Market Equilibrium and Elasticity

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4008AFE The Economics Environment of Business
Week 4: Market Equilibrium and Elasticity
Dr Alban Asllani
Lecture Outline
1 Introduction
2 Equilibrium Analysis
3 Elasticity
4 Elasticity & Total Revenue
5 Other Elasticities
6 Conclusion
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Learning Outcome
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Market Equilibrium
What happens to demandwhen wechangeprices?
Different types of elasticity.
How to useelasticity in economicanalysis.
Equilibrium Point
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Equilibrium is the point where the demandand supply curves
intersect.
The quantity demanded is equal to the quantity the suppliers
arewilling to supply.
If anything changesin the market, the price level will adjust to
restorethe equilibrium.

Price Mechanism
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Acts assignal: Price adjusts to demonstrate whereresources
arerequired, and where they arenot.
Transmits preference:By their responseto price, consumers
send amessageabout their preferences.
Ration scarceresources: Asresources arescarce,price serves as
amethod to ration who receives goods andservices.

Equilibrium Analysis
P O
Q
Equilibrium
S
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Equilibrium Analysis
P O
Q
Equilibrium
S D
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Equilibrium Analysis
P O
Q
Equilibrium
S D
P
Q
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Change in Income
P
(0,0) Q
Income Increase
S D
D
,
P ∗∗
P
QQ∗∗
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Change in Production Technology
(0,0) Q
P
Advance inTechnology
S
S
,
P
P ∗∗
D
QQ∗∗
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Equilibrium Analysis
P
(0,0) Q
Combined
S D
D
,
S ,
P

P
QQ∗∗Q∗∗∗
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Equilibrium Analysis
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When afactor that affects demandchangesthen the whole
Demandcurve shifts. If the changeis positive, i.e. increasein
demand,then the curve will shift to the right and vice versa.
When afactor that affects supply changesthen the whole
Supply curve shifts. If the changeis positive, i.e. increasein
supply, then the curve will shift to the right and vice versa.
Important: If the price changeswemovealong the same
curve.
The position of the final equilibrium point will dependon the
magnitude of the changes.

Excess Supply
P O
S D Q
P

Q
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Excess Supply
P O
S D Q
Q

Pmin
P
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Excess Supply
P O
S D Q
Q

Pmin
P
Qd Qs
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Excess Supply
P O
S D Q
Q

Pmin
P
Qd Qs
Surplus
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Excess Demand
P O
S D Q
P

Q
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Excess Demand
P O
S D Q
Q

P
Pmax
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Excess Demand
P O
S D Q
Q

P
Pmax
Qs Qd
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Excess Demand
P O
S D Q
Q

P
Pmax
Qs Qd

Shor
tage

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Further Equilibrium Analysis
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A shortage or excess demand is asituation in which the
quantity demanded for aproduct (
QD ) exceedsthe quantity
supplied in amarket (
QS ), i.e. (QD ) > (QS).
A shortagecan only occur at aprice level below the
equilibrium.
A surplus orexcess supply is asituation in which the quantity
supplied (
QS ) for aproduct exceedsthe quantity demanded
(
QD ) in amarket, i.e. (QD ) < (QS ).
A surplus can only occur at aprice level above the
equilibrium.

The concept of elasticity
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If the price of agood rises by 10% – what will happen to
demand?
Basedon what wehavelearned quantity demanded will
(probably) decrease.
By how much?More or lessthan 10%?
Elasticity measuresthe responseof the quantity demanded (or
supplied) following changesin the market.

Price Elasticity of Demand
Price elasticity of Demand(Pεd )
The price elasticity of demandmeasuresthe responsiveness of
the quantity demanded of agood to achangein itsprice.
It is computed asthe percentage changein quantity demanded
divided by the percentagechangein price.
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Price Elasticity of Demand
Wehavetwo waysto calculate it:
Point Elasticity of Demand
Pεd =
percentage changein quantity
=
%∆
Q
percentage change in price %∆P
Midpoint or Arc Elasticity of Demand
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Pεd =
(
Q2 Q1)/[(Q2 + Q1)/2]
(
P2 P1)/[(P2 + P1)/2]
Example: Chocolate bars
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Pεdfor different products
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Different products responddifferently in price changes.
For somegoods the responseto aprice change maybe
relatively large, for others quantity demanded may changeby a
very smallamount.
Classexercise: Think of somegoods that fit in the two
categories.

Elastic or Inelastic
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It follows from the abovethat basedon the value of thePεd
wecan classify all goods in two broad categories.
Elastic: Whenthe percentagechangein the quantity
demanded is higher than the percentagechangein the price
and
Pεd >1
Inelastic: Whenthe percentagechangein the quantity
demanded is lessthan the percentage changein the price and
Pεd < 1
Different degreesof price elasticity
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elastic demand (Pεd > 1): the responseof quantity demanded is
proportionately greater than the price change
inelastic demand (Pεd < 1): the responseof quantity
demanded is proportionately smaller than the price change
unit elastic demand (Pεd = 1): the responseof quantity
demanded is equalto the pricechange
perfectlyinelastic demand (Pεd = 0): quantity demanded
doesnot respondto price changes
perfectlyelastic demand (Pεd = ): the responseof quantity
demanded to the price changeis infinitely large

Elastic Demand Curve
O Q1 Q
elastic demand (Pεd > 1): the responseof quantity demanded is
proportionately greater than the price change
P
P
εd > 1
P1
P2
D
Q2
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Inelastic Demand Curve
O Q
inelastic demand (Pεd < 1): the responseof quantity
demanded is proportionately smaller than the price change
P
P
εd < 1
P1
P2
D
Q1 Q2
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Perfectly Elastic
O Q
perfectlyelastic demand (Pεd = ): the responseof quantity
demanded to the price changeis infinitely large
P

Pεd = 0

PD
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Perfectly Inelastic
perfectlyinelastic demand (Pεd = 0): quantity demanded
doesnot respondto price changes
P O
Q

Pεd =

Q
D
P2
P1
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Elasticity vs Slope
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In general, Elasticity and Slope aretwo DIFFERENT things,
evenif the demandcurve is astraight line.
The value of Elasticity depends on the point at which you
calculate it, while the slope of a straight demand curve is
constant.
On the other hand, for aconstant elasticity the demandcurve
HAS to be convex.
Note: Wecan usethe slope asan indication of elasticity and
vice versa.

Determinants of Elasticity
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Price of relatedgoods: A good with moreclose substitutes
will likely haveahigher elasticity, asit will be easier for
consumersto shift to other goods.
The proportion of income used to pay forthe product: The
relative high cost of somegoods will causeconsumersto pay
attention to the purchaseand seeksubstitutes, asaresult they
tend to havehigh elasticity.
Degree of necessity: Consumerswill buy necessaryproducts
(e.g. critical medications like insulin) regardless of the price or
addictive (tobacco and alcohol).

Determinants of Elasticity
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Market definition: How wedefine the market? For example,
the market of smart phonesin generalwehaveavery high
elasticity becausethere aremany brands, you could buy an
iPhone, an Android phoneor aWindows phone.
Brand loyalty : An attachment to acertain brand (either out of
tradition or becauseof proprietary barriers) can override
sensitivity to price changes,resulting in moreinelastic demand.
Time Horizon: The shorter the period of time wearelooking
at, the lower the elasticity.

Elasticity and Total Revenue
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Total Revenue(TR) or afirm is the value of goods they sold.
It is calculated by multiplying the price of the good with the
quantity of the goods sold.
TR = P Q
Elasticity and Total Revenue
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A changein price (∆P) is followed by achangein quantity
(∆
Q)
The elasticity givesusthe information weneedin order to
analyse how much the revenue of the firm will changeif the
price of the good changes.
For example: ?TR =P∗ ↓Q
Graph: TR and Elastic Demand
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Graph: TR and Inelastic Demand
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Graph: TR and Unit Elastic Demand
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Demand Elasticity and TR
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Elasticity of Demand P&Q Changes TR if P TR if P
Elastic: Pεd > 1 Q >P TR TR
Inelastic: Pεd < 1 Q <P TR TR
Unit Elastic: Pεd = 1 Q = ∆P 0 0

Cross-Price Elasticity
Cross-Priceelasticity of Demand(Cross Pεd )
Measures the responsivenessof the quantity demanded for a
good to achangein the price of another good, ceterisparibus.
Formula
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Cross Pε
d
=
% change in quantity of good A
=
%∆
QA
% change in price of good B %∆PB
Cross-Price Elasticity
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If crossprice elasticity > 0, then the two goods are substitutes
If crossprice elasticity < 0, then the two goods are
complementary
If crossprice elasticity = 0, then the two goods are
independent
Income Elasticity
Incomeelasticity of demand(Yεd)
Measures the responsiveness of the quantity demanded for a
good or service to a change in the income of the people
demandingthe good.
Formula
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Yεd = % change in quantity demanded = %∆QD
% change in income %∆Y
Income Elasticity
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Normal goods haveapositive incomeelasticity, when income
increasesthe quantity increasesas well.
Necessities haveincome elasticity between 0 and1
Luxury goods havean incomeelasticity > 1, quantity
increasesby more than income.
Inferior goods haveanegative incomeelasticity, quantity
decreaseswhen incomeincreases.

Price elasticity of supply
Price elasticity of supply (Pεs )
Measures the responsivenessof the quantity supplied of a
good or service to achangein its price.
Formula
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Pεs = % change in quantity supplied = %∆Qs
% changein price %∆P
Price elasticity of supply
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WhenPεs> 1, then supply is price elastic
When Pεs < 1, then supply is priceinelastic
WhenPεs = 0, supply is perfectly inelastic
WhenPεs = , supply is perfectly elastic
Determinants of Elasticity of Supply
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In general, price elasticity of supply dependson the flexibility of
sellers to changethe quantity. The easier it is to respondto a
changein price, the higher the elasticity would be.
Time period. The shortest the time period the lower the
flexibility.
Productive Capacity : Limits in production How much can the
firm produce?

Determinants of Elasticity of Supply
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Size of firm/industry: The larger the firm the easier it is to
respondto achangein price. For example if the price
increases,it is easier for afactory that producesfurniture to
increaseproduction than it is for acarpenter.
Mobility of Factors of Production: How easyit is to transfer
production.
Ease of Storing Stock: The easier it is for afirm to maintain
stock product the moreflexibility they haveto changesin
prices. For example, storing fresh fruit isnot easy.

Supply Elasticity and TR
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Wecan do the samewith the elasticity of supply.

Elasticity of Supply P&Q Changes TR if P TR if P
Elastic: Pεs>1 Q >P TR TR
Inelastic: Pεs<1 Q <P TR TR
Unit Elastic: Pεs = 1 Q = ∆P TR TR

What We Learned Today
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Equilibrium Demand = Supply
Price Mechanism: Prices will changeto restore Equilibrium
Equilibrium Analysis, how the market reallocates resourcesto
moveto anewequilibriumpoint

What We Learned Today
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Elasticity of demandmeasuresthe responsivenessof the
quantity demanded to achangein price.
Typesof elasticity
The factors that determine the elasticity of agood
Elasticity and Total Revenue
Other types of elasticity
Conclusion
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Review today’s lesson.
Readthe relevant chapters in the book (Ch.3 pg. 42-51 and
Ch.4, including all boxes and casestudies)
Searchonline for moresources.
Ask questions in seminar if anything isunclear.
Do self-test questions at the endof the chapter and online.
Thank youfor your attention.
Questions?
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