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1-2 Introduction Demand Supply Equilibrium Elasticity

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1-2 Introduction Demand Supply Equilibrium Elasticity

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lemma4a
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© © All Rights Reserved
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Department of Economics

Introduction to Economics
Fundamental of Economics

 Economics is the social science that deals with the allocation


of scarce resources among competing means to satisfy
human wants.

 From the definition of economics it is important to note the


following four points.

 Scarce resources: Any society faces a problem of scarcity.

 If resources are scares, then outputs are limited.


 Therefore, a society tries to allocate its scarce resources so as to
satisfy as much society’s material wants as possible.

 Human wants: - refers to people’s effective desires for goods


and services.

 Wants vary greatly among individuals and over time for the same
individual.

 Some people like sports, others like books; some want to travel,
others want to putter in the yard.

 An individual’s desire for a particular good during a particular


period of time is not infinite, but in the aggregate human wants
seem to be insatiable.
 People’s needs and desires for goods and services are virtually
unlimited.

 On the other hand, resources (land, labour and capital) required


to produce those goods and services are limited.

 Hence, the central economic problem for society is how to


reconcile the conflict between people’s unlimited wants and
scarce resources, and there comes the need for studying
economics.

 Competing means: - refers to the alternative ways of using


scarce resources to satisfy human wants.
 In order to satisfy competing society’s competing ends, a
society is forced to make choice as to what outputs to produce,
in what quantise, how to use the available resources.

 Allocation: - refers to the employment of resources among


alternative uses.
Branches of Economics

 Economics can be divides in to two main branches:


Microeconomics and Macroeconomics.

Microeconomics

 It is concerned with the economic behaviour of individual


economic units, well defined group of individual economic
groups, and how market of individual commodities function.

 These individual economic unities can be a household or a


firm.
Macroeconomics

 It deals with the economy as a whole and sub aggregates of the


economy.

 It does not deal with the individual household, firm or industry.

 It deals with the magnitudes such as the total output level in the
economy, national income of the country, total employment
level in the economy, the general price level of goods and
services in the economy.
Scarcity
Choice
Opportunity Cost
Factors of Production

Payments
to factors
Land Labor Capital Enterprise
of
Productio
n

Rent Wages Interest Profit

INCOME
Production Possibilities Frontier (PPF)
PPF shows the various possible combinations of goods and services
that the society can produce given its resources and technology.

The underline assumption of PPF:


Efficiency: the economy is operating at full employment and
achieving full production.

Fixed resources: the quantity or the amount of resources of a


given quality is fixed in supply.

Fixed technology: technology does not change for a given


period of time.

Two products: assume that the society is producing two goods.


Production Possibilities Frontier (PPF)
 Consider an economy that
can produce only two types
of goods: wine and cotton.

 Points A, B and C-most


efficient use of resources by
the economy.

 Point X-inefficient use of


resources,

 Point Y- cannot attain with


its present levels of
resources.
Production Possibilities Frontier (PPF)
 Change in technology- the level of land, labour
and capital remained the same, the time required to
pick cotton and grapes would be reduced.

 Output would increase, and the PPF would be


pushed outwards.

 A new curve, on which Y would appear, would


represent the new efficient allocation of resources.

 PPF shifts outwards,-growth in an economy.

 The PPF shifts inwards -economy is shrinking as a


result of a decline in its most efficient allocation of
resources and optimal production capability.

 A shrinking economy could be a result of a


decrease in supplies or a deficiency in technology.
Opportunity cost
 Opportunity cost is the value of what is foregone in order to have
something else; OC= scarify/gain

 Important to the PPF because a country will decide how to


best allocate its resources according to its opportunity cost.

 E.g., assume that an individual has a choice between two


telephone services.

 If he or she were to buy the most expensive service, that


individual may have to reduce the number of times he or
she goes to the movies each month.
Giving up these opportunities to go to the
movies may be a cost that is too high for this
person, leading him or her to choose the less
expensive service.

Remember that opportunity cost is different for


each individual and nation.
Numerical example
Calculate Opportunity cost of producing one more
unit of X along a movement on the PPF starting from
combination A

Differentiate between total and per unit opportunity


cost

Sketch the PPF


Circular Flow Economics Activities

Resource Market

Firm Household
Flow of payments

Product market

Flow of goods & services

45
Comparative Advantage and Absolute Advantage

 An economy can focus on producing all of the goods and


services-this may lead to an inefficient allocation of resources and
hinder future growth.

 By using specialization, a country can concentrate on the


production of one thing that it can do best, rather than dividing up
its resources.
Comparative Advantage
 Let's look at a hypothetical world that has only two countries
(Country A and Country B) and two products (cars and cotton).

 Each country can make cars and/or cotton.

 Now suppose that Country A has very little fertile land and an
abundance of steel for car production.

 Country B has an abundance of fertile land but very little steel.

 If Country A were try to produce both cars and cotton, it would


need to divide up its resources.
Comparative Advantage
 Because it requires a lot of effort to produce cotton by
irrigating the land, Country A would have to sacrifice producing
cars.

 The opportunity cost of producing both cars and cotton is high for
Country A, which will have to give up a lot of capital in order to
produce both.

 Similarly, for Country B, the opportunity cost of producing both


products is high because the effort required to produce cars is
greater than that of producing cotton.

 Each country can produce one of the products more efficiently


(at a lower cost) than the other.
Comparative Advantage

 Country A, which has an abundance of steel, would need to give


up more cars than Country B would to produce the same amount
of cotton.

 Country B would need to give up more cotton than Country A to


produce the same amount of cars.

 Therefore, County A has a comparative advantage over Country B


in the production of cars, and Country B has a comparative
advantage over Country A in the production of cotton.

 Now let's say that both countries (A and B) Specialize in


producing the goods with which they have a comparative
advantage
Comparative Advantage
 If they trade the goods that they produce for other goods in which
they don't have a comparative advantage, both countries will be
able to enjoy both products at a lower opportunity cost.

 Furthermore, each country will be exchanging the best product it


can make for another good or service that is the best that the other
country can produce.

 Specialization and trade also works when several different


countries are involved.

 For example, if Country C specializes in the production of corn, it


can trade its corn for cars from Country A and cotton from
Country B.
Comparative Advantage
 Determining how countries exchange goods produced by a
comparative advantage ("the best for the best") is the backbone of
international trade theory.

 This method of exchange is considered an optimal allocation of


resources, whereby economies, in theory, will no longer be lacking
anything that they need.

 Like opportunity cost, specialization and comparative advantage


also apply to the way in which individuals interact within an
economy
Absolute Advantage
 Sometimes a country or an individual can produce more than
another country, even though countries both have the same
amount of inputs.
 E.g., Country A may have a technological advantage that, with the
same amount of inputs (arable land, labour), enables the country
to manufacture more of both cars and cotton than Country B.
 A country that can produce more of both goods is said to have an
absolute advantage.
 Better quality resources can give a country an absolute advantage
as can a higher level of education and overall technological
advancement.
 It is not possible, however, for a country to have a comparative
advantage in everything that it produces, so it will always be able
to benefit from trade.
Demand
• Demand means the willingness and
capacity to pay.
• Prices are the tools by which the market
coordinates individual desires.
Demand vs. Quantity
Demanded
• Demand is the amount of a product that
people are willing and able to purchase at
each possible price during a given period
of time.

• The quantity demand is the amount of a


product that people are willing and able to
purchase at one, specific price.
The Law of Demand
• Law of demand – there is an inverse
relationship between price and quantity
demanded.
– Quantity demanded rises as price falls, other
things constant.
– Quantity demanded falls as prices rise, other
things constant.
The Law of Demand
• What accounts for the law of demand?

– People tend to substitute for goods whose


price has gone up.
The Demand Curve
• The demand curve is the graphic
representation of the law of demand.
• The demand curve slopes downward and
to the right.
• As the price goes up, the quantity
demanded goes down.
The Demand Table
• The demand table assumes all the
following:
– As price rises, quantity demanded declines.
– Quantity demanded has a specific time
dimension to it.
– All the products involved are identical in
shape, size, quality, etc.
The Demand Table
• The demand table assumes all the
following:
– The schedule assumes that everything else is
held constant.
From a Demand Table to a
Demand Curve
• You plot each point in the demand table
on a graph and connect the points to
derive the demand curve.
From a Demand Table to a
Demand Curve
• The demand curve graphically conveys
the same information that is on the
demand table.
From a Demand Table to a
Demand Curve
A Demand Table $6.00
A Demand Curve

Price per DVD rentals 5.00

Price per DVDs (in dollars)


cassette demanded per
week 4.00 E

A $0.50 9 3.50 G
3.00 D
B 1.00 8 Demand for
C
C 2.00 6 2.00 DVDs
D 3.00 4 1.00
F B
A
E 4.00 2 .50
0
1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of DVDs demanded (per week)
A Sample Demand Curve
Price (per unit)

PA A

D
0
QA
Quantity demanded (per unit of time)
Demand Schedule and
Demand Curve for DVDs
Other Things Constant
• Other things constant places a limitation
on the application of the law of demand.
– All other factors that affect quantity demanded
are assumed to remain constant, whether
they actually remain constant or not.
Other Things Constant
• Other things constant places a limitation
on the application of the law of demand.
– These factors may include changing tastes,
prices of other goods, income, even the
weather.
Shifts in Demand Versus
Movements Along a Demand
Curve
• Demand refers to a schedule of
quantities of a good that will be bought
per unit of time at various prices, other
things constant.
• Graphically, it refers to the entire
demand curve.
Shifts in Demand Versus
Movements Along a
Demand Curve
• Quantity demanded refers to a specific
amount that will be demand per unit of
time at a specific price.

• Graphically, it refers to a specific point


on the demand curve.
Shifts in Demand Versus
Movements Along a Demand
Curve
• A movement along a demand curve is
the graphical representation of the effect
of a change in price on the quantity
demanded.
Shifts in Demand Versus
Movements Along a
Demand Curve
• A shift in demand is the graphical
representation of the effect of anything
other than price on demand.
Change in Quantity Demanded

$2 B
Price (per unit)

Change in quantity demanded


(a movement along the curve)

A
$1

D1
0
100 200
Quantity demanded (per unit of time)
Shift in Demand

Change in demand
(a shift of the curve)
$2
Price (per unit)

B A
$1

D0

D1
100 200 250
Quantity demanded (per unit of time)
Determinants of Demand

Number of buyers
Income

Tastes

Expectations
Prices of related goods
Shift Factors of Demand
• Shift factors of demand are factors that
cause shifts in the demand curve:
– Society's income.
– The prices of other goods.
– Tastes.
– Expectations.
– Number of Buyers
– Taxes on subsidies to consumers.
Income
• An increase in income will increase
demand for normal goods.
• An increase in income will decrease
demand for inferior goods.
Price of Other Goods
• When the price of a substitute good falls,
demand falls for the good whose price has
not changed.
• When the price of a complement good
falls, demand rises for the good whose
price has not changed.
Tastes
• A change in taste will change demand with
no change in price.
Expectations
• If you expect your income to rise, you may
consume more now.
• If you expect prices to fall in the future,
you may put off purchases today.
Individual and Market Demand
Curves
• A market demand curve is the horizontal
sum of all individual demand curves.
– This is determined by adding the individual
demand curves of all the demanders.
Individual and Market Demand
Curves
• Sellers estimate total market demand for
their product which becomes smooth and
downward sloping curve.
From Individual Demands
to a Market Demand Curve

(1) (2) (3) (2) (3) $4.00


Price per Alice’s Bruce’s Cathy’s Market G
cassette demand demand demand demand 3.50

Price per cassette (in dollars)


3.00 F
A $.0.50 9 6 1 16 E
B 1.00 8 5 1 14 2.50
D
C 1.50 7 4 0 11 2.00
D 2.00 6 3 0 9 C
1.50
E 2.50 5 2 0 7 B
F 3.00 4 1 0 5 1.00
A
G 3.50 3 0 0 3 0.50
H 4.00 2 0 0 2 Cathy Bruce Alice Market demand
0
2 4 6 8 10 12 14 16
Quantity of cassettes demanded per week

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.


Aggregation of Demand (I)
Aggregation of Demand (II)
Factors that Shift Demand
Number
Of
Buyers
Consumer Price of
Income Related Goods

Demand
Tastes
And Expectations
Preferences

Demographics
Taxes and Subsidies
• Taxes levied on consumers increase the
cost of goods to consumers, thereby
reducing demand.
• Subsidies have an opposite effect.
Changes in Demand
and Quantity Demanded
• Change in Quantity Demanded -
movement along the same demand curve
in response to a price change.

• Change in Demand - shift in entire


demand curve in response to a change
in a determinant of demand (a ceteris
paribus variable)
Change in Demand vs. Change
in the Quantity Demanded
The Law of Demand
• The demand curve is downward sloping
for the following reasons:
– At lower prices, existing demanders buy
more.
– At lower prices, new demanders enter the
market.
Supply
• Individuals control the factors of
production – inputs, or resources,
necessary to produce goods.
• Individuals supply factors of production to
intermediaries or firms.
Supply
• The analysis of the supply of produced
goods has two parts:
– An analysis of the supply of the factors of
production to households and firms.
– An analysis of why firms transform those
factors of production into usable goods and
services.
The Law of Supply
• There is a direct relationship between
price and quantity supplied.
– Quantity supplied rises as price rises, other
things constant.
– Quantity supplied falls as price falls, other
things constant.
Law of Supply
• Law of Supply
– As the price of a product rises, producers will be
willing to supply more.
– The height of the supply curve at any quantity shows
the minimum price necessary to induce producers
to supply that next unit to market.
– The height of the supply curve at any quantity also
shows the opportunity cost of producing the next
unit of the good.
The Law of Supply
• The law of supply is accounted for by two
factors:
– When prices rise, firms substitute
production of one good for another.
– Assuming firms’ costs are constant, a
higher price means higher profits.
The Supply Curve
• The supply curve is the graphic
representation of the law of supply.
• The supply curve slopes upward to the
right.
• The slope tells us that the quantity
supplied varies directly – in the same
direction – with the price.
A Sample Supply Curve
Price (per unit)

A
PA

0
QA
Quantity supplied (per unit of time)
Supply Curve DVDs
Shifts in Supply Versus Movements
Along a Supply Curve

• Supply refers to a schedule of quantities a


seller is willing to sell per unit of time at
various prices, other things constant.
Shifts in Supply Versus Movements
Along a Supply Curve

• Quantity supplied refers to a specific


amount that will be supplied at a specific
price.
Shifts in Supply Versus Movements
Along a Supply Curve

• Changes in price causes changes in


quantity supplied represented by a
movement along a supply curve.
Shifts in Supply Versus Movements
Along a Supply Curve

• A movement along a supply curve – the


graphic representation of the effect of a
change in price on the quantity supplied.
Shifts in Supply Versus Movements
Along a Supply Curve

• If the amount supplied is affected by


anything other than a change in price,
there will be a shift in supply.
Shifts in Supply Versus Movements
Along a Supply Curve

• Shift in supply – the graphic


representation of the effect of a change in
a factor other than price on supply.
Change in Quantity Supplied
S0
Price (per unit)

Change in quantity
A supplied (a movement
$15
along the curve)

1,250 1,500
Quantity supplied (per unit of time)
Shift in Supply
S0
Price (per unit) S1

A B
$15
Shift in Supply
(a shift of the curve)

1,250 1,500
Quantity supplied (per unit of time)
Shift Factors of Supply
• Other factors besides price affect how
much will be supplied:
– Prices of inputs used in the production of a
good.
– Technology.
– Suppliers’ expectations.
– Taxes and subsidies.
Factors that Shift Supply

Resource
Prices

Technology
Prices of Related
Goods and Services
And
Productivity
Supply

Number Expectations
Of Of
Producers Producers
Price of Inputs (Resource Prices)
• When costs go up, profits go down, so that
the incentive to supply also goes down.
Technology
• Advances in technology reduce the
number of inputs needed to produce a
given supply of goods.
• Costs go down, profits go up, leading to
increased supply.
Expectations
• If suppliers expect prices to rise in the
future, they may store today's supply to
reap higher profits later.
Number of Suppliers
• As more people decide to supply a good
the market supply increases (Rightward
Shift).
Individual and Market Supply
Curves
• The market supply curve is derived by
horizontally adding the individual supply
curves of each supplier.
From Individual Supplies to a Market
Supply
(1) (2) (3) (4) (5)
Quantities Price Ann's Barry's Charlie's Market
Supplied (per DVD) Supply Supply Supply Supply
A $0.00 0 0 0 0
B 0.50 1 0 0 1
C 1.00 2 1 0 3
D 1.50 3 2 0 5
E 2.00 4 3 0 7
F 2.50 5 4 0 9
G 3.00 6 5 0 11
H 3.50 7 5 2 14
I 4.00 8 5 2 15
From Individual Supplies to a Market
Supply
Charlie Barry Ann Market Supply
$4.00 I
3.50 H
3.00 G
Price per DVD

2.50 F
2.00 E
1.50 D
1.00 C
0.50 B CA
0 A
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quantity of DVDs supplied (per week)
Aggregation of Supply (I)
Aggregation of Supply (II)
Price of Related Goods or Services
• The opportunity cost of producing and
selling any good is the forgone opportunity
to produce another good.
• If the price of alternate good changes then
the opportunity cost of producing changes
too!
• Example Mc Don selling Hamburgers vs.
Salads.
Taxes and Subsidies
• When taxes go up, costs go up, and profits
go down, leading suppliers to reduce
output.
• When government subsidies go up, costs
go down, and profits go up, leading
suppliers to increase output.
Decrease in Supply
Increase in Supply
Change in Supply vs.
a Change in the Quantity Supplied
The Interaction of Supply and Demand

• The English historian Thomas Carlyle


once said:
“Teach any parrot the words supply and
demand and you’ve got an
economist.”
Equilibrium
• Equilibrium is a concept in which opposing
dynamic forces cancel each other out.
Equilibrium
• In a free market, the forces of supply and
demand interact to determine equilibrium
quantity and equilibrium price.
Equilibrium
• Equilibrium price – the price toward which
the invisible hand drives the market.

• Equilibrium quantity – the amount


bought and sold at the equilibrium
price.
What Equilibrium Isn’t
• Equilibrium isn’t a state of the world, it is a
characteristic of a model.
• Equilibrium isn’t inherently good or bad, it
is simply a state in which dynamic
pressures offset each other.
What Equilibrium Isn’t
• When the market is not in equilibrium, you
get either excess supply or excess
demand, and a tendency for price to
change.
Excess Supply
• Excess supply – a surplus, the quantity
supplied is greater than quantity
demanded
• Prices tend to fall.
Excess Demand
• Excess demand – a shortage, the quantity
demanded is greater than quantity
supplied
• Prices tend to rise.
Price Adjusts
• The greater the difference between
quantity supplied and quantity demanded,
the more pressure there is for prices to
rise or fall.
Price Adjusts
• When quantity demanded equals quantity
supplied, prices have no tendency to
change.
The Graphical Interaction of
Supply and Demand

Price (per Quantity Quantity Surplus (+)


DVD) Supplied Demanded Shortage (-)
$3.50 7 3 +4
$2.50 5 5 0
$1.50 3 7 -4
The Graphical Interaction of Supply and
Demand

$5.00
S
4.00 Excess supply
Price per DVD

3.50 A
3.00
2.50 E

2.00 C
1.50
Excess demand
1.00 D
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded
The Graphical Interaction of Supply and
Demand

• When price is $3.50 each, quantity


supplied equals 7 and quantity
demanded equals 3.

• The excess supply of 4 pushes price


down.
The Graphical Interaction of Supply and
Demand
• When price is $1.50 each, quantity
supplied equals 3 and quantity
demanded equals 7.

• The excess demand of 4 pushes price


up.
The Graphical Interaction of Supply and
Demand

• When price is $2.50 each, quantity


supplied equals 5 and quantity
demanded equals 5.

• There is no excess supply or excess


demand, so price will not rise or fall.
Equilibrium (Graph)
Shifts in Supply and Demand
• Shifts in either supply or demand change
equilibrium price and quantity.
Increase in Demand
• An increase in demand creates excess
demand at the original equilibrium price.
• The excess demand pushes price upward
until a new higher price and quantity are
reached.
Increase in Demand

S0

B
$2.50 Excess demand
A
2.25

D0 D1

0 8 9 10
Quantity of DVDs (per week)
The Effects of a Shift
of the Demand Curve
Decrease in Supply
• A decrease in supply creates excess
demand at the original equilibrium price.
• The excess demand pushes price upward
until a new higher price and lower quantity
are reached.
Decrease in Supply

S1
S0
C
$2.50 Excess demand
B
2.25 A

D0

0 8 9 10
Quantity of DVDs (per week)
The Limitations Of Supply And Demand
Analysis

• Sometimes supply and demand are


interconnected.
• Other things don't remain constant.
The Limitations Of Supply And Demand
Analysis

• All actions have a multitude of ripple and


possible feedback effects.

• The ripple effect is smaller when the


goods are a small percentage of the
entire economy.
The Limitations Of Supply And Demand
Analysis

• The other-things-constant assumption is


likely not to hold when the goods
represent a large percentage of the
entire economy.
A Price Floor
Rent Controls
3. Elasticity of Demand
 The degree to which a demand or supply curve reacts to a change
in price is the curve's elasticity

 Elasticity varies among products because some products may be


more essential to the consumer.

 Products that are necessities are more insensitive to price changes


because consumers would continue buying these products despite
price increases.

 Conversely, a price increase of a good or service that is


considered less of a necessity will deter more consumers because
the opportunity cost of buying the product will become too high.
Cont…
 A good or service is considered to be highly elastic if a slight
change in price leads to a sharp change in the quantity demanded
or supplied.

 Usually these kinds of products are readily available in the market


and a person may not necessarily need them in his or her daily
life.

 On the other hand, an inelastic good or service is one in which


changes in price witness only modest changes in the quantity
demanded or supplied, if any at all.

 These goods tend to be things that are more of a necessity to the


consumer in his or her daily life.

 To determine the elasticity of the supply or demand curves, we


can use this simple equation:
Cont…
Elasticity =
(% change in quantity /
% change in price)
 If elasticity is greater than or equal to one,
the curve is considered to be elastic.

 If it is less than one, the curve is said to be


inelastic.
 the demand curve is a negative slope, and
if there is a large decrease in the quantity
demanded with a small increase in price,
the demand curve looks flatter, or more
horizontal.
 This flatter curve means that the good or
service in question is elastic.
Cont…
 Inelastic demand is represented
with a much more upright curve
as quantity changes little with a
large movement in price.
Factors Affecting Demand Elasticity

 There are three main factors that influence a demand’s price


elasticity.
The availability of substitutes
 This is probably the most important factor influencing the
elasticity of a good or service.

 In general, the more substitutes, the more elastic the demand will
be.

 For example, if the price of a cup of coffee went up by $0.25,


consumers could replace their morning caffeine with a cup of tea

 This means that coffee is an elastic good because a raise in price


will cause a large decrease in demand as consumers start buying
more tea instead of coffee.
Cont…
 However, if the price of caffeine were to go up as a whole, we
would probably see little change in the consumption of coffee or
tea because there are few substitutes for caffeine.

 Most people are not willing to give up their morning cup of


caffeine no matter what the price.

 We would, therefore, say that caffeine is an inelastic product


because of its lack of substitutes.

 Thus, while a product within an industry is elastic due to the


availability of substitutes, the industry itself tends to be inelastic.

 Usually, unique goods such as diamonds are inelastic because they


have few - if any - substitutes.
Amount of income available to spend on the good
 This factor affecting demand elasticity refers to the total a person
can spend on a particular good or service.

 Thus, if the price of a can of Coke goes up from $0.50 to $1 and


income stays the same, the income that is available to spend on
Coke, which is $2, is now enough for only two rather than four
cans of Coke.

 In other words, the consumer is forced to reduce his or her


demand of Coke.

 Thus if there is an increase in price and no change in the amount


of income available to spend on the good, there will be an elastic
reaction in demand: demand will be sensitive to a change in price
if there is no change in income.
Time
 The third influential factor is time.

 If the price of cigarettes goes up $2 per pack, a smoker, with very


little available substitutes, will most likely continue buying his or
her daily cigarettes.

 This means that tobacco is inelastic because the change in the


quantity demand will have been minor with a change in price.

 However, if that smoker finds that he or she cannot afford to


spend the extra $2 per day and begins to kick the habit over a
period of time, the price elasticity of cigarettes for that consumer
becomes elastic in the long run.
Income Elasticity of Demand
• Income elasticity of demand – the
percentage change in demand divided by
the percentage change in income.

Percentage change in demand


EIncome =
Percentage change in income
Income Elasticity of Demand
• Income elasticity of demand tells us the
responsiveness of demand to changes in
income.
Income Elasticity of Demand
• An increase in income generally increases
one’s consumption of almost all goods.

• The increase may be greater for some


goods than for others.
Income Elasticity of Demand
• Normal goods are those whose
consumption increases with an increase in
income.

• They have income elasticities greater than


zero.
Income Elasticity of Demand
• Normal goods are divided into luxuries and
necessities.
Income Elasticity of Demand
• Luxuries are goods that have an income
elasticity greater than one.

• Their percentage increase in demand is


greater than the percentage increase in
income.
Income Elasticity of Demand
• A necessity has an income elasticity less
than 1.

• The consumption of a necessity rises by a


smaller proportion than the rise in income.
Income Elasticity of Demand
• Inferior goods are those whose
consumption decreases when income
increases.

• Inferior goods have income elasticities


less than zero.
Income Elasticities
of Selected Goods

Income elasticity
Product Short Run Long Run
Motion pictures 0.81 3.41
Foreign travel 0.24 3.09
Tobacco products 0.21 0.86
Furniture 2.60 0.53
Jewelry and watches 1.00 1.64
Hard liquor — 2.50
Private university tuition — 1.10
Other Demand Elasticities
• Income Elasticity of Demand: the
percentage change in the quantity
demanded divided by the percentage
change in income.
– Normal goods: goods for which the income
elasticity of demand is positive.
– Inferior goods: Goods for which the income
elasticity of demand is negative.
Necessities and Luxuries
• Goods with lower income elasticities are often
called necessities, since the quantities
demanded don’t vary much with income.
– Typical income elasticities are 0.4 or 0.5.

• Goods with higher income elasticities are often


called luxuries, since people give them up
readily when their incomes fall.
– Typical elasticities are 1.5 to 2.0.
Cross-Price Elasticity of
Demand
• Cross-price elasticity of demand – the
percentage change in demand divided by
the percentage change in the price of
another good.

Percentage change in demand


ECross - Price =
Percentage change in price
of a related good
Cross-Price Elasticity of
Demand
• Cross-price elasticity of demand tells us
the responsiveness of demand to changes
in prices of other goods.
Complements and Substitutes
• Substitutes are goods that can be used in
place of another.
• Substitutes have positive cross-price
elasticities.
Complements and Substitutes
• Complements are goods that are used in
conjunction with other goods.

• Complements have negative cross-price


elasticities.
Cross-Price Elasticities
Cross-Price
Commodities Elasticity
Beef in response to price change in pork 0.11
Beef in response to price change in chicken 0.02
U.S. cars in response to price changes
in European and Asian automobiles 0.28
European automobiles in response to price
changes in U.S. and Asian automobiles 0.61
Beer in response to changes in wine 0.23
Hard liquor in response to price changes in
beer - 0.11
Calculating Income Elasticity

(26 - 20)
2 (26  20) 26
1
Eincome    1.3
20 20

P0 P0
Shift due to
20% rise in
D0 D1 income

20 26 Quantity
Calculating Cross-Price Elasticity

(108 - 104)
2 (108  104 ) .038
1

D1 Ecross    .12
.33 .33
D0
P0 P0
Shift due to 33% rise
in price of pork

104 108
Quantity of Beef
Price elasticity of supply
Definition and measurement
 It measures the percentage change in quality supplied of a
product due to a % change in the price of the same product,
ceteris paribus.
Percentage change in quantity Supplied of a product
(€s) = Percentage change in price of the same product

 The price elasticity of supply formula are similar with that of


price elasticity of demand formula except that, here, we have
quantity supplied rather than quantity demanded.

 Price elasticity of supply is always positive.

 It varies between 0 and infinitive, i.e.0< €s< infinitive .


Cont…
 Like price elasticity of demanded, price elasticity of supply is
divided in to three ranges.

 When Es >1, the supply elasticity is said to be elastic

 When 0 <= Es<1 , the supply is said to be inelastic.

 When Es=1, the supply is said to be unitary elastic.

 Till now we know only a positively sloped supply curve. But there
are also some special types of supply curves.
I. A perfectly inelastic supply curve [when €s=0] price

S0

Price
P0 S0

0 Q0
Quantitysupplied
Cont…
 A Perfectly inelastic supply curve is a vertical line above a
certain minimum price.

 In order to supply a product sellers require a minimum price.


Once the firm gets the minimum price, p0, they will provide Q0
amount irrespective of the change in price above the minimum
price, p0.
I. Perfectly elastic supply curve [when €s= infinitive )

Price

P0 S0

Quantity supplied
Cont...
 A perfectly elastic supply curve is a horizontal supply curve.

 It implies that producers are willing to provide any amount they


can at certain specific price, po.

 They need no incentive to do so.

 This usually happens if the unit cost of production [cost per unit]
doesn’t change as the firm produces more and more of the
product
Determinants of price elasticity of supply
 What makes price elasticity of supply more or less elastics?

 There are basically three determinants of price elasticity of supply.


Unit cost of production:
 it refers to the cost of production per unit of output.

 Supply of a product, tends to be more elastic if unit cost of


production doesn’t change much as the firm provider more of the
product

Time: - with time supply tends to be more elastic.


 In the long-run, firms have time to change their size and adjust
their production plants to suit whatever new product they want to
produce.
Status of stock: if three is large stock of unsold goods. Supply can
easily and quickly increase.
Thank You

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