Module 3 Changes in Supply and Demand

Computing the Price Elasticity of Demand

Formula To compute the price elasticity of demand, use the following formula and be sure to take the absolute value of the final value: fraction numerator Percentage space change space in space quantity space demanded over denominator Percentage space change space in space price end fraction ______________________________________________________________________ Scenario The following table shows two points on the demand curve for hamburgers from a college cafeteria. When the price per hamburger is $1, the quantity demanded is 30 hamburgers per day. When the price per hamburger is $2, the quantity demanded is 20 hamburgers per day. ex: Scenario: Computing the Price Elasticity of Demand ______________________________________________________________________ Calculating the Price Elasticity of Demand Now, let's calculate the price elasticity of demand using the data and the midpoint method: Find the absolute value of the percentage change in quantity demanded by fraction numerator left parenthesis 30 minus 20 right parenthesis over denominator 25 end fraction space cross times 100 space equals space 40 % Find the absolute value of the percentage change in price by fraction numerator left parenthesis $ 1 space minus space $ 2 right parenthesis over denominator $ 1.5 end fraction cross times space 100 space equals space 66.7 % Using the midpoint formula, the price elasticity of demand between the two points is fraction numerator 40 % over denominator 66.7 % end fraction space equals space.06 ______________________________________________________________________ Summary Demand is elastic when the price elasticity of demand is greater than one, demand is unit elastic if the price elasticity of demand equals one, and demand is inelastic if the price elasticity of demand is less than one. Because the price elasticity of the demand for the college cafeteria's hamburgers is less than one, the demand for hamburgers is inelastic. After determining whether the good or service is elastic or inelastic, we can make some assumptions about that good, including the number of available substitutes and how much of a person's income the good or service takes up. Last, we can also discern how a change in price will affect the quantity demanded of a good or service. If the good or service is elastic, there is a much larger change in quantity demanded with even a small change in price. If the good or service is inelastic, then a change in price only creates a small change in the quantity demanded.

Subsidy

Government payment to producers to cover part of their production costs.

The two general approaches to fairness are in conflict with each other.

If the rules aren't fair Examining economic fairness, we can see that this perspective supports the equality of economic opportunity versus the equality of economic outcomes. Under this principle, a competitive market is fair if there are no inefficiencies in the market, property rights are protected, and exchange in the market is not forced by an outside agent. ------------------------------------------------------- If the result isn't fair This principle, simply explained, is based on the equality of income. It states that differences in income should result in a redistribution of income. One of the results of redistribution is illustrated by the idea of the big tradeoff, which measures the opportunity cost of efficiency versus equity.

Are Markets Fair? Two broad and generally conflicting approaches to fairness are as follows:

It's not fair if the rules aren't fair It's not fair if the result isn't fair

Deadweight losses

Market equilibrium exists when marginal benefits equal marginal costs. Either underproduction or overproduction can disrupt balance and reducemarket efficiency. The resulting losses are known as deadweight losses

The different methods of resource allocation include the following:

Market price Market price represents the price people are willing to pay to obtain the particular resource. Command When resources are allocated by a single authority, this power is representative of a command system, such as that seen in North Korea. Majority rule The majority rule method allows voters to determine how a resource is used and by whom. An example of this is an elected official who is given the authority to allocate scarce resources. Contest A contest allocation method is an unbiased selection of one winner. Contests are used when it is difficult to monitor and reward the actual effort put in by the individual. First-come, first-served The first-come, first-served allocation method means that a resource is supplied to those that purchase it first, until the resource is no longer available. For example, tickets to a special event like a football game are sold on a first-come, first-served basis. Sharing equally With the sharing equally method, everyone gets the same amount of a resource. For example, you and three other friends order a pizza. The pizza is cut into eight slices. By using the sharing equally allocation method, each of you receive two slices of the whole pie. Lottery Similar to the contest method, the winner gets the resource. An example of a lottery is a lottery held by a school board to admit students to a magnet school program. Personal characteristics The personal characteristics allocation method can lead to unfair and discriminatory allocation of resources because it allocates the resource according to the characteristics of the people. Force The force allocation method is based on the idea that the more powerful people get the resource. An example of this method is the relationship between Great Britain and its American colonies prior to the Revolutionary War.

The following table summarizes the sources of market inefficiency and the possible remedies: (Alternatives to the Market)

Reason for market inefficiency ---------------------------------- Possible remedy Common resources Allocate by majority rule Externalities Minimize deadweight loss by majority rule High transaction costs Allocate by command or first-come, first-served rule Monopoly Regulate by majority rule Price and quantity regulations Remove regulation by majority rule Public goods Allocate by majority rule Taxes and subsidies Minimize deadweight loss by majority rule

Transactions Cost

The opportunity costs of conducting a transaction.

Applications of the Price Elasticity of Demand

The price elasticity of demand is an indicator of the effects that a change in quantity will have on the price of a good or service. For example, take two different goods like apples and oranges. If the price elasticity of demand for apples is 0.5, and the quantity of oranges decreases by 1%, then the price of oranges will increase by 1% ÷ 0.5 = 2%. The price elasticity of demand for tobacco is small, which means that even substantial price increases do not decrease the quantity consumed by much. The price elasticity of demand shows that the elasticity of demand for cigarettes by teenagers is larger than for adult smokers. So although a tax does not have much of an effect on adult smokers' behavior, it discourages smoking by teenagers. We've examined the price elasticity of demand. How changes in demand or supply conditions affect markets depend also on the price elasticity of supply, which is what we examine next.

The Price Elasticity of Supply

The price elasticity of supply calculates the amount of change in price that is created in relation to a change in quantity supplied by comparing the percentage change in the quantity supplied to the percentage change in the price. When the percentage change in supply is more than the percentage change in price, supply is elastic. When the quantity supplied changes drastically in reaction to a small change in price, supply is perfectly elastic. Supply is unit elastic when the percentage change in price equals the percentage change in quantity supplied. When the percentage change in the quantity supplied is less than the percentage change in the price, supply is inelastic. When the quantity supplied remains the same despite a large or small change in price, supply is perfectly inelastic.

Producer Surplus

The price of a good minus the marginal cost of producing it.

Consumer Surplus

We don't always pay what we're willing to pay for a product. If you are willing to pay $3 for a CD but the market price is only $2, then you can buy that CD for less than it is worth to you. In economics, this difference between your marginal benefit from the CD and the price you pay for it is called consumer surplus. The total amount of consumer surplus is the marginal benefit from a good or service less the price paid for it, summed over the units purchased. In the figure for the demand curve of CDs, consumer surplus is the sum of the consumer surplus on the 200 CDs that people buy. This amount is the shaded triangle between the demand curve and the price of $2 per CD.

Market Efficiency

We studied the market for CDs as an example, examining the demand curve and the supply curve. This figure shows the market for CDs with its demand curve and supply curve together. In the figure, the demand curve is labeled D and the supply curve is labeled S. The demand curve is the same as the curve of marginal benefit (MB), and the supply curve is the same as the marginal cost (MC) curve. At market equilibrium, the equilibrium price is $2 and the equilibrium quantity is 200 CDs per day. The market forces that we've studied pull the CD market to its equilibrium, and are used to coordinate the plans of buyers and sellers. But, does this competitive equilibrium deliver the efficient quantity of CDs? If the equilibrium is efficient, the market does more than coordinate plans. It coordinates them in the best possible way. In other words, resources are used to produce the quantity of CDs that people value most highly. It is not possible to produce more CDs without giving up some of another good or service that is valued more highly.

Cross-elasticity

is a measure of how much the demand for a good changes when the price of either a substitute or a complement changes.

Substitute product

is something consumers can acquire in place of another

Consumer surplus

is the marginal benefit of a good or service minus the price paid for it

Producer surplus

is the price of a good minus the cost of producing it

Price elasticity

is used as a measurement of how quantities and price changes relate to each other

Efficiency

means getting the most out of the whole economy.

Price elasticity of demand

measures how responsive the quantity demanded of a good or service is to a change in price. To calculate this figure, use the ratio of percentage change in quantity demanded over the percentage change in price. -To predict by how much a price will change when an event occurs in a market, we need to know more about a demand curve than the fact that it slopes downward. We need to know how responsive the quantity demanded is to a price change. This is the concept of elasticity. -The price elasticity of demand measures the responsiveness of the quantity demanded of a good or service to a change in its price. To calculate the price elasticity of demand, we compare the percentage change in the quantity demanded with the percentage change in price. -It equals the absolute value of the ratio: Percentage of change in quantity demanded -------------------------------------------------- Percentage change in price

Price elasticity of supply

measures price fluctuations in relation to a change in quantity supplied. This measurementis obtained by comparing percentage change in quantity supplied to percentage change in price.

Inelastic

since no matter the price, most people will still need to purchase this product to get to the places they need to be

Consumer surplus On a graph, this is located in the triangular area above the market price and below the demand curve.

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If two goods are complements, then their cross-elasticity of demand is negative. As buyers' income increases, a good that has an income elastic demand takes an increasing share of income.

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Market equilibrium is efficient because the sum of consumer surplus and producer surplus is the largest at the equilibrium. Deadweight loss is a loss to society as a whole.

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Other things remaining the same, the price elasticity of the demand for a good is higher if it has more substitutes. Other things remaining the same, the price elasticity of the supply of a good is higher if it has more production possibilities.

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Producer surplus On a graph, this is located in the triangular area below the market price and above the supply curve.

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Suppose that the quantity demanded of pizza increases by five percent when the price of burgers increases by ten percent. The *cross-elasticity* of demand for pizza with respect to the price of a burger is 0.5. Suppose that a one percent increase in income causes a two percent increase in quantity demanded of a DVD movie. A DVD movie is a *normal good* and its demand is *income elastic*.

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Suppose the quantity demanded of gasoline decreases by two percent when the price increases by two percent. The demand for gasoline is unit elastic . ----------- At a point above the midpoint of a demand curve, elasticity is elastic. --------- Supply is unit inelastic if a one percent change in price --------------- causes a one percent change in the quantity supplied.

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The marginal benefit of a good is the same as the good's demand curve. Consumer surplus occurs when marginal benefit exceeds the market price. The marginal cost of a good is the same as the good's supply curve.

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Public Good

A good or service that can be consumed simultaneously by everyone and from which no one can be excluded.

Monopoly

A market in which a firm sells a good or service with no close substitutes and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

Allocative Efficiency, Marginal Benefit, and Marginal Cost

Allocative Efficiency Allocative efficiency is the idea that the goods and service produced are the ones that people value most. In other words, resources are allocated efficiently when we cannot produce more of a good or service without giving up some of another good or service that people value more highly. The concept of efficiency can best be understood using the production possibilities frontier (PPF), with which you may be familiar. Economies operate efficiently when the proportion of highly valued goods produced is maximized by each other. By using the PPF, we can see what combination of goods and services produced allows the most efficient production of highly valued goods and services. From this information, we can derive the marginal benefit and marginal cost of the production of certain goods and services. Marginal Benefit It is easy to say that owning a pair of shoes is much better than owning just one shoe. This additional benefit of owning/consuming one more unit of a good or service is called the marginal benefit. Because peoples' likes or dislikes determine what they are willing to give up in order to get another good or service, we can use these preferences to determine the marginal benefit of individual goods and services. Marginal Cost In contrast to marginal benefit, the marginal cost of a good or service is illustrated by the opportunity cost of producing one more unit of the good, and it is represented graphically by the slope of the PPF.

Total Surplus Is Maximized

Another way to determine whether the market equilibrium is efficient is to look at the total surplus that it generates. Total surplus is the sum of producer surplus and consumer surplus. When the efficient quantity of CDs is produced, the sum of the consumer surplus and producer surplus is maximized. What if the market price is not at equilibrium? A price above the equilibrium increases producer surplus, but it decreases consumer surplus by more. A price less than the equilibrium price increases consumer surplus, but it decreases producer surplus by more. In other words, the equilibrium price is the price that maximizes total surplus. In competitive markets, buyers and sellers try to do the best they can for themselves. In other words, they pursue their self-interest. No one plans for an efficient outcome for society as a whole. Buyers look for the lowest possible price; sellers look for the highest possible price. However, when buyers and sellers pursue their self-interest in this way, they serve the social interest in the end. The idea of the "invisible hand" was first explained by Adam Smith in his book the Wealth of Nations (1776) to illustrate the idea that consumers and producers often make decisions that, to them, seem to serve only a self-interest, but in actuality do a lot to benefit the social interest, seemingly led by an invisible hand. You can see the effects of the invisible hand every day. Your bookstore is stuffed with texts at the start of each semester. It has the quantities that match the amounts that students will buy. The coffee shop has the variety and quantities of drinks and snacks that people plan to buy. The bookstore and coffee shop managers work hard to satisfy your wants even though they don't know you.

Store Of Value

Any commodity or token that can be held and exchanged later for goods and services.

Computing the Price Elasticity of Supply

Formula To calculate the price elasticity of supply, use the following formula: fraction numerator Percentage space change space in space quantity space supplied over denominator Percentage space change space in space price end fraction ______________________________________________________________________ Scenario The following table shows two points on the supply curve for hamburgers from a college cafeteria. When the price per hamburger is $1, the quantity supplied is 10 hamburgers per day. When the price per hamburger is $2, the quantity supplied is 20 hamburgers per day. ex: Scenario: Computing the Price Elasticity of Supply ______________________________________________________________________ Calculating the Price Elasticity of Supply Now, let's calculate the price elasticity of supply using the data: Find the percentage change in quantity supplied by fraction numerator left parenthesis 20 minus 10 right parenthesis over denominator 15 end fraction cross times space 100 space equals space 66.7 % Find the percentage change in price by fraction numerator left parenthesis $ 2 space minus space $ 1 right parenthesis over denominator 1.5 end fraction space cross times space 100 space equals space 66.7 % Using the midpoint formula, the elasticity of supply between the two points is fraction numerator 66.7 % over denominator 66.7 % end fraction space equals space 1

Elasticity along a Linear Demand Curve

Graphically, the slope of a line measures responsiveness; but, elasticity is not the same as slope. We can see the distinction between slope and responsiveness more clearly by looking at the price elasticity of demand along a linear or straight-line demand curve. The elasticity is zero along a vertical demand curve, and the elasticity is infinite along a horizontal curve. Except for these two types of demand curves, the price elasticity of demand changes when moving along a linear demand curve. The figure shows the demand curve for hamburgers. The demand curve is constructed with data on the price and the quantity demanded of hamburgers per day. At point X, the price for a hamburger is $1 and the quantity demanded is 30 burgers per day. At point Y, the price is $2 and the quantity demanded is 20. At point Z, the price is $3, the quantity demanded is 10. The midpoint of the demand curve is point Y, where the price is $2 and the quantity demanded is 20. When the price increases from $2 to $3, the price elasticity of demand is 1.67. This means that at $3, demand is elastic. When the price decreases from $2 to $1, the price elasticity of demand is 0.6. This means that at $1, demand is inelastic. When the price increases from $1 to $3, then the price elasticity is 1. This means that at $2, demand is unit elastic. The demand curve for hamburgers shows that Demand is unit elastic at the midpoint of the curve Demand is elastic at all points above the midpoint of the curve Demand is inelastic at all points below the midpoint of the curve

Demand and Marginal Benefit

How do we know the marginal benefit of something? Marginal benefit is the benefit that people receive from consuming one more unit of a good or service. Marginal benefit is measured as the maximum price that people are willing to pay for another unit of a good or service. Demand is determined by the willingness of a consumer to pay a certain price for a good. Because of this relationship, the demand curve for a good also represents the marginal benefit curve. The figure shows the demand curve of CDs. The y-axis has CD prices in dollars per copy, and the x-axis has quantity in millions of CDs per day. The demand curve is constructed with the following data: When the price is $3, the quantity demanded is 100 CDs; when the price is $2, the quantity demanded is 200 CDs; and when the price is $1, the quantity demanded is 300 CDs. The demand curve is the line that connects these points. The demand curve of CDs is also its marginal benefit curve. Now, draw a horizontal line that illustrates the market price of $2. The demand curve in the figure shows that the maximum price a person is willing to pay for the 200th CD is $2. So $2 is the value and marginal benefit of this CD.

Underproduction and Overproduction

Markets very often do not produce at the efficient quantity. Instead, they very often produce more (overproduction) or less (underproduction) than the efficient levels. This under- or overproduction creates what is known as deadweight loss. Let's look at the figure for the CD market again. The equilibrium price is $2 and the equilibrium quantity is 200 CDs per day. What if the amount of production is different from this equilibrium quantity? For example, if only 150 CDs are produced per day, then underproduction occurs. If 250 CDs are produced per day, then overproduction occurs. In either case, the quantity produced is inefficient. A deadweight loss is the decrease in the total surplus that results from producing an inefficient quantity of a good. The figure to the right shows the deadweight losses from overproduction and underproduction. When 150 CDs are produced, the deadweight loss equals the shaded triangle between the supply and demand curves for the quantity between 150 and 200 CDs. When 250 CDs are produced, the deadweight loss equals the shaded triangle between the supply and demand curves for the quantity between 200 and 250 CDs. In either scenario, the total surplus is smaller than its maximum by the amount of the deadweight loss. The deadweight loss is borne by society as a whole. It is not a loss for a person as a result of a gain for another person. It is a social loss.

The key obstacles to achieving an efficient allocation of resources in a market are as follows:

Price and quantity regulations: Price and quantity regulations are restrictions on trade, such as price floors or quotas. Sometimes price and quantity regulations are implemented that make the equilibrium price illegal. When this occurs, the market shifts to maintain legality, but the result is an inefficient market with deadweight loss. Taxes and subsidies: Inefficiency can arise from the implementation of a tax or subsidy if the gap between the price consumers pay and the price producers receive is too wide. Externalities: If the demand curve for a good is not the same as the marginal benefit curve, we can assume that an externality is present and affecting efficient production. The same goes for a difference between a good's supply curve and the marginal cost curve of a good. Public goods: Because public goods are available to use for everyone, the free rider without an ability to pay directly impacts the efficiency of the production of that good. Common resources: When a common resource become overused and falls to the tragedy of the commons, the efficiency of production declines. Monopoly: Because a monopoly is a sole producer of a good or service, it often produces at less efficient levels because it increases its profits. High transactions costs: For most firms in a market there is an opportunity cost of operating in the market. These opportunity costs are collectively referred to as transactions costs. If transactions costs are too high, a firm produces below the efficient market level.

Marginal Benefit Equals Marginal Cost

The condition in which marginal benefit equals marginal cost is also the condition that generates efficient use of resources. To determine whether the equilibrium in the CD market is efficient, we need to examine what the demand curve and the supply curve tell us. The demand curve tells us the marginal benefit from CDs. The supply curve tells us the marginal cost of CD production. How can the relationship between marginal cost and marginal benefit help us determine the efficient quantity of a good? If the supply curve in the figure is the same as the marginal cost curve, and the demand curve is the same as the marginal benefit curve, then the point where the demand curve and supply curve intersect is both the equilibrium quantity and efficient quantity. Let's revisit the figure for the demand and supply curves of CDs. In the figure, the equilibrium quantity is 200 CDs per day. The efficient quantity is the quantity at which the marginal benefit of the last unit produced equals its marginal cost. In the same figure, which also show the marginal benefit and marginal cost curves of CDs, the efficient quantity is 200 CDs. Therefore, the equilibrium quantity is also the efficient quantity.

Cross Elasticity of Demand

The cross elasticity of demand, with all other variables remaining the same, calculates the effect that a change in price of a substitute good (hamburgers) has on the quantity demanded in another good (tacos). To find the cross elasticity of demand, use the following formula: P e r c e n t a g e space i n space c h a n g e space i n space q u a n t i t y space d e m a n d e d ------------------------------------------------------ P e r c e n t a g e space c h a n g e space i n space p r i c e space o f space a space r e l a t e d space g o o d What is the difference between the cross-elasticities of substitute goods and complementary goods? Complements have a negative cross-elasticity of demand Substitutes have a positive cross-elasticity of demand

More on Allocative Efficiency

The figure compares the marginal benefit and marginal cost of CD production. The line of marginal benefit is labeled MB; the line of marginal cost is labeled MC. The MB line intersects the MC line when 200 CDs are produced and bought per day. At this intersection, both the marginal cost and marginal benefit of one CD equals two cell phones. When marginal cost equals marginal benefit, efficient allocation—the highest valued allocation—has been achieved because it is impossible to make people better off by reallocating resources. In the figure, when 100 CDs are produced per day, the marginal benefit from another CD exceeds its marginal cost, which means that people prefer another CD more than the cell phone they must give up. When 300 CDs are produced per day, the marginal benefit from another CD is less than its marginal cost, which means that people prefer another CD less than the cell phone they must give up.

Income Elasticity of Demand

The income elasticity of demand, with all other variables remaining the same, calculates the effect that a change in income has on the quantity demand for a good or service: Formula To calculate the income elasticity of demand, use the following formula: fraction numerator Percentage space change space in space demand over denominator Percentage space change space in space income end fraction ------------------------------------------------------- Three ranges The income elasticity of demand decreases in three ranges: A value more than one indicates that the demand is income elastic for a normal good A value between zero and one indicates that the demand is income inelastic for a normal good A value less than zero indicates that the demand is for an inferior good ------------------------------------------------------- Increase in income As buyers' income increases, a good that has An income elastic demand takes an increasing share of income An income inelastic demand takes a decreasing share of income A negative income elasticity of demand takes an absolutely smaller amount of income ------------------------------------------------------- Summary The income elasticities of demand for different goods and services help us make predictions about how our consumption will change in the future. For example, air travel, movies, and restaurant meals all have income elastic demand. As our income increases, we can expect these services to take more shares of our income. On the other hand, the income elasticities of demand for food, clothing, and newspapers are less than one. Therefore, we know that we'll spend a decreasing percentage of our income on those items.

Price Floor

The lowest price at which it is legal to trade a particular good, service, or factor of production. The minimum wage is an example of a price floor.

Factors Affecting the Price Elasticity of Demand

The size of the price elasticity of demand depends on the following two factors: The amount of readily available substitutes If a good or service has a large number of easily available substitutes, it is more elastic. Conversely, the smaller the number of available substitutes for a good or service means that the good or service is more inelastic. For example, a luxury good generally has a larger number of substitutes than necessities, making luxury goods more elastic than necessities. Other factors that influence demand elasticity include how well defined a good is. For example, a blue Mercedes-Benz E-class is a more well-defined good than a luxury automobile, meaning that a blue Mercedes-Benz E-class has a higher elasticity than a luxury car. Time also plays a part in demand elasticity, because the longer the elapsed time between the price changes of a good means that good is more elastic. ----------------------------------------------------- The proportion of income spent on the good The proportion of income spent on the good simply means that the more of your income that you spend on a good or service, the more elastic the demand for the good or service.

Market equilibrium

This condition generates a zero deadweight loss.

Marginal benefit equals marginal cost

This condition generates an efficient use of resources.

Percentage Change in Price and Quantity Demanded

To calculate the price elasticity of demand, we first need to find the percentage change in price as well as the percentage change in quantity demanded. Let's examine how we can do this: Change in price To calculate the percentage change in price, use the following formula: left parenthesis fraction numerator New space price space minus space Initial space price over denominator Initial space price end fraction right parenthesis space straight x space 100 This method is only partially useful because it gives a different percentage change depending on whether the price increases or decreases. For instance, the $2 change from $10 to $12 is a 20% change, and the $2 change from $12 to $10 is only a 16.7% change. ------------------------------------------------------- Midpoint method To find a more accurate percentage change in price, economists use the midpoint method: left parenthesis fraction numerator New space price space minus space Initial space price over denominator left parenthesis New space price space plus thin space Initial space price right parenthesis space divided by 2 end fraction right parenthesis space cross times space 100 Economists prefer this method because it gives the same percentage change regardless of whether the price increases or decreases. For instance, the $2 change from $10 to $12 is a 18.2% change regardless of whether the price increases or decreases. ------------------------------------------------------- Change in quantity demanded Similarly, the midpoint method for calculating the percentage change in the quantity is as follows: left parenthesis fraction numerator New space quantity space minus space Initial space quantity over denominator left parenthesis New space quantity space plus thin space Initial space quantity right parenthesis space divided by space 2 end fraction right parenthesis space cross times 100 When calculating price elasticity of demand, it is important to remember to disregard any negative signs in your computations because the midpoint method deals in absolute values. Now we can use the midpoint method to compare the price elasticity of demand for different goods or services.

Total Revenue and the Price Elasticity of Demand

Total revenue Total revenue is equal to the price of a good multiplied by the quantity sold, and is also the total amount received by a seller for a good or service. If demand for a good or service is elastic, then a 2% price cut increases the quantity sold by more than 1%, and total revenue increases If demand for a good or service is unit elastic, then a 2% price cut increases the quantity sold by 1%, and total revenue does not change If demand for a good or service is inelastic, then a 2% price cut increases the quantity sold by less than 1%, and total revenue decreases ______________________________________________________________________ Total revenue test The total revenue test allows an economist to estimate price elasticity of demand by examining the change in total revenue that results in a particular change in price. Demand is elastic if price and total revenue change in opposite directions, such as when a price cut increases total revenue, and a price hike decreases total revenue Demand is unit elastic if a price change leaves total revenue unchanged. Either a price cut or a price hike does not change total revenue Demand is inelastic if price and total revenue change in the same direction, such as when a price cut decreases total revenue, and a price hike increases total revenue

Producer Surplus (continued)

We've learned about consumer surplus. Now, let's learn about cost, price, and producer surplus, which parallel what we've learned about value, price, and consumer surplus. Marginal cost of supply is the relationship illustrated by the cost of producing one more unit of a good. The marginal cost of supply gives us other information about the supply of a good. The marginal cost of supply also represents the minimum price that a supplier will accept, which in turn means that the marginal cost of supply curve (marginal cost curve) is the same as the supply curve for a good or service. The figure shows the supply curve of CDs. The y-axis has CD price in dollars, and the x-axis has quantity in CDs per day. The supply curve is constructed with the following data: when the price is $1, the quantity supplied is 100 CDs; when the price is $2, the quantity supplied is 200 CDs; when the price is $3, the quantity supplied is 300 CDs. The supply curve is the line that connects the points. The supply curve of CDs is also its marginal cost curve. Now, draw a horizontal line that illustrates the market price of $2. The supply curve in the graph shows that the minimum price a producer must receive to be willing to produce the 200 CDs per day is $2. So $2 is the marginal cost of this CD. To find the producer surplus, you take the price of a good and subtract the marginal cost of production, then add the totals over the quantity produced. In the figure for the supply curve of CDs, consumer surplus is the sum of the producer surplus on the 200 CDs that producers receive. This amount is the shaded triangle between the supply curve and the price of $2 per CD.

Allocative Efficiency and the Production Possibilities Frontier

When the marginal benefit of a resource is equal to the marginal cost of the same resource, we know that the good is being allocated at its highest efficiency possible. Consider an economy that produces two goods: CDs and cell phones. The following table shows the information on the marginal costs of a CD using the information from the PPF. At point A of the PPF, zero CDs are produced. Moving from point A to point B, 100 more CDs are produced. However, because this movement along the PPF involves a loss of 100 cell phones produced, the marginal cost of a CD is one cell phone. At point C, 200 CDs are produced and the marginal cost is two cell phones per CD. At point D, 300 CDs are produced and the marginal cost is three cell phones per CD.

Elastic and Inelastic Demand

When we have data on the prices and quantities demanded of different goods, we can compare their price elasticities of demand. The following are five possibilities about the price elasticity of demand: Demand is elastic when the percentage change in quantity demanded is larger than the percentage change in price. Demand is inelastic when the percentage change in quantity demanded is smaller than the percentage change in price. Demand is perfectly elastic when a small price change creates a large change in the percentage change in quantity demanded, as represented by a horizontal demand curve. Demand is perfectly inelastic when, regardless of the change in price, the quantity demanded stays constant, as represented by a vertical demand curve. Demand is unit elastic if the percentage change in price equals the percentage change in quantity demanded.

Factors Affecting the Price Elasticity of Supply

Whether the elasticity of supply of a good or service is large or small depends on many factors: Production possibilities Unique goods and services like precious metals or professional athletes have smaller elasticities of supply than common goods such as water or agricultural products. ----------------------------------------------------- The amount of elapsed time since the price change Supply is more elastic when the time that elapses between price changes is longer. ------------------------------------------------------ Storage possibilities The length of time that a good can be stored directly affects its elasticity of supply.

Complement

accompanies the goodsbeing bought