Robert F. Mulligan WESTERN CAROLINA UNIVERSITY COLLEGE OF BUSINESS Department of Economics, Finance, & International Business

MBA 505 ECONOMICS AND PUBLIC POLICY

Chapter 4 SUPPLY AND DEMAND APPLICATIONS

FUNDAMENTAL QUESTIONS
1. How do we measure whether and how much consumers alter their purchases in response to a price change?
2. Why are measurements of elasticity important?
3. How does a business determine whether to increase or decrease the price of the product it sells in order to increase revenues?
4. Why might senior citizens or children receive price discounts relative to the rest of the population?
5. What determines whether consumers alter their purchases a little or a lot in response to a price change?
6. How do we measure whether and how much income changes, changes in the prices of related goods, or changes in advertising expenditures affect consumer purchases?
7. How do we measure whether and how much producers respond to a price change?

Key Terms 

price elasticity of demand	price discrimination	price elasticity of supply
perfectly elastic demand curve	cross-price elasticity of demand	short run
perfectly inelastic demand curve	income elasticity of demand	long run
arc elasticity	normal goods	tax incidence
total revenue (TR)	inferior goods

Recall:

1. Markets
Markets are places where buyers and sellers meet and decide on prices and quantities for exchanging goods and services.

2. Demand
The Law of Demand - for a given, well-defined good or service, the quantity demanded, that is, the quantity consumers are willing and able to buy, decreases as the price is increased, ceteris paribus.

The Demand Schedule - a table of the quantities demanded at different prices.

The Demand Curve - a graph of the demand schedule. Price is always on the vertical axis, quantity is on the horizontal axis. Price and quantity have an inverse relationship along the demand curve, thus the demand curve is downward sloping.

Changes in demand v. changes in the quantity demanded: A change in demand is a shift of the demand curve to the left or right, which requires a change in one of the determinants of demand: income, tastes, the prices of related goods, expectations, and the number of buyers. A change in the quantity demanded is a movement along the horizontal axis.

Market v. individual demand curves: The market demand curve is arrived at from the horizontal addition of the individual consumers' demand curves.

3. Supply
The Law of Supply - The quantity of goods and services producers sell increases as the price increases, ceteris paribus.

The Supply Schedule - a table of the quantities supplied at different prices.

The Supply Curve - a graph of the supply schedule. Just like the demand curve, price is always on the vertical axis, quantity is on the horizontal axis. Price and quantity have a direct relationship along the supply curve, thus the supply curve is upward sloping.

Changes in supply v. changes in the quantity supplied: A change in supply is a shift of the supply curve to the left or right, which requires a change in one of the determinants of supply: resource prices, technology, producer expectations, the number of producers, or the prices of related goods. A change in the quantity supplied is a movement along the horizontal axis.

Market v. individual supply curves: The market supply curve is arrived at from the horizontal addition of the individual producers' supply curves.

4. Equilibrium
Equilibrium occurs when the quantity supplied equals the quantity demanded at a set price.

Disequilibrium can occur naturally for short periods of time. Shortage occurs when the quantity demanded exceeds the quantity supplied at a certain price. Equilibrium can be achieved by raising the price. Surplus occurs when the quantity supplied exceeds the quantity demanded at a certain price. Equilibrium can be achieved by lowering the price. Price ceilings and floors, if they are effective, succeed in moving a market out of equilibrium and create either shortages or surpluses. An ineffective price ceiling would be one set higher than the current price. The price ceiling would only become effective if the equilibrium price rose above the ceiling. Then a shortage would occur.

1. The Price Elasticity of Demand

1.a. The definition of price elasticity: Price elasticity is the percentage change in the quantity demanded of a product that results from a 1 percent change in the price of the product, ceteris paribus. The price elasticity for a new car is well above the value of 1, while that of medicine is close to zero. When measuring the price sensitivity of demand (or any other type of elasticity) a relative measure of sensitivity is preferred to an absolute measure.

1.b. Demand curve shapes and elasticity: A perfectly elastic demand curve is a horizontal line; a perfectly inelastic demand curve is a vertical line. Note the difference between the slope of a demand curve and the elasticity of demand. A farmers' market is an example of a perfectly elastic demand curve for produce. The demand for penicillin is an example of a perfectly inelastic demand curve. 

1.b.1. Price elasticity along a straight-line demand curve: The price elasticity of demand varies along a straight-line demand curve, declining as we move down the curve. 
If you list a series of price/quantity demanded levels, draw the respective demand curve, and compute the price elasticity values at each price level, you will find that although the prices and quantities change in reverse proportion, the percent changes are different at each point on the curve, because the percent changes are divided by the starting price and quantity.

Geoffrey Gerdes's Straight-line Demand Curve JAVA Applet
Use the applet to see how the elasticity changes when you change the price and quantitity.

1.c. The price elasticity of demand is defined in percentage terms. A hundred dollar increase in price would be a 5000% increase for Big Macs, but only a 2.5% increase in WCU tuition. What would be the accompanying decreases in quantity demanded?

1.d. Average or arc elasticity: The elasticity coefficient obtained when the midpoint, or average, price and quantity are used is known as the arc elasticity. The arc elasticity is generally different from the point elasticities. Since point elasticities can be computed from either the starting point or the ending point, one advantage of the arc elasticity is that there is only one value, which is the average of the two point elasticities defined over the same interval or arc of the demand curve.

2. The Use of Price Elasticity of Demand

2.a. Total revenue (TR) and price elasticity of demand: Whether a reduction in price leads to increased revenues depends on the price elasticity of demand.

TR is negatively related to price change when price elasticity is elastic and positively related to price changes when price elasticity is inelastic. For example, if Delta Airlines faces elastic (tourist/leisure) demand on weekend and inelastic (business) demand on weekdays, it can increase revenue in both cases by lowering fares on weekends and raising fares during the week.

Geoffrey Gerdes's Elasticity and Total Revenue JAVA Applet
Take another look at this applet and notice how TR changes as price and quantity change.

2.b. Price discrimination: If different groups of customers have different price elasticities of demand for the same product and the groups can be segmented, the supplier can increase total revenue by charging each group a different price, that is, a high price where demand is inelastic and a low price where demand is elastic. A perfectly discriminating monopolist charges each customer the highest price that customer is willing to pay. A perfectly discriminating monopolist can get away with this pricing strategy only because they are the only supplier.

Movie theaters practice price discrimination when they discount tickets to senior citizens and students.

3. Determinants of the Price Elasticity of Demand

3.a. The existence of substitutes: The more substitutes there are for a product, the greater is the price elasticity of demand.

How would you characterize the demand for gasoline and the demand for candy bars? For which are substitutes available?

3.b. The importance of the product in the consumer's total budget: The greater the portion of the consumer's budget a good constitutes, the more elastic is the demand for the good. 

How would you characterize the demand for housing and the demand for candy bars? Which is a larger part of your budget? 

3.c. The time period under consideration: The longer the period under consideration is, the more elastic is the demand for the product. 

Consider how the demand for petroleum changed over time as nuclear, solar, and wind energy were developed in response to the oil price shock (1974).

4. Other Demand Elasticities

4.a. The cross-price elasticity of demand: This measures the degree to which goods are substitutes for or complements of each other.

Cross-price elasticity is positive for substitutes like movies and VCR rentals, and negative for complements like film and cameras.

4.b. The income elasticity of demand: This measures the magnitude of consumer responsiveness to income changes.

Normal goods have income elasticity greater than zero, for example, steak, and inferior goods have income elasticity less than zero, for example, hamburger or cabbage.

5. Supply Elasticity

5.a. The price elasticity of supply: This measures the percentage change in quantity supplied caused by a 1 percent change in the price of the good.

The price elasticity of supply depends on the ability of firms to change production techniques. Consider the different elasticities of supply for a bakery versus an automobile manufacturing plant in response to changes in demand. Which can change production faster and more cheaply?

5.b. The long and short runs
Supply elasticity is greater in the long run than the short run because suppliers are more free to vary the amount of different inputs used in production the longer the time period involved. Producers respond to relative changes in resource prices by substituting relatively cheaper inputs for relatively more expensive inputs. The short run is arbitrarily defined as any time period short enough so that at least some resources cannot be varied. In the long run, the amounts of all resources can be adjusted.

5.c. Price elasticities of demand and supply: Who pays the tax?

Consumers pay most of a tax on gasoline due to the very inelastic demand.

Opportunities for Discussion

1. List the goods you believe are price inelastic and price elastic and discuss why.
2. Why is Spam an inferior good and Cognac a normal good? 
3. List goods that are substitutes for and complements of each other and discuss each group's cross-elasticity of demand coefficient.