Chapter 2: Demand, Supply, and Elasticity 2.1 2.

2 Markets and Resource Allocation Market Structure Demand and the Demand Curve ndividual Demand and Market Demand Movements Alon! a Demand Curve Demand Shi"ters Supply and the Supply Curve ndividual Supply and Market Supply Movements Alon! a Supply Curve Supply Shi"ters Measurin! the Responsiveness o" Demand to %rice: Elasticity %rice Elasticity o" Demand %oint Arc Relationship to &otal Spendin! '&otal Revenue( Constant Elasticity Demand Curve ncome Elasticity Supply Elasticity

2.#

2.$

2.)

&his chapter introduces and applies three *asic components o" economic analysis: demand, supply, and elasticity. Each o" these is, indeed, a separate topic. As +e see *elo+, demand re"lects the *ehavior o" many individuals, each o" +hom *uys a su""iciently small part o" the market ,uantity that her or his decision a*out ho+ much to *uy o" the !ood under consideration has no impact on its price. -ike+ise, supply re"lects the *ehavior o" many individuals, each o" +hom sells a su""iciently small part o" the market that her or his decision a*out ho+ much to *uy o" the !ood under consideration has no impact on its price. .inally, demand 'and supply( elasticity helps us understand ho+ *uyers 'and sellers( o" a !ood respond to a chan!e in its price. . ach o" the demand and supply represents a model that depicts reality more or less +ell.

All models "ail to replicate reality completely. &he important ,uestion is not +hether a model is /realistic/ or even /ri!ht/ *ut +hether it is more use"ul than alternative models. &he models developed in this chapter have proved use"ul over the many decades economists have *een applyin! them to real +orld phenomena. 0ne assumption a*ove +arrants attention *e"ore lookin! at the uses o" demand and supply. &hrou!hout this chapter, re"erence is made to the ,uantity o" a !ood and to its price. 1o attention is paid to the nature o" that !oodits /,uality,/ its dura*ility, its color, its taste, etc. Also, no re"erence is made to individuals +ho meet to *uy or sell the !ood. 2e proceed this +ay *ecause the model developed herein is strictly appropriate "or a !ood like +heat that can *e purchased *y speci"ication. Every unit o" the !ood is the same, *uyers and sellers kno+ all a*out the !ood, and accordin!ly they need not meet to discuss any details. &his representation is close to descriptive o" the +heat market, *ut not "or the used car or la*or markets. Even so, much can *e !ained *y i!norin! the details o" individual transactions. &his is especially true in the la*or market. Even thou!h real transactions involve personal contact and every 3o* is in some +ays uni,ue, many important aspects o" the la*or market can *e analy4ed +ithin the "rame+ork developed in this and the ne5t chapter 'Chapter #(. 2. 1. 1 Markets and Resource Allocation &he analysis o" markets is the main component o" microeconomic analysis *ecause the vast ma3ority o" actions re!ardin! +hich !oods and services +e produce and consume are in"luenced and coordinated *y markets. -ar!e components o" our economy, such as schoolin! and hi!h+ays, are directed via political processes. Even so, these pale in comparison to the num*er o" commodities, ran!in! "rom entertainment to housin! and "ood, that +e o*tain throu!h markets. Accordin!ly, it is essential to !ain an understandin! o" ho+ the market system +orks.

&his understandin! depends on our understandin! o" the *uildin! *locks, demand and supply. 2e put the t+o to!ether in chapter #. 2. 1. 2 Market Structure 6o+ the *uildin! *locks "it to!ether depends on the structure o" markets. Economists identi"y "our !eneral structure types "or product markets: per"ect competition, per"ect monopoly, oli!opoly, and monopolistic competition. n each o" these "our, the *uildin! *locks "it to!ether in some+hat di""erent +ays. Perfect competition is the market structure in +hich demand, supply, and market e,uili*rium provide the +hole story. &his chapter and Chapter 5 develop the lo!ic o" this market structure. As noted earlier, in per"ect competition each seller 'and each *uyer( is too small to in"luence the market price apprecia*ly. Each one is a price taker rather than a price maker. &he demand curve, as developed *elo+, e5ists only +hen all *uyers are price takers7 the supply curve like+ise e5ists only +hen all sellers are price takers. .or other market structures the supply curve does not e5ist. Rather, analysts look at the "irm8s 'or "irms8( cost structure and, coupled +ith in"ormation a*out the demand curve, deduce the nature o" the market8s *ehavior. Monopoly 'Chapter 9( is the simplest o" all market structures. A sin!le "irm "aces a demand curve 'some times more than one demand curve( "or its product. &he "irm uses the in"ormation in the demand curve to determine +hat price 'or prices( to char!e and +hat ,uantity to produce.1 Oligopoly 'Chapter 1:( is the most complicated o" all market structures. A "e+ "irms "ace a market demand "or their product. Complicatin! the issue, ho+ever, is that the demand "or the product o" each o" the "irms is not related to market demand in any direct +ay. Rather, the

relationship depends on ho+ each "irm reacts to the other "irms8 *ehavior. &his interdependence induces strategic behavior, +hich rules out precise statements a*out the per"ormance o" oli!opolistic markets. Analysis is limited to derivin! insi!hts a*out their per"ormance in various sets o" circumstances. Monopolistic Competition (chapter 11). Monopolistically competitive markets occur +here many "irms sell ,uite similar products and in +hich entry o" ne+ "irms is relatively easy. n these markets, +e com*ine the analysis o" monopolistic markets +ith the condition that entry occurs as lon! as it is pro"ita*le in order to determine relevant aspects o" market *ehavior.

2. 2

Demand and the Demand Curve ;e"ore proceedin! to employ the concepts o" demand and supply, +e must speci"y 3ust

+hat the terms mean "or the purposes o" analysis. Economists use these t+o terms in a precise +ay. &his section addresses the meanin! o" /demand./ /Supply/ is addressed in the "ollo+in! section. Economists vie+ demand as *ein! *ased on consumers8 response to incentives. Chapter $ develops a rather detailed model o" demand. .or no+ +e de"ine a demand function as a relationship that sho+s the ,uantity that *uyers are +illin! and a*le to purchase o" a !ood or service at each o" a set o" values taken *y speci"ic varia*les. .or e5ample, the market demand "or <ood = mi!ht *e: >= ? "'%=, %@, %A, , 1(, '2.1(

+here >= is the ,uantity demanded per time period o" <ood =7 %=, %@, and %A are prices o" <oods =, @, and A7 is income, and 1 is the num*er o" potential *uyers in a the market. Amon! these varia*les, %= +arrants special attention. &his attention is not *ecause the

!ood8s o+n price is necessarily the most important sin!le determinant o" the ,uantity demanded. Rather, +e accord the /o+n price/ special attention "or t+o reasons. .irst, "or virtually any !ood, its o+n price has at least some in"luence on that !ood8s consumption. &he other "actors a""ectin! demand can vary "rom one !ood to another. A more compellin! reason "or payin! special attention to price is that it in"luences *oth sides o" the market: &he price simultaneously a""ects the actions o" *uyers and sellers. ndeed, it coordinates the actions o" the t+o other+ise unrelated !roups. .or these reasons, +e rephrase the demand "unction a*ove in terms o" the demand curve: >= ? "'%= B %@, %A, , 1(. Read this "unction as "ollo+s: the ,uantity o" <ood = is determined *y the price o" <ood =, holdin! constant the prices o" <ood @ and <ood A, the income level, and the num*er o" potential consumers. More !enerally the demand curve is de"ined as "ollo+s: The market demand curve is the quantity of a good that buyers are willing and able to purchase at each of a set of prices, holding other things constant. '2.2(

.i!ure 2.1 sho+s one such demand curve. &his demand curve sho+s the ,uantity demanded at each price *et+een 4ero and C#::. Some o" the priceD,uantity pairs also appear in the ta*le to the le"t o" the !raph. &his !raph o*eys the law of demand, that an inverse relationship e5ists *et+een the price o" a !ood and the ,uantity that *uyers are +illin! and a*le to purchase, other thin!s e,ual. &his la+ is an empirical re!ularity7 theory does not dictate that demand curves slope do+n+ard, thou!h it su!!ests that this is the most common state o" a""airs.

.i!ure 2.1 A Demand Curve

2. 2. 1 ndividual Demand and Market Demand ndividuals rather than !roups make decisions and take actions, includin! reactin! to price chan!es. &here"ore, the market demand curve must *e derived "rom individual demand curves. .i!ure 2.2 sho+s ho+ the market demand curve relates to individual demand curves. 2e consider 3ust t+o individuals, Chris and ;lair, and e5amine ho+ their individual demand curves determine the market demand curve.

.i!ure 2.2 ndividual and Market Demand Curves At prices a*ove C#.:: Chris chooses not to consume this !ood. At lo+er prices Chris is more responsive to price than ;lair is, increasin! the num*er o" units purchased *y $ per C1 price decrease, in contrast to ;lair8s t+oEunit chan!e per dollar. &o calculate market demand re,uires simple summation o" the individuals8 ,uantities at each possi*le price. n this case, the market demand curve /kinks/ at C#.::, +here Chris enters the market7 at hi!her prices the market demand is the same as ;lair8s demand. &he nature o" the summation process does not depend on the num*er o" individual *uyers. n most markets, o" course, the num*er is ,uite lar!e. 2. 2. 2 Movements alon! a Demand Curve &he de"inition o" a demand curve divides the "actors that a""ect the amount o" a !ood that a person 'or !roup( *uys into t+o cate!ories: the !ood8s price and all others. 2hen the /all

others/ remain unchan!ed, the location o" the demand curve remains the same. &hat is, the ,uantity purchased at each price remains the same. n this case, the only thin! that chan!es the amount that people are +illin! and a*le to consume is the !ood8s o+n price. Economists re"er to ,uantity chan!es induced *y price chan!es as changes in the quantity demanded, as distinct "rom changes in demand, +hich are addressed in the section 2.2.#. .i!ure 2.# illustrates a chan!e in the ,uantity demanded o" the !ood under consideration. &he price chan!es "rom C1): to C1F:. '&he user o" the spreadsheet can choose any other price(. n response to this price chan!e, the quantity demanded chan!es "rom #: units at a price o" C1): to 2$ units at a price C1F:. 2e o*serve a movement up+ard alon! the 'unchan!ed( demand curve.

.i!ure 2.# Movement Alon! a Demand Curve

2. 2. # Demand Shi"ters

2hile price is central to the analysis o" +hat determines the ,uantity o" the !ood that *uyers choose to purchase, it is not the +hole story. &he income level, prices o" related !oods, or any o" a host o" other "actors can chan!e. &hese chan!es a""ect the ,uantity that *uyers are +illin! and a*le to purchase at each of the prices listed on the demand curve. &hus, any o" these chan!es renders the initial demand curve o*solete, causin! it to *e replaced *y a ne+ curve. n the terminolo!y o" economics, demand has changed. .i!ure 2.$ illustrates that a chan!ed demand 'in this case a demand increase( +ill result in a ne+ quantity demanded at each possi*le price. n particular, at the price o" C1):, the ,uantity demanded increases "rom #: units per time period to ): units per time period.

.i!ure 2.$. A Chan!e in Demand .i!ure 2.) "ocuses attention on the "actors that can shi"t the demand curve. &o *e concrete,

the illustration takes into account three such "actors: the price o" a su*stitute, the price o" a complement, and the income o" the consumer.

2hen the price o" a su*stitute "or <ood = chan!es, the demand "or <ood = chan!es in the same direction.2 .or e5ample, i" the price o" %epsi Cola +ere to rise to C1.:: per can "rom C:.): per can, 'at least some( people +ould *uy more Coke at each possi*le price o" Coke. &he demand "or Coke +ould increase. 2hen the price o" a complement chan!es, demand "or <ood = chan!es in the opposite direction. " the price o" tires "or SGHs 'Sport Gtility Hehicles( dou*les, then 'at least some( consumers +ould purchase another style o" vehicle. &he demand "or SGHs +ould shi"t to the le"t. .inally, income a""ects the demand "or most !oods. More o"ten than not, a chan!ed income shi"ts the demand curve in the same direction. .i!ure 2.) sho+s the e""ect o" a chan!ed price o" the su*stitute !ood "rom C1:: to C11). &he C1) increase in the su*stitute !ood8s price causes the demand "or <ood = to shi"t ri!ht+ard *y 12 units. &he other t+o "actors can *e e5amined separately +ith the result that increasin! the complement8s price shi"ts the demand to the le"t and increasin! income shi"ts it to the ri!ht. 0" course, any com*ination o" these chan!es can *e e5amined.

.i!ure 2.).Demand Shi"ters 2. # Supply and the Supply Curve &he lo!ic o" the supply curve parallels that o" the demand curve. &he ,uantity o" a !ood that sellers provide depends on the !ood8s price, on technolo!y, on input prices, and on any o" a num*er o" "actors that are peculiar to the !ood under consideration. .or our purposes, price is the varia*le o" most interest. &his section sketches the relationship *et+een price and ,uantity, "ollo+in! the precedin! analysis o" demand. 2. #. 1 ndividual Supply and Market Supply As +ith demand, the market supply derives "rom the individual supply decisions o" many sellers. .or purposes o" illustration +e a!ain limit the num*er to t+o priceEtakin! sellers, &erry and -ee. .i!ure 2.I sho+s &erry8s and -ee8s supply curves and the implied market supply curve. Each individual supply curve sho+s ho+ the seller reacts to price. n each case, the hi!her price induces additional output. &his need not *e true "or all individual sellers, *ut seems likely "or at

least some. Chapter F develops the lo!ic o" the supply *y the individual seller.

.i!ure 2.I ndividual and Market Supply

2. #. 2 Movements Alon! a Supply Curve A!ain, as +ith demand, +e distin!uish *et+een movements alon! a speci"ic supply curve and a chan!e in demand. &he "ormer results "rom a chan!e in the product8s price +hile all other "actors are held constant. 2hen any o" those other "actors chan!e, the entire supply curve shi"ts. &hat is, the ori!inal supply curve is supplanted *y a ne+ one. .i!ure 2.I illustrates movements alon! supply curvesin this case the t+o individual supply curves and the market supply curve. At a price o" C2.::, the individual ,uantities o" ) and

F are supplied "or a market ,uantity o" 1# units. &he hi!her price calls "or more output "rom each o" the t+o sellers and, there"ore, a lar!er ,uantity at the market level. 2.#.# Supply Shi"ters &he market supply curve is su*3ect to shi"ts, as is the market demand curve. Some important supply shi"ters are these: the prices o" inputs used to produce the !ood, the num*er o" potential sellers, and technolo!y. An increased input price implies that sellers must *e paid more to produce a !iven ,uantity or, e,uivalently, that at a !iven price the ,uantity supplied decreases. &he supply curve shi"ts to the le"t. &he num*er o" potential sellers in a market can *e a""ected *y transportation technolo!y, in"ormation technolo!y that allo+s +ouldE*e sellers to learn o" market opportunities, or chan!es in restrictions on entry into the industry 'licensin! la+s, "or e5ample(. n any event, an increase in the num*er o" potential sellers shi"ts the supply curve to the ri!ht. .inally, improved technolo!y lo+ers cost and induces increased output at any !iven price7 that is, it shi"ts the supply curve to the ri!ht. .i!ure 2.J illustrates the shi"tin! o" a supply curve, sho+in! the e""ect o" an increased +a!e rate. ncreasin! the +a!e rate *y C) per unit o" la*or shi"ts the supply curve up+ard *y C): per unit o" the product. &hat is, the +a!e rate translates into a C): per unit increase in the cost o" *rin!in! this product to the market at each ,uantity. %hrased in terms o" ,uantity, this means that the supply curve shi"ts le"t+ard *y 1#1D# units. " the inde5 o" technolo!y had increased 'indicatin! *etter technolo!y(, the supply curve +ould have shi"ted do+n+ard and to the ri!ht. -ike+ise, an increase in the num*er o" potential sellers shi"ts the supply curve do+n+ard.

.i!ure 2.J. Supply Shi"ters

2.$

Measurin! the Responsiveness o" Demand to %rice: Elasticity &he ,uantity demanded is inversely related to the product8s price. t is important "or many

purposes to have a +ay o" descri*in! the si4e o" that relationship. &+o measures su!!est themselves, slope and elasticity. 0" the t+o, slope is a much more o*vious measure. t is the num*er o" units that the ,uantity demanded chan!es per oneEunit chan!e in the price. n .i!ure 2.), the slope is 'E(:.2. &hat is, the ,uantity chan!es *y 1D) "or each C1 chan!e in the price. 2hether this is a lar!e or small chan!e depends, o" course, on the units. 2ithout more in"ormation, +e cannot determine +hat a slope o" 'E(1D) means. &his does not imply that the slope is not a use"ul measure o" the response to price. t is, especially +hen those usin! the in"ormation are a+are o" +hat the units mean. &he second measure o" price responsiveness is elasticity. &he price elasticity of demand

"or a !ood is the percenta!e chan!e in ,uantity demanded per oneEpercent chan!e in price. &his measure is a /pure num*er/EEit has no units. " one says, "or e5ample, that the price elasticity o" demand "or !asoline is 'E(:.2), no more in"ormation is re,uired. 2e kno+ that a one percent chan!e in the price o" !asoline results in a :.2) percent chan!e in the ,uantity demanded, in the opposite direction. n addition to *ein! easily interpreted, elasticity o""ers another advanta!e over slope: elasticity determines +hether an increase in a product8s price +ill increase or decrease the amount that consumers spend on that product. 2.$.1 %rice Elasticity o" Demand .ollo+in! the de"inition o""ered a*ove, the price elasticity o" demand may *e +ritten as "ollo+s: E% ? '1::K>D>( D '1::K%D%(, 2.#

+here the 8s indicate chan!es. &hus, the denominator is the percenta!e chan!e in ,uantity and the denominator is the percenta!e chan!e in price. 0*viously, the 1::8s can *e dropped "or purposes o" calculation, so the e,uation *ecomes: E% ? '>D>( D '%D%(, 2.$

&he elasticity may *e de"ined and calculated in either o" t+o +ays: at a point or over a ran!e. &he point elasticity is closely related to the slope o" the demand curve. Rearran!in! the terms o" E,uation '2.$( yields E%%0 1& ? '>D%('%D>(. Alternatively, the price elasticity may *e computed "rom price and ,uantity data at any t+o points on a demand curve. &his is typically re"erred to as the arc elasticity, +hich is most o"ten 2.)

computed in the "ollo+in! +ay: E%ARC ? '>D'>1 L >2(D2( D '%D'%1 L %2(D2(. 2.I

>1 and >2 are the t+o ,uantities, and %1 and %2 are the respective prices. &he chan!es are > ? >2 E >1 and % ? %2 E %1. &his method, called the midEpoint method, avoids am*i!uity introduced *y choosin! either %D> pair '%1D>1 or %2D>2( as the *ases "or computin! percenta!es. Re"erence to .i!ure 2.F illustrates these computations. At any point on the demand curve, the elasticity is :.2'%D>(. '2e i!nore the si!n, treatin! the elasticity as a positive num*er(. &hus +hen % ? C1F:, > ? 2$, and E%%0 1& ? :.2'1F:D2$( ? 1.). At that point on the demand curve, ,uantity chan!es *y 1.) percent per one percent chan!e in price. 'Rou!hly, "or e5ample, i" price rises *y 1M to C1F1.F:, ,uantity +ould decrease *y 1.) percent or :.#I units to 2#.I$ units.( Computin! the arc elasticity is a *it more involved. Consider the elasticity *et+een the points on the demand curve correspondin! to prices o" C1F: and C12:. 0ver that ran!e, the percenta!e chan!e in ,uantity is 1::K'12D#:( ? $:M. &he percenta!e chan!e in price is 1::K'I:D1):( ? $:M. &he elasticity over the ran!e, the arc elasticity, is $:MD$:M or 1.:.

.i!ure 2.F. %rice Elasticity o" Demand Alon! the Demand Curve

2.$.2

Relationship to &otal Spendin! '&otal Revenue( 2hen demand is inelastic, that is +hen the price elasticity is less than 1.:, then the

,uantity demanded "alls proportionately less than the price rises. &here"ore, an increased price causes total e5penditures on the !ood to increase. ;y the same reasonin!, an increased ,uantity causes e5penditures to "all. See the "irst panel o" "i!ure 2.9, +hich sho+s a case in +hich the elasticity o" demand is :.). A 2:M price chan!e "rom C9: to C11: causes the ,uantity to chan!e in the opposite direction *y 1:M, "rom $2 to #F. &o see the e""ect on e5penditures, compare the t+o rectan!les in that panel. ncreasin! the ,uantity causes $ more units to *e purchased, addin! C9:K$ or C#I: to spendin!. &his is the area o" the small rectan!le at the ri!ht. 0""settin! this, ho+ever, is the "act that *uyers no+ spend C2: less "or each o" the #F units they +ould have purchased at the hi!her price. &his reduces spendin! *y C2:K#F or CJI:, the area o" the upper

rectan!le. &here"ore, increasin! the ,uantity 'reducin! the price( results in lo+er total spendin!.

.i!ure 2.9. %rice Elasticity, %rice, and E5penditures Contrast this outcome +ith that represented in the ri!ht panel o" .i!ure 2.9. 6ere, the t+o prices are C19: and C21:, +ith associated ,uantities o" 22 and 1F. 0ver this arc o" the demand curve, a 1: percent chan!e in price is associated +ith a 2: percent chan!e in ,uantity. 1o+ increasin! ,uantity *y "our units results in a relatively lar!e increase in spendin! 'C19:K$ ? CJI:( compared to the relatively small reduction due to lo+er spendin! on the 1F units *ou!ht at the hi!her price 'C2:K1F ? C#I:(. 1o+, increasin! the ,uantity 'reducin! the price( causes spendin! to increase. '&hese t+o numeric e5amples come "rom a spreadsheet that allo+s the user to speci"y an initial price. &he sheet, not sho+n here, provides calculations o" percenta!e chan!es, spendin! levels, and the arc elasticity.( &hese t+o panels o" .i!ure 2.9 illustrate a !eneral principle: 2henever demand is inelastic, price and spendin! move in the same direction ',uantity and spendin! move in opposite directions(7 and +henever demand is elastic, price and spendin! move in opposite directions ',uantity and spendin! move in the same direction(. &he relationship *et+een ,uantity

and revenue can *e stated more precisely: SD> ? %'1 E 1DE%(. 2.J

&he term SD> is the chan!e in total spendin! '%K>( per oneEunit chan!e in the ,uantity. Re"er to the e5amples in .i!ure 2.9. n the "irst panel SD> ? C1::K'1 E 1D:.)( ? C1::'E1( ? EC1::. &hat is, spendin! decreases *y C1:: per oneEunit chan!e in ,uantity, or *y C$:: over the ran!e considered. n the second panel, in contrast, spendin! increases: SD> ? C2::K'1 E 1D2( ? LC1:: per unit, so spendin! increases *y C$::. 2.$.# Constant Elasticity Demand Curve %recedin! material sho+s that a linear demand curve e5hi*its di""erent elasticities as one moves alon! it7 it is elastic at hi!her prices and inelastic at lo+er ones. Conversely a demand curve that e5hi*its constant elasticity at all points must have di""erent slopes at di""erent prices. .i!ure 2.1: sho+s one such curve. n this case, the curve is sli!htly inelastic, +ith a price elasticity o" :.9. As the "i!ure sho+s, and as +e sa+ +ith the linear curve, an inelastic demand curve implies a direct relationship *et+een price and spendin! 'an inverse relationship *et+een ,uantity and spendin!(. n this case, price rises *y a*out $9.I percent 'usin! the midpoint "ormula(, +hile ,uantity decreases *y a*out $: percent. &here"ore, spendin! rises +ith the price increases.

.i!ure 2.1:. A ConstantEElasticity Demand Curve 1o demand curve +ill e5hi*it constant price elasticity at all prices. Such a demand curve +ould imply that no price could choke o"" consumption completely. &his cannot hold, *ecause *ud!ets are limited. Even so, the representation can serve as a !ood appro5imation over a ran!e o" prices. Also, this type o" curve can sho+ ho+ demand curves look +hen elasticity is very lo+ and very hi!h. .or e5ample, settin! the value o" Elasticity at 1: results in a curve that is very nearly hori4ontal. -ike+ise, an elasticity o" :.:1 results in a demand curve that is nearly vertical e5cept at ,uite lo+ prices. 2.$.$ ncome Elasticity &he ,uantity o" a !ood that a consumer *uys depends on income as +ell as price. A use"ul summary measure o" the responsiveness o" the ,uantity demanded to income chan!es is the income elasticity of demand. t is calculated much as the price elasticity o" demand: the

income elasticity o" demand e,uals the percenta!e chan!e in ,uantity demanded per one percent chan!e in income, other thin!s e,ual. &he income elasticity is calculated as "ollo+s: E ? '>D>(D' D ( As +ith the price elasticity, this computation may *e e5ecuted at a point or over a ran!e. .i!ure 2.11 *elo+ sho+s some ,uantityEincome relationships in +hich the point price elasticity is the same at all points. &he solid line is do+n+ard slopin!, representin! a !ood "or +hich hi!her income results in reduced consumption7 such !oods are called inferior goods. Such !oods are rare *ut in theory can e5ist. 'Alon! this curve, the income elasticity is E:.1. &he relatively !entlyEsloped !ood 'dotted +ith small circles( represents a normal good, one "or +hich the ,uantity increases alon! +ith increased income. '&he income elasticity alon! this curve is :.2).( .inally, the more steeplyEsloped curve 'dotted +ith small diamonds( is a special case o" a normal !ood, one "or +hich the percenta!e chan!e in ,uantity e5ceeds the percenta!e chan!e in price. n this case, the income elasticity is 1.), so a $ percent chan!e in income '"or e5ample( causes the ,uantity to increase *y I percent. 2.F

.i!ure 2.11. ncome and >uantity Demanded '%rice Constant( An important reason "or attention to the income elasticity is that it provides in"ormation on the share o" *ud!et allocated to speci"ic !oods as incomes chan!e. .or those !oods +hose income elasticities are *elo+ unity, the share o" income spent on those !oods decreases as incomes rise. 'An e5ample "or these !oods is "ood products.( .or those +ith income elasticities a*ove unity, increased income results in a lar!er share o" the *ud!et *ein! allocated to the !oods. 'An e5ample "or these !oods is e5pensive vacations 'can you think o" a *etter e5ample, 2ilsonN.( .i!ure 2.12 illustrates this relationship. t is "rom a spreadsheet in +hich the user indicates ho+ many units the consumer purchases at the hi!her o" t+o incomes. &he spreadsheet then calculates the e5penditures, share o" income spent on the !ood, and the income elasticity. n the value selected *elo+, the income elasticity e5ceeds 1.:, and the share o" income spent on the !ood increases +ith the increased income. '&he product price o" C:.): is ar*itrary and can *e chan!ed. 1othin! o" importance turns on the price.(

.i!ure 2.12. An ncome Elasticity Calculator

2.)

Elasticity o" Supply 0"ten the responsiveness o" the ,uantity supplied to price chan!es is as important as that

o" ,uantity demanded. An e5ample, +e consider in chapter #, is the incidence o" ta5ation. 2hether the lar!er impact o" a ta5 is on *uyers or sellers depends critically on the relative responsiveness o" the ,uantity demanded and the ,uantity supplied to price chan!es. As +ith demand, the responsiveness may *e measured in terms o" either slope or elasticity. A!ain, elasticity has the advanta!e o" *ein! unitE"ree, so responsiveness o" various products may *e compared. &he computation o" elasticity is accomplished the same +ay +ith supply as +ith demand. As +ith demand, the price elasticity o" supply may *e computed at points on a curve or alon! an arc. .i!ure 2.1# sho+s a supply curve and the point elasticities o" supply at various points on the curve.

.i!ure 2.1#. Supply Elasticities &his supply curve ran!es "rom ,uite elastic at lo+er prices to ,uite inelastic at hi!her ones. Arc elasticities are not sho+n *ut are easily calculated. 0"ten the analyst need kno+ only +hether the supply curve is elastic or inelastic at a point. .or supply this is easily determined. Dra+ a line tan!ent to the curve at the point o" interest. " that line intersects the vertical 'price( a5is "irst, then the supply curve is elastic at that point7 i" it intersects the hori4ontal ',uantity( a5is at that point, then the supply curve is inelastic at that point. 'A supply curve that hits the ori!in in unitary elastic.( ;ecause the supply curve slopes up+ard, the relationship *et+een price and spendin! as +e move alon! the curve raises no concern. A hi!her price induces an increased ,uantity. ;oth add to the result that total spendin! increases as +e move ri!ht+ard alon! any supply curve

2.I

Chapter Summary: &his chapter e5plains demand and supply and the responsiveness o" individuals to

chan!es in a !oodOs price. Demand re"lects the ,uantity o" a !ood that consumers are +illin! and a*le to *y at every price. -ike+ise, supply re"lects the ,uantity o" a !ood that consumers are +illin! and a*le to *y at every price. .inally, demand 'and supply( elasticity helps us understand ho+ demand 'and supply( o" a !ood responds to a chan!e in its price. 2.J -ookin! Ahead: 1o+ that +e kno+ ho+ demand and supply o" a !ood are determined, +e +ill put the t+o to!ether in chapter # to analy4e ho+ the price o" a !ood is determined in the market. 2e +ill also discuss special applications o" demand and supply to ta5es and international markets. &he discussion o" ta5es +ill *uild on our understandin! o" price elasticity o" supply and demand. 1e+ &erms