Econ 201 (02):

Principles of Microeconomics

Lecture 9
Associated Text Chapter 5 & 6
October 5, 2023
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Roadmap for today’s lecture
• Announcements
• Chapter 5
• Elasticity
• Quick recap of price elasticity of demand
• Revenue implications
• Other elasticities
• Supply elasticity
• Tax incidence
• Chapter 6
• Government policy in our supply/demand model

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Announcements
• Reminder: Midterm 1 on Tuesday
• Held during lecture
• No Zoom link, open book
• No collaborating
• Chapters 1 through 5
• Still finalizing question count, but will likely be 40 questions
• MC or fill in the blank
• Grading policy – if letter grade on final exam is greater than letter grade on
midterm, final exam grade overrides midterm grade
• Extra Office Hour Friday (3-4pm)

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Recap from last lecture
• We want to build on our supply and demand model
• We’ve introduced elasticity
• Elasticity is a measure of responsiveness or sensitivity of quantity
demanded or quantity supplied to one of its determinants
• Looking at the direction and magnitude of changes
• First, we looked at elasticity of demand
• How much the quantity demanded of a good responds to a change in the
price of that good?
• There are several determinants of this (close substitutes, necessity, time
horizon, and definition of market)
• We use the midpoint method to determine elasticity
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Elasticity of Demand
• Demand curves are often grouped according to elasticity
• Demand is elastic when the absolute value of elasticity is greater
than 1
• Quantity moves proportionately more than price
• Demand is inelastic when the absolute value of elasticity is less than
1
• Quantity moves proportionately less than the price
• If the absolute value of elasticity is equal to 1 (quantity moves
proportionately with price) then demand is unit elastic
• The price elasticity of demand determines whether the demand curve
is steep or flat!
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Graphing Price Elasticity of Demand

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Graphing Price Elasticity of Demand

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Graphing Price Elasticity of Demand

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Graphing Price Elasticity of Demand

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Graphing Price Elasticity of Demand

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Elasticity of a linear demand curve
• The slope of a linear demand curve
is constant, but its elasticity is not
• At points with a low price and high
quantity, the demand curve is
inelastic
• At points with a high price and low
quantity, the demand curve is
elastic
• This has to do with the nature of
percentage change
• If consumption is relatively low, it is
easier to have a significant percentage
change
• If consumption is relatively high, it is
relatively difficult
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Revenue implications
• Total revenue in a market is the price times the quantity sold
• TR = P × Q

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Revenue implications
• How does total revenue change as one moves along the demand
curve?
• It depends on the price elasticity of demand!

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Revenue implications
• When demand is inelastic (elasticity less than 1), a price increase
leads to a smaller quantity decrease, and total revenue rises!
• When demand is elastic (greater than 1), a price increase leads to a
larger quantity decrease, and total revenue falls!
• If demand is unit elastic (elasticity is equal to 1), a price increase
leads to a same-percentage-size quantity decrease and total revenue
remains constant

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Revenue implications
• Let’s think about a real-world example to drive this home…
• How does a drug dealer operate?
• New users have very elastic demand curves
• Therefore, charge low prices to new consumers
• Free samples, low cost to consumers of trying
• Frequent users have very inelastic demand curves
• Therefore, charge higher prices to these existing consumers
• Higher direct price and imposition of costs related to dealing

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 Other demand elasticities
• Income elasticity of demand measures how much quantity demanded
responds to a change in consumers’ income
percentage change in quantity demanded
Income elasticity of demand =
percentage change in income

• Cross-price elasticity of demand measures how much quantity demanded of

good 1 responds to change in price of good 2
percentage change in quantity demanded good 1
Cross − price elasticity of demand =
percentage change in price of good 2

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Elasticity of supply
• Price elasticity of supply measures how much quantity supplied
responds to changes in the price of a good
• It’s the percentage change in quantity supplied divided by the
percentage change in price
percentage change in quantity supplied
Price elasticity of supply =
percentage change in price

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Elasticity of supply
• Supply of a good is:
• Elastic if percentage change in quantity supplied is more than percentage change in
price
• Inelastic of percentage change in quantity supplied is less than percentage change in
price
• The key determinant of price elasticity in most markets is the time period
being considered
• Consider the short-run supply (capital is fixed in the short-run)
• All responses to price are due to changes in the other input (say, labour)
• Consider long-run supply (all inputs are variable)
• Responses to price changes can be accommodated by changes in both labour and
capital
• Supply is usually more elastic in the long run than in the short run!
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Elasticity of supply

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Elasticity of supply

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Elasticity of supply

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Elasticity of supply

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Elasticity of supply example
• Consider the markets for beachfront property and new cars
• Elasticity of supply
• Supply of beachfront property is inelastic
• Supply of new cars is elastic
• Suppose the population doubles resulting in a doubling of demand for
both goods
• For which good would the price change the most?
• For which good would quantity change the most?
• We now have the tools to analyze this!
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 Elasticity of supply example

• When supply is inelastic, quantity doesn’t respond very much so the increase in demand has a larger effect on price than
quantity
• When supply is elastic, quantity responds significantly so the increase in demand has a larger effect on quantity than on
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Elasticity of supply
• When supply is inelastic, quantity doesn’t respond very much so the
increase in demand has a larger effect on price than on quantity
• When supply is elastic, quantity responds significantly so the increase
in demand has a larger effect on quantity than on price

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Tax Incidence
• The degree to which a given tax policy affects consumers and
producers
• Consumers respond according to price elasticity of demand
• Producers respond according to price elasticity of supply
• Central question: how are the effects of a tax borne by each group?
• The burden of tax is divided between consumers and producers
• Tax is imposed
• How each group responds will affect the extent to which they bear the tax
• To illustrate this, let’s consider two markets:
• 1. Elastic supply and inelastic demand
• 2. Inelastic supply and elastic demand
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Elastic Supply, Inelastic Demand

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Inelastic Supply, Elastic Demand

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Tax Incidence
• Elastic supply and inelastic demand:
• Consumers are relatively unresponsive and absorb the majority of the tax
• Cigarette taxes, gasoline taxes, etc.
• Inelastic supply and elastic demand
• Producers are relatively unresponsive and absorb the majority of the tax
• Berkeley soda tax, tariffs on luxury goods
• Since elasticity is determined by several factors that may differ across
groups on consumers and producers (available substitutes, income),
there may be distributional implications

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Chapter 6: Supply, Demand and Government
Policies
• In Chapter 4, we discussed the equilibrium price and quantity
• In a competitive market, free of government regulation, at the
equilibrium price, the quantity buyers want to buy equals the
quantity sellers want to sell
• Some people might not be happy with this free-market process
• Producer groups lobby for higher prices
• Consumer groups lobby for lower prices

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Price Ceiling
Price Ceiling
• A price ceiling is a legal maximum on the price at which a good can be
sold
• Price ceilings can be binding or non-binding

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Price Floor
Price Floor
• A price floor is a minimum price at which a good can be sold
• As with price ceilings, they can be binding or non-binding

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