Econ 101: Microeconomics by jJ80M0k

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									    Econ 101:
 Microeconomics

      Chapter 4:
Working with Supply and
   Demand: Part 2
    Total Revenue and Total Expenditure

   In the market for a particular good:
    • Total revenue (TR) is the amount of money
      sellers take in.
    • Total expenditure (TE) is the amount of money
      buyers pay out.
    • Assuming no excise tax:
               TR=TE =p x Q = Price x Quantity
        Elasticity and Total Revenue

   When p and Q change as the result of
    movement along a demand curve, what is
    the relationship between changes in price
    and changes in TR?
    • When p increases, Q decreases, so it is not clear,
        without more information, how TR is affected.
    •   When p and Q are both changing, percentage
        change in their product is (approximately) the sum
        of their individual percentage changes.
    •   Need information about elasticity of demand.
    Elasticity and Total Revenue

   Case 1:
    • Suppose demand is inelastic ( %Q  %p ) and
      price increases (quantity decreases).
              TR = TE = p x Q


    • Big increase in p combined with small decrease
      in Q
              TR = TE increases as the result
        Elasticity and Total Revenue

   This is easy to remember by visualizing a
    demand curve close to the limiting case of
    perfectly inelastic:
    p
p2                 For a demand curve that is close to perfectly
                     inelastic, it’s obvious that TR=TE rectangle
                     gets bigger when price increases.
p1




           Q2 Q1                Q
    Elasticity and Total Revenue

   Case 2:
    • Suppose demand is elastic (%Q  %p ) and price
        increases (quantity decreases).
                TR = TE = p x Q


    •    Small increase in p combined with big decrease
        in Q
                TR = TE decreases as the result
         Elasticity and Total Revenue

   Once again, visualizing a demand curve
    close to the limiting case of perfectly elastic:

     p

                       For a demand curve that is close to perfectly
                         elastic, it’s obvious that TR=TE rectangle
    p2                   gets smaller when price increases.
    p1




            Q2    Q1                Q
      Elasticity and Total Revenue

     Lets summarize the results in the table:

                      Increases        Decreases
Perfectly inelastic   TR = TE          TR = TE
Inelastic             TR = TE          TR = TE
Unit Elastic            No change in TR = TE
Elastic               TR = TE          TR = TE
Perfectly Elastic     Can’t talk about price changes
                    Determinants
             of the Elasticity of Demand
   Availability of Substitutes:
    •   Demand is more elastic:
         •   If close substitutes are easy to find and buyers can cut back on
             purchases of the good in question
    •   Demand is less elastic
         •   If close substitutes are difficult to find and buyers can not cut back on
             purchases of the good in question

   Narrowness of Market:
    •   More narrowly we define a good, easier it is to find
        substitutes
         •   More elastic is demand for the good
    •   More broadly we define a good
         •   Harder it is to find substitutes and the less elastic is demand for the
             good
    •   Different things are assumed constant when we use a narrow
        definition compared with a broader definition
                    Determinants
             of the Elasticity of Demand
   Necessities vs. Luxuries
    •   The more ―necessary‖ we regard an item, the harder it is to
        find a substitute
         •   Expect it to be less price elastic
    •   The less ―necessary‖ (luxurious) we regard an item, the
        easier it is to find a substitute
         •   Expect it to be more price elastic

   Time Horizon
    •   Short-run elasticity
         •   Measured a short time after a price change
    •   Long-run elasticity
         •   Measured a year or more after a price change
    •   Usually easier to find substitutes for an item in the long run
        than in the short run
         •   Therefore, demand tends to be more elastic in the long run than in the
             short run
                     Determinants
              of the Elasticity of Demand

   Importance in the Buyers Budget
    •   The more of their total budgets that households spend on
        an item
         •   The more elastic is demand for that item
    •   The less of their total budgets that households spend on an
        item
         •   The less elastic is demand for that item
     Other Elasticities in Economics


   Elasticity is a general concept. Whenever we
    have one variable (X) that depends on
    another variable (Y) we can use elasticity to
    provide unit-free measure of the degree of
    responsiveness of X to changes in Y.

   Elasticities are always ratios of percentage
    changes.
         Income Elasticity of Demand

   Percentage change in quantity demanded divided by
    the percentage change in income
    •   With all other influences on demand—including the price of
        the good—remaining constant

                       % change in Quantity Demanded
             E Y
                   
                            % Change in Income


• Interpret this number as percentage increase in
  quantity demanded for each 1% rise in income
Income Elasticity of Demand

   Income elasticities vs. price elasticities of
    demand
    •   Price elasticity of demand
         • Measures effect of change in price of good
             •   Assumes that other influences on demand, including
                 income, remain unchanged
    •   Income elasticity
         • Measures effect on demand we would observe if income
           changed and all other influences on demand—including
           price of the good—remained the same
   Instead of letting price vary and holding income
    constant, now we are letting income vary and
    holding price constant
        Income Elasticity of Demand

   Another difference between price and
    income elasticity of demand
    • Price elasticity measures sensitivity of
        demand to price as we move along a demand
        curve from one point to another
    •   Income elasticity tells us relative shift in
        demand curve—increase in quantity
        demanded at a given price
   While a price elasticity is virtually always
    negative income elasticity can be
    positive or negative
        Income Elasticity of Demand

   Economic necessity
    •   Good with an income elasticity of demand between 0 and 1
   Economic luxury
    •   Good with an income elasticity of demand greater than 1
   An implication follows from these definitions
    •   As income rises, proportion of income spent on economic
        necessities will fall
         •   While proportion of income spent on economic luxuries will rise
   But, it is important to remember that economic
    necessities and luxuries are categorized by actual
    consumer behavior
    •   Not by our judgment of a good’s importance to human survival
       Cross-Price Elasticity of Demand

      Cross-price elasticity of demand
       •   Percentage change in quantity demanded of one good
           caused by a 1% change in price of another good
            •   While all other influences on demand remain unchanged
                         % Change in Quantity of Good (X) Demanded
                E XZ          % Change in Price of Good (Z)
• While the sign of the cross-price elasticity helps us
  distinguish substitutes and complements among related
  goods
   • Its size tells us how closely the two goods are related
       – A large absolute value for EXZ suggests that the two goods are close
         substitutes or complements
            – While a small value suggests a weaker relationship
         Price Elasticity of Supply

   Percentage change in quantity of a good
    supplied that is caused by a 1% change in the
    price of the good
    •   With all other influences on supply held constant

                      % Change in Quantity Supplied
               ES         % Change in Price
         Price Elasticity of Supply

   When do we expect supply to be price elastic,
    and when do we expect it to be price inelastic?
    •   Ease with which suppliers can find profitable activities
        that are alternatives to producing the good in question
         • Supply will tend to be more elastic when suppliers can
           switch to producing alternate goods more easily
             •   When can we expect suppliers to have easy alternatives?
                 Depends on
                   • Nature of the good itself
                   • Narrowness of the market definition—especially
                     geographic narrowness
                   • Time horizon—longer we wait after a price change,
                     greater the supply response to a price change
       Price Elasticity of Supply

   Extreme cases of supply elasticity
    • Perfectly inelastic supply curve is a vertical
      line
       • Many markets display almost completely inelastic
         supply curves over very short periods of time
    • Perfectly elastic supply curve is a horizontal
      line
                            Excise Tax

   A tax on a particular good or service is called an
    excise tax
    •   Shifts market supply curve upward by amount of tax
         • For each quantity supplied, the new, higher curve tells us
           firms’ gross price, and the original, lower curve tells us the
           net price
   Who really pays excise taxes?
    •   Buyers and sellers share in the payment of an excise
        tax
         • Called tax shifting
             •   Process that causes some of tax collected from one side of
                 market (sellers) to be paid by other side of market (buyers)
          Tax and Demand Elasticity

   In most cases excise tax will be shared
    by both buyer and seller
    • For a given supply curve, the more elastic is
        demand, the more of an excise tax is paid by
        sellers
    •   The more inelastic is demand, the more of the
        tax is paid by buyers
Tax Incidence and Supply Elasticity

   Although there are extreme cases of
    supply elasticity, in general the following
    is true
    • For a given demand curve, the more elastic is
        supply, the more of an excise tax is paid by
        buyers
    •   The more inelastic is supply, the more of the
        tax is paid by sellers

								
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