Variables

• Economic Models are described by variables. These are two main types:
• Exogenous: used in the model, but determined outside the context of the
model(Already Given).
• E.g. Income, Level of technology, Weather….
• Y might be changed other variables, which are not in our model.
• Endogenous: determined by the model.
• I want to know Y according to X
• E.g. Relation b/w X and Y -> Quantity and Price

𝑌 = 𝑎 + 𝑏𝑋 + 𝑐𝑍

• Y is an endogenous/dependent variable

• X and Z are exogenous/ independent variables

• a, b, and c are parameters / constants; a is the intercept; b and c are slope

1

Let’s try in an Economic model

• Consider the consumption function

𝐶 = 300 + 0.6𝐼
• “Income-Consumption relation”

• Endogenous variable?

• Exogenous variable?

• Intercept?

• Slope?

1
 Graphing

• To graph this function (𝐶 = 300 + 0.6𝐼) we will pick some values and
substitute them in…
Let 𝐼=0
𝐶 = 300 + 0.6 0
𝐶 = 300
Sample values:

I 0 10 100 1000 …
C 300 306 360 900 …
Remember that there is one and only one y for each x.

Graphing cont/.
• 𝑦 = 𝑓(𝑥); we write point as (x,y) where x is the abscissa and y
is the ordinate.

• Very important: Graphs MUST be labeled completely.

Otherwise, they do not count!

2
Finding the slope

Consider the following function 𝑦 = 𝑎 + 𝑏𝑥

𝑦 = 𝑓 𝑥 = 𝑎 + 𝑏𝑥
𝑦
( )
= =
𝑦

( ) ( )
=

=𝑏
𝑥 𝑥

The Market Forces of Supply

and Demand

3
 Competition: Perfect and Otherwise
• Market – a group of buyers and sellers of a particular good or service

• Competitive market – a market in which there are many buyers and many sellers
so that each has a negligible impact on the market price

• Characteristics of a perfectly competitive market

• The goods being offered for sale are all the same
• The buyers and sellers are so many that none can influence the market price
• Because buyers and sellers must accept the market price as given, they are
often called “price takers.”
• Not all goods are sold in a perfectly competitive market
• A market with only one seller is called a monopoly market
• seller controls price
• A market with only a few sellers is called an oligopoly
• Not always aggressive competition
• A market with a large number of sellers, each selling a product that is slightly
different from its competitor’s products, is called monopolistic competition

Demand
• Demand comes from the behavior of buyers.
• The demand curve: the relationship between price and quantity
demanded
• Quantity demanded – the amount of a good that buyers are willing and
able to purchase
• One important determinant of quantity demanded is the price of the
product
• Quantity demanded is negatively related to price. This implies that the
demand curve is downward sloping
• Law of demand – the claim that, other things equal, the quantity
demanded of a good falls when the price of the good rises.

4
 Demand Schedule
Price Quantity
of of coffee
• A table that shows the coffee demanded
relationship between the
price of a good and the $0.00 16
quantity demanded
1.00 14
• Example:
Helen’s demand for coffee.
2.00 12
3.00 10
• Notice that Helen’s
preferences obey the 4.00 8
Law of Demand.
5.00 6
6.00 4

Price of Demand Curve

Coffee
$6.00 • A graph of the relationship
between the price of a good
$5.00 and the quantity demanded
• Price is generally drawn on
$4.00 the vertical axis
$3.00 • Quantity demanded is
represented on the
$2.00 horizontal axis
$1.00
$0.00
Quantity
0 5 10 15 of Coffee

5
 Demand Schedule & Curve
Price of Quantity
Price
Coffee of lattes
of lattes
$6.00 demanded
$0.00 16
$5.00
1.00 14
$4.00
2.00 12
$3.00
3.00 10
$2.00 4.00 8
$1.00 5.00 6
$0.00 6.00 4
Quantity
0 5 10 15
of Coffee

Utility
• Utility measures the want-satisfying power of a good or service.
Subjective notion
• Marginal utility is the additional or incremental satisfaction
(utility) a consumer receives from acquiring one additional unit of
a product.
• Total utility: the total amount of satisfaction or pleasure a person
derives from consuming some quantity.
• Disutility results when total satisfaction decreases with the
consumption of an additional unit.
• A normal person can eat only so many burgers (total utility) before they get
ill-effects of overeating. After total utility is achieved and person is still
consuming burgers - results into - disutility

6
 Law of Diminishing Marginal Utility
• A law of economics stating that as a
person increases consumption of a
product - while keeping consumption
of other products constant - there is a
decline in the marginal utility that
person derives from consuming each
additional unit of that product.
• The more a good, a consumer already
has, the lower the extra (marginal)
utility (satisfaction) provided by each
extra unit
• A util = a unit of satisfaction
• When total utility is at its peak, marginal
utility becomes zero. MU reflects the change
in total utility so it is negative when total
utility declines

Law of Diminishing Marginal Utility

•Consumers want:
•1)To maximize their total utility
•2) The most (max quantity ?) for their money

3)

4)

P = number of units, MU – Marginal utility, TU – Total Utility

7
 Market Demand versus Individual Demand
• The market demand is the sum of all of the individual demands for a particular
good or service
• The market demand curve shows how the total quantity demanded of a good
varies with the price of the good, holding constant all other factors that affect
how much consumers want to buy
• Suppose Helen and Ken are the only two buyers in the Latte market. (Qd =
quantity demanded)
Price Helen’s Qd Ken’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6

The Market Demand Curve for Lattes

Qd
P P
$6.00
(Market)
$0.00 24
$5.00
1.00 21
$4.00
2.00 18
$3.00 3.00 15
$2.00 4.00 12
$1.00 5.00 9
$0.00 Q 6.00 6
0 5 10 15 20 25

8
 Shifts in the Demand Curve
• The demand curve shows how much consumers want to buy at any price,
holding constant the many other factors that influence buying decisions
• The demand curve will shift, if any of these other factors change
• An increase in demand can be represented by a shift of the demand curve to the right (on
which graph?)
• A decrease in demand can be represented by a shift of the demand curve to the left

• Income
• The relationship between income and quantity demanded depends on what type
of good the product is
• Normal good – a good for which, other things equal, an increase in income leads
to a increase in demand
• Demand for a normal good is positively related to income.
• Inferior good – a good for which, other things equal, an increase in income leads
to a decrease in demand
• Demand for an inferior good is negatively related to income.

Shifts in the Demand Curve

• Prices of related goods
• Substitutes – two goods for which an increase in the
price of one good leads to an increase in the
demand for the other
• Example: hot dogs and hamburgers.
An increase in the price of hot dogs
increases demand for hamburgers,
shifting hamburger demand curve to the right.
• Other examples: Coke and Pepsi,
laptops and desktop computers,
compact discs and music downloads

• Complements – two goods for which an increase in

the price of one good leads to a decrease in the
demand for the other
• Example: computers and software.
If price of computers rises, people buy fewer
computers, and therefore less software.
Software demand curve shifts left.
• Other examples: college tuition and textbooks,
bagels and cream cheese, eggs and bacon

9
 Shifts in the Demand Curve
• Tastes
• Example:
The Atkins diet became popular in the ’90s, caused an increase in demand for
eggs, shifted the egg demand curve to the right.

• Expectations – future income or future prices

• Examples:
• If people expect their incomes to rise, their demand for meals at expensive
restaurants may increase now.
• If the economy turns bad and people worry about their future job security,
demand for new autos may fall now.

• Number of buyers
• An increase in the number of buyers causes an increase in quantity demanded
at each price, which shifts the demand curve to the right.

Demand Curve Shifters: # of

buyers
P Suppose the number of
$6.00 buyers increases.
Then, at each price,
$5.00 quantity demanded will
increase
$4.00
(by 5 in this example).
$3.00
$2.00
$1.00

$0.00 Q
0 5 10 15 20 25 30

10
Summary: Variables That Affect Demand
Variable A change in this variable…

Price …causes a movement

along the D curve
No. of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve

A C T I V E L E A R N I N G 1:
Demand curve
Draw a demand curve for music downloads.
What happens to it in each of the following
scenarios? Why?
A. The price of iPods /
mobiles / audio devices
falls
B. The price of music
downloads falls

22

11
A C T I V E L E A R N I N G 1:
A. price of iPods/ mobiles / audio devices
falls Music downloads and
Price of iPods/ mobiles / audio
music devices are
complements.
down-
loads A fall in price of iPods
mobiles / audio devices
shifts the demand
P1 curve for music
downloads
to the right.

D1 D2

Q1 Q2 Quantity of
music downloads
23

A C T I V E L E A R N I N G 1:
B. price of music downloads falls
Price of
music
down- The D curve
loads does not shift.
Move down along
P1
curve to a point with
P2 lower P, higher Q.

D1

Q1 Q2 Quantity of
music downloads
24

12
 Supply
• Supply comes from the behavior of sellers.
• The Supply Curve: The Relationship between Price and Quantity Supplied
• Quantity Supplied – the amount of a good that sellers are willing and able to sell
• Quantity supplied is positively related to price
• Law of supply – the claim that, other things equal, the quantity supplied of a
good rises when the price of the good rises
Quantity
• Supply schedule – Price
of lattes
the relationship between the price of lattes
supplied
of a good and the quantity supplied
$0.00 0
• Example: 1.00 3
Starbucks’ supply of lattes.
• Notice that Starbucks’ supply schedule obeys the 2.00 6
Law of Supply. 3.00 9
4.00 12
5.00 15
6.00 18

Supply Curve
P
$6.00
• Supply curve – a graph of
$5.00 the relationship between
the price of a good and
$4.00
the quantity supplied
$3.00
$2.00

$1.00

$0.00 Q
0 5 10 15

13
 Supply Curve
• Change in price causes a change in
quantity supplied
• At X the price is P1 and quantity is Q1.
• An increase in price increases the
quantity supplied
• Moving to point Y where price is P2
and quantity is Q2.

Starbucks’ Supply Schedule & Curve

Price Quantity
P of of lattes
$6.00 lattes supplied
$5.00 $0.00 0
$4.00 1.00 3
$3.00
2.00 6
3.00 9
$2.00
4.00 12
$1.00
5.00 15
$0.00 Q 6.00 18
0 5 10 15

14
 Market Supply vs. Individual Supply

• The market supply curve can be found by summing individual supply

curves
• Individual supply curves are summed horizontally at every price
• The market supply curve shows how the total quantity supplied
varies as the price of the good varies

Market Supply versus Individual Supply

• Suppose Starbucks and Jitters are the only two sellers in this market. (Qs
= quantity supplied)

Price Starbucks Jitters Market Qs

$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30

15
 The Market Supply Curve
QS
P P
(Market)
$6.00
$0.00 0
$5.00 1.00 5
$4.00 2.00 10
$3.00 3.00 15
$2.00 4.00 20
$1.00
5.00 25
6.00 30
$0.00 Q
0 5 10 15 20 25 30 35

Shifts in the Supply Curve

• The supply curve shows how much producers offer

for sale at any given price, holding constant all other
factors that may influence producers’ decisions
about how much to sell
• When any of these factors change, the supply curve
will shift
• An increase in supply can be represented by a shift of the
supply curve to the right
• A decrease in supply can be represented by a shift of the
supply curve to the left

16
 9/22/202

Shifts in the Supply Curve

• Input prices/Resource(factor) prices
• Examples of input prices:
wages, prices of raw materials.
• A fall in input prices makes production
more profitable at each output price,
so firms supply a larger quantity at each price,
and the S curve shifts to the right.

• Technology
• Technology determines how much inputs are
required to produce a unit of output.
• A cost-saving technological improvement has
same effect as a fall in input prices,
shifts the S curve to the right.

Supply Curve Shifters: input

prices
P Suppose the price
$6.00 of milk falls.
At each price, the
$5.00
quantity of
$4.00 Lattes supplied
will increase
$3.00
(by 5 in this
$2.00 example).
$1.00

$0.00 Q
0 5 10 15 20 25 30 35

17
 Shifts in the Supply Curve

• Expectations
• Suppose a firm expects the price of the good it sells to
rise in the future.
• The firm may reduce supply now, to save some of its
inventory to sell later at the higher price.
• This would shift the S curve leftward.
• Number of sellers
• An increase in the number of sellers increases the
quantity supplied at each price, shifts the S curve to the
right.

Shifts in the Supply Curve

• Taxes/subsidies
• When a tax is added to a good the supply
will decrease, when a subsidy is added to a
good the supply will increase.
• Price of other goods => production
substitution
• Example: Corn syrup cheaper than sugar.
Coca-Cola replaces sugar with corn syrup
and increases the supply.

18
 Summary: Variables That Affect Supply

Variable A change in this variable…

Price …causes a movement

along the S curve
Input prices …shifts the S curve
Technology …shifts the S curve
No. of sellers …shifts the S curve
Expectations …shifts the S curve

A C T I V E L E A R N I N G 2:
Supply curve

Draw a supply curve for tax return preparation

software. What happens to it in each of the
following scenarios?

A. Retailers cut the price of the software.

B. A technological advance allows the software to
be produced at lower cost.
C. Professional tax return preparers raise the
price of the services they provide. 38

19
A C T I V E L E A R N I N G 2:
A. fall in price of tax return software
Price of
tax return The S curve
S1
software
does not shift.
P1 Move down
along the curve
P2 to a lower P
and lower Q.

Q 2 Q1 Quantity of tax
return software
39

A C T I V E L E A R N I N G 2:
B. fall in cost of producing the software
Price of
tax return The S curve
S1 S2
software shifts to the
right:
P1
at each price,
Q increases.

Q1 Q2 Quantity of tax
return software
40

20
 A C T I V E L E A R N I N G 2:
C. professional preparers raise their price
Price of
tax return
software
S1 This shifts the
demand curve for
tax preparation
software, not the
supply curve.

Quantity of tax
return software
41

Supply and Demand Together

• Equilibrium
• The point where the supply and demand
curves intersect is called the market’s
equilibrium
• Equilibrium – a situation in which the price
has reached the level where quantity
supplied equals quantity demanded
• Equilibrium price – the price that balances
quantity supplied and quantity demanded
• the equilibrium price is often called the
“market-clearing” price because both buyers
and sellers are satisfied at this price
• Equilibrium quantity – the quantity supplied
and the quantity demanded at the
equilibrium price

21
 Supply and Demand Together

P Equilibrium:
$6.00 D S
P has reached
$5.00 the level where
$4.00 quantity supplied
$3.00
equals
quantity demanded
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30 35

22
__________
Equilibrium
_____
price:
The price that equates quantity supplied
with quantity demanded
P
$6.00 D S
P QD Q S
$5.00 $0 24 0
$4.00 1 21 5
$3.00 2 18 10
$2.00 3 15 15
$1.00 4 12 20
$0.00
5 9 25
Q
0 5 10 15 20 25 30 35 6 6 30

__________
Equilibrium________
quantity:
The quantity supplied and quantity demanded at
the equilibrium price
P
$6.00 D S
P QD Q S
$5.00 $0 24 0
$4.00 1 21 5
$3.00 2 18 10
$2.00 3 15 15
$1.00 4 12 20
$0.00
5 9 25
Q
0 5 10 15 20 25 30 35 6 6 30

23
 Supply and Demand Together

• If the actual market price is

higher than the equilibrium
price, there will be a surplus of
the good
• Surplus – a situation in which
quantity supplied is greater
than quantity demanded
• To eliminate the surplus,
producers will lower the price
until the market reaches
equilibrium

Surplus:
when quantity supplied is greater than
quantity demanded
P
$6.00 D Surplus S Example:
If P = $5,
$5.00
then
$4.00 QD = 9 lattes
$3.00 and
$2.00 QS = 25 lattes
resulting in a surplus of
$1.00
16 lattes
$0.00 Q
0 5 10 15 20 25 30 35

24
 Surplus:
when quantity supplied is greater than
quantity demanded
P
$6.00 D Surplus S Facing a surplus,
sellers try to increase sales
$5.00 by cutting the price.
$4.00 This causes
$3.00 QD to rise and QS to fall…

$2.00 …which reduces the

surplus.
$1.00
$0.00 Q
0 5 10 15 20 25 30 35

Surplus:
when quantity supplied is greater than
quantity demanded
P
$6.00 D Surplus S Facing a surplus,
sellers try to increase sales
$5.00 by cutting the price.
$4.00 Falling prices cause
$3.00 QD to rise and QS to fall.

$2.00 Prices continue to fall until

market reaches equilibrium.
$1.00
$0.00 Q
0 5 10 15 20 25 30 35

25
 Supply and Demand Together

• If the actual price is lower than the equilibrium

price, there will be a shortage of the good
• Shortage – a situation in which quantity demanded
is greater than quantity supplied.
• Sellers will respond to the shortage by raising the
price of the good until the market reaches
equilibrium
• Law of supply and demand – the claim that the
price of any good adjusts to bring the supply and
demand for that good into balance

Shortage:
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Example:
If P = $1,
$5.00
then
$4.00 QD = 21 lattes
$3.00 and
QS = 5 lattes
$2.00
resulting in a
$1.00 shortage of 16 lattes
$0.00 Shortage Q
0 5 10 15 20 25 30 35

26
 Shortage:
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise,
$3.00 …which reduces the
shortage.
$2.00
$1.00
Shortage
$0.00 Q
0 5 10 15 20 25 30 35

Shortage:
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise.
$3.00 Prices continue to rise
until market reaches
$2.00
equilibrium.
$1.00
Shortage
$0.00 Q
0 5 10 15 20 25 30 35

27
 Three steps to analyzing changes in
equilibrium
• Decide whether the event shifts the supply or demand curve
• Decide in which direction the curve shifts
• Use the supply-and-demand diagram to see how the shift
changes the equilibrium price and quantity
• A shift in the demand curve is called a “change in demand.” A shift in
the supply curve is called a “change is supply.”
• A movement along a fixed demand curve is called a “change in
quantity demanded.” A movement along a fixed supply curve is called
a “change in quantity supplied.”

EXAMPLE: The Market for Hybrid Cars

P
price of
S1
hybrid cars

P1

D1
Q
Q1
quantity of
hybrid cars

28
 EXAMPLE 1: A Change in Demand
EVENT TO BE
ANALYZED: P
Increase in price of gas. S1
P2
STEP 1: D curve shifts
because price of gas affects demand
P1
for hybrids.
S curve does not shift, because price
of gas does not affect cost of
producing hybrids. D1 D2
STEP 2: D shifts right Q
because high gas price makes hybrids more Q1 Q2
attractive relative to other cars.
STEP 3:
The shift causes an increase in price
and quantity of hybrid cars.

EXAMPLE 1: A Change in Demand

Notice: P
When P rises,
S1
producers supply
a larger quantity P2
of hybrids, even
though the S curve P1
has not shifted.
Always be careful to
D1 D2
distinguish b/w a
shift in a curve and a Q
Q1 Q2
movement along the
curve.

29
 Shift vs. Movement Along Curve
• Change in supply: a shift in the S curve
• occurs when a non-price determinant of supply changes (like technology or costs)
• Change in the quantity supplied:
a movement along a fixed S curve
• occurs when P changes
• Change in demand: a shift in the D curve
• occurs when a non-price determinant of demand changes (like income or # of buyers)
• Change in the quantity demanded:
a movement along a fixed D curve
• occurs when P changes

EXAMPLE 2: A Change in Supply

EVENT: New technology
reduces cost of producing P
hybrid cars. S1 S2

STEP 1: S curve shifts

because event affects cost of
P1
production.
D curve does not shift, because P2
production technology is not one of
the factors that affect demand.
D1
STEP 2: S shifts right because event
Q
reduces cost, makes production Q1 Q2
more profitable at any given price.

STEP 3: The shift causes price to fall

and quantity to rise.

30
 EXAMPLE 3: A Change in Both Supply
EVENTS:
and Demand
P
price of gas rises AND
new technology reduces S1 S2
production costs
P2
P1
STEP 1: Both curves shift.
STEP 2:
Both shift to the right. D1 D2
STEP 3: Q
Q rises, but effect Q1 Q2
on P is ambiguous:
If demand increases more than
supply, P rises.

EXAMPLE 3: A Change in Both Supply

and Demand
P
EVENTS:
S1 S2
price of gas rises AND
new technology reduces
production costs
P1
P2
STEP 3, cont.
But if supply D1 D2
increases more Q
Q1 Q2
than demand,
P falls.

31
A C T I V E L E A R N I N G 3:
Changes in supply and demand

Use the three-step method to analyze the effects of each event on the
equilibrium price and quantity of music downloads.
Event A: A fall in the price of compact discs
Event B: Sellers of music downloads negotiate a reduction in the royalties
they must pay for each song they sell.
Event C: Events A and B both occur.

63

A C T I V E L E A R N I N G 3:
A. fall in price of CDs
P
STEPS
S1

1. D curve shifts P1

2. D shifts left P2

3. P and Q both
D2 D1
fall. Q
Q2 Q1

The market for

music downloads 64

32
A C T I V E L E A R N I N G 3:
B. fall in cost of
The market for
royalties music downloads
P
S1 S2
STEPS
1. S curve shifts P1
(royalties are part
P2
of sellers’ costs)
2. S shifts
right
D1
3. P falls, Q
Q1 Q2
Q rises.
65

A C T I V E L E A R N I N G 3:
C. fall in price of CDs
AND fall in cost of royalties

STEPS
1. Both curves shift (see parts A & B).
2. D shifts left, S shifts right.
3. P unambiguously falls.
Effect on Q is ambiguous:
The fall in demand reduces Q,
the increase in supply increases Q.

66

33
 CONCLUSION:
How Prices Allocate Resources

• One of the Ten Principles from Chapter 1: Markets are usually a good
way
to organize economic activity.

 In market economies, prices adjust to balance

supply and demand. These equilibrium prices
are the signals that guide economic decisions
and thereby allocate scarce resources.

34
 Elasticity

Elasticity . . .

• … allows us to analyze supply and demand with greater precision.

• … is a measure of how much buyers and sellers respond to changes in

market conditions

35
 THE ELASTICITY OF DEMAND

• Price elasticity of demand is a measure of how much the quantity

demanded of a good responds to a change in the price of that good.

• Price elasticity of demand is the percentage change in quantity

demanded given a percent change in the price.

What determines price elasticity?

To learn the determinants of price elasticity,

we look at a series of examples.
Each compares two common goods.
In each example:
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent) has the
highest price elasticity of demand.
Which good is it? Why?
• What lesson does the example teach us about the
determinants of the price elasticity of demand?

36
 Determinants of Elasticity

• Whether close substitutes are available

• Broadly defined goods vs. narrowly defined goods
• Necessities vs. Luxuries
• How much of the consumer’s budget is spent on the good
• Long run vs. Short run

EXAMPLE 1:
Rice Krispies vs. Sunscreen
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
• Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
• Lesson: Price elasticity is higher when close substitutes are
available.

37
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
• The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
• For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
• There are fewer substitutes available for broadly defined
goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
• Lesson: Price elasticity is higher for narrowly defined goods
than broadly defined ones.

EXAMPLE 3:
Insulin vs. Caribbean Cruises
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in
demand.
• A cruise is a luxury. If the price rises,
some people will forego it.
• Lesson: Price elasticity is higher for luxuries than for
necessities.

38
EXAMPLE 4: Gasoline in the Short Run
vs. Gasoline in the Long Run

• The price of gasoline rises 20%. Does Qd drop more in the

short run or the long run? Why?
• There’s not much people can do in the
short run, other than ride the bus or carpool.
• In the long run, people can buy smaller cars
or live closer to where they work.
• Lesson: Price elasticity is higher in the
long run than the short run.

How much of the consumer’s budget

is spent on the good
• When a good represents a large share of a
consumer’s budget, a price increase importantly
reduces the amount of the good that a consumer is
able to buy
• The amount demanded will decrease significantly.
• When the good represents a smaller share of the
consumer’s budget, the consumer’s overall income
and purchasing power are less effected by an
increase in price.
• Therefore, demand is less price elastic in these cases.

39
Percentage of Income

• The higher the percentage of the consumer's income that the

product's price represents, the higher the elasticity tends to be, as
people will pay more attention when purchasing the good because of
its cost. (Income effect)
• When the goods represent only a small portion of the budget the
income effect will be insignificant and demand inelastic

The Price Elasticity of Demand and Its

Determinants
• Demand tends to be more elastic :
• the larger the number of close substitutes.
• if the good is a luxury.
• the more narrowly defined the market.
• the longer the time period.
• Percentage of income

40
Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as the percentage change

in the quantity demanded divided by the percentage change in price.

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

Computing the Price Elasticity of Demand

Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
• Example: If the price of an ice cream cone increases from $2.00 to
$2.20 and the amount you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:

(10  8)
 100 20%
10  2
(2.20  2.00) 10%
 100
2.00

41
The Midpoint Method: A Better Way to
Calculate Percentage Changes and Elasticities
• The midpoint formula is preferable when calculating the price
elasticity of demand because it gives the same answer regardless of
the direction of the change.

(Q 2  Q1 ) / [(Q 2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]

The Midpoint Method: A Better Way to

Calculate Percentage Changes and Elasticities
• Example: If the price of an ice cream cone increases from $2.00 to
$2.20 and the amount you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint formula, would be
calculated as:

(10  8)
(10  8) / 2 22%
  2.32
(2.20  2.00) 9.5%
(2.00  2.20) / 2

42
The Variety of Demand Curves

• Inelastic Demand
• Quantity demanded does not respond strongly to price changes.
• Price elasticity of demand is less than one.
• Elastic Demand
• Quantity demanded responds strongly to changes in price.
• Price elasticity of demand is greater than one.

The Variety of Demand Curves

• Perfectly Inelastic
• Quantity demanded does not respond to price changes.
• Perfectly Elastic
• Quantity demanded changes infinitely with any change in price.
• Unit Elastic
• Quantity demanded changes by the same percentage as the price.

43
 The Variety of Demand Curves

• Because the price elasticity of demand measures how much quantity

demanded responds to the price, it is closely related to the slope of
the demand curve.

Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Copyright©2003 Southwestern/Thomson Learning

44
 Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price
ΔQ<ΔP

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Copyright©2003 Southwestern/Thomson Learning

45
 Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price
ΔQ>ΔP

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.

46
 Total Revenue and the Price Elasticity of
Demand
• Total revenue is the amount paid by buyers and received by sellers of
a good.
• Computed as the price of the good times the quantity sold.

TR = P x Q

Figure 2 Total Revenue

Price

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q
Copyright©2003 Southwestern/Thomson Learning

47
 Elasticity and Total Revenue along a
Linear Demand Curve
• With an inelastic demand curve, an increase in price leads to a
decrease in quantity that is proportionately smaller. Thus, total
revenue increases.

Figure 3 How Total Revenue Changes When Price Changes:

Inelastic Demand

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

Copyright©2003 Southwestern/Thomson Learning

48
 Elasticity and Total Revenue along a
Linear Demand Curve
• With an elastic demand curve, an increase in the price leads to a
decrease in quantity demanded that is proportionately larger. Thus,
total revenue decreases.

Figure 4 How Total Revenue Changes When Price Changes:

Elastic Demand

Price Price

An Increase in price from $4 … leads to an decrease in

to $5 … total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

Copyright©2003 Southwestern/Thomson Learning

49
 Elasticity & Total Revenue Test
• Elastic > 1 if P decreases => TR increases;
if P increases TR decreases
• Unit elastic = 1 if ΔP => no ΔTR
• Inelastic < 1 if P decreases => TR
decreases; if P increases TR increases

Figure 19-2 The Relationship Between Price Elasticity of Demand

and Total Revenues for Cellular Phone Service, Panel (b)

50
Figure 19-2 The Relationship Between Price Elasticity of Demand
and Total Revenues for Cellular Phone Service, Panel (c)

Relationship Between Price Elasticity of Demand and

Total Revenues

51
Income Elasticity of Demand

• Income elasticity of demand measures how much the quantity

demanded of a good responds to a change in consumers’ income.
• It is computed as the percentage change in the quantity demanded
divided by the percentage change in income.

Computing Income Elasticity

Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income

52
Income Elasticity

• Types of Goods
• Normal Goods
• Inferior Goods
• Higher income raises the quantity demanded for normal goods but
lowers the quantity demanded for inferior goods.

Income Elasticity

• Goods consumers regard as necessities tend to be income inelastic

• Examples include food, fuel, clothing, utilities, and medical services.
• Goods consumers regard as luxuries tend to be income elastic.
• Examples include sports cars, furs, and expensive foods.

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 Cross-Price Elasticity of Demand
• A measure of how much the quantity demanded of one good responds to a
change in the price of another good
• Cross-price elasticity of demand = percentage change in quantity demanded of
good 1/percentage change in the price of good 2
• Substitute goods – cross-price elasticity of demand is positive
• Complement goods – cross-price elasticity of demand is negative

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 THE ELASTICITY OF SUPPLY

• Price elasticity of supply is a measure of how much the quantity

supplied of a good responds to a change in the price of that good.
• Price elasticity of supply is the percentage change in quantity
supplied resulting from a percent change in price.

Figure 6 The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

Copyright©2003 Southwestern/Thomson Learning

55
Figure 6 The Price Elasticity of Supply

(b) Inelastic Supply: Elasticity Is Less Than 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

56
Figure 6 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1

Price

Supply

$5

4
1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
supplied is infinite.

$4 Supply

2. At exactly $4,
producers will
supply any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero.

Copyright©2003 Southwestern/Thomson Learning

57
Determinants of Elasticity of Supply

• Ability of sellers to change the amount of the good they produce.

• Beach-front land is inelastic.
• Books, cars, or manufactured goods are elastic.
• Time period. (Key determinant)
• The amount of time a seller has to change the amount of the good they can
produce
• Supply is more elastic in the long run.

Elasticity of Supply – Slope of Curve

• Immediately
• Inelastic supply
• Vertical or steep
• Short Run
• More elastic due to the firm’s
intense use of fixed resources

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Elasticity of Supply – Slope of Curve

• Long run
• All resources can change
• Elastic supply: horizontal flat

Computing the Price Elasticity of Supply

• The price elasticity of supply is computed as the percentage change

in the quantity supplied divided by the percentage change in price.

Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price

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APPLICATION of ELASTICITY
• Can good news for farming be bad news for farmers?
• What happens to wheat farmers and the market for wheat when
university agronomists discover a new wheat hybrid that is more
productive than existing varieties?

THE APPLICATION OF SUPPLY,

DEMAND, AND ELASTICITY
• Examine whether the supply or demand curve shifts.
• Determine the direction of the shift of the curve.
• Use the supply-and-demand diagram to see how the market
equilibrium changes.

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Figure 8 An Increase in Supply in the Market for Wheat

Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning

Compute the Price Elasticity of Supply

100  110
(100  110) / 2
ED 
3.00  2.00
(3.00  2.00) / 2

0.095
  0.24
0.4 Supply is inelastic

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 Summary
• Price elasticity of demand measures how much the quantity demanded
responds to changes in the price.
• Price elasticity of demand is calculated as the percentage change in quantity
demanded divided by the percentage change in price.
• If a demand curve is elastic, total revenue falls when the price rises.
• If it is inelastic, total revenue rises as the price rises.

Summary
• The income elasticity of demand measures how much the quantity demanded
responds to changes in consumers’ income.
• The cross-price elasticity of demand measures how much the quantity
demanded of one good responds to the price of another good.
• The price elasticity of supply measures how much the quantity supplied
responds to changes in the price. .

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Summary

• In most markets, supply is more elastic in the long run than in the
short run.
• The price elasticity of supply is calculated as the percentage change
in quantity supplied divided by the percentage change in price.
• The tools of supply and demand can be applied in many different
types of markets.

Demand Elasticity

• Demand elasticity – the extent to which a change in

price causes a change in the quantity demanded.
• A given change in price will cause a relatively larger,
a relatively smaller, or a proportional change in
quantity demanded.
• A corporation must estimate if they change the
price either up or down will demand increase,
decrease or stay the same.

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Elastic

• Elastic – when the change in price causes a relatively larger

change in quantity demanded
• During the summer price of vegetables decreases so the
amount purchased is increased.
• But during the winter the price of vegetables increases so
the amount purchased decreases drastically. A big change in
the amount purchased over the seasons.
• If a change in price causes a relatively large change in the
quantity demanded, demand is elastic.

Inelastic

• Inelastic – means that a given change in the price causes a

relatively smaller change in quantity demanded.
• If table salt dropped in price by half going from $1 to $.50
then demand would not change because you can consume
only so much salt. And if salt goes from $1 to $2 then
demand would not change because it is still a small
percentage of your budget.
• If change in price causes a relatively smaller change in
quantity demanded, demand is inelastic

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Unit elastic

• Unit elastic – a given change in price causes a proportional change in

quantity demanded
• So if there is a 5% change in price then there will be a 5% change in
quantity.

Price elasticity

• Price elasticity = percentage change in quantity

percentage change in price
• Perfectly inelastic: elasticity equals 0
• Inelastic: elasticity is less than 1
• Unit elastic: elasticity equals 1
• Elastic: elasticity is greater than 1
• Perfectly elastic: elasticity equals infinity

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“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D P
D
curve: vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%

“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D P
curve: relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: < 1 by 10% Q 1 Q2

Q rises less
than 10%

66
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: 1 by 10% Q1 Q2

Q rises by 10%

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1 Q rises more
than 10%

67
 “Perfectly elastic demand” (the other
extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity Q changes
by any %

Elasticity of a Linear Demand Curve

P
200%
$30 E = = 5.0
40% The slope
of a linear
67% demand curve is
20 E = = 1.0 constant,
67%
but its elasticity
is not.
40%
10 E = = 0.2
200%

$0 Q
0 20 40 60

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Supply Elasticity

• Supply Elasticity – describes how a change in quantity

supplied responds to a change in price
• What is the difference between supply elasticity and
demand elasticity?
• If quantities are being purchased, the concept is demand elasticity. If
quantities are being brought to market for sale, the concept is supply
elasticity
• If supply is elastic, a given change in price will cause a more
than proportional change in quantity supplied.
• If supply is inelastic, a given change in price will cause a less
than proportional change in quantity supplied.
• If supply is unit elastic, a given change in price will cause a
proportional change in quantity supplied.

Price Elasticity Problems

• Are the following examples elastic, inelastic, or unit elastic

• 1) change in price = 30%;
change in quantity demanded = 50%
• 2) change in price = 30%;
change in quantity supplied = 30%
• 3) change in price = 30%
change in quantity demanded = 15%

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 Price Elasticity Answers

• 1) 50/30 = 1.66… Elastic demand

• 2) 30/30 = 1 Unit Elastic supplied
• 3) 15/30 = 0.50 Inelastic demand

A C T I V E L E A R N I N G 2:
Elasticity and expenditure/revenue

A. Pharmacies raise the price of insulin by 10%. Does total expenditure

on insulin rise or fall?
B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue rise or fall?

140

70
A C T I V E L E A R N I N G 2:
Answers

A. Pharmacies raise the price of insulin by 10%. Does total expenditure

on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

141

A C T I V E L E A R N I N G 2:
Answers

B. As a result of a fare war, the price of a luxury cruise

falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue. Which
effect is bigger?
Since demand is elastic, Q will increase more than
20%, so revenue rises.
142

71
Calculating Percentage Changes

Demand for
your websites
P
B
$250
A
$200
D
Q
8 12

Calculating Percentage Changes

• So, we instead use the midpoint method:

end value – start value

x 100%
midpoint
The midpoint is the number halfway
between the start & end values, also
the average of those values.
It doesn’t matter which value you use
as the “start” and which as the “end” –
you get the same answer either way!

72
Calculating Percentage Changes
• Using the midpoint method, the % change
in P equals

$250 – $200
x 100% = 22.2%
$225
The % change in Q equals
12 – 8
x 100% = 40.0%
10

The price elasticity of demand equals

40/22.2 = 1.8

A C T I V E L E A R N I N G 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

146

73
A C T I V E L E A R N I N G 1:
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals

50%
= 2.0
25%

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74