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Microeconomics

Eighth Edition, Global Edition

Chapter 3
Applying the
Supply-and-
Demand Model

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Learning Objectives
3.1 How Shapes of Supply and Demand Curves
Matter.
3.2 Sensitivity of the Quantity Demanded to Price.
3.3 Sensitivity of the Quantity Supplied to Price.
3.4 Effects of a Sales Tax.

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How Shapes of Supply and Demand
Curves Matter
• The shapes of the supply and demand curves
determine by how much a shock affects the
equilibrium price and quantity.
• Example: avocado
– The supply of avocados depends on the price of
avocados and the price of fertilizer, a major input in
producing avocados.

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Figure 3.1 How the Effect of a Supply Shock
Depends on the Shape of the Demand Curve

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Sensitivity of Quantity Demanded to
Price
• Elasticity – the percentage change in a variable in
response to a given percentage change in another
variable.
• Price elasticity of demand  
the percentage change in the quantity demanded in
response to a given percentage change in the price, at
a particular point on the demand curve.

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Price Elasticity of Demand (1 of 2)
• Formally,
Q
%Q Q Q p
  
%p p p Q
p
– where D indicates a change.
• Example
– If a 1% increase in price results in a 3% decrease in
the quantity demanded, the elasticity of demand is
3%
e  3.
1%
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Price Elasticity of Demand (2 of 2)
• Along a linear demand curve with a function of:
Q  a  bp
– Where −b is the ratio of the fall in quantity to the rise in
price:
Q
b 
p
– the elasticity of demand is
Q p p
  b
p Q Q

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Solved Problem 3.1
• The estimated demand curve for the U.S. corn is:
Q  15.6  0.5 p
– where Q is the quantity demanded in billion bushels per
year and p is the price in dollars per bushel.
– What is the elasticity of demand at the point on the
demand curve where the price is p = $7.20 per bushel?

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Solved Problem 3.1: Answer
• Substitute the slope coefficient b, the price,
and the quantity values into Equation 3.4.
• The slope coefficient for this demand equation
is b = 0.5 (and a = 15.6). Substituting b = 0.5,
p = $7.20, and Q = 12 into Equation 3.4, we
find that the elasticity of demand at this point
on the demand curve is:
p 7.20
  b  0.5   0.3
Q 12

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Elasticity Along the Demand Curve
• The elasticity of demand varies along most demand
curves.
– The elasticity of demand is different at every point
along a downward-sloping linear demand curve.
– the elasticities are constant along horizontal and
vertical linear demand curves.

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Figure 3.2 Elasticity Along the Corn
Demand Curve

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Horizontal Demand Curve
• Along a horizontal demand curve, elasticity
is infinite – perfectly elastic demand.
– People are willing to buy as much as firms
sell at any price less than or equal to p * .
– If the price increases even slightly above p*,
demand falls to zero.
– A small increase in price causes an infinite drop in
quantity demanded.

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Vertical Demand Curve
• Along a vertical demand curve, elasticity is zero –
perfectly inelastic demand.
– If the price goes up, the quantity demanded is
unchanged.
– A demand curve is vertical for essential goods: goods
that people feel they must have and will pay anything
to get.

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Figure 3.3 Vertical and Horizontal
Demand Curves

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Demand Elasticity and Revenue
• Any shock that changes the equilibrium price to
change will affect the industry’s revenue.
• Whether the revenue rises or falls when the
equilibrium price increases depends on the elasticity
of demand.
– With elastic demand, a higher price reduces revenue.
– With inelastic demand, a higher price increases
revenue.

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Figure 3.4(a) Effect of a Price Change
on Revenue

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Figure 3.4(b) Effect of a Price Change
on Revenue

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Solved Problem 3.2
• Does a price increase cause revenue to rise or fall if
the demand curve is elastic at the initial price? How
does revenue change if the demand curve is
inelastic?

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Solved Problem 3.2: Answer (1 of 2)
1. Show that if the demand curve is elastic at the initial
price, then area C is relatively small.
2. Consider the extreme case where the demand curve
is perfectly inelastic and then generalize to the
inelastic case.

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Solved Problem 3.2: Answer (2 of 2)

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Application: Amazon Prime

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Demand Elasticities Over Time
• Demand elasticities may be different in the short-run
and the long-run.
• The difference depends on substitution and storage
opportunities.
• For most goods elasticities tend to be larger in the
long-run.
• For easily storable or durable goods, the reverse is
true.

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Income Elasticity
• Formally,
Q
%Q Q Q Y
  
%Y Y Y Q
Y
– where Y stands for income.
• Example
– If a 1% increase in income results in a 3% increase in
quantity demanded, the income elasticity of demand is
3%
x  3.
1%
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The Income Elasticity: Example
• The estimated demand function for avocados is:
Q  104  40 p  20 pt  0.01Y
– where we measure quantity in millions of lbs per
month, avocado and tomato prices in dollars per lb,
and average monthly income in dollars.
Question: what would be the income elasticity of
demand for avocados if Q = 80 and Y = 4,000?

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Cross-Price Elasticity (1 of 2)
• Formally,
Q
%Q Q po
 Q 
%po po po Q
po
– where Po stands for price of another good.

• Example
– If a 1% increase in the price of a related good results in a
3% decrease in quantity demanded, the cross-price
elasticity of demand is
3%
  3.
1%
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Cross-Price Elasticity (2 of 2)
• If the cross-price elasticity is negative, the goods are
complements.
• If the cross-price elasticity is positive, the goods are
substitutes.

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Cross-Price Elasticity: Example
• Again, the estimated demand function for avocados is:

Q  104  40 p  20 pt  0.01Y

Question: what would be the cross-price elasticity


between the price of tomatoes and the quantity of
avocados if Q = 80 and pt = $0.80?

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Elasticity of Supply (1 of 2)
• Formally,
Q
%Q Q Q p
  
%p p p Q
p
– where Q indicates quantity supplied.
• Example
– If a 1% increase in price results in a 2% increase in
quantity supplied, the elasticity of supply is
2%
  2.
1%
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Elasticity of Supply (2 of 2)
• Along a linear supply curve with a function of:
Q  g  hp
– Where h is the slope or
Q
h
p
– the elasticity of supply is

Q p p
 h
p Q Q

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Elasticity of Supply: Example
• The estimated linear supply function for corn is:
Q  10.2  0.25 p
– where Q is the quantity of corn supplied in billion
bushels per year and p is the price of corn in dollars
per bushel.
– If p = $7.20 and Q = 12, the elasticity of supply is:

Q P 7.20
  0.25   0.15
p Q 12

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Figure 3.5 Elasticity Along the Corn
Supply Curve

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Supply Elasticities Over Time
• Supply elasticities may differ in the short-run and the
long-run.
• The difference depends on the ability to convert fixed
inputs into variable inputs.
• Firms’ long-run supply elasticity is generally greater
than short-run elasticity.

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Solved Problem 3.3
• What would be the effect of ANWR production on the
world price of oil given that   0.25,   0.25,
the pre-ANWR daily world production of oil is Q1 = 94
million barrels per day, the pre-ANWR world price is
p1 = $50 per barrel, and daily ANWR production
would be 0.8 million barrels per day? We assume that
the supply and demand curves are linear and that the
introduction of ANWR oil would cause a parallel shift
in the world supply curve to the right by 0.8 million
barrels per day.

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Solved Problem 3.3: Answer

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Effects of a Sales Tax
1. What effect does a sales tax have on equilibrium prices
and quantity as well as on tax revenue?
2. Are the equilibrium price and quantity dependent on
whether the government collects a specific tax from the
suppliers or their customers?
3. Is it true, as many people claim, that producers pass
along to customers any taxes collected from producers?
That is, do consumers pay the entire tax?
4. Do comparable ad valorem and specific taxes have
equivalent effects on equilibrium prices and quantities
and on tax revenue?
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Two Types of Sales Taxes
• Ad valorem tax - for every dollar the consumer
spends, the government keeps a fraction,  ,
which is the ad valorem tax rate.
• Specific tax (or unit tax) - where a specified dollar
amount, t, is collected per unit of output.

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Figure 3.6(a) Specific Tax Collected
from Producers

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Figure 3.6(b) Specific Tax Collected
from Customers

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Solved Problem 3.4
• Show mathematically the effects on the
equilibrium price and quantity of corn from a
specific tax of t = $2.40 collected from suppliers,
as illustrated in panel a of Figure 3.6.

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Solved Problem 3.4: Answer
1. Show how the tax shifts the supply curve.
2. Determine the after-tax equilibrium price by equating
the after-tax supply function and the original demand
function.
3. Determine the after-tax equilibrium quantity by
substituting the equilibrium price in either the
demand function or the after-tax supply function.

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Tax Incidences
• The government sets a new specific tax of t, it raises
the tax from 0 to t, so the change in the tax is
t  t  0  t .
• The incidence of a tax on consumers is the share
of the tax that consumers pay.
• The incidence of the tax that falls on consumers is p ,
t
the amount by which the price to consumers rises as a
fraction of the amount the tax increases.

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Tax Effects Depend on Elasticities (1 of 2)
• The tax incidence on customers depends on the
elasticities of supply and demand.
– The price customers pay increases by:
  
p    t
   
• If   0.3 and   0.15, a change of a tax of
t  $2.40 causes the price buyers pay to rise by

   0.15
p    t   $2.40  80¢
    0.15  [ 0.3]

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Tax Effects Depend on Elasticities (2 of 2)
• The incidence of tax that consumers pay is

– Therefore, the incidence of the corn tax on


consumers is
0.15 1

0.15  [ 0.3] 3

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Solved Problem 3.5
• If the supply curve is perfectly elastic and demand
curve is downward sloping, what is the effect of a $1
specific tax collected from producers on equilibrium
price and quantity, and what is the incidence on
consumers? Why?

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Solved Problem 3.5: Answer

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Figure 3.7 Comparison of an Ad
Valorem and a Specific Tax

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Solved Problem 3.6
• If the short-run supply curve for fresh fruit is perfectly
inelastic and the demand curve is a downward-sloping
straight line, what is the effect of an ad valorem tax on
equilibrium price and quantity, and what is the
incidence on consumers? Why?

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Solved Problem 3.6: Answer

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Who Pays the Gasoline Tax?

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