Principles of Microeconomics

Prof. Balu Pawde

GIPE, Pune
[email protected]
Review

• A closer look at demand: Demand curve and demand function

• Digressions on functions, marginal thinking and derivatives

• A closer look at supply: Supply curve and supply function

Market Equilibrium, shapes of curves & elasticities
Equilibrium
• Equilibrium: all traders are able to buy or sell as much as they want
• A situation in which no participant wants to change its behavior.
• Graphical: Supply & demand jointly determine equilibrium 𝑃 & 𝑄 (Diagram)
• Intersection e

• Equations. Idea is at e we need 𝑄𝑑 = 𝑄𝑠 = 𝑄

• Demand function: Qd = 12 − 𝑝
• Supply function: Qs = 9 + 0.5𝑝
• At e, 12 − 𝑝 = 9 + 0.5𝑝 i.e. 𝑝 = 2
So, 𝑝 = 2 is the equim. price.

• What is equim. 𝑄𝑒 ?
Substituting 𝑝 = 2 in either 𝑄𝑑 or 𝑄𝑠 will give 𝑄𝑒
Qe = 12 − 𝑝 = 12 − 2 = 10 Qe = 10
Equilibrium

• When in equilibrium,
• One can buy as many units of a good Pe
- Evidence that market is in equilibrium.

• Sellers don’t make explicit attempts for

equilibrium - invisible hand

• Disequilibrium at all prices other than Pe

Govt. intervention & equilibrium
• Interventions: Price floors & price ceilings
• Price floor:
• Govt. regulates P by setting P > Pe

• Example: Minimum wage regulation

y-axis = wages (P) & x-axis = hours of labour (Q)
• 𝑤 > 𝑤 ∗ , not allowed to go below 𝑤

• At floor price 𝑤 there is excess supply

- Meaning unemployment in this case
• w/o intervention, no excess supply – market clears

• What if 𝑤 < 𝑤 ∗ ?
Govt. intervention & equilibrium
• Price ceiling:
• Price set s.t. can’t go above
• Example: Gas price ceiling
y-axis = price (P) & x-axis = quantity (Q)
• 𝑃ത < 𝑃2 , not allowed to go above 𝑃ത

• At ceiling price 𝑃ത there is excess demand

• Existence of excess demand does 2 damages:

• Lost efficiency: less trades made
- pie is not getting maximized
• Allocation problem: with excess demand,
who gets the gas?
Elasticities
• Elasticity = a summary measure of responsiveness of 𝑄𝑑 to change in influencing factors.

• Generally, a measure of responsiveness of DepVar w.r.t. IndepVar.

• E.g. in a demand function 𝑄𝑑 = 8.56 − 𝑃 − 0.3𝑃𝑠 + 0.1𝑌,
how 𝑄𝑑 responds to changes in either of three IndepVars

𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %𝛥𝑄𝑑

• Elasticity of demand is defined as 𝜖𝑑 = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 %𝛥𝑃
𝛥𝑄𝑑
𝑄𝑑 𝛥𝑄𝑑 𝑃
𝜖𝑑 = 𝛥𝑃 = ∗
𝛥𝑃 𝑄𝑑
𝑃
𝛥𝑄𝑑
Term looks familiar? Difference quotient? Derivative?
𝛥𝑃
Yes, the limit of this difference quotient is derivative & therefore 𝜖𝑑 can be written as
𝜕𝑄𝑑 𝑃
𝜖𝑑 = ∗
𝜕𝑃 𝑄𝑑
Elasticities
𝜕𝑄𝑑 𝑃
• Elasticity of demand: 𝜖𝑑 = ∗
𝜕𝑃 𝑄𝑑
• 𝜕 = partial derivative holding other variables constant in DD function

• Elasticity answers question:

“How much does 𝑄𝑑 fall in response to a 1% increase in 𝑃?”

• For a DD function 𝑄𝑑 = 𝑎 − 𝑏𝑝, to calculate 𝜖𝑑 , we need to know three things:

𝜕𝑄𝑑
1. The derivative ; 2. 𝑃 and finally 3. Qd
𝜕𝑃
𝜕𝑄𝑑 𝑃
Here, = −𝑏 and therefore the 𝜖𝑑 = −𝑏 ∗ for this function.
𝜕𝑃 𝑄𝑑
Elasticities
• Real world example (from Roberts and Schlenker (2013)):
• The DD function is: 𝑄𝑑 = 15.6 − 0.5𝑝,
what is elasticity of demand at 𝑝 = 7.2?
• Ans:
Elasticities
• Ans:
Remember, we need to know 3 things?

From given price, we can find 𝑄𝑑 by simple substitution:

𝜕𝑄𝑑
𝑄𝑑 = 15.6 − 0.5𝑝 = 15.6 − 0.5 ∗ 7.2 = 12, 𝑄𝑑 = 12 | 𝑝 = 7.2 And = −0.5
𝜕𝑃

Plugging these in elasticity formula gives us elasticity of demand

𝜕𝑄𝑑 𝑃 7.2
𝜖𝑑 = ∗ = (−0.5) ∗ − 0.3 So, 𝜖𝑑 = −0.3
𝜕𝑃 𝑄𝑑 12
• -ve sign illustrates law of demand.
• Interpretation: “a 1% increase in the price reduces the demand by -0.3%.”
Price elasticity along DD curve

• The 𝜖𝑑 along DD curve varies. Why?

𝜕𝑄𝑑 𝑃
Look at 𝜖𝑑 = ∗
𝜕𝑃 𝑄𝑑

• Slope is constant but others vary

• As 𝑃 ↑ (& 𝑄 ↓ following law of demand),
𝜖𝑑 becomes more -ve.

• So, though the slope is constant.

elasticity is not.
Price elasticity along DD curve
• Elasticity values: (DD function: 𝑄𝑑 = 𝑎 − 𝑏𝑃)
• Elasticity in 5 areas
1. 𝑃 = 0; 2. 𝑄 = 0; 3. Midpoint
4. Midpoint to 𝑄 = 0 and 5. Midpoint to P = 0

• Area 1: 𝑃 = 0 ; DD function hits quantity axis, with

𝑄𝑑 = 𝑎, 𝜖𝑑 = −𝑏 ∗ (0/𝑎) i.e 𝜖𝑑 = 0
- One end of the range of 𝜖𝑑
- Demand is perfectly inelastic
Like a steel rod, stretching - length does not change

• Area 2: Q = 0 ; DD function hits price axis at

𝑎/𝑏
𝑃 = 𝑎/𝑏, 𝜖𝑑 = −𝑏 ∗ = −𝑏 ∗ ∞ = −∞ i.e 𝜖𝑑 = −∞
0
- This is the toehr end of the range of 𝜖𝑑 . So 𝜖𝑑 = {−∞, 0}. Here, demand is perfectly elastic
Price elasticity along DD curve
• Area 3: Midpoint. (DD function: 𝑄𝑑 = 𝑎 − 𝑏𝑃)
DD function hits 𝑃 axis at P = 𝑎/𝑏; & 𝑄 axis at P = 0
𝑎
−0 𝑎
𝑏
Midpoint at 𝑃 = =
2 2𝑏 Area 2
similarly, at 𝑄𝑑 = (𝑎 − 0)/2 = 𝑎/2
𝑎 𝑎
so, the midpoint is at P = and Q = Area 4
2𝑏 2
𝑎
2𝑏
𝜖𝑑 = −𝑏 ∗ 𝑎 = −1 i.e 𝜖𝑑 = −1
2
- Demand is unitary elastic Area 3 Area 5

Area 1
• Area 4: Midpoint to 𝑄 = 0;
𝜖𝑑 < −1, Demand is relatively elastic
• Area 5: Midpoint to 𝑃 = 0;
0 > 𝜖𝑑 > −1, Demand is relatively inelastic
Price elasticity
• Horizontal DD curve: 𝜖𝑑 is perfectly elastic - small Δ in 𝑃 leads to huge Δ in 𝑄𝑑
• Vertical DD curve: 𝜖𝑑 is perfectly inelastic - small Δ in 𝑃 leads to no Δ in 𝑄𝑑  necessities
Other elasticities, income elasticity
• What about responsiveness of 𝑄𝑑 w.r.t change in other factors? Demand Function:
• Other factors: price of substitute, price of complement & income 𝑸𝒅 = 𝟖. 𝟓𝟔 − 𝒑 − 𝟎. 𝟑𝒑𝒔 + 𝟎. 𝟏𝒀
• We can find elasticities for these factors also

• Income elasticity of demand

• We know that increase in 𝒀 shifts DD curve
• If 𝑸𝒅 ↑ with 𝒀 ↑ ; the DD curve shifts to the right and
• If 𝑸𝒅 ↓ with 𝒀 ↑ ; the DD curve shifts to the left
• Responsiveness of 𝑸𝒅 to changes in 𝒀 => income elasticity of demand
𝛥𝑄𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %𝛥𝑄𝑑 𝑄𝑑 Δ𝑄𝑑 𝑌 𝜕𝑄𝑑 𝑌
𝜉= = | 𝜉= 𝛥𝑃 = ∗ = ∗
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 %𝛥𝑌 Δ𝑌 𝑄 𝜕𝑌 𝑄
𝑃

• Income elasticity (𝜉) can be +ve, -ve & 0,

𝜉 > 0 if 𝑄𝑑 ↑ with 𝑌 ↑ ; 𝜉 < 0 if 𝑄𝑑 ↑ with 𝑌 ↑ ; & 𝜉 = 0 if 𝑄𝑑 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 with 𝑌 ↑

Other elasticities, income elasticity
• Example: income elasticity of DD for 𝑸𝒅 = 𝟖. 𝟓𝟔 − 𝒑 − 𝟎. 𝟑𝒑𝒔 + 𝟎. 𝟏𝒀 at 𝑄 = 10, & 𝑌 = 35?

𝜕𝑄𝑑
What is for this function?
𝜕𝑌

𝜕𝑄𝑑 𝑌 𝜕𝑄𝑑 𝑌 35
𝜉= ∗ ; plugging the values we get 𝜉 = ∗ = 0.1 ∗ = 0.35
𝜕𝑌 𝑄 𝜕𝑌 𝑄 10
• +ve 𝜉 shows that 𝒀 ↑ causes the coffee demand to shift to right (i.e. increase in 𝑸𝒅 )

• Goods that are necessities have income elasticities near zero

• Goods that are luxuries have high income elasticities
Other elasticities, cross-price elasticity
• Responsiveness of 𝑸𝒅 of a good to change in other good’s 𝑷 Demand Function:
𝑸𝒅 = 𝟖. 𝟓𝟔 − 𝒑 − 𝟎. 𝟑𝒑𝒔 + 𝟎. 𝟏𝒀
𝛥𝑄𝑑
𝑄𝑑 𝜕𝑄𝑑 𝑃𝑠
𝜖𝑑𝑐𝑟 = 𝛥𝑃𝑠 = ∗
𝜕𝑃𝑠 𝑄
𝑃𝑠

• 𝜖𝑑𝑐𝑟 > 0 for substitutes: If 𝑃𝑠 ↑, the 𝑸𝒅 of the first good increases - curve shifts to right
• 𝜖𝑑𝑐𝑟 < 0 for compliments: If 𝑃𝑠 ↑, the 𝑸𝒅 of the first good decreases - curve shifts to left
• Example: Coffee & Sugar are compliments in 𝑸𝒅 = 𝟖. 𝟓𝟔 − 𝒑 − 𝟎. 𝟑𝒑𝒔 + 𝟎. 𝟏𝒀
𝜕𝑄𝑑 𝑃𝑠 𝜕𝑄𝑑
𝜖𝑑𝑐𝑟 = ∗ What is here ?
𝜕𝑃𝑠 𝑄𝑑 𝜕𝑃𝑠
0.2
At the original equilibrium 𝑄𝑑 = 10 & 𝑃𝑠 = 0.2 ; 𝜖𝑑𝑐𝑟 = −0.3 ∗ = −0.006
10
• Interpretation: as price of sugar increases by 1%, quantity demanded of coffee reduces by 0.006%

• The elasticities are important for business and policy decisions – examples?
Elasticity of supply
• Like DD, summarise information about responsiveness of supply to influencing factors – elasticity

%𝛥𝑄𝑠 𝛥𝑄𝑠 /𝑄𝑠 𝜕𝑄𝑠 𝑃

• Supply elasticity: 𝜂 = = = ∗
%𝛥𝑃 𝛥𝑃/𝑃 𝜕𝑃 𝑄
• So, if 𝜂 = 2, it means 1% increase in price leads to 2% increase in quantity supplied.

• Demand elasticity & supply elasticity are very similar except:

• Demand elasticity is movement along the demand curve

Supply elasticity is movement along the supply curve

%𝛥𝑄𝑠
• The difference is only the numerator in
%𝛥𝑃
Elasticity of supply
• Direction of 𝜂 depends on the slope of the supply curve

𝜕𝑄𝑠
• Upward sloping curve, > 0 and hence 𝜂 > 0
𝜕𝑃

𝜕𝑄𝑠
• Downward sloping curve, < 0 and hence 𝜂 < 0 (similar to demand curve)
𝜕𝑃

• Values:

• When 𝜂 = 0, the supply curve is perfectly inelastic.

• 0 < 𝜂 < 1 is relatively inelastic - as price changes by 1% , change in quantity is less than 1%.

• 𝜂 > 1 the supply curve is relatively elastic

• 𝜂 = ∞ the supply curve is perfectly elastic

Elasticity of supply
• Example:
• Supply function for coffee 𝑄𝑠 = 9.6 + 0.5𝑝 − 0.2𝑝𝑐 . What is elasticity at 𝑝 = 2 given 𝑝𝑐 = 3 is constant

%𝛥𝑄𝑠 𝛥𝑄𝑠 /𝑄𝑠 𝜕𝑄𝑠 𝑃 2

Ans: 𝜂 = = = ∗ = 0.5 ∗ = 0.1
%𝛥𝑃 𝛥𝑃/𝑃 𝜕𝑃 𝑄𝑠 10

• Interpretation: as coffee’s 𝑃 ↑ by 1%, suppliers increase 𝑄𝑠 by 0.1% ; supply curve is relatively inelastic here

• Similar to 𝜖𝑑 , the 𝜂 is also not constant across the supply curve.

• Constant elasticity of supply:

Example: 𝑄𝑠 = 5𝑝3
𝜕𝑄𝑠 𝜕𝑄𝑠 𝑃 𝑝
= 15𝑝2 ; 𝜂 = ∗ = 15𝑝2 ∗ =3 | For any value of 𝑃, the elasticity is 3
𝜕𝑃 𝜕𝑃 𝑄𝑠 5𝑝3
Elasticity: Practice
• Calculate demand elasticity; price, cross price and income

• Demand functions

• 𝑄𝑑 = 𝐴𝑝𝜖

• 𝑄𝑑 = 8 − 𝑝, at the point 𝑝 = 2

• Calculate supply elasticity: price and others

• Supply functions

• 𝑄𝑠 = 10.2 + 0.25𝑝, at the point 𝑝 = 7.2

• 𝑄𝑠 = 9.6 + 0.5𝑝, at the point 𝑝 = 3.5

Elasticity and tax incidence
• Effects of tax on equilibrium & burden of tax depends on the elasticities of demand & supply
• Info about elasticities of demand & supply help make accurate predictions about effects of a tax

• In the context of elasticity, we can think of the tax incidence

• Tax incidence = who bears the burden of the tax

• Statutory tax incidence = whoever is making payment of tax to authority, bears statutory burden
• Economic Incidence = Difference in a party’s resources before and after the tax is imposed.

• Economic incidence differs from statutory incidence. This is because the market reacts to a tax.
Elasticity and tax incidence
• Statutory tax incidence != economic incidence

• If tax is imposed on the producer, the producer might increase price which offsets the amount
paid to the government as tax.
• So, the economic incidence on the producer will be less than the statutory incidence.

• If tax is levied on the consumers, they buy less and hence lower the price.
• Therefore economic incidence on consumers would be less than amount they send to the government.

• So, price responses offset statutory burdens.

• 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = ( 𝑃𝑟𝑖𝑐𝑒𝑝𝑜𝑠𝑡𝑡𝑎𝑥 − 𝑃𝑟𝑖𝑐𝑒𝑝𝑟𝑒𝑡𝑎𝑥 ) + 𝑡𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

• 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = ( 𝑃𝑟𝑖𝑐𝑒𝑝𝑟𝑒𝑡𝑎𝑥 − 𝑃𝑟𝑖𝑐𝑒𝑝𝑜𝑠𝑡𝑡𝑎𝑥 ) + 𝑡𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
Elasticity and tax incidence
• Example – market for Gas:
• Panel A: equim. 𝑄𝑒 = 100 & 𝑃𝑒 = 1.5 Rule 1: Statutory incidence ≠ economic incidence
• Panel B: tax of 0.5/per unit
• As the tax is other factor, SS curve
shifts to the left  cost increase
• New, 𝑄𝑒 = 90 and 𝑃𝑒 = 1.8

𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛

= 1.8 − 1.5 + 0 = $0.3
&
𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛
= ( 1.5 − 1.8) + 0.5 = $0.2
• So, in spite of gas station paying the tax,
the consumer bears more burden
• Taxes usually shared by both sides of
market, regardless of who pays
Elasticity and tax incidence
• It doesn’t matter who pays the tax. Rule 2: The side of the market is irrelevant
• 0.5 tax levied on consumer
• DD curve shifts to left by 0.5
• Due to this producer reduces the price
• New, 𝑄𝑒 = 90 and 𝑃𝑒 = 1.3 as in the case of tax
on producer
• Burden is the same!

𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = 1.3 − 1.5 + 0.5

= $0.3

𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = ( 1.5 − 1.3) + 0

= $0.2

• Everything is exactly same – who pays tax is

immaterial
Economic incidence depends on Elasticity
• The elasticity determines how burden of tax is split
• If demand is perfectly inelastic: seller shift all burden, so P ↑= 𝑇
• 𝐶𝑜𝑛𝑠. 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = 2 − 1.5 + 0 = $0.5 & 𝑃𝑟𝑜𝑑. 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = ( 1.5 − 2) + 0.5 = $0
• If demand is perfectly elastic: seller can’t raise the price above $1.50
• 𝐶𝑜𝑛𝑠. 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = 1.5 − 1.5 + 0 = $0 & 𝑃𝑟𝑜𝑑. 𝑇𝑎𝑥 𝐵𝑢𝑟𝑑𝑒𝑛 = ( 1.5 − 1.5) + 0.5 = $0.50
• Extreme cases, generally curve becoming inelastic = losing bargaining power = bear larger burden

Rule 3: elasticities determine

economic incidence
Homework
• From the referred study write a 1 page explanation about how the demand elasticities
for the apple store and that for the android store compare? What are the conclusions
about the elasticities?
Refer: Ghose, A., & Han, S. P. (2014). Estimating demand for mobile applications in the new
economy. Management Science, 60(6), 1470-1488.
Link: https://www.jstor.org/stable/pdf/42919615.pdf
Resources/references
• Perloff, chapter 2 – supply and demand
• Varian, chapter 15 – market demand
• Serrano, chapters 4 & 5 – demand functions & supply functions

• Refer: Ghose, A., & Han, S. P. (2014). Estimating demand for mobile applications in the new
economy. Management Science, 60(6), 1470-1488.
Link: https://www.jstor.org/stable/pdf/42919615.pdf