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Advanced Topics

Advanced Topics. Elasticity and Equilibrium Price Changes. Changes in Equilibrium. When events cause a supply or demand curve to shift, the equilibrium price will shift. But how much? Knowledge of elasticities can provide the answer to this question. Quantitative Changes Equilibrium Effects.

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Advanced Topics

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  1. Advanced Topics

  2. Elasticity and Equilibrium Price Changes

  3. Changes in Equilibrium • When events cause a supply or demand curve to shift, the equilibrium price will shift. But how much? • Knowledge of elasticities can provide the answer to this question.

  4. Quantitative Changes Equilibrium Effects

  5. Negative Supply Shock • Negative supply shock like embargo on Iranian oil would raise prices and reduce quantity of oil available. • But how much? Clearly depends on the supply

  6. Equilibrium Change in Price • A 1% shift out in the demand curve leads to a change in equilibrium price. • A 1% shift out in the supply curve leads to a change in equilibrium price.

  7. Example 1 • Elasticity of demand for oil is eD = -.061 and elasticity of supply is eS = .04. World oil demand goes up by 1%. How much does the price change? • Answer:

  8. Example 2 • What would happen to oil prices for Geo-Political reasons there were a shut-down of Iranian oil production and there was an inward shift in the oil supply curve of 4.9%?

  9. A shift in the supply schedule(Spreadsheet) A 4.9% shift in the supply schedule • At the new supply curve there is excess demand for oil. • Excess demand will induce additional supply and cut back in demand. What is the new equilibrium?

  10. Example 3 • The cross price elasticity of bacon with respect to eggs is -.2. • The elasticity of demand for bacon is -.5. The elasticity of supply for bacon is .5. • The price of eggs goes up by 1%. What happens to the price of bacon?

  11. What would the oil price change be in the long run, if world income went up permanently by 10% and no shift in supply curve? Example

  12. Excise Tax

  13. Own Price Elasticity Matters as well. • A less important effect is that the steepness of the demand curve will also impact the size of a demand shift. • The steepness of the supply curve will impact the size of a supply shift.

  14. . Steeper (less elastic) demand curve means that a demand shift will have a bigger impact on both price and quantity. P D2’ P2** 2 1 P1** 0 P* D1’ D1 D2 Q Q* Q1** Q2**

  15. . Steeper (less elastic) supply curve means that a supply shift will have a stronger impact on quantity and bigger impact on price. S1’ S1 P S2’ S2 P1** 1 2 P2** P* 0 D Q Q* Q1** Q2**

  16. Advanced Topic Gains from Trade

  17. Market System • A free market allows people to sell goods that they value relatively little to buyers who value them more. • A price can be obtained between buyers and sellers valuations at which they can both benefit. • You own shares of stock that you think are worth $5 and someone else thinks are worth $9 per share. If you sell them at $7 both the buyer and the seller are happy.

  18. Demand Curves are Valuation Curves • To measure the benefits of the market, economists invert the meaning of the demand curve. • Standard definition of the demand curve: how many units of Q will buyers want at price P. • Inverted definition: What is the maximum price that buyers are willing to pay to buy the Qth unit of the good. • Implication: What is the value that the consumer places on the Qth good.

  19. . Demand curve P P1D Maximum that the buyer on the fence will pay to for Q1thgood is P1 D Q1 Q

  20. Supply Curves are Valuation Curves • To measure the benefits of the market, economists invert the meaning of the supply curve. • Standard definition of the supply curve: how many units of Q will sellers want at price P. • Inverted definition: What is the minimum price that sellers are willing to accept for the Qth unit of the good. • Implication: What is the value that the seller places on the Qth good.

  21. . Supply curve P S P1S Maximum that the buyer on the fence will pay to for Q1thgood is P1 Q1 Q

  22. Equilibrium Price • Price will be between the value that the seller places on the Qth good and what the buyer places on the same good. • Both buyer and seller benefit. • We can calculate exactly how much each benefits by comparing the value they place on the good vs. either the price they pay for it or sell it for. • The gains from trade on the final good Q*is zero.

  23. . Gains from Trade of selling Q1 is [P1D– P1S]. Buyers Benefit is [P1D – P*]. Sellers benefit is [P*- P1S]. P S P1D P* P1S D Q1 Q

  24. Surplus • The sum total of gains from trade is the sum of the benefits from each good. • This sum of gains of trade, called surplus, can be divided into two parts…consumer surplus and producer surplus.

  25. . Sum of the benefits from all goods. P S Q1 Q

  26. . Represented as a triangle P S Q1 Q

  27. . Triangle can be split into two triangles, total consumer benefit and total producer benefit. P S Consumer Surplus P* Producer Surplus Q1 Q

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