Econ 200 Lecture 7 January 24, 2017

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1 1. Learning Catalytics Session 2. Elasticity and Total Revenue Econ 200 Lecture 7 January 24, Cross-Price and Income Elasticities 4. Elasticity of Supply 5. Consumer & Producer Surplus 1

2 Total Revenue Along a Linear Demand Curve Suppose we have a linear demand curve. What happens to total revenue as price increases? Initially, total revenue rises, suggesting demand is inelastic. But then total revenue starts to fall, suggesting demand is elastic! 2

3 Total Revenue Along a Linear Demand Curve cont. 3 The data from the table are plotted in the graphs. As price decreases from \$8, revenue rises hence demand is elastic. As price continues to fall, revenue eventually flattens out demand is unit elastic. Then as price falls even further, revenue begins to fall demand is inelastic.

4 Other Elasticities: Cross-Price Elasticity of Demand Cross - price elasticity of Percentage change in quantity demanded of one good demand Percentage change in price of another good Substitutes: Goods and services that can be used for the same purpose. (Cross-price elasticity >0) Complements: Goods and services that are used together. (Cross-price elasticity <0) Cross-price elasticity of demand measures the strength of substitute or complement relationships between goods: 4

5 Income Elasticity of Demand Income elasticity of demand Percentage change in quantity demanded Percentage change in income Normal goods: Goods and services for which the quantity demanded increases as income increases (Income elasticity >0) Inferior goods: Goods and services for which the quantity demanded falls as income increases (Income elasticity <0) Income elasticity of demand measures the strength of the effect of income on quantity demanded: 5

6 Summary of Income Elasticity of Demand 6 If the income elasticity of demand is then the good is Example positive but less than 1 normal and a necessity Bread positive and greater than 1 normal and a luxury Caviar negative inferior Ramen noodles

7 Elasticities of Alcoholic Beverages 7 Price elasticity of demand for beer Cross-price elasticity of demand between beer and wine Cross-price elasticity of demand between beer and spirits Income elasticity of demand for beer Demand for beer is price inelastic. Beer and wine are complements. Beer and spirits are also complements, but the relationship is not as strong. Beer is a normal good; a necessity.

8 Price Elasticity of Supply Price elasticity of supply is analogous to price elasticity of demand: Price elasticity of supply Percentage change in quantity supplied Percentage change in price Price elasticity of demand Percentage change in quantity demanded Percentage change in price Note: You should also use the midpoint formula here. 8

9 Price Elasticity of Supply Terminology 9 Price Elasticity of Supply tends to be positive. Formally: -Price Elastic: If price elasticity of supply is larger (in absolute value) than 1. -Price Inelastic: If price elasticity of supply is smaller than 1, but greater than zero. -Perfectly Inelastic: If price elasticity of supply is exactly zero (a vertical line may happen in very short time frame) -Perfectly Elastic: If price elasticity of supply is infinity (a horizontal line may happen in a very long time frame)

10 Why Are Oil Prices So Unstable? 10 Oil producers cannot change output very quickly. When demand increases suddenly, price rises, acting as a rationing mechanism for the increased demand. On the other hand, during a recession, demand for oil falls. Oil producers cannot adjust their output quickly, so the price falls dramatically.

11 Why Is Knowing Price Elasticity of Supply Useful? 11 Knowing the price elasticity of supply can help us to predict the effect that a change in demand will have. When demand increases, we know equilibrium price and quantity will increase. But if supply is inelastic, quantity supplied cannot change much in response to the demand change; so price will rise a lot. If supply is elastic, price will rise much less. The next two slides illustrate these statements.

12 Parking on the 4 th of July Inelastic Supply 12 Demand Typical : Typical demand for parking on a summer weekend at a beach resort. Demand July 4 : Demand on the 4 th of July. When supply is inelastic, the price increase will be large.

13 Parking on the 4 th of July Elastic Supply 13 If supply is elastic instead, then the resulting price change will be much smaller.

14 What determines the price elasticity of supply? 14 To answer this, we need to know the ability and willingness of firms to change the quantity they offer for sale as the price changes. Since firms really only care about profit, they have no additional preferences to consider, just ability. Time is the most important determinant!

15 What determines the price elasticity of supply? For example, it is difficult to change the amount of gasoline produced in the short run, but what happens over a longer time frame? P S SLR Producers can enter the market, new oil sources can be discovered Supply becomes much more responsive to price! D Q 15

16 16 Should the Government Control Apartment Rents? Rent control puts a legal limit on the rent that landlords can charge for an apartment. Does it make tenants better off? What about landlords? How should we measure that? Would you prefer to look for an apartment in a city with or without rent control?

17 Consumer and Producer Surplus 17 Surplus : Something that remains above what is used or needed Consumer surplus is the difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer receives. Producer surplus is the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives.

18 Deriving the Demand Curve for Chai Tea 18 Suppose four people are each interested in buying a cup of chai tea. We can characterize them by the highest price they are willing to pay. At prices above \$6, no chai tea will be sold. At \$6, one cup will be sold, etc.

19 How Much Benefit Will Chai Tea Drinkers Receive? 19 That depends on the price and their marginal benefit, the additional benefit to a consumer from consuming one more unit of a good or service. If the price is low, many of the consumers benefit. If the price is high, few (if any) of the consumers benefit.

20 Consumer Surplus at a Price of \$ Theresa was willing to pay \$6.00; a cup of chai tea is worth \$6.00 to her. She got it for \$3.50, so she derives a net benefit of \$6.00 \$3.50 = \$2.50. Area A represents this net benefit, and is known as Theresa s consumer surplus in the chai tea market.

21 Consumer Surplus at a Price of \$3.50 continued 21 Tom and Terri also obtain consumer surplus, equal to \$1.50 (area B) and \$0.50 (area C). The sum of the areas of rectangles A, B, and C is called the consumer surplus in the chai tea market.

22 Consumer Surplus If Price Falls to \$ If the price falls to \$3.00, Theresa, Tom, and Terri each gain an additional \$0.50 of consumer surplus. The overall consumer surplus remains the area below the demand curve, above the (new) price.

23 Total Consumer Surplus in the Market for Chai Tea 23 The market for chai tea is larger than just our four consumers. Consumer surplus in this market = the area below the demand curve, above price.

24 CS from Broadband Internet continued In 2006, the average price for broadband internet service was \$36 per month. CS = Area of shaded triangle = ½ (47 0) (\$73.89 \$36) = \$890.4 million per month 24

25 Producer Surplus Producer surplus can be thought of in much the same way as consumer surplus. Producer surplus: The difference between the lowest price a firm would accept for a good or service and the price it actually receives. What is the lowest price a firm would accept for a good or service? The marginal cost of producing that good or service. Marginal cost: the additional cost to a firm of producing one more unit of a good or service

26 Measuring Producer Surplus (Single Firm) When the market price of tea is \$2.00, Heavenly Tea receives producer surplus of \$0.75 on the first cup, \$0.50 on the second cup, and \$0.25 on the third cup

27 Measuring Producer Surplus (Entire Market) Total producer surplus is equal to the area above the supply curve and below the market price of \$

28 What Consumer and Producer Surplus Measure 28 Consumer surplus measures the net benefit to consumers from participating in a market rather than the total benefit. Consumer Surplus = Total Benefit Total Price Paid Similarly, producer surplus measures the net benefit received by producers from participating in a market. Producer Surplus = Total Revenue Total Cost (incurred from production)