# 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
• 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,
•   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
• 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