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APPLICATIONS OF SUPPLY

AND DEMAND
Sensitivity to Price Changes
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Firms need to know how much demand changes when


prices change.

Will an increase in price raise a firm's revenue even


though the quantity sold falls?

If a firm raises its price, it loses customers. How many?


Price Elasticity of Demand
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Price elasticity of demand is defined as the percentage change in the


quantity demanded divided by the percentage change in price. In
mathematical terms,

elasticity of demand = Percentage change in quantity demanded


Percentage change in price
When a 1 percent change in price calls forth more than a 1 percent
change in quantity demanded, the good has price-elastic demand.

When a 1 percent change in price produces less than a 1 percent


change in quantity demanded, the good has price-inelastic demand.

When the percentage change in quantity is exactly the same as the


percentage change in price, it is called unit-elastic demand.
Elastic Demand Shows Large Quantity
Response to Price Change
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Elastic Versus Inelastic Demand Curves
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Price Elasticity in Diagrams
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Price Elasticity of Demand Falls into Three Categories


Price Elasticity in Diagrams
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Perfectly Elastic and Inelastic Demands


Slope and Elasticity Are
Not the Same Thing
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Calculating Elasticities: A Short Cut
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A Simple Rule for Calculating the Demand Elasticity


Changing Elasticity Along
a Demand Curve
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Elasticity of Demand over Time
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Elasticity and Revenue
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Firms earn revenue from sales; total revenue TR = pQ

If p rises but Q falls, what happens to TR? Which effect


dominates?

n If %p > %Q , then TR .

n If %p < %Q , then TR .
Total Revenue
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Value of Demand Description Definition Impact on Revenues


Elasticity

Percentage change in quantity


Revenues Increase
Ed > 1 Elastic demand demanded greater than
when price decreases
percentage change in price

Percentage change in quantity


Ed = 1 Unit-elastic demanded equal to Revenues unchanged
demand percentage change in price when price decreases

Percentage change in quantity


Ed < 1 Inelastic demanded less than Revenues decrease
demand percentage change in price when price decreases
Price Elasticity of Supply
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Price Elasticity of Supply is the percentage change in quantity


supplied divided by the percentage change in price.

elasticity of supply = Percentage change in quantity supply


Percentage change in price

Definitions of price elasticities of supply are exactly the same as


those for price-elasticities of demand. The only difference is that for
supply the quantity response to price is positive, while for demand
the response is negative.
Supply Elasticity Depends upon
Producer Response to Price
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Examples of Elasticity of Supply
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The Short Run versus the Long Run
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When a product can be stored, demand will be much more price


sensitive in the short run than in the long run.

When a product or service is part of a system, demand will be much


more price sensitive in the long run than in the short run.

The shorter the time frame, the less substitution is possible; the longer
the time frame, the more substitution is possible.

In the short run, demand is less elastic than in the long run.

In the short run, some inputs are fixed, so supply is difficult to


change, while in the long run, all inputs are variable.
Tax Policy and the Law of
Supply and Demand
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Shortages and Surpluses (b)
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In this figure, the horizontal gap between Qd and Qs is


the size of the shortage. Consumers compete to get a
bargain.
Shortages and Surpluses (b) (cont.)
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In this figure, the horizontal gap between Qd and Qs is


the size of the surplus.
Now sellers compete to "move the merchandise."
The rate of adjustment depends on the kind of market as well
as the size of the surplus.
Price Ceilings and Price Floors
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Governments are often asked to interfere with the outcomes of the law of
supply and demand because they are politically undesirable to some
people.

If rents on apartments are seen as too expensive, there will be pressure on


city hall to regulate the market for apartments.

If wages are seen as being too low, there will be pressure on the
government to regulate the labor market.

An obvious way to try to circumvent the law of supply and demand is to


legislate the price of an object.

Usually, such legislation involves either price ceilings or price floors.


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