To calculate the %change in price or quantity demanded, the following formula should be used: Change in P or Qd divided by Initial P or Qd
Price elasticity of demand aims to use a numerical value to show how sensitive the quantity demanded is to the price. This is calculated by doing
Price elasticity of demand= % change in Qd divided by % Change in P
The elasticity of the product is determined in this table.
Cross price elasticity of demand(CPED) calculates how sensitive the price change of a product is to the quantity demanded of another product.
CPED= %change Qd of Product A divided by %change of price product B
A negative CPED means the two goods are complements while positives means the two goods are substitutes.
Normal good=demand rises as income rises
Inferior good=demand decreases as income rises
Income elasticity of demand measures how sensitive a product is to a change in the income of consumers. This is calculated by the % change in quantity demanded divided by the change in consumer income. This can help economists decipher whether a good is normal or inferior. If the income elasticity value is positive it is a normal good while it is inferior if it's negative. A normal good is a good whose demand rises as income rises and an inferior good is one that's demand decreases as income rises.
Economics studies how to maximize both the consumer and producer surplus. The consumer surplus, the triangle located below the demand curve and above the equilibrium price, is the difference between how much a consumer is willing to pay and how much they actually pay. The producer surplus, above the supply curve and below the equilibrium price, is the profit producers get from selling a product.
The government will often implement price ceilings and price floors to benefit a specific group. A price ceiling is the maximum price that a product can be sold for whereas a price floor is the minimum price a product can be sold for. For a price ceiling to be effective, it must be below the equilibrium price so as to actually affect producers. Likewise, an effective price floor must be implemented above the equilibrium price for it to work.
When a price restriction is implemented, there will be disequilibrium and introduce a deadweight loss which is part of the total surplus no longer available.
For example, consider this graph as a hypothetical market for milk and a price ceiling was implemented by the government to lower the price so that more people can afford this good. Obviously, consumers benefit from this as shown by the enlarged consumer surplus but it is bad for producers as they profit less. In addition, as shown on the graph, there is actually a disequilibrium causing a shortage because fewer suppliers will be willing to supply milk. Thus, despite the government originally trying to let more people afford milk, fewer people are now able to get milk. In addition to this, there is also now a deadweight loss because there are so many consumers not able to consume because there are not enough goods. Before implementing a price ceiling or price floor it is important to understand its true impacts.
Per unit taxes, meaning that there is the same amount of tax taxed for every unit, result in deadweight loss and a change to the total surplus. Both parties, the suppliers and the consumers, pay part of the price, but one pays more for it. When supply is inelastic, consumers pay more tax and when demand is more elastic, suppliers pay more tax. For a perfectly inelastic demand, consumers pay all tax and for a perfectly elastic demand, consumers pay all the tax.
In this example, the demand curve is more elastic than the supply curve so the producers will pay more tax.
Oftentimes, when a country gets opened to the global market, various products will be available for much cheaper prices. Thus, consumers will buy more from these cheap imports and less from local producers. To address this issue, a tariff is commonly used. This is a tax on imports and exports. Similar to a per-unit tax, this tax also results in a deadweight loss and a smaller total surplus.
The first graph shows when a country gets opened to the global market and does not implement a tariff. The equilibrium price drops drastically, making the producer surplus shrink and the consumer surplus enlarge.
The second graph shows a market when the government does implement a tariff. The consumer surplus shrinks but the producer surplus grows.
A quota is a limit on how much of a product a country can import. It does exactly what a tariff does but without the tax revenue. However, the advantage of a quota over a tariff is that it is more restrictive. Therefore, quotas are used for inelastic products while tariffs are used for elastic products.
Vocabulary/Summary:
Price elasticity of demand: How sensitive the demand is to a change in price
Cross-price elasticity of demand: How sensitive the demand for a product is to a change in the price of another product
Consumer surplus: The difference between how much consumers are willing to pay and how much they actually pay
Producer surplus: The difference between how much producers are willing to sell for and how much they actually sell for
Income elasticity of demand: How sensitive the demand for a product is to a change in income
Deadweight loss: Loss from the total surplus
Tariff: A tax on imports or exports
Quota: A restriction in the quantity of imports or exports