Demand—1

• Quantity demanded
– The amount of a good buyers are willing and
able to purchase at the current price

• Law of demand
– All else equal (ceteris paribus), there is an
inverse relationship between price and
quantity demanded
• If price , quantity demanded 
• If price , quantity demanded 
3 The Market at Work:
Supply and Demand
Previously

• “Scarcity” refers to the limited nature of

society's resources.
• The production possibilities frontier (PPF)
is an illustration of the goods and services
an economy is capable of producing.
• Trade is mutually beneficial for both
parties involved.
Big Questions

1. What are the fundamentals of markets?

2. What determines demand?

3. What determines supply?

4. How do supply and demand shifts affect a

market?
Here’s a question for you…

• Where do prices
come from? How
are they
determined?
• What factors affect
the price of
gasoline?
What determines the price of a
smartphone?
Demand for smartphones
• How many smartphones do consumers want to buy?
• Affected by price of the smartphones
• Affected by other factors, including prices of other
goods

Supply of smartphones
• How many smartphones are producers willing to sell?
• Affected by price of the smartphones
• Affected by other factors, including prices of other
goods
Fundamentals of Markets—1
• Markets bring trading partners together
- Firms and consumers
• Firms
– Supply goods (or services)

• Consumers
– Purchase goods (or services) supplied by firms

• Exchange/transaction happens
– Through prices established in markets
– Supply or demand factors can change the market
price
Fundamentals of Markets—2
• Market
– Place where buyers and sellers meet
• Doesn’t have to be a physical place
Fundamentals of Markets—3
• Market economy
– Resources are allocated among households and
firms with little or no government interference.
– Producers and consumers are motivated by their self-
interests – expressed through prices.
– We are concerned about market outcomes. Prices
change based on level of demand.

• The invisible hand of the market guides

resources to their highest valued uses
(Adam Smith, see quote on p. 70).
 Competitive Markets
• Characteristics of a competitive market:
– Many buyers and sellers
– The goods sold by each vendor are similar
– No one individual has any influence over the
price – each is a “price taker.”
– Example =>
• Green apples
Imperfect Markets
• Imperfect market
– Buyer or seller has an influence on the price

• Market power
– The firm’s ability to influence price.
– Imperfect competition: eg oligopoly

• Monopoly
– A single company that supplies the entire market
for a good or service
The Demand Side of the Market
•In the market system, consumers ultimately determine
which goods and services will be produced.
•The most successful firms respond to consumer
demand.

 Let’s look at the behavior of buyers/consumers.

 If a consumer demands something, then they:
 Want it, can afford it, and plan to buy it => what a
consumer is willing and able to buy
 Wants are unlimited desires/wishes given scarcity of
resources. Based on tastes and preferences. So which
wants get satisfied?

© 2015 Pearson Education, Inc. 12 of 49

Demand—2

• Demand schedule
– Table showing the relationship between price
and quantity demanded

• Demand curve
– Graph of the relationship between price and
quantity demanded
 Demand Schedule
Ryan’s Demand Schedule
for Salmon
Price of Pounds of
Salmon Salmon
(per pound) Demanded
Higher price $20.00 0 Lower quantity
demanded
$17.50 1
$15.00 2
$12.50 3
$10.00 4
$ 7.50 5 Higher quantity
Lower price $ 5.00 6 demanded
$ 2.50 7
$ 0.00 8
Demand Curve
Market Demand—1

• Market demand
– Horizontal sum of all individual quantities
demanded by each buyer in the market at
each price
Market Demand—2

Price of Melissa’s Market

Ryan’s Demand
Salmon Demand Demand
$20.00 0 0 0
$17.50 1 0 1
$15.00 2 1 3

+ =
$12.50 3 1 4
$10.00 4 2 6
$ 7.50 5 2 7
$ 5.00 6 3 9
$ 2.50 7 3 10
$ 0.00 8 4 12
Changes in Quantity Demanded
versus Changes in Demand
• Change in quantity demanded
– Movement along a demand curve
– Caused by a change in the price of the good

• Change in demand
– Shift of the demand curve
• Entire demand curve will shift to the left or right
– Caused by changes in nonprice factors
– Also referred to as “demand shifters”
Change in demand vs. change in quantity demanded
•A change in the price
of the product being
examined causes a
movement along the
demand curve.
• This is a change in
quantity demanded.

•Any other change

affecting demand
causes the entire
demand curve to shift
at a given price.
• This is a change in • Figure •A change in demand
versus a change in
demand. quantity demanded

© 2015 Pearson Education, Inc. 19 of 49

Practice What You Know—1

P Event:
A
$3
The price of
Oreos falls

$2 B

D
4 5 Q (Oreos)
 Practice What You Know—2

P Event:
B
$20 The price of
movie tickets
A
increases
$15

D
2 3 Q (movie tickets)
Changes in Demand
Factors that Shift Demand—1

1. Changes in income

• Normal good
– Good we buy more of when we get
more income

• Inferior good
– Good we buy less of when we get more
income
Factors that Shift Demand—2

2. Price of related goods

• Complements
– Two goods used together

• Substitutes
– Goods that can be used in place of each other
Prices of Related Goods
• Event: Price of peanut butter increases
Peanut butter: Jelly:
Movement along A shift in demand
the demand curve
P P
B
$4
A
$3
D D2 D1
2 4 Q Q
Factors that Shift Demand—3

3. Changes in Tastes and Preferences

• A good may become more fashionable or may go
out of style
• A good may come into or go out of season
Factors that Shift Demand—4

4. Price expectations
– Our consumption today may depend on what
we think the price may be tomorrow

5. Number of buyers
– More individual buyers means more market
demand (and vice versa)

6. Taxes
– Excise taxes raise the cost to consumers
Change in income of consumers
-Normal goods:
Goods for which the demand increases as
income rises, and decreases as income falls.
-Examples: Clothing
- Restaurant meals
- Vacations Effect of increase in income,
if good is normal

-Inferior goods:
Goods for which the demand decreases as
income rises, and increases as income falls.
-Examples: Second-hand clothing
- Ramen noodles
Effect of increase in income,
if good is inferior

-Are smartphones normal or inferior goods?

© 2015 Pearson Education, Inc. 28 of 49
Change in the price of related goods
-Substitutes:
Goods and services that can be used for
the same purpose.
-Examples: Big Mac and Whopper
- Ford F-150 and Dodge Ram
- Jeans and Khakis Effect on demand for Big
Macs, if price of Whopper
increases

-Complements:
Goods and services that are consumed
together.
-Examples: Big Mac and McDonald’s fries
- Hot dogs and hot dog buns
Effect on demand for Big
- Left shoes and right shoes Macs, if price of McDonald’s
fries increases

© 2015 Pearson Education, Inc. 29 of 49

 Making
the Are tablets substitutes for e-readers?
Connection
•Tablet computers and e-readers are not
identical products, but they are similar.
•To see whether consumers view tablets
(such as Apple’s iPad) as substitutes for e-
readers (such as Amazon’s Kindle), we
need to look at data.

•As tablets have become more popular

in the early 2010s, worldwide sales of
e-readers have fallen:
• 2011: 23 million
• 2012: 16 million
• 2013: 5.8 million (forecast)
•It seems consumers have decided that
tablets are a close substitute for e-readers.
© 2015 Pearson Education, Inc. 30 of 49
Change in tastes or population/demographics
-Tastes
-If consumers’ tastes change, they may buy
more or less of the product.
-Example:
-If consumers become more concerned about Effect on demand for fast food,
eating healthily, they might decrease their if consumers want to eat
healthy
demand for fast food.

-Population and demographics

-Increases in the number of people buying
something will increase the amount
demanded.
-Example: An increase in the elderly Effect on demand for medical
population increases the demand care, as the population ages

for medical care.

© 2015 Pearson Education, Inc. 31 of 49
Change in expectations about future prices
-Consumers decide which products to buy
and when to buy them.
• Future products are substitutes for
current products
• An expected increase in the price
tomorrow increases demand today.
Effect on today’s gasoline
• An expected decrease in the price demand, if price will rise tomorrow
tomorrow decreases demand today.

-Example: If you found out the price of

gasoline would go up
tomorrow, you would increase
your demand today.

© 2015 Pearson Education, Inc. 32 of 49

Two ways to reduce the quantity of smoking demanded

1. Public policymakers often want to reduce

the amount of smoking because of
adverse health effects of smoking
cigarettes
• Shift the demand curve for cigarettes and
other tobacco products with ff. policies
– Public service announcements
– Mandatory health warnings on cigarette packages
– Prohibition of cigarette advertising on television
• If successful
– Shift demand curve to the left and reduce quantity of
cigarettes demanded.
Two ways to reduce the quantity of smoking demanded

2. Try to raise the price of cigarettes

– Government taxes the manufacturer
• Manufacturer charges higher price
– Movement along demand curve
• 10% ↑ in price → 4% ↓ in smoking
• Teenagers (more sensitive):
• 10% ↑ in price → 12% ↓ in smoking
• Demand for cigarettes (a gateway drug)
vs. demand for marijuana
– Appear to be complements
Shifts in the Demand Curve versus Movements along the Demand Curve
Figure
(a) A Shift in the Demand Curve (b) A Movement along the Demand Curve
Price of Cigarettes, per Pack Price of Cigarettes, per Pack
A policy to discourage A tax that raises the
smoking shifts the price of cigarettes
demand curve to the left results in a movement
along the demand curve
$4.00
C

B A
$2.00 2.00
A

D1
D2 D1

0 10 20 0 12 20
Number of Cigarettes Smoked per Day Number of Cigarettes Smoked per Day
If warnings on cigarette packages convince smokers to smoke less, the demand curve for cigarettes shifts to
the left. In panel (a), the demand curve shifts from D1 to D2. At a price of $2.00 per pack, the quantity
demanded falls from 20 to 10 cigarettes per day, as reflected by the shift from point A to point B. By contrast, if
a tax raises the price of cigarettes, the demand curve does not shift. Instead, we observe a movement to a
different point on the demand curve. In panel (b), when the price rises from $2.00 to $4.00, the quantity
demanded falls from 20 to 12 cigarettes per day, as reflected by the movement from point A to point C.
 Practice What You Know—3

Event:
P
The price of a
Burger King
Whopper falls

D2 D1

Q (Big Macs)
Practice What You Know—4

Event:
P You get a pay
raise at your job

D1 D2
Q (steak dinners)
 Practice What You Know—5

Event:
P
You get a pay
raise at your
job

D2 D1
Q (generic cheese)
 Practice What You Know—6

Event:
P The price of
your favorite
beverage falls

D1 D2
Q (pizza)
 Practice What You Know—7

Event:
P Doctors discover
that oranges
cure baldness

D1 D2
Q (oranges)
Practice What You Know—8
• The following three questions
are considering the market for
the same good:

PEPSI
• We are considering:
– Change in quantity demanded
(movement)
– Change in demand (shift)
Practice What You Know—8.1

1. Assume you like Pepsi and your income

increases.

A. The demand for Pepsi increases.

B. The demand for Pepsi decreases.
C. The quantity demanded of Pepsi increases.
D. The quantity demanded of Pepsi decreases.
Practice What You Know—8.2

2. Assume the price of Pepsi decreases.

A. The demand for Pepsi increases.

B. The demand for Pepsi decreases.
C. The quantity demanded of Pepsi increases.
D. The quantity demanded of Pepsi decreases.
Practice What You Know—8.3

3. Assume the price of Coke decreases.

A. The demand for Pepsi increases.

B. The demand for Pepsi decreases.
C. The quantity demanded of Pepsi increases.
D. The quantity demanded of Pepsi decreases.
 Practice What You Know—9

• Suppose the price of good X increases. In terms

of demand, what is the result?
A. The demand for X increases.
B. The demand for X decreases.
C. The quantity demanded of X increases.
D. The quantity demanded of X decreases.
 Practice What You Know—10

• Suppose goods X and Y are substitutes for

each other. If the price of good Y increases,
what is the result in the market for good X?
A. The demand for X increases.
B. The demand for X decreases.
C. The quantity demanded of X increases.
D. The quantity demanded of X decreases.
 Class Activity: Think-Pair-Share
• You work at a restaurant/bar.
– Your boss comes to you, knowing you are studying
economics, and asks for your opinion on the following
question:
• Which of the following would increase the demand
for drinks the most?
A. a reduction in the price of a complementary good such
as an appetizer
B. a reduction in the price of drinks
C. both
• Think carefully about your answer for a minute. Pair
up with a classmate and share your thoughts.
Economics in The Hudsucker
Proxy
• The Hudsucker Proxy (1994)
– Watch for changes in price. Which price
changes are an illustration of a movement
along a demand curve, and which are the
result of demand increase?
Supply
 Let’s look at the behavior of sellers/producers.
 A firm supplies a good or service if it
 Has resources and technology to produce it, can profit
from producing it, and plans to produce and sell it.
 The quantity supplied of any good is the amount
that sellers are willing and able to sell (at a given
price and time), ceteris paribus.

© 2015 Pearson Education, Inc. 49 of 49

Supply—1

• Quantity supplied
– The amount of the good or service that
producers are willing and able to sell at the
current price – it’s a number

• Law of supply
– All else equal, there is a direct relationship
between price and quantity supplied (ceteris
paribus)
• If price , quantity supplied 
• If price , quantity supplied 
Supply—2

• Supply schedule
– Table showing the relationship between price
and quantity supplied

• Supply curve
– Graph of the relationship between price and
quantity supplied
 Supply—3
Pure Food Fish’s Supply Schedule

Price of Salmon Pounds of

(per pound) Salmon Supplied

Higher price $20.00 800 Higher quantity

$17.50 700 supplied
$15.00 600
$12.50 500
$10.00 400
$ 7.50 300
$ 5.00 200 Lower quantity
Lower price
supplied
$ 2.50 100
$ 0.00 0
Market Supply—1

• Market supply
– Horizontal sum of all individual quantities
supplied by each seller in the market at each
price
Market Supply—2

Price of Pure Food Fish’s City Fish’s Market

Salmon Supply Supply Supply
$20.00 800 200 1000
$17.50 700 175 875
$15.00 600 150 750
$12.50
$10.00
500
400 + 125
100 = 625
500
$ 7.50 300 75 375
$ 5.00 200 50 250
$ 2.50 100 25 125
$ 0.00 0 0 0
Changes in Quantity Supplied
versus Changes in Supply
• Change in quantity supplied
– Movement along a supply curve
– Caused by a change in the price of the good

• Change in supply
– Shift in the supply curve
• Entire supply curve will shift to the left or right
– Caused by a change in nonprice factors
– Also referred to as “supply shifters”
Change in supply vs. change in quantity supplied
•A change in the price
of the product being
examined causes a
movement along the
supply curve.
• This is a change in
quantity supplied.

•Any other change

affecting supply
causes the entire
supply curve to shift.
• This is a change in
supply. • Figure •A change in supply
versus a change in
quantity supplied

© 2015 Pearson Education, Inc. 56 of 49

Changes in Supply
Factors that Shift Supply—1

1. The cost (price) of inputs

• Inputs
– Resources used in the production
process
– What are examples of inputs?

2. Changes in technology
• Technology
– Knowledge that producers have about
how to produce a product
Factors that Shift Supply—2

3. Taxes and subsidies

• Tax
– Tax paid by producer  added cost of production
• Increases the cost of production and reduces supply

• Subsidy
– “Opposite” of a tax; government pays sellers to
produce goods
• Reduces the cost of production and increases supply
Factors that Shift Supply—3

4. Number of sellers (firms) in market

– More individual sellers means more market
supply

5. Price expectations
– Higher price expected tomorrow? If so, delay
sales until future if possible
– Typically this is possible for products that
won’t spoil – non-perishable products
Changes in prices of inputs (resources)
Inputs are things used in the production of a good
or service.

Examples of inputs for smartphones:

Computer processor
Plastic housing Effect of an increase in the
price of input goods
Labor

An increase in the price of an input decreases the

profitability of selling the good, causing a decrease
in supply.

A decrease in the price of an input increases the Effect of a decrease in the

price of input goods
profitability of selling the good, causing an increase
in supply.
© 2015 Pearson Education, Inc. 61 of 49
Technological change (Example of Productivity)
-A firm may experience a positive or negative
change in its ability to produce a given level of
output with a given quantity of inputs. This is a
technological change.

-Changes raise or lower firms’ costs, hence Effect of a positive change

their supply of the good. in technology

-Examples:
•A new, more productive variety of wheat would
increase the supply of wheat.
•Governmental restrictions on land use for
Effect of a negative change
agriculture might decrease the supply of wheat. in technology

© 2015 Pearson Education, Inc. 62 of 49

Prices of substitutes** and number of firms
-Many firms can produce and sell more than
one product.

-Example:
-An Illinois farmer can plant corn or soybeans.
If the price of soybeans rises, he will plant
(supply) less corn.
Effect on the supply of corn,
of an increase in the price of
soybeans

-More firms in the market will result in more

product available at a given price (greater
supply).

Effect of a increase in the

-Fewer firms → supply decreases. number of firms

© 2015 Pearson Education, Inc. 63 of 49

Change in expected future prices
If a firm anticipates the price of its product
will be higher in the future, it might decrease
its supply today in order to increase it in the
future.

What types of products could be “stored” like

Effect of an increase in
this? future expected price of a
Perishable products, or good

Non-perishable products

© 2015 Pearson Education, Inc. 64 of 49

Practice What You Know—11
• Assume the price of cheese decreases. What
will happen in the pizza market?

A. The supply of pizza increases.

B. The supply of pizza decreases.
C. The quantity supplied of pizza increases.
D. The quantity supplied of pizza decreases.
Practice What You Know—12
• Which of the following will
cause the supply curve for
oranges to shift to the left?

A. The government begins subsidizing orange

growers.
B. A study is released showing oranges improve
eyesight.
C. An ice storm strikes Florida.
D. A new orange juice commercial airs on TV.
 Practice What You Know—13
• Which of the following will most likely cause a
decrease in the supply of most fruits and
vegetables?
A. an increase in demand for meat
B. the introduction of an environmentally friendly
pesticide
C. a decrease in the price of corn and rice
D. harsh punishments for farmers who hire
undocumented workers
Bringing Supply and Demand
Together
• How is the price of a good determined?
– Through the market forces of supply and
demand
• Law of supply and demand
– The market price of any good will adjust to
bring the quantity supplied and quantity
demanded into balance
Supply and Demand—1
• Equilibrium price
– The price at which quantity supplied is equal to
quantity demanded
– The price that “clears the market”

• Equilibrium quantity
– The quantity at which quantity demanded is equal to
quantity supplied
Shortages and Surpluses—1

• Shortage
– Occurs when QD > QS
– Occurs at any price below equilibrium
• Price will rise over time toward equilibrium

• Why does price rise over time with a

shortage?
– Some buyers can’t find sellers
– Consumers will “outbid” other consumers
– Sellers will then respond to the price increase
Shortages and Surpluses—2

• Surplus
– Occurs when QS > QD
– Occurs at any price above equilibrium
• Price will fall over time toward equilibrium

• Why does price fall over time with a

surplus?
– Some sellers can’t find buyers
– Firms will lower prices to get rid of mounting
inventories
Supply and Demand—2
Demand and supply both count
•To Summarize:

•In the market (Perfect competition):

•Price is determined by the interaction of buyers and sellers.

•Neither group can dictate price in a competitive market (i.e. one with
many buyers and sellers).

•However changes in supply and/or demand will affect the price and
quantity traded.

© 2015 Pearson Education, Inc. 73 of 49

The usefulness of the demand and supply model
•Predictions about price and quantity in model require us to know
supply and demand curves.

•Typically, we know price and quantity, but do not know the curves
that generate them.

•The power of the demand and supply model is in its ability to predict
directional changes in price and quantity traded.

•Major relevant question:

•How do shifts in demand and supply curves affect equilibrium price

and quantity for a good produced and sold in the market?

© 2015 Pearson Education, Inc. 74 of 49

Economics in Pawn Stars

• Pawn Stars (History Channel)

– Bartering is a great way to see the forces of
supply and demand at work.
 Practice What You Know—14
• Suppose there is a shortage in the market for
avocados. Assuming a competitive and
unrestrained market, what happens over time?
A. The price of avocados will fall, and the shortage
will worsen.
B. The price of avocados will rise, and the market
will eventually reach equilibrium.
C. The price of avocados will rise, and a large
surplus will be created.
D. Producers will stop growing avocados.
Three Steps for Analyzing Changes in Equilibrium

1. Decide whether the event shifts the supply or

demand curve (or perhaps both).

2. Decide in which direction the curve shifts.

3. Use the supply-and-demand diagram to see how

the shift changes the equilibrium price and quantity.
Graphs of Shifts—1
Impact on Price and
Change Illustration
Quantity

The demand curve shifts

to the right. As a result,
Demand increases the equilibrium price and
equilibrium quantity
increase.

The supply curve shifts

to the right. As a result,
the equilibrium price
Supply increases
declines and the
equilibrium quantity
increases.
Graphs of Shifts—2
Impact on Price and
Change Illustration
Quantity

The demand curve shifts

to the left. As a result,
Demand decreases the equilibrium price and
equilibrium quantity
decrease.

The supply curve shifts

to the left. As a result,
the equilibrium price
Supply decreases
increases and the
equilibrium quantity
decreases.
Economics in Willy Wonka &
The Chocolate Factory
• Willy Wonka & The Chocolate Factory
– What sort of market effect is happening here?
Why is the price of candy bars increasing?
Effects of changes in demand or supply
•The table summarizes what happens when the demand curve
shifts or the supply curve shifts, with the other curve remaining
unchanged.
Supply Curve Supply Curve Shifts Supply Curve Shifts
Unchanged to the Right to the Left

Demand Curve Unchanged Q unchanged Q increases Q decreases

P unchanged P decreases P increases

Demand Curve Shifts to the Q increases

Right P increases

Demand Curve Shifts to the Q decreases

Left P decreases

• Table •How shifts in demand

and supply affect
equilibrium price (P)
and quantity (Q)
© 2015 Pearson Education, Inc. 81 of 49
Shifts in demand and supply over time
•Over time, it is likely that both
demand and supply will
change.

•For example, as new firms

enter the market for
smartphones and incomes
increase, we expect
• The supply of smartphones
will shift to the right, and
• The demand for
smartphones will shift to
the right.
• Figure •Shifts in demand and
supply over time:
demand shifting more
than supply
© 2015 Pearson Education, Inc. 82 of 49
Demand shifting more than supply
•What does our model
predict?

•S↑  ( P↓ and Q↑ )

•D↑  ( P↑ and Q↑ )

•So we can be sure

equilibrium quantity will rise;
but the effect on equilibrium
price is not clear.

•This panel shows demand • Figure •Shifts in demand and

shifting more than supply: supply over time:
demand shifting more
equilibrium price and quantity than supply
both
© 2015 rise.
Pearson Education, Inc. 83 of 49
Supply shifting more than demand
•This panel shows supply
shifting more than demand:
quantity rises, but equilibrium
price falls.

•Without knowing the relative

size of the changes, the effect
on equilibrium price is
ambiguous.

•It is possible, but unlikely,

that the equilibrium price will
remain unchanged.
• Figure •Shifts in demand and
supply over time:
supply shifting more
than demand
© 2015 Pearson Education, Inc. 84 of 49
Effect of changes in demand or supply—redux
•We can now fill in the rest of the Table below:
•The cell in red is the example that we just did.

Supply Curve Supply Curve Shifts Supply Curve Shifts

Unchanged to the Right to the Left

Demand Curve Unchanged Q unchanged Q increases Q decreases

P unchanged P decreases P increases

Demand Curve Shifts to the Q increases Q increases Q increases or

Right P increases P increases or decreases
decreases P increases

Demand Curve Shifts to the Q decreases Q increases or Q decreases

Left P decreases decreases P increases or
P decreases decreases

• Table •How shifts in demand

and supply affect
equilibrium price (P)
and quantity (Q)
© 2015 Pearson Education, Inc. 85 of 49
Conclusion
• If you take away just one thing from this course,
it will probably be supply and demand
– Powerful tool for explaining market changes

• In competitive markets, supply and demand

allow prices to adjust toward equilibrium
– This means there are no surpluses or shortages
 Market Outcomes
(Demand, Supply, &

2.1 Economic
Efficiency) and Tax
Incidence
Key Characteristic of a Great Teacher…

© 2015 Pearson Education, Inc. 88 of 49

Big Questions

1. What are consumer surplus and producer

surplus?

2. When is a market efficient?

3. Why do taxes create deadweight loss in

otherwise efficient markets?
What Are Consumer and
Producer Surplus?
• Welfare economics
– The study of how the allocation of resources affects
economic well-being

• Welfare is composed of two measures of

market value:
– Consumer surplus
– Producer surplus
A demand curve illustrating a willingness to pay (WTP)
curve shows the price consumers are willing to pay for a
given quantity of the product in the market.
Consumer Surplus—1
• Suppose there are three students who have different
willingness to pay (WTP) for a textbook.
• WTP is also referred to as their reservation price.
• Assume that these students were bidding at auction.
Consumer Surplus—2

• None are willing to pay more than $200 => if price is

above $200, quantity demanded = 0.
• Who buys the book if the price is $140? What is the
consumer surplus?
Consumer Surplus—3
• Consumer surplus is the difference between
willingness to pay for a good and the price
actually paid to get the good.

CS = $200 - $140 = $60

CS = $150 - $140 = $10

• How much consumer surplus does Beanie get? Mitch?

Using Demand to Illustrate
Consumer Surplus
Consumer Surplus, Graphically—1
Consumer Surplus, Graphically—2
Producer Surplus—1

• Instead of buying a textbook, suppose

Beanie, Mitch, and Frank are thinking
about tutoring.
• What is their willingness to sell (WTS)?
Producer Surplus—2

• Willingness to sell (WTS) is the minimum price a seller will accept to

sell a good or service.
• Which students will tutor if the market price is $25 per hour?
• How much producer surplus do Mitch and Frank get?
Producer Surplus—3

• Producer surplus—difference between

willingness to sell a good and the price
actually received for that good

PS = $25 - $20 = $5
PS = $25 - $10 = $15

• How do producers determine their WTS? 2 factors: the direct cost of

producing the good/service + indirect cost or opportunity cost.
Using Supply to Illustrate
Producer Surplus
Producer Surplus, Graphically—1
Producer Surplus, Graphically—2
Practice What You Know—1

• The height of the demand curve at any

quantity can be thought of as the
A. willingness to buy.
B. willingness to sell.
C. consumer surplus.
D. producer surplus.
Practice What You Know—2

• The difference between the price the good

was sold at and the minimum price the firm
would have accepted for the good is called
A. willingness to sell.
B. product markup.
C. producer surplus.
D. price-cost margin.
When Is a Market Efficient?

• How do economists measure social

welfare?
– Total surplus = CS + PS
– CS and PS represents the gains from participating in
the market => benefits the market creates from
trade/exchanges.
– Want to show how total surplus is maximized in
markets without government intervention
– An outcome is efficient when an allocation of
resources maximizes total surplus.
– So an increase in economic welfare is a good thing.
CS and PS for a Slice of Pie—1
CS and PS for a Slice of Pie—2
Total Surplus Measured

• Now, let’s measure the Total surplus:

• Total surplus = CS + PS
CS = ($8 - $4) x 6/2 mill. (assuming the highest WTP is $8)
= $12 million
PS = ($4 - $1) x 6/2 mill. (assuming the lowest WTS is $1)
= $9 million
So for our example, Total surplus = $12 mill. + $9 mill.
= $21 million – the efficient market outcome!
Market Equilibrium is where market participants receive the highest TS
possible => the highest overall gains from trade based on the values
placed on the good by consumers and the opportunity costs of it to
sellers. And there is no deadweight loss (DWL) due to price
distortions.
 Taxation, Welfare, and
Deadweight Loss
• Why do we pay taxes?
- Taxes pay for many services society
needs such as Police, Military, schools
infrastructure, public parks, etc.
• What are some different types of
taxes?
- Include taxes paid on income, payroll,
property, corporate profits, sales, etc.
• What are excise taxes?
- Taxes imposed on a particular good
or service. Such goods and/or services
could include cigarettes and alcohol
Tax Incidence
• Economists want to know how taxes affect choices
consumers and producers make
• Suppose the government imposes an excise tax on milk.
– Who pays for the tax?
– Do buyers switch to alternative goods that aren’t taxed?
– How do producers respond when the products they sell are
taxed?

• Tax incidence
– The burden of taxation on the party who pays the tax
through higher prices
– This occurs regardless of whom the tax is actually
levied on
Tax on Buyers – Not as common
Tax on Sellers - Common
Comparing Both Cases

• Tax levied on consumers:

– Some of the burden is passed to producers
since the market price falls.
• Tax levied on a business:
– The firm will attempt to raise prices to pass
some of the burden to consumers.
• Incidence:
– Incidence is the same.
Deadweight Loss

• So far we have shown that a tax hurts both

buyers and sellers.
– Buyers pay a higher price, and sellers receive a lower
price.
• What did we miss? There are less milk sold and
bought – from 1,000 to 750 – reduces surplus!
• Deadweight loss:
– The decrease in economic activity caused by market
distortions.
– In this case, by imposing a tax, government causes
the quantity of milk to fall and reduces total surplus
Deadweight Loss, Graphically
Tax, Deadweight Loss, and
Elasticity—1
• How does tax incidence and DWL change
depend on the elasticity of demand?
– Typically, necessary goods and services – for
example water, electricity, phone service – have
highly inelastic demand but often taxed
– When demand is inelastic (elastic), QD is relatively
unresponsive (responsive) to a change in price.
– The more inelastic demand is, the greater the burden
on consumers and the smaller the DWL.
– For example, consider all the taxes associated with
your cell phone bill – sales tax, city tax, county tax,
federal excise tax, and annual regulatory fees, etc.
Tax and DWL with Perfectly
Inelastic Demand – cell phone
Tax, Deadweight Loss, and
Elasticity—2
• Why would the government want to tax a
good with almost perfectly inelastic
demand?
– No substitution (ensures steady tax revenue)
– Purchases will not change very much
– So that there is little or no deadweight loss

– Do we tax Brussels sprouts or

cigarettes?
Tax and DWL with Somewhat
Elastic Demand
Tax and DWL with Perfectly
Elastic Demand
Comparing the Three Cases

• If demand is perfectly inelastic, the burden

of the tax falls on consumers but there
was no DWL.
• As demand becomes less inelastic (or
more elastic) the tax burden starts to fall
more on producers but there is a DWL.
• If demand is perfectly elastic, the burden
of the tax falls on producers and there is a
larger DWL.
Practice What You Know—3

• Deadweight loss can be thought of as

surplus that is transferred from producers
or consumers and given to
A. the government.
B. competitors in other markets.
C. taxpayers.
D. nobody.
Practice What You Know—4

• If the government wants to create tax

revenues without generating any
deadweight loss, what type of good should
they tax?
A. a good with a perfectly elastic demand
B. a good with a relatively elastic demand
C. a good with a perfectly inelastic demand
D. a good with a relatively inelastic demand
Interaction of Demand and
Supply Elasticity
• What would happen if we varied the
elasticity of the supply curve as well as the
demand curve?

• Compare the elasticity of demand with the

elasticity of supply.
Realistic Example
Balancing Deadweight Loss
and Tax Revenues
• What happens if the government increases
a tax?
– Tradeoff between tax revenue and DWL

• Ireland (2002): 15 cent tax on plastic bags

Deadweight Loss and Tax Revenue—1
Deadweight Loss and Tax Revenue—2
Deadweight Loss and Tax Revenue—3
Deadweight Loss and Tax Revenue—4
Deadweight Loss and Tax Revenue—5
Real-World Example: Smoking
Tax versus Smoking Ban
• Why tax a good if it reduces efficiency in the
market by creating deadweight loss?

• Which policy, tax or ban, would be more

effective at reducing smoking?
Unusual Taxes

• What’s the purpose of the

tax? How effective is it?
• Bagel tax:
– In New York, a prepared
bagel is subject to an 8
cent tax.
• Window tax:
– England passed a tax in
1696 on windows on
homes.
Conclusion
• Unregulated markets are beneficial because
they generate the largest possible total surplus.

• Taxing specific goods leads to a deadweight

loss, which reflects reduced economic activity.

• Society must balance the benefits of government

services that taxes pay for with the costs of the
inefficiencies created in the market.
3 Elasticity of
Demand and Supply
Previously
• Demand and supply balance the desires of
consumers and producers.
• Demand and supply steer the market price
toward equilibrium.
• We learned the direction of changes in quantity
demanded and quantity supplied as a result of a
price change.
• In this chapter, studying elasticity will help us
understand the sensitivity of consumers and
producers to changes in price.
Big Questions

1. What is the price elasticity of demand, and

what are its determinants?
2. How do changes in income and the prices of
other goods affect elasticity?
3. What is the price elasticity of supply?
4. How do the price elasticity of demand and
supply relate to each other?
Here’s a question for you…
• How do you respond when the price of gasoline
rises by 10 percent?
– Does your answer change if we are talking about a 10 percent rise
in the price of a Big Mac meal?
– Review the various questions and scenarios provided in your ALG
Project text.
– The concept of Elasticity enables us to predict by how much a
variable changes in response to change in another.
Price Elasticity of Demand—1

• Elasticity
– A measure of the degree of responsiveness
or sensitivity of buyers and sellers to changes
in certain variables such as in price or income

• Why is it useful?
– When price or income changes, we can
determine how much buyers and sellers
change their behavior
Price Elasticity of Demand—2

• Price elasticity of demand

– A measure of the responsiveness of quantity
demanded to a change in price
– This gives us the sensitivity of the relationship
between these two variables.
– Remember that the demand curve is downward
sloping => provides direction of the relationship
between quantity demanded and price

– Businesses know if they raise prices, they will sell

fewer units. But how many fewer inputs? This is
something they want to know!
Price Elasticity of Demand—3
• Demand is elastic if
– Quantity demanded changes significantly as
the result of a price change
– Elastic = “sensitive” or “responsive”

• Demand is inelastic if
– Quantity demanded changes a small amount
as the result of a price change
– Inelastic = “insensitive” or “unresponsive”
 Determinants of the Price
Elasticity of Demand—1
1. Existence of (Close) substitutes
• Determines the options consumers have
when the price changes
– Many substitutes  elastic demand
– Few substitutes  inelastic demand
 Determinants of the Price
Elasticity of Demand—2
2. Share of the budget (income)
spent on the good
• Determines how much the price
change affects the consumer
– “Big-ticket items”  elastic
demand
– Inexpensive items  inelastic
demand
 Determinants of the Price
Elasticity of Demand—3
3. Necessities versus luxuries
• Affects the options the consumer faces
– Luxuries  elastic demand
– Necessities  inelastic demand
 Determinants of the Price
Elasticity of Demand—4
4. Whether the market is broadly or narrowly
defined
• Affects the options the consumer faces
– Narrowly defined  elastic demand
– Broadly defined  inelastic demand
 Determinants of the Price
Elasticity of Demand—5

5. Time span and Adjustment Process

• Affects the ability of consumers to respond
to changes in prices
– Long time horizon  elastic demand
– Long time or long run = consumers can fully adjust to
market conditions
– Short time horizon  inelastic demand
– Short time or short run = consumers can partially adjust
their behavior
 Practice What You Know—1

• In terms of price elasticity of demand, which

of the following goods do you think is the
least elastic (most inelastic)?
A. new house
B. electricity to power your home
C. a specific brand of breakfast cereal
D. new vehicle
The Price Elasticity of Demand
Formula
% change in quantity demanded
price elasticity of demand = ED =
% change in price

%QD
ED 
%P

∆ = change
 Example: Calculating ED—1

• University parking pass prices increase

by 50 percent.
PLUG IN
NUMBERS • As a result, 25 percent fewer people
purchase a parking pass.

%D QD - 25%
ED = = =- 0.5
%DP +50%
Example: Calculating ED—2
%QD  25%
ED    0.5
% P  50%
• What does the numerical result mean?
– If the price of parking rises by 1 percent, the
quantity demanded will fall by only 0.5
percent. It is “unitless.”
• The demand for parking is not very price elastic.
• Why is it negative?
– Inverse relationship between price and
quantity demanded
 Practice What You Know—2

• Suppose that the price of candy bars

increases by 100 percent. As a result of this,
you decide to purchase 50 percent less
candy bars. How would you describe your
demand for candy bars?
A. Demand is elastic.
B. Demand is unit elastic.
C. Demand is inelastic.
D. Demand is perfectly inelastic.
 Midpoint Method—1

• One issue with using the percent change

formula
– Price decreases from $100 to $80
• A 20 percent change [(100 – 80)/100] x 100
– Price increases from $80 to $100
• A 25 percent change [(80 – 100)/80] x 100

• We would get different answers in

calculating elasticity
Midpoint Method—2
• The midpoint method is way to calculate
elasticity that corrects this problem.

ED 
 QD  /  average of QD 
 P  /  average of P 
 Q2  Q1  /  Q1  Q2  / 2
ED 
 P2  P1  /  P1  P2  / 2
Midpoint Method—3
• Example:
– “Old” price = P1 = $6; Q1 = 15 Plug in
– “New” price = P2 = $4; Q2 = 25 numbers

( Q2 - Q1 ) / éë( Q1 +Q2 ) / 2ùû

ED =
( P2 - P1 ) / éë( P1 + P2 ) / 2ùû
( 25 - 15) / éë( 15 + 25) / 2ùû
ED =
( 4 - 6) / éë( 6 + 4) / 2ùû
10 / 20
ED = =- 1.25
-2/5
Graphing Price Elasticity—1

• If demand is relatively elastic

– We are relatively sensitive to price changes
– The demand curve is relatively flatter
• If demand is relatively inelastic
– We are relatively insensitive to price changes
– The demand curve is relatively steeper
Graphing Price Elasticity—2

Numerator is
zero!

%QD
ED  0
%P
Graphing Price Elasticity—3

%QD " small"

ED  
% P " big"
Graphing Price Elasticity—4

%QD " big"

ED  
%P " small"
Graphing Price Elasticity—5
%QD
ED  
%P

Denominator
is zero!
Time, Elasticity, and Demand Curve
Slope and Elasticity

• Elasticity and the slope of the demand

curve are related but are NOT the same.
• In fact, with a linear demand curve:
– The slope will be the same (constant) at all
points.
– Elasticity will be different at all points.
– Elasticity decreases (gets more inelastic) as
we move down and right along a linear
demand curve.
Difference between Slope and Elasticity
Demand Elasticity and Total
Revenues
• Total revenue
– The amount that consumers pay and
sellers receive for goods and services
– Calculated as:
• Price of the good × Quantity Sold

• Elasticity is related to total revenue

– Firms want to know how changing
their prices affects their total revenue
 %D QD
Example ED =
%DP
TR =
P QD %∆P %∆QD ED Interpretation
(P) × (QD)

$5 0 $0
-22% 200% -9.1 Highly elastic

$4 1 $4
-29% 67% -2.3 Relatively elastic

$3 2 $6
-40% 40% -1.0 Unitary

$2 3 $6
-67% 29% -0.4 Relatively inelastic

$1 4 $4
-200% 22% -0.1 Highly inelastic

$0 5 $0
Price Elasticity of Demand and
Total Revenue
• Graphically, we can also show trade-
offs when a firm changes the price of
its good.
– Increase price
• Good news: Receive higher price per unit
• Bad news: Sell fewer units
– Reduce price
• Good news: Sell more units
• Bad news: Receive lower price per unit
Total Revenue Trade-Offs—1
Total Revenue Trade-Offs—2
Total Revenue Trade-Offs—3
 Practice What You Know—3

• Suppose a firm is selling a product at a price

on the inelastic portion of the demand line.
This firm could increase revenue by doing
what?
A. lowering the price, selling more units
B. lowering the price, selling less units
C. increasing the price, selling more units
D. increasing the price, selling less units
Income Elasticity—1

• Changes in income
– Shift the demand curve
– But, by how much?

• Income elasticity of
demand
– Measures how a change in
income affects spending
 Income Elasticity—2
% change in quantity demanded
income elasticity of demand = EI =
% change in income

%DQD
EI =
%DI
• EI can be positive or negative
– Normal good: EI > 0
• Necessities: 1 > EI > 0
• Luxuries: EI > 1

– Inferior good: EI < 0

Practice What You Know—4

• State whether you think the following goods

are inferior, necessity, or luxury goods:
• Steak • Lawn-care service
• Toothpaste • Milk
• Fast food • Gasoline
• Pedicures • Cigarettes
• New vehicles • Lottery tickets
• Used vehicles
• Laptop computers
 Practice What You Know—5

• Suppose that Doug receives a pay increase

at work, and his income increases by 20
percent. As a result, Doug decides to buy 12
percent less ground beef. For Doug, ground
beef is a(n) ________.
A. luxury good
B. necessity good
C. normal good
D. inferior good
Cross-Price Elasticity—1

• Changes in the prices of complements and

substitutes also affect demand.
• Cross-price elasticity of demand
– Measures the responsiveness (percent change) of
the quantity demanded of one good to a (1%) change
in the price of a related good
 Cross-Price Elasticity—2
% change in quantity demanded of one good
cross-price elasticity of demand = EC =
% change in price of a related good

%D QA
EC =
%DPB
• EC can be positive or negative
– Substitute goods: EC > 0
– Complementary goods: EC < 0
 Practice What You Know—6
• Economists have studied that when the price of
chicken increases, people purchase less rice. With
these two goods, which of the following is true?

A. EC < 0, chicken and rice are complements

B. EC > 0, chicken and rice are complements
C. EC < 0, chicken and rice are substitutes
D. EC > 0, chicken and rice are substitutes
Price Elasticity of Supply

• Producers also respond to changes in

price.
• Price elasticity of supply
– Measures the responsiveness (percentage
change) of the quantity of a good supplied to a
(one percentage) change in price
Determinants of the Price
Elasticity of Supply—1
• Flexibility of producers
– More production flexibility implies firms are
more able to respond to changes in price

– A firm will have more production flexibility if it

is able to:
• Have spare capacity
• Maintain inventory
• Relocate easily
The Determinants of the Price
Elasticity of Supply—2
• Time span and adjustment process
– Immediate run
• Suppliers are stuck with what they have on hand;
no adjustment

– Short run, long run

• Over time, the firm is able to adjust to market
conditions.
• Supply becomes more elastic.
Supply Elasticity over Time
Calculating the Price Elasticity of
Supply
% change in quantity supplied
price elasticity of supply = ES =
% change in price

%QS
ES 
%P
• This ratio will be positive
– Law of Supply
• Positive relationship between price and quantity
supplied
Combining Supply and Demand

• We’ve previously drawn shifts in demand

and supply, and studied the changes in
equilibrium price and quantity.
• How will the magnitude of the price and
quantity changes be affected if we alter
the demand or supply elasticity?
Increase in Demand for Oil from China
How Do We Decrease Illegal
Drug Use?—1
• Do you think the demand for illegal drugs
is relatively elastic or inelastic. Why?
– Relatively inelastic
– No substitutes
– May make up a small percent of income
– Addiction may increase willingness to pay
– Purchases may be made in the immediate or
short run
How Do We Decrease Illegal
Drug Use?—2
• Suppose that we wanted to enact a policy
with the following goals:
– Greatly decrease drug consumption
– Make drug-dealing a less attractive business

• Should we try to:

– Decrease the supply of drugs?
– Decrease the demand for drugs?
How Do We Decrease Illegal Drug Use?—3

Let’s start with a

decrease in supply:
P S2 • Only a small decrease
S1 in drug transactions
P2 E2
• Increase in drug prices
P1 E1 • Increase in drug
revenues
• This may actually make
drug-dealing more
lucrative (and
D dangerous)

Q2 Q 1 Q
How Do We Decrease Illegal Drug Use?—4

Let’s try a decrease in

demand:
P • Larger decrease in drug
S transactions
• Decrease in drug prices
P1
E1 • Decrease in drug
P2 revenues
E2
• Drug dealing is now less
attractive

D2 D1
Q2 Q1 Q
How Do We Decrease Illegal
Drug Use?—5
• If we want to accomplish our two goals . . .
– Policy of decreasing drug demand will be
better than trying to decrease drug supply

– Better to use resources on education and

offering legal substitutes rather than
increasing penalties and police enforcement
Conclusion

• Elasticity is a measure of sensitivity

(responsiveness) between two variables.
• The ability to determine whether demand
and supply are elastic or inelastic allows
economists to calculate the effects of
personal, business, and policy decisions.
• Understanding elasticity helps our
economic model say much more about the
world.