4

Microeonomics
TAYLOR l WEERAPANA

Xia Tong
 Chapter 4
MICROECONOMICS
FINANCIAL CRISIS UPDATED EDITION The Art of Supply and
Demand :
Ceilings, Floors, and
Elasticity
TAYLOR l WEERAPANA
• Achievement is founded on
diligence and wasted upon
recklessness.
• Qingming Festival, or Tomb Spring
Festival known as a day when
people visit cemeteries and pay
tribute to ancestors.
• Tomb Sweeping Day
 Interference with Market
Prices
•Price Control: a government
control or regulation that sets or
limits the price to be charged for a
particular good.
•Two Broad Types of Price Controls:
• Price Floor
• Price Ceiling
 Price Ceilings and Floors
•Price Ceiling: a government price
control that sets the maximum
allowable price for a good or a
service.
•Example:
– Rent control: a government price
control that sets a maximum
allowable rent to a house or an
apartment.
 Price Ceilings and Floors
•Price Floor: a government price
control that sets the minimum
allowable price for a good or a
service.
•Example:
– Minimum wage: a wage per hour
below which it is illegal to pay
workers.
Side Effects of Price Ceilings
•If the government sets the price
ceiling below the equilibrium price, a
shortage will result.
•Ways We Deal with Persistent
Shortages:
• Coupons
• Long lines
• Reduction in the quality of the good
sold
 Side Effects of Price Floors
•If the government sets the price floor
above the equilibrium price, a surplus
will result.
•Dealing with surpluses:
• With agricultural products, the surpluses
are purchased by the government.
Sometimes, the government pays
farmers not to produce.
• Minimum wages cause a surplus in labor
(a.k.a. unemployment). The government
does not lower wages to eliminate the
surplus labor.
 Figure 2: Effects of
a Minimum-Price Law

(Top graph)
 Figure 2: Effects of
a Minimum-Price Law

(Top graph)
 Figure 2: Effects of
a Minimum-Price Law

(Bottom Graph)
 Elasticity of Demand
•Price Elasticity of Demand: the
percentage change in the quantity
demanded of a good divided by the
percentage change in the price
of that good.
 Figure 3: Elasticity of
Demand
•In Figure 3, the top graph shows a
demand curve where an increase in
the price from $20 to $22 results in
a decrease in the quantity
demanded from 60 million barrels to
48 million barrels.
 Figure 3:
Comparing
Different
Sizes
of the Price
Elasticity of
Demand
p88
 Elasticity of Demand

•Percentage 48  60  12
 100  100  20 percent
change in Qty. 60 60

demanded

•Percentage
22  20 2
•change in 
20
100  100 10 percent
20
price
 Elasticity of Demand
•The price elasticity of demand for the
top graph in Figure 3 is:
Price Elasticity 20%
   2 2
of Demand 10%
•Note: A price elasticity of demand of 2
implies that a one percentage point increase
in the price results in a two percentage point
decrease in the quantity demanded.
 Size of the Elasticity: High
versus Low
•We compare the demand curve
found on the top graph with the
demand curve found on the bottom
graph on Figure 3. On the bottom
graph, an increase in the price from
$20 to $22 results in a decrease in
the quantity demanded from 60
million barrels to 57 million barrels.
 Figure 3: Comparing Different
Sizes
of the Price Elasticity of Demand
Size of the Elasticity: High versus
Low

•Percentage  57  60 100   3 100  5 percent

change in Qty. 60 60
demanded

22  20 2
 100  100 10 percent
20 20
•Percentage
change in
price
Size of the Elasticity: High versus
Low
•The elasticity of demand for the top
graph is:
Price Elasticity 5% 1 1
  
of Demand 10% 2 2

•Note: A price elasticity of demand of 1/2

implies that a one percentage point
increase in the price results in a one-half
percentage point decrease in the quantity
demanded.
Size of the Elasticity: High
versus Low
•Note: The top graph in Figure 3 had
a higher price elasticity of demand
(elasticity = 2) than the price
elasticity of demand for the bottom
graph (elasticity = 1/2). Hence, the
demand curve on the top graph is
more sensitive to price changes
than the demand curve on the
bottom graph.
 Impact of a Change in
Supply on the Price of Oil
•In the next slide, Figure 4 analyzes
the effect of a decrease in the
supply of oil on the equilibrium price
of oil. The top graph features a
demand curve with a higher
elasticity (elasticity = 2) than the
bottom graph (elasticity = ½).
 Figure 4 :
The
Importance
of the Size of
the Price
Elasticity of
Demand
p89
Percentage
= （ 60-46 ） /60=14/60=7/30
change in Qty. demanded
Percentage =(28-20)/20=8/20=2/5
change in price
Ed=(7/30)/(2/5)=7/12
 Impact of a Change in
Supply on the Price of Oil
•Note: The same shift in the supply
of oil to the left (decrease by 14
million barrels) results in a higher
equilibrium price on the bottom
graph, where the demand curve has
a lower price elasticity (elasticity =
½) than in the top graph (elasticity
= 2).
 Working with Demand
Elasticities

• The general formula that we will

use for demand elasticity (ed) will
be: Q P Q P
ed  d
  d

Qd P P Qd
 Working with Demand
Elasticities
•An attractive feature of the price
elasticity of demand is that it is a
unit-free measure; it allows the
comparison of the price elasticity of
different goods and different prices.
•Unit-Free Measure: a measure
that does not depend on the unit of
measurement.
 Working with Demand
Elasticities
•Assume the price of rice rises by 10
cents, from 50 to 60 cents per
pound, and the quantity demanded
falls from 20 to 19 tons. This implies
a decrease of 1 ton per 10 cent
increase in the price, or:Elasticity of
Demand:
Qd P  1 .10 1 1
ed      
Qd P 20 .50 4 4
 Elasticity versus Slope
• One common mistake made when
dealing with elasticity is to
interchange the elasticity of the
demand curve with its slope. These
concepts are similar, but not the
same. Q
d
Qd Qd P
ed   
P P Qd
P

slope
 Elasticity versus Slope
•Notes: The elasticity is a unit-free
measure, while the slope is not.
•With a straight-line demand curve,
the slope is constant, while the
elasticity varies at different points in
the line.
The Midpoint Formula

or
 Q2  Q1 
 
(Q  Q ) / 2
ed   2 1 
 P2  P1 
 
(
 2 P  P1 ) / 2 
 The Midpoint Formula

• Recall Figure 4. If we use the

midpoint formula to calculate the
elasticity on the top graph, the
elasticity of demand is:
60  48 20  22
ed    2.33
60  48  / 2 20  22  / 2
ACTIVE LEARNING 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

33
ACTIVE LEARNING 1
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals

50%
= 2.0
25%
34
 Figure 6: Perfectly Elastic
and Perfectly Inelastic Demand
 The Variety of Demand
Curves
• The price elasticity of demand is closely
related to the slope of the demand curve.
• Rule of thumb:
The flatter the curve, the bigger the
elasticity.
The steeper the curve, the smaller the
elasticity.
• Five different classifications of D curves.…

37
“Perfectly inelastic demand” (one
extreme case) 0%
Price elasticity % change in Q
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
38
 “Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
39
 “Unit elastic
demand” % change in Q 10%
Price elasticity
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

ELASTICITY AND ITS APPLICATION 40

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
ELASTICITY AND ITS APPLICATION 41
“Perfectly elastic demand” (the
other extreme) any %
Price elasticity % change in Q
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
ELASTICITY AND ITS APPLICATION 42
 Revenue and the
Price Elasticity of Demand
•Revenue of a firm
– = (P × Q)
– = (price of a good) × (quantity
of the good sold)
 Revenue and the
Price Elasticity of Demand
•Example:
•If people purchase 60 million
barrels of oil at $20, then the firm’s
revenues equal:
•Revenue = 60 million × $20
• = $1200 million = $1.2
billion
 Revenue and the
Price Elasticity of Demand
•Figure 7 shows that if the price
increases in an elastic demand
curve, the firm revenues will
decrease. If the price increases in an
inelastic demand curve, the firm
revenues will increase.
Figure 7:
Effects of
an
Increase
in the
Price of
Oil on
Revenue
p97
 Revenue and the
Price Elasticity of Demand
•In the inelastic region of a straight-
line demand curve, an increase (a
decrease) in the price will result in
an increase (a decrease) in
revenues.
•In the elastic region of a straight-
line demand curve, an increase (a
decrease) in the price will result in a
decrease (an increase) in revenues.
Revenue and
Elasticity of a
Straight-Line
Demand
Curve
p98
 Q Q dQ P
点 EP  lim  
P  0 P P dP Q
ACTIVE LEARNING
Elasticity and expenditure/revenue

A. Pharmacies raise the price of insulin

by 10%. Does total expenditure on
insulin rise or fall?
B. As a result of a fare war, the price of
a luxury cruise falls 20%.
Does luxury cruise companies’ total
revenue rise or fall?

51
ACTIVE LEARNING
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

52
ACTIVE LEARNING
Answers
B. As a result of a fare war, the price of a luxury
cruise falls 20%. Does luxury cruise companies’
total revenue rise or fall?
Revenue = P x Q
The fall in P reduces revenue, but Q increases,
which increases revenue. Which effect is
bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.

53
 What Determines the Size
of the Price Elasticity of Demand?
• Determinants of the Price Elasticity of
Demand:
• Degree of substitutability
• Big-ticket versus little-ticket items
• Temporary versus permanent price
change
• Differences in preferences
• Long-run versus short-run elasticity
 Degree of Substitutability

•Goods with a lot of substitutes have

a high price elasticity of demand.
•Goods with few substitutes have a
low price elasticity of demand.
 EXAMPLE 1:
Breakfast cereal vs. Sunscreen
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
– Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, leftover pizza),
so buyers can easily switch if the price rises.
– Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
• Lesson: Price elasticity is higher when close
substitutes are available.

ELASTICITY AND ITS APPLICATION 57

 Big-Ticket versus Little-Ticket
Items
•If a good represents a large share
fraction of people’s income, then the
price elasticity will be high.
•If a good represents a small share
fraction of people’s income, then the
price elasticity will be low.
 Temporary versus
Permanent Price Change
•If the price change is perceived to
be temporary, then the price
elasticity of demand will be high.
•If the price change is perceived to
be permanent, then the price
elasticity of demand will be low.
 Differences in Preferences
•Some goods have varying price
elasticity of demand across different
consumer groups.
•Examples:
• New smokers have a higher price
elasticity of demand for cigarettes
than established (addicted?)
smokers.
• Retired persons have a lower price
elasticity of demand for motor
homes than persons in the 18-26
 Long Run vs. Short Run
•The length of time elapsed since a price change
affects the price elasticity of demand.
•Example:
– There’s not much people can do in the
short run, other than ride the bus or carpool.
– In the long run, people can buy smaller cars
or live closer to where they work.
•Lesson: Price elasticity is higher in the
long run than the short run.
Income Elasticity of Demand
•Income Elasticity of Demand: the
percentage change in the quantity
demanded of a good divided by the
percentage change in income.
Income
Elasticity
of Demand
 Income Elasticity of Demand
• If the income elasticity of demand is
positive (i.e., you buy more as income
increases), then the good is a normal
good.
• If the income elasticity of demand is
negative (i.e., you buy less as income
increases), then the good is an inferior
good.
• Note: With income elasticity of demand,
it is incorrect to take the absolute value
of the computed elasticity.
 Cross-Price Elasticity of
Demand

•Cross Price Elasticity of

Demand: the percentage change in
the quantity demanded of a good
divided by the percentage change in
the price of a related good (a
substitute or a complement).
Cross-price elast. % change in Qd for good 1
=
of demand % change in price of good 2

 For substitutes, cross-price elasticity > 0

(e.g., an increase in price of beef causes an
increase in demand for chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)

66
 Cross-Price Elasticities in the News
“As Gas Costs Soar, Buyers Flock to Small Cars”
-New York Times, 5/2/2008
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008
“Gas prices knock bicycle sales, repairs into higher
gear”
-Associated Press, 5/11/2008
“Camel demand soars in India”
(as a substitute for “gas-guzzling tractors”)
-Financial Times, 5/2/2008
“High gas prices drive farmer to switch to mules”
-Associated Press, 5/21/2008

ELASTICITY AND ITS APPLICATION 67

Cross-Price Elasticity of Demand
•If the cross-price elasticity of
demand is positive (i.e., you buy
more as price of the other good
increases), then the two related
goods are substitutes.
•If the cross-price elasticity of
demand is negative (i.e., you buy
less as price of the other good
increases), then the two related
goods are complements.
 Elasticity of Supply
•Elasticity of Supply: the
percentage change in the quantity
supplied of a good divided by the
percentage change in the price of a
Price
same good.
Elasticity
of Supply
 Elasticity of Supply

•The general formula that we will

use for price elasticity of supply (es)
will be:
Qs P Qs P
es    
Qs P P Qs
 Elastic versus Inelastic
Supply
•Elastic Supply: supply where the
price elasticity is greater than one.
•Inelastic Supply: supply where
the price elasticity is less than one.
•Unit Elastic Supply: supply where
the price elasticity is exactly equal
to one.
 Perfectly Elastic versus
Perfectly Inelastic Supply

•Perfectly Elastic Supply: supply

where the price elasticity is infinite,
indicating an infinite response to a
change in price. A perfectly elastic
supply curve is a horizontal line.
 Perfectly Elastic versus
Perfectly Inelastic Supply
•Perfectly Inelastic Supply:
supply where the price elasticity is
zero, indicating no response to a
change in price. A perfectly inelastic
supply curve is a vertical line.
•Examples:
• The Mona Lisa
• Super Bowl Tickets
 Elastic
and Perfectly Inelastic
Supply
Figure 10: Comparing Different
Sizes of the Price Elasticities of
Supply

(Top Graph)
Figure 10: Comparing Different
Sizes of the Price Elasticities of
Supply

(Bottom Graph)
Elastic vs. Inelastic Supply

•Figure 11 shows that the same shift

in the demand for oil to the left
results in a smaller drop in the
equilibrium price when the supply
curve has a higher elasticity than
when it has a lower elasticity.
 Figure 11:
Importance
of Knowing
the Size of
the Price
Elasticity of
Supply
The Variety of Supply Curves
• The slope of the supply curve is
closely related to price elasticity of
supply.
• Rule of thumb:
The flatter the curve, the bigger
the elasticity.
The steeper the curve, the smaller
the elasticity.
• Five different classifications.…

79
“Perfectly inelastic” (one
extreme) % change in Q 0%
Price elasticity
= = =0
% change in P 10%
of supply
S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
80
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of supply
S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
81
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of supply
S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
82
“Elastic”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of supply
S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
83
“Perfectly elastic” (the other
extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of supply
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
Elasticity: P changes Q
by 0% Q1 Q2
infinity
Q changes
by any %
84
ACTIVE LEARNING
Elasticity and changes in equilibrium
 The supply of beachfront property is inelastic.
The supply of new cars is elastic.
 Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
 For which product will P change the most?
 For which product will Q change the most?

85
ACTIVE LEARNING
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A

Q
Q1 Q2
86
ACTIVE LEARNING
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1

Q
Q1 Q2
87
• price control • perfectly elastic
• price ceiling demand
• price floor • income elasticity of
• rent control • demand
• minimum wage • cross-price
• price elasticity of elasticity of
demand • demand
• unit-free measure • price elasticity of
• elastic demand supply
• • perfectly elastic
inelastic demand
• supply
perfectly inelastic
• perfectly inelastic
demand
supply