Micro Wk3: Equilibrium and Elasticity
Equilibrium (Chapter 4) and Elasticity (Chapter 5)
Lecture Overview
The lecture covers competitive market equilibrium and the price elasticity of demand and supply.
Defines when demand and supply are considered inelastic.
Market Equilibrium
Equilibrium: A state where supply and demand are balanced.
Equilibrium Price: The price at which quantity demanded equals quantity supplied; also known as the market-clearing price.
Graphically, it's the intersection of supply and demand curves.
Equilibrium Quantity: The quantity demanded and supplied at the equilibrium price.
Graphically, it's the quantity at the intersection of supply and demand curves.
Markets Not in Equilibrium
Surplus (Excess Supply): Occurs when the market price is above the equilibrium price.
Quantity supplied exceeds quantity demanded.
Suppliers reduce prices to increase sales, moving towards equilibrium.
Shortage (Excess Demand): Occurs when the market price is below the equilibrium price.
Quantity supplied is less than quantity demanded.
Suppliers raise prices due to high demand, moving towards equilibrium.
Law of Supply and Demand
In competitive markets, the actions of buyers and sellers naturally move the price toward equilibrium.
The price of a good adjusts to balance supply and demand.
This law differs from the individual laws of supply and demand.
Markets may experience surpluses and shortages temporarily, but these are typically eliminated by market forces.
Once equilibrium is reached, buyers and sellers are satisfied, and there's no pressure for price changes.
Changes in Equilibrium Analysis
Changes in equilibrium are analyzed through comparative statics, involving three steps:
Determine whether the exogenous event shifts the supply or demand curve (or both).
Decide the direction of the curve shift.
Use the supply-and-demand diagram to observe how the shift alters the equilibrium (endogenous change).
Exogenous Event/Change: An event that changes demand or supply.
Endogenous Change: The resulting change in equilibrium.
Examples of Equilibrium Shifts
Increase in Demand: A hot summer increases ice-cream demand.
Increases both the equilibrium price and quantity of ice cream.
Decrease in Supply: A bushfire destroys ice-cream factories.
Leads to an increase in the equilibrium price and a decrease in the equilibrium quantity.
Combined Events: A hot summer combined with a bushfire.
Leads to a higher equilibrium price, but the effect on equilibrium quantity is unclear.
Table of Equilibrium Changes
Summarizes all possible scenarios of simultaneous changes in supply and demand.
Cases where both demand and supply change simultaneously are the most complex.
Include graphically representing each of the cases below
No change in Supply | An increase in Supply | A decrease in Supply | |
|---|---|---|---|
No change in Demand | P same, Q same | P down, Q up | P up, Q down |
An increase in Demand | P up, Q up | P ambiguous, Q up | P up, Q ambiguous |
A decrease in Demand | P down, Q down | P down, Q ambiguous | P ambiguous, Q down |
Free Markets and Role of Prices
A free market allows prices to adjust freely.
Supply and demand forces drive prices to an equilibrium that balances the market.
Prices serve as a mechanism for allocating scarce resources.
Any buyer willing and able to pay the equilibrium price can purchase the good.
Any seller willing and able to produce and sell at the equilibrium price will do so.
Elasticity
Elasticity measures the responsiveness of a variable to changes in its determinants.
Focus on:
Price elasticity of demand
Income elasticity of demand
Cross-price elasticity of demand
Price elasticity of supply
Price Elasticity of Demand
Calculated as the percentage change in quantity demanded divided by the percentage change in price.
Formula: \text{Price elasticity of demand} = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}
Example: A 10% increase in milk price leads to a 20% decrease in quantity demanded. Elasticity = \frac{-20\%}{10\%} = -2, but ignore the minus sign, so we interpret it as 2.
Elastic, Inelastic, and Unitary Elastic Demand
Elastic Demand: Price elasticity > 1.
Buyers are highly responsive to price changes.
A given percentage change in price leads to a proportionally larger percentage change in quantity demanded.
Inelastic Demand: Price elasticity < 1.
Buyers are not very responsive to price changes.
A given percentage change in price leads to a proportionally smaller percentage change in quantity demanded.
Unitary Elasticity: Price elasticity = 1.
A given percentage change in price leads to a proportionally equal change in quantity demanded.
Determinants of Price Elasticity of Demand
Availability of Close Substitutes: Higher elasticity when many substitutes exist (e.g., specific brands of ice cream).
Necessities vs. Luxuries: Higher elasticity for luxuries (e.g., sports cars) compared to necessities (e.g., electricity).
Scope of the Market: Higher elasticity when the market is defined narrowly (e.g., apples vs. food).
Time Horizon: Higher elasticity over longer time periods (e.g., petrol).
Price Elasticity and Demand Curves
The price elasticity of demand is related to the slope of the demand curve.
Rule of thumb: Steeper demand curve = lower price elasticity; Flatter demand curve = greater price elasticity.
Two extreme cases:
Perfectly inelastic demand (elasticity=0)
Perfectly elastic demand (elasticity=infinity)
Interpreting Price Elasticity of Demand
Allows comparison of price responsiveness across goods with different units of measurement.
Example: Comparing milk (liters) and cereals (kilograms).
Using Mid-Point Formula:
Milk:
Price increases from $1 to $3, demand decreases from 7 to 3 liters.
Percentage change in quantity: (\frac{3-7}{(3+7)/2}) = -0.8 = -80\%.
Percentage change in price: (\frac{3-1}{(3+1)/2}) = 1 = 100\%.
Elasticity: \frac{-80\%}{100\%} = -0.8
Cereals:
Price increases from $1 to $3, demand decreases from 3 to 1 kg.
Percentage change in quantity: (\frac{1-3}{(1+3)/2}) = -1 = -100\% .
Percentage change in price: (\frac{3-1}{(3+1)/2}) = 1 = 100\%.
Elasticity: \frac{-100\%}{100\%} = -1
Cereals are more price elastic than milk.
Price Elasticity Changes Along the Demand Curve
The price elasticity varies at different points on the demand curve.
Total Revenue and Price Elasticity of Demand
Total Revenue (TR) = Price (P) x Quantity (Q).
TR is the amount received by sellers and the amount paid by buyers (Total Expenditure).
If demand is inelastic: an increase in P leads to a less than proportional decrease in Q, resulting in an increase in TR.
If demand is elastic: an increase in P leads to a proportionally larger decrease in Q, resulting in a decrease in TR.
If demand has unit elasticity: a change in P leads to a proportionally equal change in Q, leaving TR unchanged.
Application: Drug Bans and Drug-Related Crime
Consider government policies to reduce drug-related crime by reducing total expenditure on drugs.
Two policies:
Increase law enforcement.
Increase drug education and treatment programs.
Evaluate the effects of these policies on total expenditure on drugs.
Drug Bans: Law Enforcement
Demand for drugs is typically inelastic.
Increased law enforcement reduces the supply of drugs.
This reduces the equilibrium quantity.
Since demand is inelastic, the rise in equilibrium price is proportionately larger than the fall in quantity demanded.
Total expenditure by drug users increases, which may increase drug-related crime.
Drug Bans: Education and Treatment
Drug education and treatment programs reduce the demand for drugs.
As demand decreases, both the equilibrium price and quantity fall.
Total expenditure falls, suggesting that this policy may reduce drug-related crime.
Income Elasticity of Demand
Measures how much the quantity demanded of a good responds to a change in consumers’ income.
Formula: \text{Income elasticity of demand} = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in Income}}
Normal goods have positive income elasticity (> 0).
Inferior goods have negative income elasticity (< 0).
Among normal goods:
Necessities tend to be income inelastic (low positive income elasticity, < 1).
Luxuries tend to be income elastic (high positive income elasticity, > 1).
Cross-Price Elasticity of Demand
Measures how much the quantity demanded of one good responds to a change in the price of another related good.
Formula: \text{Cross-price elasticity of demand} = \frac{\text{Percentage change in quantity demanded of good 1}}{\text{Percentage change in price of good 2}}
Complements (e.g., cars and petrol) have negative cross-price elasticity.
Substitutes (e.g., Pepsi and Coke) have positive cross-price elasticity.
Price Elasticity of Supply
Measures how much the quantity supplied of a good responds to a change in the price of that good.
Formula: \text{Price elasticity of supply} = \frac{\text{Percentage change in quantity supplied}}{\text{Percentage change in price}}
It is positive (due to the law of supply).
Supply is said to be:
Elastic if price elasticity of supply is greater than 1.
Inelastic if price elasticity of supply is less than 1.
Unit elastic if price elasticity of supply is equal to 1.
Determinants of Price Elasticity of Supply
Ability of Suppliers to Change the Amount of the Good They Sell:
Inelastic supply: Picasso painting or beach-front land.
Elastic supply: Manufactured goods (e.g., books, cars).
Time Period Being Considered: Supply is more elastic over longer periods.
Price Elasticity of Supply and Supply Curves
Same rule of thumb as demand: Steeper supply curve = less elastic supply.
Two extreme cases:
Perfectly inelastic supply (elasticity = 0).
Perfectly elastic supply (elasticity = infinity).
Lecture Summary
Competitive Market Equilibrium: The situation when quantity demanded equals quantity supplied. Markets can be out of equilibrium, but the forces of supply and demand will lead the market to a new equilibrium.
Price Elasticity of Demand and Supply: A measure of how much the quantity demanded (or supplied) responds to changes in prices. It is calculated as the % change in Q divided by the % change in P. Other types of elasticity are income elasticity and cross-price elasticity.
Inelasticity: Demand or supply is defined as inelastic when their elasticity is less than 1. Graphically, this is characterized by steep Demand (or Supply) curves.