SUPPLY & DEMAND IN INDIVIDUAL MARKETS

By: Dr. Nazir Saeed Secretary Information Technology Government of the Punjab

Elasticity of Demand and Supply

Elasticity of Demand and Supply

Price Elasticity of Demand The law of download-sloping demand tell us that quantity demanded tends to vary inversely with price. Want to know how much quantity demanded will change in response to a change in price? The price elasticity of demand (sometimes simply called price elasticity) measures how much the quantity demanded of a good changes when its price changes.

Elasticity of Demand and Supply contd.

Elasticity denotes responsiveness. The price elasticity of demand is the responsiveness of the quantity demanded of a good to changes in the goods price, other things held constant. The precise definition of price elasticity, ED, is the percentage change in quantity demanded divided by the percentage change in price, i.e. ED = percentage change in quantity demanded
percentage change in price

Elastic and Inelastic Demand

A good is elastic when its quantity demanded responds greatly to price changes and is inelastic when its quantity demanded responds little to price changes.
When 1% change in price call forth more than 1% change in quantity demanded, this is price-elastic demand. When 1% change in price evokes less than 1% change in quantity demanded, this is priceinelastic demand.

Elastic and Inelastic Demand contd.

Three important points about elasticity measurements: Prices and demand moves in opposite directions because of the law of downward-sloping demand. For convenience percentage changes are treated as positive number. The use of percentage changes rather than actual changes gives a nice property that the elasticity measure is a pure number. Slight ambiguity in measuring percentage changes. The formula for a percentage change is P/P.

Elastic and Inelastic Demand contd.

Price was 90 and quantity demanded was 240 units. A price increase led to 110 led consumers to reduce their purchases to 160 units. The price elasticity of demand is evidently ED = 40/20=2

Elastic and Inelastic Demand contd.

To avoid ambiguity, always take the average price to be the base price for calculating price changes. The exact formula for calculating elasticity is therefore: ED = Q P (Q1 +Q2) (P1 + P2) Where P1 and Q1 represent the original price and quantity and P2 and Q2 stand for the new price and quantity.

Elastic and Inelastic Demand contd.

Price elasticity varies from zero to infinity along a straight line demand curve. At mid-point of the demand curve is unitelastic demand, which occurs when percentage change in quantity is exactly the same size as the percentage change in price.

Price Elasticity in Diagrams

Price is cut in half and consumers change their quantity demanded from A to B.

Halving of price has tripled quantity demanded. This case shows price-elastic demand.

Price Elasticity in Diagrams contd.

Cutting price in half led to only 50% increase in quantity demanded. This case shows priceinelastic.

Price Elasticity in Diagrams contd.

Doubling of quantity demanded exactly matches the halving of price. Borderline case of unit-elastic demand.

Price Elasticity in Diagrams contd.

Perfectly inelastic demands are ones where quantity demanded responds not at all to price changes. When quantity demanded is infinitely elastic, this implies that a tiny change in price will leads to indefinitely large change in quantity demanded, shown above.

Slopes Vs. Elasticities

A steep slope for the demand curve means inelastic demand and a flat slope signifies elastic demand? Wrong interpretation!

Slopes Vs. Elasticities contd.

This straight-line demand curve has the same slop everywhere but the top of line near A has a very small percentage price change and a very large percentage quantity change, i.e. elasticity is extremely high. When price is very low, price elasticity is very low. Above the mid-point M of any straight line, demand is elastic with ED > 1. At the midpoint, demand is unit-elastic, with ED =1. Below the mid-point, demand is inelastic, with ED < 1.

Elasticity and Revenue

An increase in supply would tend to depress price. Gregory King observed a less obvious point: Farmers as a whole receive less total revenue when the harvest is good than when its bad. Paradoxically, good weather is bad for farmers incomes. The reason is that a low price elasticity of food means that a large harvests (high Q) tend to be associated with low revenue (low P x Q)

Elasticity and Revenue contd.

Three cases of elasticity correspond to three different relationships between total revenue and price changes: When demand is price inelastic, a price decrease reduces total revenue. When demand is price elastic, a price decrease increases total revenue. In the borderline case of unit-elastic demand, a price decrease leads to no change in total revenue.

Total revenue at any point on a demand curve can be found by examining the area of the rectangle formed by the P and Q at that point.

Elasticity and Revenue contd.

shaded revenue region (P x Q) is $1000 million for both points A and B. Unit-Elastic Demand.

Elasticity and Revenue contd.

The revenue expands from $1000 million to $1500 million when the price is halved. Demand is elastic.

Elasticity and Revenue contd.

The revenue rectangle falls from $40 million to $30 million when price is halved. Inelastic Demand.

Elasticity and Revenue contd.

Value of demand elasticity
Greater than one (ED > 1)

Description

Definition

Impact on revenue
Revenues increases when price decreases

Elastic demand

% change in quantity demanded greater than % change in price % change in quantity demanded equal to % change in price % change in quantity demanded less than % change in price

Equal to one (ED = 1) Less than one (ED < 1)

Unit-elastic demand Inelastic demand

Revenues unchanged when price decreases Revenues decreases when price decreases

Determinants of Elasticities
For necessities like food, fuel etc demands tends to be elastic. Such items are the staff of life and cannot easily be forgone when their prices rise. The length of time that people have to respond to price changes also plays a role, for e.g.
Driving across country when the price of gasoline suddenly increases.

For many goods, the ability to adjust to consumption patterns implies that demand elasticities are higher in the long run than in the short run.

Determinants of Elasticities contd.

Another factor affecting price elasticities is the importance of a good in the consumer budget. Those goods that require a large fraction of income tend to be more responsive to price than those that are a trivial part of spending. For e.g,
the comparison of choice importance between gasoline and shoelaces.

Price Elasticity of Supply

The Price elasticity of supply measures the percentage change in quantity supplied in response to a 1 percent change in goods price. Definition of price elastic ties of supply are exactly the same as those for price elasticities of demand. The only difference is that, for supply, the quantity response to price is positive, while for demand the response is negative. ES = percentage change in quantity supplies percentage rise in price

Price Elasticity of Supply

The vertical supply curve showing perfectly inelastic supply , the horizontal supply curve displaying perfectly elastic supply, and an intermediate case of a straight line, going through the origin, illustrating the borderline case of unit elasticity.

Price Elasticity of Supply contd.

What factors determine supply elasticity? Major factor influencing supply elasticity is the extent to which production in the industry can be increase. If inputs can be easily found at going market prices, output can be greatly increased with little increase in price. This would indicate that supply elasticity is relatively large. If production capacity is severely limited, then even shape increase in the price will call forth but a small increase in production.

Applications of Supply and Demand

Introduction
Supply and demand to analyze a number of important micro economic problems. One of the most interesting application is to agriculture where supply and demand allows us to understand the variability of farms incomes and to evaluate government measures to boost farm incomes. Another application is effect of a tax, which is one of the ways that government can intervene in markets.

Crop Restrictions
In response to falling incomes, farmer often lobbied the federal government for economic assistance. Over the ages, government have taken many steps to help farmers. One of the most controversial government farm program requires farmers to restrict production.
Department of agriculture requires every farmer to set aside 20 percent of corn acreage planted last year, this has the effect of shifting the supply curves of corn up and to the left. Because food demands are inelastic, crop restrictions not only tend to raise farmers total revenue and earning.

Further example of supply and demand

Supply and demand apply strictly speaking, only to perfectly competitive markets. Where a homogenous product is auctioned off in markets served by larger number of buyers and seller.

Impact of Tax on Price and Quantity

Let us use supply and demand to analyze the incidence of a $1 tax on gasoline.

Impact of Tax on Price and Quantity

The original equilibrium at E, the intersection of the SS and DD curves, at the gasoline price of $1 a gallon and total consumption of 100 gallons per year. The supply curve shifts upward by $1. At each quantity supplied, the market price must rise by exactly the amount of the tax. The new equilibrium output, at which purchases and sales are in equilibrium, has fallen from 100 billions to about 80 billion gallons.

Impact of Tax on Price and Quantity contd.

A tax will fall most heavily on consumers or on producers depending on the relative elastic ties on demand and supply. A tax is shifted forward to consumer if the demand is inelastic relative to supply, a tax is shifted backward to producers if supply is relatively more inelastic than demand.

Supply demand at work

Deregulating Airlines

shows how deregulation of the airline industry led to lower prices and more air travel

Supply demand at work

Limiting Doctors

shows how limiting the number of doctors can raise the price of medical care along with the income of doctor

Supply demand at work

Restricting imports

shows how an import tariff lowers the quantity and raises the price of imported cars.

Government Intervention in Markets

Is Law of Supply and Demand Immutable ? Government actions do not add the forces of supply and demand; rather, they are among the numerous forces that act through supply and demand to determine price and quantity. In other words, supply and demand are not ultimate explanations of price. They are instead useful, general categories for analyzing and describing the multitude of forces impinging on price and quantity. Government affect price by influencing supply or demand or both. Over the ages, government have raised prices by restricting outputs.

Prices Fixed by Law

The government sometimes legislates maximum or minimum prices. Important examples are minimum wages for workers, rent control for apartment, and interest rate ceilings.

Prices Fixed by Law contd.

Price Ceilings

Prices Fixed by Law contd.

Price Ceilings The diagram above illustrates such a legal maximum prices as the ceiling price line CJK at the legal ceiling price, supply and demand do not match. Consumer wants much more gasoline than producers are willing to supply at the going price

Prices Fixed by Law contd.

Price Ceilings

Prices Fixed by Law contd.

Price Ceilings If, on the other hand, the free market were allowed to operate, the market would clear with a price of $2 or more; consumers would grumble but would willing pay the higher price than go with out fuel. But the market control cannot clear because it is against the law of producers to change a higher price. The inadequate supply of gasoline must somehow be rationed.

Prices Fixed by Law contd.

Rationing Some kind of non price rationing mechanism evolves for gasoline and other storable goods, the shortage is often managed by making people wait in line- rationing by the queue. Or people who have access to the rationed good engage in black- market sales. Eventually, governments designs a more efficient way of non price rationing through formal allocation or coupon rationing.

Prices Fixed by Law contd.

Rationing Coupon rationing, each customer must have a coupon as well as money to buy the goods in effect; there are two kinds of money. When rationing is adopted and coupons are meted out according to family size, occupational need, or other criteria, shortages disappear because demand is limited by the allocation of coupons.

Prices Fixed by Law contd.

Rationing

Prices Fixed by Law contd.

Rationing The government must issue just enough of them to lower the demand curve to DD. If too many coupons are issued there is excess demand and shortage and lines reappear, but to a lesser degree. If too few coupons are issued, stocks of goods will pile up and the price will fall below the ceiling. This is the signal for liberalizing the ration.

Prices Fixed by Law contd.

Rationing In period of shortage market prices rise to choke off excessive consumption and to encourage production. When government set into interface with supply and demand money no longer fills the role of rationer. Waste, inefficiency, and aggravation are certain companions of these interference.

Minimum Floors and Maximum Ceilings

Minimum Floors and Maximum Ceilings contd.

The three examples of government interventions presented in the previous diagram: the minimum wages, rent control on housing and interest rate ceilings.

The diagram illustrates the surprising side effect that can arise when government interface with market determination of price and quantity.

Minimum Floors and Maximum Ceilings contd.

Minimum wage rates Studies shows that a high minimum wage often hurts those it is designed to help. What does it profit an unskilled youth to know that a job will pay $ 4 an hour if no jobs are available?

Minimum Floors and Maximum Ceilings contd.

Minimum wage rates

Shows how a high minimum wage creates a pool of unemployed workers.

Minimum Floors and Maximum Ceilings contd.

Minimum wage rates Studies suggests that the price elasticity of demand for low skilled workers is greater than unity, as firms substitute medium skilled workers, capital and low wages foreign workers for domestic low skilled workers if the demand for low wage workers is elastic, then can you see whey an increase in the minimum wage will lower the total wages earned by this group.

Minimum Floors and Maximum Ceilings contd.

Rent Controls At the controlled rental price, there is a large group of buyers who cannot find apartments. People stay too long in large apartments because rents are kept below market levels. Non- Price rationing occurs, and people have to bribe land lords or pay enormous security deposits to obtain a rental apartment.
New York has seen tens of thousands of buildings abandoned because the controlled rents were too low to cover expenses and taxes.

Minimum Floors and Maximum Ceilings contd.

Interest-rate ceilings

shows the impact of to low a ceiling of interest rates

Minimum Floors and Maximum Ceilings contd.

Interest-rate ceilings Funds dry up make Banks and other financial institutions refuse to make unprofitable loans at the legal rate. Those who are the intended benefits of controls find that they cannot borrow from anyone. The inexpensive loan you cannot get does you no good.

Thank You