EPM Lecture 3 - Application of Demand and Supply

LECTURE 3:
Applications
of Supply &
Demand
Model
Topics
1. How Shapes of Supply and Demand

Curves Matter.
2. Sensitivity of the Quantity Demanded to
Price.
3. Sensitivity of the Quantity Supplied to
Price.
4. Effects of a Sales Tax.
Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-2

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 (same as Chapter 2)

– The supply of avocados depends on the price of
avocados and the price of fertilizer.

Figure 3.1 How the Effect of a Supply Shock
Depends on the Shape of the Demand Curve
A 55¢ increase in the price of fertilizer shifts the avocado supply

curve to the left from S1 to S2.

Sensitivity of Quantity
Demanded to Price
• Elasticity – the percentage change in one
variable in response to a given percentage
change in another variable.
• Price elasticity of demand (e) – 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.

Price Elasticity of Demand
• Formally,
– 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 e = -3%/1% = -3.

Price Elasticity of Demand
(cont.)
• 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

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.

Figure 3.2 Elasticity Along the
Corn Demand Curve

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.

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.

Figure 3.3 Vertical and
Horizontal Demand Curves
(a)Perfectly Elastic Demand (b)Perfectly Inelastic Demand (c) Individual

’s Demandfor Insulin
p , P rice of
p , P rice per unit
p , P rice per unit
insulin dose
p*
p*
Q, Units per Q* Q, Units per Q* Q, Insulin

time period time period doses perayd

Demand Elasticity and Revenue
• Any shock that changes the equilibrium price

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.

Figure 3.4 Effect of a Price
Change on Revenue
Revenue decreases by B, but

increases by C, resulting in
revenue of A+C
An increase in price to
p2 reduces quantity
Revenue = A + B

The Problem:
• Does revenue increase or decrease if the

demand curve is inelastic at the initial price?
How does it change if the demand curve is
elastic?

Answer:
– Consider the extreme case where

the demand curve is perfectly
inelastic and then generalize to the
inelastic case.
– Show that if the demand curve is

elastic at the initial price, then area
C is relatively small.

Answer (cont.)

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.

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
x = 3%/1% = 3.

The Income Elasticity: Example
• The estimated demand function for avocados is:

Q = 104 – 40p + 20pt + 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 = 50 and Y = 4,000?
– Answer:
Since = 0.01, then

Cross-Price Elasticity
• Formally,
Q
%Q Q Q po
 
%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%/1% = -3.

Cross-Price Elasticity (cont.)
• If the cross-price elasticity is positive, the

goods are substitutes.
– Question: can you think of any examples of two
goods that are substitutes?
• Roses and carnations
• If the cross-price elasticity is negative, the

goods are complements .
– Question: can you think of any examples of two
goods that are complements?
• Peanut butter and jelly

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

avocados is:
Q = 104 – 40p + 20pt + 0.01Y
– Question: what would be the cross-price
elasticity between the price of tomatoes and
the quantity of avocados if Q = 50 and pt=
$0.80?
– Answer:
• Since = 20, then

Elasticity of Supply
• 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 h =
2%/1% = 2.

Elasticity of Supply (cont.)
• 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
Elasticity of Supply: Example
• The estimated linear supply function for

corn is:
Q = 10.2 + 0.25p
– 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:

Figure 3.5 Elasticity Along the
Corn Supply Curve
The elasticity of supply η, varies along the corn supply curve. The
higher the price, the larger is the supply elasticity.

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.

Solved Problem 3.3: Answer

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. Do the equilibrium price and quantity depend on
whether the specific tax is collected from the
suppliers or their customers?
3. Is it true, as many people claim, that taxes
assessed on producers are passed along to
customers?
4. Do comparable ad valorem and specific taxes
have the same effects on equilibrium prices and
quantities and on tax revenue?

Two Types of Sales Taxes
• Ad valorem tax - for every dollar the

consumer spends, the government keeps a
fraction, α, which is the ad valorem tax rate.
• Specific tax (or unit tax)- where a
specified dollar amount, t, is collected per
unit of output.

Figure 3.6 Equilibrium Effects of a
Specific Tax
• The specific tax on
producers shifts the
supply curve upward by
the amount of the tax
(t=$2.40)….
• which causes the market
price to increase…
• After the tax,

– buyers pay an
additional $.80 per unit
($8.00 - $7.20)
– sellers receive $1.60
less per unit ($7.20 -
$5.60)
– and the government
collects $27.84 billion in
tax revenue.

Figure 3.6 Equilibrium Effects of a
Specific Tax (cont.)
• The specific tax
collected on customers
shifts the demand
curve down by the
amount of the tax
(t=$2.40)….
• which causes the

market price to
decrease…
• The new equilibrium is

the same as when the
tax is applied to
suppliers.

Tax Incidence
• The government sets a new specific tax

of t, it raises the tax from 0 to t, so the
change in the tax is Dt = t – 0 = t.
• The incidence of a tax on consumers is
the share of the tax that falls on
consumers.
• The incidence of the tax that falls on
consumers is Dp/Dt , the amount by
which the price to consumers rises as a
fraction of the amount the tax increases.

Tax Effects Depend on
Elasticities
• The tax incidence on customers depends on
the elasticities of supply and demand.
 The price customers pay increases by:
where, h and e are elasticities of
supply and demand
respectively
• If e = -0.3 and h = 0.15, a change of a tax of

Dt = $2.40 causes the price buyers pay to rise
by

Tax Effects Depend on
Elasticities (cont.)
• The incidence of tax that falls on
consumers is
– Therefore, the incidence of the corn tax that

falls on consumers is

Solved Problem 3.5
• If the supply curve is perfectly elastic and

demand is linear and 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?

Solved Problem 3.5: Answer

Figure 3.7 Comparison of an Ad
Valorem and a Specific Tax

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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LECTURE 3:

1. How Shapes of Supply and Demand

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-2

• Example: avocado (same as Chapter 2)

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-3

A 55¢ increase in the price of fertilizer shifts the avocado supply

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-4

• Price elasticity of demand (e) – the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-5

– where D indicates a change.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-6

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-7

– The elasticity of demand is different at every

– the elasticities are constant along horizontal

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Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-9

• Along a horizontal demand curve,

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• Along a vertical demand curve, elasticity

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(a)Perfectly Elastic Demand (b)Perfectly Inelastic Demand (c) Individual

Q, Units per Q* Q, Units per Q* Q, Insulin

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• Any shock that changes the equilibrium price

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Revenue decreases by B, but

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• Does revenue increase or decrease if the

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– Consider the extreme case where

– Show that if the demand curve is

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• Demand elasticities may be different in the

• The difference depends on substitution and

• For most goods elasticities tend to be larger in

• For easily storable or durable goods, the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 3-18

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• The estimated demand function for avocados is:

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• If the cross-price elasticity is positive, the

• If the cross-price elasticity is negative, the

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• Again, the estimated demand function for

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• Along a linear supply curve with a

– Where h is the slope or

• The estimated linear supply function for

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• Supply elasticities may differ in the short-

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1. What effect does a sales tax have on equilibrium

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• Ad valorem tax - for every dollar the

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• After the tax,

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• which causes the

• The new equilibrium is