curve:

Figure 1: Normal Linear Demand Curve

Determinants of Price Elasticity of Demand

What determines elasticity of demand, i.e., what factors influence people to respond greatly
or slightly to price changes? Because the demand reflects the many economic, social, and
psychological forces that shape consumer preferences, there is no simple, universal rule for
what determines the demand curve’s elasticity. Based on experience, however, we can state
some rules-of-thumb about what influences the price elasticity of demand.

a. Availability of Close Substitutes (or more substitutes) - Goods with close substitutes (or
more substitutes) tend to have more elastic demand because it is easier for consumers to
switch from that good to others.

b. Necessities vs. Luxuries - Necessities tend to have inelastic demands, whereas luxuries
have elastic demands.

c. Definition of the Market – The elasticity of demand in any market depends on how we
draw the boundaries of the market. Narrowly defined markets tend to have more elastic
demand than broadly defined markets because it is easier to find close substitutes for
narrowly defined goods. For example, food, a broad category, has a fairly inelastic
demand because there are no good substitutes for food. Ice cream, a narrower category,
has a more elastic demand because it is easy to substitute other desserts for ice cream.
Vanilla ice cream, a very narrow category, has a very elastic demand because other
flavors of ice cream are almost perfect substitutes for vanilla.

d. Time Horizon – Goods tend to have more elastic demand over longer time horizons.
Because over time, consumers are able to adjust to their consumption patterns as more
and more consumers find they have the time and inclination to search for substitutes.
For example, when the price of gasoline rises, the quantity of gasoline demanded falls
only slightly in the first few months. Over time, however, people buy more fuel-efficient
cars, switch to public transportation, and move closer to where they work. Within
several years, the quantity of gasoline demanded falls more substantially.

e. The Proportion of Income Spent on a Good – The greater the proportion of income
spent on a good, the good is more elastic. On the other hand, the smaller proportion of
income spent on a good, the good is inelastic.

Examples of Goods According to the Type of Elasticity

Table 6: Elasticity Type and Examples

Type Examples Factor/s to Elasticity
Elastic Most luxury goods (e.g.,  Expensive (use greater proportion of
jewelries, cars) income to spend on these items)
Accessories  With close and a lot of available
Non-essential clothing substitutes (especially for branded
Branded items (e.g., perfumes, items)
watches)  Lobster is categorized in a narrowly
Appliances defined market, therefore, it is elastic
Lobster in demand
Unitary Elastic Electronics  In general, these goods are unitary
Cigarettes* elastic, as only a certain segment of
Diapers* population utilizes these goods
Inelastic Rice (a staple in the country)  Necessities
Salt  Uses a small proportion of income
Public transportation
Perfectly Elastic Vegetable/fruit vendors located  All vendors have to keep an almost
on street same price to get the demand
 Type Examples Factor/s to Elasticity
Seasonal agricultural produce  For seasonal agricultural produce, we
Market for “trivial” things take the opportunity to buy the product
(e.g., paperclips, erasers, as it is in season (Qd takes varying
printing paper) values, at an average price in the
market)
Perfectly Insulin (for diabetics)  Perfectly inelastic demand for a good
Inelastic Electricity happens when virtually there are no
Land substitutes for the good
 Goods are considered very essential
*Cigarettes can also be considered inelastic by smokers; diapers are inelastic among infants/toddlers

Application: Price Elasticity of Demand and its Relationship to Total Revenue

Total Revenue (TR) – the amount received sellers for selling a product

TR = P X Q (Price times the quantity sold)

Changes in the P of good generally affects the TR received by sellers. But the law of
demand says that as P increases Qd (which is quantity sold) decreases, v-v. But is an
increase in P guarantee sellers an increase in TR? (Or, is a decrease in P also result to a
decrease in TR?)

Summary Relationship of ℇ d and TR

Table 7: ℇ d and TR
Elasticity Change in Price Effect on TR
Elastic Increase Decrease
Decrease Increase
No effect on TR
Unitary Elastic Any change in P
TR is maximum
Increase Increase
Inelastic
Decrease Decrease

Illustration: TR Test

Q = –P + 150 (or P = –Q + 150)

Table 8: TR Test
Graphical illustration:

Consider a decrease in P from P140 to 130:

The demand is elastic in this range. In this case, a decrease in P leads to an increase in Qd
that is proportionately larger, so TR rises from P1,400 to 2,600. From the figure we see that
a decrease in P results to a loss in revenue (given by area A). However, the increase in Qd is
large enough to cause a gain in revenue (area C) that is larger than the loss in revenue:

Change in TR = TR2 – TR1 = 2,600 – 1,400 = 1,200 (increase in TR)

Gain in revenue = area C = 10 x 130 = 1,300

Loss in revenue = area A = 10 x 10 = 100

Gain in revenue (C) – Loss in revenue (A) = 1,300 – 100 = 1,200

Figure 2: Effect a P Decrease on TR: Elastic Demand

Consider a decrease in P from P40 to 30:

The demand is inelastic in this range. In this case, a decrease in P leads to an increase in Qd
that is proportionately smaller, so TR falls from P4,400 to 3,600. From the figure we see
that a decrease in P results to a greater loss in revenue (given by area D). However, the
increase in Qd is small enough to cause a gain in revenue (area C) that is smaller than the
loss in revenue:

Change in TR = TR2 – TR1 = 3,600 – 4,400 = –800 (decrease in TR)

Gain in revenue = area E = 10 x 30 = 300

Loss in revenue = area D = 110 x 10 = 1,100

Gain in revenue (E) – Loss in revenue (D) = 300 – 1,100 = –800

Figure 3: Effect of a P Decrease on TR: Inelastic Demand

Summary Relationship of Demand, ℇ d and TR: Graphical

The graphical illustration presents the relationship between demand curve, price elasticity of
demand and TR. Moving down the demand curve, as P decreases and Qd increases, TR also
rises, and demand is elastic in this region of the demand curve. At mid-point of the demand
curve, demand is unitary elastic, we find that TR is maximum. A further decrease in P and
Qd increases, TR decreases and demand is inelastic in this region of the demand curve.

TR curve is described as parabolic (parabola that opens downward, with maximum point).
TR behavior is initially increasing, reaches a maximum, and eventually decrease (see Figure
4).
 Elastic
Unitary elastic

Inelastic

D-curve

Max! TR

TR-curve

Figure 4: Demand Curve, ℇ d and TR

TR Function:

TR function can be derived directly from the demand function. Let the demand function be
expressed as P-function, and substitute the value of it into the TR equation:

Let demand function be: P = a – bQ

TR = P X Q

TR = a – bQ X Q TR = aQ – bQ2 quadratic function

For example: P = 150 – Q

TR = (150 – Q)Q TR = 150Q – Q2

The slope of the TR function can also be derived. The slope of TR function is called MR or
marginal revenue, i.e., it is the additional revenue received for selling additional output. MR
describes the shape or behavior of the TR curve.

Δ TR
MR= Used when deriving the slope from point to point on a TR curve
ΔQ

MR can also be derived taking the first derivative of the (d)TR-function:

 dTR
TR = aQ – bQ2 MR= =( 1 ) a Q1−1 +(2)(−b)Q2−1
dQ

MR=a−2 bQ MR is a linear equation

The slope of TR curve is a linear function of MR.

For example: TR = 150Q – Q2 quadratic function

MR = 150 – 2Q linear function

Graph:

MR curve

Figure 5: Demand, TR, and MR curves

Table 9: ℇ d , TR and MR
Elasticity & P Change TR MR
Elastic: Price decrease TR increase Positive
Unitary Elastic TR maximum Zero
Inelastic: Price decrease TR decrease Negative

When P decreases and Qd increases, TR increases at the region of elastic demand. Notice
that MR curve (the slope of TR curve) is still positive, but decreasing in value. This means
that TR increases at a decreasing rate. At the mid-point of the demand curve, where price
 elasticity of demand is unitary elastic, MR is equal to 0 (slope is zero at maximum point; see
Figure 5 where MR curve touches x-axis at Qd = 75). When P further decrease (and Qd
increases), TR decreases at the region of inelastic demand. Notice that MR is already below
the x-axis, indicating that MR is negative in values. When MR is negative it means that TR
curve is downward sloping.

Table 10: TR and MR Test

P Qd ℇd TR (P) MR = 150 – 2Q
150 0 α 0 -
140 10 |14| 1,400 130
130 20 |6.5| 2,600 110
120 30 |4| 3,600 90 MR +, but
110 40 |2.75| 4,400 70 decreasing
100 50 |2| 5,000 50
90 60 |1.5| 5,400 30
80 70 |1.14| 5,600 10
75 75 |1| 5,625 0
70 80 |0.88| 5,600 –10
60 90 |0.67| 5,400 –30
50 100 |0.5| 5,000 –50
40 110 |0.36| 4,400 –70 MR –, and
30 120 |0.25| 3,600 –90 increasing
20 130 |0.15| 2,600 –110
10 140 |0.07| 1,400 –130
0 150 0 0 –150

(2) Other Demand Elasticities

In addition to the price elasticity of demand, economists use other elasticities to describe the
behavior of buyers in a market. As there are other factors affecting to demand, we can have
other demand elasticities. Two types are presented here.

 Income Elasticity of Demand

It is a measure of how much the quantity demanded of a good responds to a change in

consumers’ income, computed as the percentage change in quantity demanded divided
by the percentage change in income.

Calculation: (same formula as in price elasticity of demand)

Mid-point Arc Income Elasticity Formula:

Q2−Q1
Q1 +Q2
2
ℇY =
Y 2−Y 1
Y 1 +Y 2
2

where Y: Income (disposable income)

Sign of Income Elasticity Coefficient

 1. ℇ Y = + Good is normal
ℇ Y > 1 Good is a luxury
ℇ Y < 1 Good is a necessity
ℇ
2. Y = – Good is inferior

Example:

Data: Y (Income, P) QdX (in units)

20,000 200
30,000 350

Q2−Q1 350−200
Q1 +Q2 200+350 150
2 2 275 0.54
ℇY = ℇY = ℇY = ℇY = =1.35
Y 2−Y 1 30,000−20,000 10,000 0.4
Y 1 +Y 2 20,000+30,000 25,000
2 2

Interpretation: Since the income elasticity coefficient is positive, then the good under
consideration (X) is a normal good. Further, the coefficient is greater than 1, therefore
good X is a luxury good.

 Cross-Price Elasticity of Demand

It is a measure of how much the quantity demanded of a good responds to a change in

the price of a related good, computed as the percentage change in quantity demanded
divided by the percentage change in the price of a related good.

Calculation:

Mid-point Arc Cross-price Elasticity Formula:

Q2 −Q1
Q 1+Q2
2
ℇY =
PY 2 −P Y 1
P Y 1+ P Y 2
2

where PY: Price of a related good Y

Sign of Cross-price elasticity coefficient

1. ℇ XY = + (or greater than zero), Goods X and Y are substitutes
ℇ XY = + but less than one, Goods X and Y are weak substitutes
ℇ XY = + but greater than one, Goods X and Y are close substitutes
2. ℇ XY = – (or less than zero), Goods X and Y are complements inferior
ℇ XY = –, less than –1, Goods X and Y are weak complements
ℇ XY = –, greater than –1, Goods X and Y are strong complements
3. ℇ XY = 0 Goods X and Y are unrelated
 Note: X = good under consideration; Y = a related good

Example:

Data: PY QdX
P150 575
225 650

Q2−Q1 650−575
Q1 +Q 2 575+ 650 75
2 2 612.5 0.12
ℇ XY = ℇ XY = ℇ XY = ℇY = =0.3
PY 2−PY 1 225−150 75 0.4
P Y 1 + PY 2 150+225 187.5
2 2

Interpretation: Since the cross-price elasticity coefficient is positive, then goods X and
Y are substitutes; also, since the coefficient is less than one, then goods X and Y are
weak substitutes.

SUPPLY AND ELASTICITY

The law of supply states that, ceteris paribus, as price rises quantity supplied rises (& vice
versa). But just like in the law of demand, HOW MUCH does quantity supplied change in response to
a change in P (or is the change in QS small or large)? (which the law of supply cannot answer). The
responsiveness of quantity supplied to a change in price is also best measured in terms of elasticity.

 Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of quantity supplied with respect to a 1%
change in quantity supplied.

Price elasticity of supply is also measured the same way as price elasticity of demand. That is,

% Δ Qs
ℇS=
%∆P

Calculation:

1. Using mid-point arc elasticity formula:

Q2−Q1
Q 1+ Q 2
2
ℇS=
P 2−P1
P 1+ P 2
2

2. Using point-slope elasticity formula: (This is used to measure elasticity at a certain point on
a supply curve.)

Q2−Q1
m=
P2−P1
 P
E S=m x
Qs

Illustration:

1. Data: (p. 207 of textbook) Price (x) Quantity Supplied (y)

100 70
110 90

90−70 Interpretation:
70+90 20 For every 1% increase in
2 80 0.25 price, quantity supplied
E S= = = =2.625 increases by 2.625%
110−100 10 0.09524
100+110 105
2

2. Supply function: Q = 50P + 150

Set up a supply schedule:

Table 4: Supply Schedule

P Qs Applying the elasticity formula ES
0 150 E S=50 x ¿ 0
2 250 E S=50 x ¿ 0.4
4 350 E S=50 x ¿ 0.57
6 450 E S=50 x ¿ 0.67
8 550 E S=50 x ¿ 0.72
10 650 E S=50 x ¿ 0.77
12 750 E S=50 x ¿ 0.8
14 850 E S=50 x ¿ 0.82
16 950 E S=50 x ¿ 0.84
18 1,050 E S=50 x ¿ 0.86
20 1,150 E S=50 x ¿ 0.87
22 1,250 E S=50 x ¿ 0.88

Note: Price elasticity of supply coefficients vary along the supply curve (while the slope is
constant).

 Type of Price Elasticity of Supply

A more meaningful interpretation of the price elasticity of demand coefficient is given by the
type of elasticity (the above interpretation is only a technical interpretation, more importantly is
the type of elasticity).

Table 5: Price Elasticity of Supply Types

Type Description Coefficient
% ∆ in Qs > % ∆ in P E S >1
1. Elastic
(Qs is responsive/sensitive to P)
% ∆ in Qd = % ∆ in P E S=1
2. Unitary Elastic
(Qs is neither responsive nor insensitive to P)
 % ∆ in Qd > % ∆ in P E S <1
3. Inelastic
(Qd is less responsive/sensitive to P)

In the previous example, the price elasticity coefficient computed was 2.625. This means that the
supply for the good under consideration is elastic, i.e., a 1% increase in price leaders to a greater
percentage increase in quantity supplied.

 Other (Extreme) Cases of Price Elasticity of Supply

Two extreme cases of price elasticity of supply can also happen:

Table 6: Extreme Cases of E S

Type Description Coefficient
At a certain P, Qs can take on different values; a
Perfectly Elastic slight decrease in P, Qs can infinitely vary, but a E S=∞
slight increase in P, Qs can be zero
Any change in P, Qs does not change (Qd is E S=0
Perfectly Inelastic
unresponsive to changes in P)

 Types of Supply Curve According to the Type of Elasticity

Supply curves can also be described according to the type of elasticity:

Table 7: Supply Curves

Type of Supply Curve Description, Slope and
Curve Elasticity Coefficients
Elastic  Flatter supply curve
P
 Slope is a low value
(but constant if linear)
 Elasticity coefficients
along the supply curve
are greater than one
Small change in P

· ·
Large change in QS

Type of Supply Curve Description, Slope and

Curve Elasticity Coefficients
Unitary Elastic  Supply curve lies in
P between elastic and
inelastic demand curves
QS  Neither flat nor steep
 Elasticity coefficients
along the supply curve
are equal to one
·
·
Change in P = Change in QS

Inelastic P  Steep supply curve

 Slope is a high value
(but constant if linear)
 Elasticity coefficients
along the supply curve

·
are less than one

Large change in P
·
Small change in QS
QS

Perfectly Elastic  Supply curve is a

P
horizontal line
 Slope is infinity
(demand is expressed as
Q-function)
 At a certain price,
suppliers can sell any
quantity in the market

Type of Supply Curve Description, Slope and

Curve Elasticity Coefficients
 Perfectly Inelastic  Supply curve is a
P
vertical line
 Slope is zero (supply is
expressed as Q-
function)
 Any P change leaves
Qs unchanged

 Determinants of Price Elasticity of Supply

What makes QS respond more or less to changes in P? Like price elasticity of demand, price
elasticity of supply is also dependent on many factors. Some of these factors are within the
control of the organization, whereas others may be beyond their control.

1. Capacity Addition. most manufactured goods today are mass produced in massive factories
and most of these factories are working to their optimum levels. Hence, if supply has to be
increased new capacity needs to be added i.e. new factories need to be built. his obviously
means that supply will remain stagnant for a while when capacity is stagnant and may then
increase by leaps and bounds when additional capacity is introduced. This is an important
determinant of elasticity of supply. Products where capacity can be easily added and
reduced have an elastic supply whereas products where it is difficult to increase or decrease
capacity have inelastic demand.

2. Related Infrastructure Growth. Industry is usually an interconnected supply chain. If one

part of the supply chain grows, whereas the rest of the supply chain remains stagnant, the
growth will be lopsided. This affects the elasticity of supply as well. Consider the case of
agriculture. Let’s assume that farmers have got hold of a revolutionary technique with which
they can increase productivity two fold. However, more production would mean more
warehouses, more cold storages and even more transport vehicles. If this related
infrastructure does not grow, producers may have to willfully cut down their production to
avoid wastage. So, if the related infrastructure is easily scalable, then the supply of such a
product will be highly elastic or else it will be inelastic.

3. Perishable vs. Non-Perishable. Storage capacity is not the only issue. The supplier also
needs to consider whether or not the goods that they hold are perishable or not. Perishable
goods have a limited shelf life and the buyers know it. The buyers can wait for some time
and producers will have to lower the prices or take the losses that arise from wastage. The
supply of perishable goods is therefore highly elastic since whatever has been produced has
to be disposed off at the earliest. However, when it comes to non-perishable goods it has
been observed that the supply is usually inelastic since producers can hold on for as long as
they have to. They are under no immediate compulsion to sell and hence the supply is
inelastic.

4. Length of Production Period. The law of supply assumes that changes in price will produce
an immediate effect in the quantity supplied. This may be theoretically correct. However,
this is not possible in reality for many products. Production is a time and resource
consuming process. Hence, it cannot be scaled up or down with that much ease. In many
cases, the time required for production stretches to many months or even years. Hence, there
is a lagging effect on supply. This is another important determinant of the elasticity of
 supply. Products whose production times take longer have relatively inelastic supply
compared to those products where the production time is less.

5. Time: Long Run vs. Short Run. In the short run, the supply of all products is more or less
inelastic. This is because there are many factors which producers cannot vary in the short
run. However, in the long run, all the factors are variable and hence the supply of all
products is completely elastic. Hence companies must be careful while making capital
decisions.

 Examples of Price Elasticity of Supply

Table 8: Examples of
Type Example
Elastic Manufactured or industrial products (short run); baked
products; fast-food/restaurant meals
Inelastic Products produced by heavy industries (e.g.,
automobiles)
Perfectly Elastic Seasonal agricultural products
Perfectly Inelastic Land; health care provided by government

TOPIC 6: APPLICATION: EFFECT OF SALES TAX

When a good is taxed, buyers and sellers of the good share the burden of the tax. But how
exactly is the tax burden divided? Only rarely will it be shared equally. To see how the burden is
divided, consider the impact of taxation in the two markets in Figure 1. In both cases, the figure shows
the initial demand curve, the initial supply curve, and a tax that drives a wedge between the amount
paid by buyers and the amount received by sellers. The difference in the two panels is the relative
elasticity of supply and demand.
 Figure 1: How the Burden of a Tax is Divided

Panel (a) of Figure 1 shows a tax in a market with very elastic supply and relatively inelastic
demand. That is, sellers are very responsive to changes in the price of the good (so the supply curve is
relatively flat), whereas buyers are not very responsive (so the demand curve is relatively steep).
When a tax is imposed on a market with these elasticities, the price received by sellers does not fall
much, so sellers bear only a small burden. By contrast, the price paid by buyers rises substantially,
indicating that buyers bear most of the burden of the tax.

Panel (b) of Figure 1 shows a tax in a market with relatively inelastic supply and very elastic
demand. In this case, sellers are not very responsive to changes in the price (so the supply curve is
steeper), whereas buyers are very responsive (so the demand curve is flatter). The figure shows that
when a tax is imposed, the price paid by buyers does not rise much, but the price received by sellers
falls substantially. Thus, sellers bear most of the burden of the tax.

The two panels of Figure 1 show a general lesson about how the burden of a tax is divided: A
tax burden falls more heavily on the side of the market that is less elastic. Why is this true? In
essence, the elasticity measures the willingness of buyers or sellers to leave the market when
conditions become unfavorable. A small elasticity of demand means that buyers do not have good
alternatives to consuming this particular good. A small elasticity of supply means that sellers do not
have good alternatives to producing this particular good. When the good is taxed, the side of the
market with fewer good alternatives is less willing to leave the market and must, therefore, bear more
of the burden of the tax.

TOPIC 7: CONSUMER SURPLUS AND PRODUCER SURPLUS

The goal of this topic is to examine the following reality: Consumers and producers obtain
“benefit surpluses” through market transactions. These surpluses vary in size among the various
buyers and sellers.

CONSUMER SURPLUS

The benefit surplus received by a consumer or consumers in a market is called consumer

surplus. It is defined as the difference between the maximum price a consumer is (or consumers are)
willing to pay for a product and the actual price. In nearly all markets, consumers individually and
collectively gain greater total utility in dollar terms (total satisfaction) from their purchases than the
amount of their expenditures (product price quantity). This utility surplus arises because all
consumers pay the equilibrium price even though many would be willing to pay more than that price
to obtain the product.
Consider Figure 1, where the demand curve shows the buyers’ maximum willingness to pay
for each unit of the product and we assume that the equilibrium price, P1, of oranges is $8 per bag.
The portion of the demand curve D lying above the $8 equilibrium price shows that many consumers
of oranges would be willing to pay more than $8 per bag rather than go without oranges.

Figure 1: Consumer Surplus

Table 1: Consumer Surplus

Maximum Price Actual Price
Individual Consumer Surplus
Willing to Pay (Equilibrium Price)
Bob $13 $8 $5 (= $13 – $8)
Barb 12 8 4 (= $12 – $8)
Bill 11 8 3 (= $11 – $8)
Bart 10 8 2 (= $10 – $8)
 Brent 9 8 1 (= $9 – $8)
Betty 8 8 0 (= $8 – $8)

See Table 1, for example, where column 2 reveals that Bob is willing to pay a maximum of
$13 for a bag of oranges; Barb, $12; Bill, $11; Bart, $10; and Brent, $9. Betty, in contrast, is willing
to pay only the $8 equilibrium price. Because all six buyers listed obtain the oranges for the $8
equilibrium price (column 3), five of them obtain a consumer surplus. Column 4 shows that Bob
receives a consumer surplus of $5 (=$13 – $8); Barb, $4 (=$12 – $8); Bill, $3 (=$11 – $8); Bart, $2
(=$10 – $8); and Brent, $1 (=$9 – $8). Only Betty receives no consumer surplus because her
maximum willingness to pay $8 matches the $8 equilibrium price.

Obviously, most markets have more than six people. Suppose there are many other consumers
besides Bob, Barb, Bill, Bart, Brent, and Betty in the market represented by Figure 1. It is reasonable
to assume that many of these additional people are willing to pay more than $8 for a bag of oranges.
By adding together the individual consumer surpluses obtained by our named and unnamed buyers,
we obtain the collective consumer surplus in this specific market. To obtain the Q1 bags of oranges
represented, consumers collectively are willing to pay the total amount shown by the sum of the green
triangle and tan rectangle under the demand curve and to the left of Q1. But consumers need pay only
the amount represented by the tan rectangle (=P1 X Q1). So, the green triangle is the consumer surplus
in this market. It is the sum of the vertical distances between the demand curve and the $8 equilibrium
price at each quantity up to Q1. Alternatively, it is the sum of the gaps between maximum willingness
to pay and actual price, such as those we calculated in Table 1.

Consumer surplus and price are inversely (negatively) related. Given the demand curve,
higher prices reduce consumer surplus; lower prices increase it. To test this generalization, draw in an
equilibrium price above $8 in Figure 1 and observe the reduced size of the triangle representing
consumer surplus. When price goes up, the gap narrows between the maximum willingness to pay and
the actual price. Next, draw in an equilibrium price below $8 and see that consumer surplus increases.
When price declines, the gap widens between maximum willingness to pay and actual price.

PRODUCER SURPLUS

Like consumers, producers also receive a benefit surplus in markets. This producer surplus
is the difference be- tween the actual price a producer receives (or producers receive) and the
minimum acceptable price. The supply curve shows the seller’s minimum acceptable price at each
unit of the product. Sellers collectively receive a producer surplus in most markets because most
sellers would be willing to accept a lower-than-equilibrium price if that were required to sell the
product. Those lower acceptable prices for each of the units up to Q1 are shown by the portion of the
supply curve in Figure 2 lying to the left of and below the assumed $8 equilibrium price.
 Figure 2: Producer Surplus

Suppose that Carlos, Courtney, Chuck, Cindy, Craig, and Chad are six of the many sellers of
oranges in the market. Due to differences in production costs, suppose that Carlos’ minimum
acceptable payment for a bag of oranges is $3, as shown in column 2 of Table 2, whereas Courtney’s
minimum acceptable payment is $4, Chuck’s is $5, Cindy’s is $6, Craig’s is $7, and Chad’s is $8. But
each seller receives as payment the equilibrium price of $8. As shown in column 4, Carlos thus
obtains a producer surplus of $5 (= $8 – $3); Courtney, $4 (= $8 – $4); Chuck, $3 (= $8 – $5); Cindy,
$2 (= $8 – $6); Craig, $1 (= $8 – $7); and Chad, zero (= $8 – $8).

Table 2: Producer Surplus

Maximum Price Actual Price
Individual Consumer Surplus
Willing to Pay (Equilibrium Price)
Carlos $3 $8 $5 (= $8 – $3)
Courtney 4 8 4 (= $8 – $4)
Chuck 5 8 3 (= $8 – $5)
Cindy 6 8 2 (= $8 – $6)
Craig 7 8 1 (= $8 – $7)
Chad 8 8 0 (= $8 – $8)

By summing the producer surpluses of these sellers along with those of other sellers, we
obtain the producer surplus for the entire market for oranges. In Figure 6.6, producers collect revenues
of P1 X Q1, which is the sum of the orange triangle and the tan area. As shown by the supply curve,
however, revenues of only those illustrated by the tan area would be required to entice producers to
offer Q1 bags of oranges for sale. The sellers therefore receive a producer surplus shown by the
orange triangle. That sur- plus is the sum of the vertical distances between the supply curve and the $8
equilibrium price at each of the quantities to the left of Q1.

There is a direct (positive) relationship between equilibrium price and the amount of producer
surplus. Given the supply curve, lower prices reduce producer surplus; higher prices increase it. If you
pencil in a lower equilibrium price than $8, you will see that the producer surplus triangle gets
smaller. The gaps between the minimum acceptable payments and the actual prices narrow when the
price falls. If you pencil in an equilibrium price above $8, the size of the producer surplus triangle
increases. The gaps between minimum acceptable payments and actual prices widen when the price
increases.