Unit-2 Market Forces of Demand and

Supply

 TOPICS COVERED:

 Demand and supply – Definition, Laws of demand and supply, Factors affecting
demand and supply – Shift Vs. Movement of the demand and supply curve
 Market Equilibrium
 Elasticities of demand (Own-price, Cross-price and Income elasticity) and
supply (Own-price elasticity)
Demand - definition
• Demand refers to the quantity of goods or services that consumers are willing to buy and
have the ability to purchase the same at a given point of time. This means a desire, backed
by purchasing power is called demand.
• If a person wants to purchase a good but does not have the purchasing power, then it is
desire. It only becomes demand if the person has the ability to purchase it.
• Example: If an economically poor person wants to buy a car but cannot afford to buy, it is only
desire. If a rich man wants to buy a car and can spend money to buy, it is a demand.
Law of demand
• The Law of Demand states that “if the price of a commodity falls, the quantity demanded will
rise, and if the price of the commodity rises, its quantity demanded will decrease”, ceterus
paribus
• Ceterus Paribus assumption means that only one variable will change, all other things
remaining constant
• This shows that there is an inverse relationship between price and quantity demanded.
• Here price is an independent factor and demand is dependent factor.
• Given, Law of Demand, demand curve will always slope downward from left to right
Assumptions for law of demand:
• No change in the consumers’ income
• No change in consumers’ tastes and preferences
• No changes in the prices of related goods
• Consumers have perfect knowledge of the market
• Consumers are rational human beings
Determinants of demand
Apart from its own price, there are other factors that affects the demand of a particular good.
• Income of the individual:
If the demand for a good rises when income rises, the good is termed as normal good. If the
demand for a good falls when income rises, the good is termed as inferior good.
• Price of related goods:
If the demand for one good increases due to the increase in the price of the other good, they are
called substitute goods. If the demand for one good falls due to the increase in the price of the
other good, they are called complement goods.
• Tastes and preferences:
One of the most obvious determinants of the demand of a particular good is the taste of the
consumer
• Expectations of future price:
Detailed Explanation of the Determinants of Demand
Consider your own demand for ice cream. How do you decide how much
ice cream to buy each month, and what factors affect your decision? Here
are some of the answers you might give.
• Income What would happen to your demand for ice cream if you lost your job one summer? Most likely, it would fall. A lower income
means that you have less to spend in total, so you would have to spend less on some—and probably most— goods. If the demand for
a good falls when income falls, the good is called a normal good.
Not all goods are normal goods. If the demand for a good rises when income falls, the good is called an inferior good. An example of an
inferior good might be bus rides. As your income falls, you are less likely to buy a car or take a cab, and more likely to ride the bus.
• Prices of Related Goods Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt.
At the same time, you will probably buy less ice cream. Because ice cream and frozen yogurt are both cold, sweet, creamy desserts,
they satisfy similar desires. When a fall in the price of one good reduces the demand for another good, the two goods are called
substitutes. Substitutes are often pairs of goods that are used in place of each other, such as hot dogs and hamburgers, sweaters and
sweatshirts, and movie tickets and video rentals.
Now suppose that the price of hot fudge falls. According to the law of demand, you will buy more hot fudge. Yet, in this case, you will buy
more ice cream as well, because ice cream and hot fudge are often used together. When a fall in the price of one good raises the demand
for another good, the two goods are called complements. Complements are often pairs of goods that are used together, such as gasoline
and automobiles, computers and software, and skis and ski lift tickets.
• Tastes The most obvious determinant of your demand is your tastes. If you like ice cream, you buy more of it. Economists normally
do not try to explain people’s tastes because tastes are based on historical and psychological forces that are beyond the realm of
economics. Economists do, however, examine what happens when tastes change.
• Expectations Your expectations about the future may affect your demand for a good or service today. For example, if you expect to
earn a higher income next month, you may be more willing to spend some of your current savings buying ice cream. As another
example, if you expect the price of ice cream to fall tomorrow, you may be less willing to buy an ice-cream cone at today’s price.
DEMAND SCHEDULE
• DEMAND SCHEDULE is a tabular representation which shows the relationship between Price
and Quantity demanded.
• Two types of demand schedule – Individual and Market Demand schedule

Individual demand Schedule

Price Quantity Demanded

5 15
4 25
3 30
2 40
1 55

• What relationship can be established from the above schedule? Inverse relationship
Individual Demand Schedule Market demand schedule
Price Quantity Price Quantity demanded Total market Demand
Demanded
A B C
5 20
5 10 8 12 10 + 8 + 12 = 30
4 25
4 15 12 18 15 + 12 + 18 = 45
3 32
3 20 17 23 20 + 17 + 23 = 60
2 40
2 35 25 40 35 + 25 + 40 = 100
1 46
1 60 35 45 60 + 35 + 45 = 140

Market demand is the sumtotal of all the individual demand of a particular good in the
market at a particular price
Demand Curve
• The demand curve shows the relationship between price per unit of the good and the
quantity demanded, all other factors that influence the demand of the good by the individual.

0 15 25 30 40 55 Q
Change in Quantity demanded (Movement) vs.
Change in demand (shift) of demand curve
Movement along the Demand Curve
• If the demand of a commodity changes due to change in its own price, other factors remaining
constant it is known as Change in Quantity Demanded.
• Here when price changes, movement occurs along the demand curve.

• Suppose tax is imposed on commodity X which

causes the price to increase from 2 to 4. For this
quantity demanded decreased from 20 to 12 units.
• The movement happens from point A to point C
along the demand curve. This is known as
Contraction
• Similarly, if for some reason, the price of cigarettes
decreases from 4 to 2, quantity demanded
increased from 12 to 20 units.
• The movement happens from point C to Point A
along the demand curve. This is known as
Expansion
Movement along the Demand Curve
• Movement: Change in Quantity Demanded

• A movement along the demand curve is caused by a change in the

price of the good, other things remaining constant. It is also called
change in quantity demanded of the commodity. Movement is always
along the same demand curve, i.e., no new demand curve is drawn. Movement
along a demand curve can bring about:
• (a) Expansion of demand, or (b) Contraction of demand
• Extension of Demand or Contraction of Demand. Expansion or Extension
of demand refers to rise in demand due to fall in the price of the good.
Contraction of demand refers to fall in demand due to rise in the price of the
good.
Shift of the Demand Curve
• If the demand of a commodity changes due to change in the other factors/determinants, own
price remaining constant, it is termed as Change in demand.
• Here, when any of the other factors change, price remaining constant, it causes shift of the
demand curve.
• Any change that increases the demand at every price, shifts the demand curve to the right.
Similarly, any change in other factors, that reduces the demand at every price shifts the
demand curve to the left.

• A shift of the demand curve is caused by changes in factors other

than price of the good. A change in factors causes shift of the demand
curve. It is also called change in demand. In a shift, a new demand curve is
drawn. A shift of the demand curve can bring about:
• (a) Increase in demand, or
• (b) Decrease in demand.
Decrease in Demand

• The introduction of some policy encourages the

smokers to smoke less. This causes the demand of
cigarette to decrease at the given price and the
demand curve shifts left.
• At price $2, the demand declined from 20 units to
10 units and there is a shift from point A to point B.
Hence the demand curve shifts from D1 to D2,
leftward shift.
• Similarly, suppose there is increase in income which
causes increase in demand for cigarettes at each
price. At price $2, the demand of cigarettes
increased from 10 units to 20 units, and there is a
shift from point B to point A. Hence, the demand
curve shifts from D2 to D1, rightward shift.
Difference between Increase and Decrease in Demand
Increase in Demand. It refers to more demand at a given price. The causes of increase
in demand are:
• Increase in the income of the consumers in case of normal goods.
• Decrease in the income of the consumers in case of inferior goods.
• Increase in the price of substitute goods.
• Fall in the price of complementary goods.
• Consumers’ taste becoming stronger in favour of the good.

Decrease in Demand. It refers to less demand at the given price. It occurs due to
unfavourable changes in factors other than the price of the good. The causes of decrease in
demand are:
• Fall in the income of the consumers in case of normal goods.
• Rise in the income of the consumers in case of inferior goods.
• Fall in the price of substitute goods.
• Rise in the price of complementary goods.
• Consumers’ taste becoming unfavourable O towards the good.
Difference between Increase in Demand and Expansion of Demand
Supply and Law of Supply
• Supply is the “quantity of a commodity which a seller offers for sale in the market at a particular price,
at a particular time”.
• The law of supply explains the functional relationship between price of a good and quantity supplies.
It states that “other things being equal (ceteris paribus), the quantity of a good produced and offered
for sale will increase as the price of the good rises and decreases when the price falls”.
• The law of supply can be understood with the help of a supply schedule and a supply curve
Assumptions for law of supply:
• No change in consumers’ tastes and preferences
• No changes in the prices of related goods
• No change in the input prices (factors of production)
• No change in technique of production
• Producers do not expect change in price of the commodity in near future
• No change in government policies
 Determinants of Supply

• Price of the commodity – If the price of a commodity is high, selling that commodity is
profitable, and so the quantity supplied is more and if the price of a commodity is less,
then selling that commodity is less profitable. Hence, as the price rises, quantity supplied
rises and as the price falls, quantity supplied also falls.
• Prices of related goods - If prices of other goods increases they become relative more
profitable to produce and sell, than the goods in question. It implies that for example, if
the price of wheat increases the farmers may shift lands to wheat prodn. and go away
from producing paddy.
• Input Prices – In the production process, various factors of production are required. The
four broad factors of production are land, labour, capital and entrepreneurs. The
payments made to these factors of production, are called cost of production. If the price
of any of these inputs increases, the cost of production increases which causes the
production of the goods to be less profitable. Hence, the supply of the commodity
decreases in this case. Thus, the supply of the good is inversely related to the input prices.
• Technology - Inventions and innovations tend to make it possible to produce more or
better goods with same resources and tend to increase the qty supplied of some products
Determinants of Supply
• Expectations – The amount of a particular commodity a producer supply today depends on his/her
expectations of the future. If the producer expect the price to rise in future, he/she will produce less
in the current situation and the supply will be less in the market.
• Govt policy – Production of goods may be subject to imposition of taxes, excise duty, etc. these
increases the price of goods. Subsidies, on the other hand, reduce the cost of production and provide
incentive to the firm to increase supply.
Supply Schedule and Supply Curve
• Supply Schedule – The tabular representation of quantity supplied of a commodity at each price is
the supply schedule.

Price of ice Quantity of cones Supply Curve – The graphical representation of price of the
cream cone ($) supplied commodity and quantity supplied is called supply curve
0 0
0.5 0
1 1
1.5 2
2 3
2.5 4
3 5
Individual Supply and Market Supply
• Market Supply - The sum of individual supply of all sellers is called market supply. The Law of supply
holds both for individual and market supply

Price of ice A B Market

cream cone ($)
0 0 0 0
0.5 0 0 0
1 1 0 1
1.5 2 2 4
2 3 4 7
2.5 4 6 10
3 5 8 13
Movement along the supply curve
• If the supply of a commodity changes due to change in its own price, other factors remaining constant
it is known as Change in Quantity Supplied.
• Here when price changes, movement occurs along the supply curve.
P
SS
B • If the price increases from P2 to PI, the
P1
movement happens along the supply curve
A from point A to B. This is called expansion
P2 • If the price decreases from P1 to P2, the
movement happens along the supply curve
from point B to A. This is called contraction

0 Q
Q1 Q2
Shift of the supply curve
• If the supply of a commodity changes due to change in the other factors/determinants, own price
remaining constant, it is termed as Change in supply.
• Here, when any of the other factors change, price remaining constant, it causes shift of the supply
curve.
• Any change that increases the supply at every price, shifts the supply curve to the right. Similarly, any
change in other factors, that reduces the supply at every price shifts the supply curve to the left.

P
𝑆𝑆 1 Suppose the initial supply curve is . At price , quantity
supplied is . Suppose due to the change in other factors,
𝑆𝑆 2 price remaining constant, the supply increases from to .
A B In this case, the supply curve shifts to the right from to .
P1

Q1 Q2 Q
Market Equilibrium (Supply and Demand together)
Topics to be covered:

• Concept of Market Equilibrium

• Cases of Excess Demand and Excess Supply (Market not in equilibrium)
• Analysis of Equilibrium when demand changes and supply changes
- Demand Changes: Increase Vs. Decrease
- Supply Changes: Increase Vs. Decrease
Equilibrium
• The point at which demand and supply equals is called equilibrium. The price at which the demand
and supply is equal is called the equilibrium price and the corresponding quantity is called the
equilibrium quantity.
• Diagrammatically, the point where demand and supply curves intersect each other is the equilibrium
point and the corresponding price and quantity are called equilibrium price and quantity respectively.
𝑃
𝑆
• In the diagram, at price , the demand and supply curve
intersect each other.
• Hence, the equilibrium price is and the equilibrium
quantity is .
𝑃1 • The equilibrium price is also called market clearing
price.

𝐷
0 𝑄1 𝑄
Excess Demand and Excess Supply
• The actions of buyers and sellers naturally move markets toward the equilibrium of supply
and demand. To see why, consider what happens when the market price is not equal to the
equilibrium price.
• The situation where the quantity demanded is greater than the quantity supplied is called
excess demand in the market.
• The situation where the quantity supplied is greater than the quantity demanded is called
excess supply in the market.
• Let us consider the table below.
Price Demand Supply Pressure on price
10 1000 10000 Downward
8 3000 8000 Downward Excess Supply
6 4000 6000 Downward
5 5000 5000 Neutral Equilibrium
4 7000 4000 Upward
3 10000 2000 Upward Excess Demand
Excess Supply (S>D)
• Suppose first that the market price is
above the equilibrium price.
• At a price of $2.50 per cone, the quantity
of the good supplied (10 cones) exceeds
the quantity demanded (4 cones).
• There is a surplus of the good: Suppliers
are unable to sell all they want at the going
price.
• When there is a surplus in the ice-cream
market, for instance, sellers of ice cream
find their freezers increasingly full of ice
cream they would like to sell but cannot.
• They respond to the surplus by cutting
their prices.
• Prices continue to fall until the market
reaches the equilibrium.
Excess Demand (D>S)
• Suppose now that the market price is
below the equilibrium price
• In this case, the price is $1.50 per cone,
and the quantity of the good demanded
exceeds the quantity supplied
• There is a shortage of the good:
Consumers are unable to buy all they want
at the going price. When a shortage occurs
in the ice-cream market, for instance,
buyers have to wait in long lines for a
chance to buy one of the few cones that
are available.
• With too many buyers chasing too few
goods, sellers can respond to the shortage
by raising their prices without losing sales.
• As prices rise, the market once again
moves toward the equilibrium.
 • Let us consider price P2. At this price, the
demand is at A and the supply is at B. Here
Excess Supply supply is greater than demand. Hence this is
P
excess supply. There is downward pressure in
S1
price. The price starts to decline and quantity
A B demanded starts to increase (Law of
P2 demand). On the other hand, the quantity
supplied starts to fall (Law of supply). Thus,
E the market gradually reaches equilibrium.
P1 Excess Demand
• Let us consider price P3. At this price, the
demand is at D and the supply is at C. Here
demand is greater than supply. Hence this is
P3 excess demand. There is upward pressure in
C D
price. The price starts to rise and quantity
demanded starts to fall (Law of demand). On
D1 the other hand, the quantity supplied starts to
rise (Law of supply). Thus, the market
0 Q1 Q gradually reaches equilibrium.
 Analysis of Equilibrium – Demand Increase
• Suppose the income of the consumer increases. That leads to increase in the demand for a
commodity. The effect of this change on equilibrium price and quantity is described below:
S • The initial equilibrium point is E where the equilibrium price
is P1 and quantity is Q1.
• As the income of the consumer increases, the demand for the
commodity increases, this causes the demand curve to shift
rightward to D2. The demand increases from Q1 to Q3, but
P2 F the supply in the market still remains Q1. This is the
P1 E situation of excess demand.
• As a result the price starts to increases. With the price
increasing, the quantity demanded decreases and the
contraction happens along the demand curve. On the other
hand, the quantity supplied starts to increase and expansion
happens along the supply curve.
D2 • Thus, the market reaches a new equilibrium point F, which is
D1 at a higher price P2 and higher Quantity Q2 (higher than Q1).
• Thus the market settles at a higher equilibrium price (P2)
Q1 Q2 Q3
and equilibrium quantity (Q2).
 Analysis of Equilibrium – Demand Decrease
• Suppose the income of the consumer decreases. That leads to decrease in the demand for a
commodity. The effect of this change on equilibrium price and quantity is described below:
S • The initial equilibrium point is E where the equilibrium price
is P1 and quantity is Q1.
• As the income of the consumer decreases, the demand for the
commodity decreases, this causes the demand curve to shift
leftward to D2. The demand decreases from Q1 to Q3, but the
P1 E supply in the market still remains Q1. This is the situation of
P2 F excess supply.
• As a result the price starts to fall. With the price falling, the
quantity demanded increases and the expansion happens
along the demand curve (D2). On the other hand, the
quantity supplied starts to decrease and contraction happens
along the supply curve.
D1 • Thus, the market reaches a new equilibrium point F, which is
D2 at a lower price P2 and lower quantity Q2 (lower than Q1). .
• Thus the market settles at a higher equilibrium price (P2)
Q3 Q2 Q1
and equilibrium quantity (Q2).
 Analysis of Equilibrium – Supply Increase
• Suppose the cost of production has decreased. That leads to increase in the supply for a
P
commodity. The effect of this change on equilibrium price and quantity is described below:
S1 • The initial equilibrium point is E where the equilibrium price
S2 is P1 and quantity is Q1.
• As the cost of production of the commodity decreases, the
supply for the commodity increases, this causes the supply
curve to shift rightward to S2. The supply increases from Q1
to Q3, but the demand in the market still remains Q1. This is
P1 E the situation of excess supply.
• As a result the price starts to fall. With the price falling, the
P2 F quantity supplied decreases and the contraction happens
along the supply curve. On the other hand, the quantity
demanded starts to increase and expansion happens along
the demand curve.
• Thus, the market reaches a new equilibrium point F, which is
D1 at a lower price P2.
• Thus the market settles at a lower equilibrium price (P2) and
0 Q1 Q2 Q3 Q higher equilibrium quantity (Q2).
Analysis of Equilibrium – Supply Decrease
Elasticity of Demand & Supply
• Elasticity, a measure of how much buyers and sellers respond to changes in market conditions,
allows us to analyze supply and demand with greater precision.

• In law of demand, we saw that buyers usually demand more of a good when its price is lower,
when their incomes are higher, when the prices of substitutes for the good are higher, or when
the prices of complements of the good are lower. Our discussion of demand was qualitative,
not quantitative. That is, we discussed the direction in which the quantity demanded moves,
but not the size of the change.

• To measure how much demand responds to changes in its determinants, economists use the
concept of elasticity.
Demand Elasticity
Topics to be covered:

• Define Price Elasticity of Demand

• Determinants of Price Elasticity of Demand
• Calculating Price Elasticity of Demand
• 5 Degrees of Demand Elasticity & their graphs
• Relationship between total revenue & price elasticity of demand
• 2 Types of Demand Elasticities:
- Income elasticity of demand
- Cross-price elasticity of demand
Price Elasticity of Demand
• Demand for a good is said to be elastic if the quantity demanded responds substantially to
changes in the price.

• Demand is said to be inelastic if the quantity demanded responds only slightly to changes in
the price.

• Measure of responsiveness: Measures the responsiveness of quantity demanded to changes in PRICE,

holding constant the values of all other variables.

• %age change in dependent variable Y, because of %age change in Independent variable X.

Percentage Change in Y
Percentage Change in X
Determinants of Price Elasticity of Demand
• Availability of Close Substitutes Goods with close substitutes tend to have more elastic
demand because it is easier for consumers to switch from that good to others.
• Definition of the Market. Narrowly defined markets tend to have more elastic demand than
broadly defined markets, because it is easier to find close substitutes for narrowly defined
goods.
• Time Horizon Goods tend to have more elastic demand over longer time horizons.
Price Elasticity of Demand

Percentage Change in Quantity

Point Price Elasticity εX= Percentage change in Price

Or,
Numerical Calculation

P1= 20, P2= 15

Q1= 500, Q2= 700

SOLUTION:

ΔQ= 700-500= 200 (200/5)x(20/500)

ΔP= 15-20 = 5 = 1.6

P= 20
Q=500
Why Elasticity
• Elasticity is important because it describes the fundamental relationship between the price of
a good and the demand for that good.
• Elastic goods and services generally have plenty of substitutes. As an elastic service/good's
price increases, the quantity demanded of that good can drop fast. Example of elastic goods
and services include furniture, motor vehicles, instrument engineering products, professional
services, and transportation services.
• Inelastic goods have fewer substitutes and price change doesn't affect quantity demanded as
much. Some inelastic goods include gas, electricity, water, drinks, clothing, tobacco, food, and
oil.
Perfectly Inelastic Demand
• A perfectly inelastic demand is one when there is no change produced in the demand of a
product with change in its price.
• The numerical value for perfectly inelastic demand is zero (ep=0).
• In case of perfectly inelastic demand, demand curve is represented as a straight
vertical line.
• It can be interpreted from Figure
that the movement in price from OP1
to OP2 and OP2 to OP3 does not
show any change in the demand of a
product (OQ).
• The demand remains constant for
any value of price.
• Perfectly inelastic demand is a
theoretical concept and cannot be
applied in a practical situation.
• However, in case of essential goods,
such as salt or insulin, the demand
does not change with change in
price. Therefore, the demand for
essential goods is perfectly inelastic.
Inelastic Demand
• percentage change produced in demand is less than the percentage change in the price of a
product.
• For example, if the price of a product increases by 30% and the demand for the product
decreases only by 10%, then the demand would be called relatively inelastic.
• The numerical value of relatively elastic demand ranges between zero to one (ep<1).
• Example- Tobacco products
It can be interpreted from the Figure
given here that the proportionate
change in demand from OQ1 to
OQ2 is relatively smaller than the
proportionate change in price from
OP1 to OP2.
Unit Elastic Demand
• When the proportionate change in demand produces the same change in the price of the
product, the demand is referred as unitary elastic demand.
• The numerical value for unitary elastic demand is equal to one (ep=1).
• The demand curve for unitary elastic demand is represented as a rectangular
hyperbola:
• From Figure, it
can be
interpreted that
change in price
OP1 to OP2
produces the
same change in
demand from
OQ1 to OQ2.
Relatively Elastic Demand

• when the proportionate change produced in demand is greater than the

proportionate change in price of a product.
• Mathematically, (ep>1).

• If the price of a product increases by 10% and the demand of the product
decreases by 20%, then the demand would be relatively elastic and,
(Co-efficient of demand) PED= 20/10= 2
 It can be interpreted that the proportionate
change in demand from OQ1 to OQ2 is relatively
larger than the proportionate change in price
from OP1 to OP2.
Relatively elastic demand has a practical
application as demand for many of products
respond in the same manner with respect to
change in their prices.
2.20 For example, the price of a particular brand of
cold drink increases from Rs. 15 to Rs. 20. In
2 such a case, consumers may switch to another
brand of cold drink. However, some of the
consumers still consume the same brand.
Therefore, a small change in price produces a
larger change in demand of the product.

8 10
Perfectly Elastic Demand

• When a small change in price of a product causes a major change in its

demand, it is said to be perfectly elastic demand.
• small rise in price--------demand fall to zero,
• small fall in price ----------demand increases to ∞.
• ep = ∞
• Flatter the slope of the demand curve, higher the elasticity of demand.

• In highly competitive markets where no supplier has any ‘Pricing

Power”
• homogeneity products- Gold, Diamond
• They typically do this when they aren't desperate to have it or they don't
need it every day.
• Comparison Shopping- They'll also comparison shop when there are a
lot of other similar choices
At price OP, demand is
infinite; however, a slight
rise in price would result
in fall in demand to zero.

It can also be interpreted

that at price P consumers
are ready to buy as much
quantity of the product as
they want.
Total Revenue
• When studying changes in supply or demand in a market, one variable we often want to study
is total revenue, the amount paid by buyers and received by sellers of the good.
• In any market, total revenue is P x Q, the price of the good times the quantity of the good sold.

• The area of this box, P Q, equals the total revenue in this market. In this Figure, where P $4
and Q 100, total revenue is $4 100, or $400.
Price Elasticity & Total Revenue
• How does total revenue change as one moves along the demand curve?
The answer depends on the price elasticity of demand.
• If demand is elastic, an increase in the price causes a decrease in
total revenue.

• Here, when the price rises from $4 to $5, the quantity demanded falls
from 50 to 20, and so total revenue falls from $200 to $100.
• If demand is inelastic, an increase in the price causes an increase in total revenue.

• Here an increase in price from $1 to $3 causes the quantity demanded to fall only
from 100 to 80, and so total revenue rises from $100 to $240.
Price Elasticity & Total Revenue

ELASTICITY PRICE INCREASE PRICE DECREASE

[E] > 1; ELASTIC Revenue DECREASE Revenue INCREASE
[E] = 1; UNIT ELASTIC Revenue NO CHANGE Revenue NO CHANGE
[E] < 1; INELASTIC Revenue INCREASE Revenue DECREASE
Importance of PEDx,y for businesses

• Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use estimates of cross-price
elasticity to predict the effect on the quantity demanded and total revenue of their own product. For example, two or
more airlines competing with each other on a given route will have to consider how one airline might react to its
competitor’s price change. Will many consumers switch? Will they have the capacity to meet an expected rise in
demand? Will the other firm match a price rise? Will it follow a price fall?

• Consider for example the cross-price effect that has occurred with the rapid expansion of low-cost airlines in the Indian
airline industry. This has been a major challenge to the existing and well-established national air carriers, many of
whom have made adjustments to their business model and pricing strategies to cope with the increased competition.

• Pricing strategies for complementary goods: For example, popcorn, soft drinks and cinema tickets have a high negative
value for cross price elasticity– they are strong complements. Popcorn has a high mark up i.e. pop corn costs pennies to
make but sells for more than a pound. If firms have a reliable estimate for PEDx,y they can estimate the effect, say, of a
two-for-one cinema ticket offer on the demand for popcorn. The additional profit from extra popcorn sales may more
than compensate for the lower cost of entry into the cinema.

• Advertising and marketing: In highly competitive markets where brand names carry substantial value, many businesses
spend huge amounts of money every year on persuasive advertising and marketing. There are many aims behind this,
including attempting to shift out the demand curve for a product (or product range) and also build consumer loyalty to a
brand. When consumers become habitual purchasers of a product, the cross price elasticity of demand against rival
products will decrease. This reduces the size of the substitution effect following a price change and makes demand less
sensitive to price. The result is that firms may be able to charge a higher price, increase their total revenue and turn
consumer surplus into higher profit.
Cross Price Elasticity of Demand (PEDx,y)

• Cross price elasticity (PEDx,y) measures the responsiveness of

demand for good X following a change in the price of good Y.
• In effect we are measuring to which degree a good is a substitute
or complement
• PEDx,y describes the important distinction between substitutes
and complements quantitatively.
Cross Price Elasticity of Demand
• Economists use the cross- price elasticity of demand to measure how the quantity
demanded of one good changes as the price of another good changes. It is calculated as the
percentage change in quantity demanded of good 1 divided by the percentage change in the
price of good 2. That is,

• Whether the cross-price elasticity is a positive or negative number depends on whether the
two goods are substitutes or complements.

• Cross-price of substitutes : Positive

An increase in Pepsi prices induces people to drink Coke instead. Because the price of Pepsi and
the quantity of Quantity demanded move in the same direction, the cross-price elasticity is
positive.

• Cross-price of Complementary : Negative

goods that are typically used together, such as computers and software. In this case, the cross-
Income Elasticity of Demand
• Economists use the income elasticity of demand to measure how the quantity demanded changes as
consumer income changes.
• The income elasticity is the percentage change in quantity demanded divided by the percentage change
in income. That is,

• most goods are normal goods: Higher income raises quantity demanded. Because quantity demanded
and income move in the same direction, normal goods have positive income elasticities.
• A few goods, such as bus rides, are inferior goods: Higher income lowers the quantity demanded.
Because quantity demanded and income move in opposite directions, inferior goods have negative
income elasticities.
• Even among normal goods, income elasticities vary substantially in size.
• Necessities, such as food and clothing, tend to have small income elasticities because consumers,
regardless of how low their incomes, choose to buy some of these goods.
• Luxuries, such as caviar and furs, tend to have large income elasticities because consumers feel that
they can do without these goods altogether if their income is too low.
Supply Elasticity
Topics to be covered:

• Define Price Elasticity of Supply

• Determinants of Price Elasticity of Supply
• Calculating Price Elasticity of Supply
• 5 Degrees of Supply Elasticity & their graphs
Price Elasticity of Supply
• The price elasticity of supply measures how much the quantity supplied responds to
changes in the price. Supply of a good is said to be elastic if the quantity supplied responds
substantially to changes in the price.

• Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the
price.
Determinants of Price elasticity of Supply
• Flexibility of sellers: The price elasticity of supply depends on the
flexibility of sellers to change the amount of the good they produce.
For example, beach-facing land has an inelastic supply because it is
almost impossible to produce more of it. By contrast, manufactured
goods, such as books, cars, and televisions, have elastic supplies
because the firms that produce them can run their factories longer in
response to a higher price.
• Time period: In most markets, a key determinant of the price
elasticity of supply is the time period being considered. Supply is
usually more elastic in the long run than in the short run. Over short
periods of time, firms cannot easily change the size of their factories to
make more or less of a good. Thus, in the short run, the quantity
supplied is not very responsive to the price. By contrast, over longer
periods, firms can build new factories or close old ones. In addition,
new firms can enter a market, and old firms can shut down. Thus, in
the long run, the quantity supplied can respond substantially to the
price.
Calculating Price Elasticity of Supply

• This appears to be identical with the

formula for elasticity of demand.

• However, you will recall that price

elasticity of demand is always
negative.

• But price elasticity of supply is

normally positive since the supply
curve slopes upwards from left to
right; except in the case of a
backward-bending supply curve, in
which case it would have negative
elasticity.
Different Degrees of Price Elasticity of Supply
Price Ceiling & Price Floor
• The amount supplied and the quantity demanded are equal at the equilibrium
price in a market that is functioning freely. However, government interference
in markets is common. When the equilibrium price so reached is either too
high or too low (unprofitable) for the producers of the commodity, the
government may need to intervene in the process of fixing prices. The two
types of government interventions are Price Ceiling and Price Floor.
Price Floor
• A price floor is a regulation that prevents buying and selling a good or service
below a specified price.
• Price floors are often implemented with one or more of the following goals in
mind:
• To push the price of a good or service above the market price.
• To reduce the demand for goods or services thought to be harmful.
• To encourage the production of goods or services in a government-assisted
industry.
• To promote the welfare of low-wage workers (this is the case for minimum
wage laws, which are price floors set on the wages employers can pay their
workers).
• In a competitive market, the price of a good or service
is determined by the intersection of supply and
demand. This is called the market price, �p*.
• When a price floor is in place, market participants are
prevented from buying or selling below a given
price, pf​.
• If the price floor is set above the market price (pf​>p*),
buyers and sellers will adjust their behavior in response
to the higher price.
• Buyers will demand fewer units of the good and as a
result, fewer units of the good will be sold.
• Meanwhile, suppliers will want to produce greater
quantities of the good. This can lead to overproduction
or a surplus of goods in the market.
• A price floor that is set above the equilibrium price is
called a binding price floor. For a price floor to have an
effect, it must be binding. A binding price floor makes it
illegal to buy and sell at the equilibrium price or any
other price that falls below the price floor.
EXAMPLES
• A Price Floor on Tobacco
• Tobacco Products: Price floors on products such as tobacco and alcohol are
aimed at reducing demand for products considered harmful to consumers.
• Price Floors on Agricultural Products
• MSP for agriculture produce: Price floors on agricultural products are
designed to keep production levels and prices high. This incentivizes producers
to continue farming when the free market might otherwise incentivize them to
turn to other occupations. It also protects farmers against unpredictable
fluctuations in their [Link] price floors create a surplus of goods, when
governments implement agricultural price floors, they typically intervene in
the market by offering to buy the surplus directly from producers.
• A Price Floor on Wages (Minimum Wage Laws)
• Minimum wage: You can think of a minimum wage as a price floor set on the
price of labor. In this case, employers are on the demand side of the market
and employees are on the supply side of the market. The price floor regulates
the minimum wage that can be paid by employers to workers.
Price Ceiling
• A price ceiling, aka a price cap, is the highest
point at which goods and services can be
sold.
• It is a type of price control and the maximum
amount that can be charged for something.
• It often is set by government authorities to
help consumers, when it seems that prices
are excessively high or rising out of control.
• The price ceiling, Pc, is set by the government at a
level below the equilibrium price, leading to a
shortage (excess supply), since quantity demanded,
Qd is greater than quantity supplied, Qs.
• Note that to have an effect, the price ceiling must be
below the equilibrium price. If it were higher than the
equilibrium price, the market would achieve
equilibrium, and the price ceiling would have no
effect.
Examples
• Pharmaceutical Price Controls: Many countries implement price ceilings on
pharmaceutical drugs to make healthcare more affordable.
• Essential Commodities Act: India has used the Essential Commodities Act
to regulate the prices of various essential goods. This act enables the
government to declare certain commodities as essential and impose price
ceilings to ensure their availability at fair prices. Items typically covered under
this act include foodstuffs, fuels, and medicines. For example, the government
has periodically set price caps on pulses, edible oils, and sugar to control
inflation and ensure supply.
• Electricity and Utility Prices: Many countries and regions impose price
ceilings on utilities like electricity and water to ensure that these essential
services remain affordable for all consumers.
Consumer & Producer Surplus
 Consumer & Producer Surplus
• Buyers always want to pay less, and sellers always want to get paid more. But is there a “right
price” for a product from the standpoint of society as a whole?
• Earlier we saw how, in market economies, the forces of supply and demand determine the
prices of goods and services and the quantities sold.
• So far, however, we have described the way markets allocate scarce resources without
directly addressing the question of whether these market allocations are desirable.
• In other words, our analysis has been positive (what is) rather than normative (what should
be).
• Now we take up the topic of welfare economics, the study of how the allocation of
resources affects economic well-being.
• We begin by examining the benefits that buyers and sellers receive from taking part in a
market.
• We then examine how society can make these benefits as large as possible.
• This analysis leads to a profound conclusion: The equilibrium of supply and demand in a
market maximizes the total benefits received by buyers and sellers.
Consumer Surplus
Topics to be covered:

• Concept of Consumer Surplus: Willingness to Pay

• Using the Demand Curve to Measure Consumer Surplus
• How a lower price raises Consumer Surplus
• What does Consumer Surplus measure?
Consumer Surplus: Willingness to Pay
• Definition: a buyer’s willingness to pay minus the amount the buyer actually pays

• Imagine that you own a rare recording of Elvis Presley’s first album. You decide to auction it.
• Four Elvis fans show up for your auction: John, Paul, George, and Ringo. Each of them would
like to own the album, but there is a limit to the amount that each is willing to pay for it.
• The maximum price that a buyer would pay is called- willingness to pay, and it measures Buyer Willingness
how much that buyer values the good. to pay
• At a Price < Buyer’s Willingness to pay; buyer would be eager to buy John $100
• At a Price > Buyer’s Willingness to pay; buyer would refuse to buy
Paul 80
• At a Price = Buyer’s Willingness to pay; buyer would be indifferent to buying the album
George 70
To sell your album, you begin the bidding at a low price, say $10. Because all four buyers are Ringo 50
willing to pay much more, the price rises quickly. The bidding stops when John bids $80 (or
slightly more). At this point, Paul, George, and Ringo have dropped out of the bidding, because
they are unwilling to bid any more than $80. John pays you $80 and gets the album. Note that
the album has gone to the buyer who values the album most highly.
• What benefit does John receive from buying the Elvis Presley album? In a sense, John has
found a real bargain: He is willing to pay $100 for the album but pays only $80 for it.
• We say that John receives consumer surplus of $20. Consumer surplus is the amount
a buyer is willing to pay for a good minus the amount the buyer actually pays for it.
• Consumer surplus measures the benefit to buyers of participating in a market. Paul, George,
and Ringo get no consumer surplus from participating in the auction, because they left
without the album and without paying anything.
Using the demand curve to measure Consumer Surplus
• Consumer surplus is closely related to the demand curve for a product. To see how they are
related, let’s continue our example and consider the demand curve for this rare Elvis Presley
album.
• We begin by using the willingness to pay of the four possible buyers to find the demand
schedule for the album.
Buyers Price Quantity Demanded
None More than $100 0
John 80-100 1
John, Paul 70-80 2
John, Paul, George 50-70 3
John, Paul, George, Ringo 50 or less 4

• If the price is above $100, the quantity demanded in the market is 0, because no buyer is
willing to pay that much. If the price is between $80 and $100, the quantity demanded is 1,
because only John is willing to pay such a high price. If the price is between $70 and $80, the
quantity demanded is 2, because both John and Paul are willing to pay the price. In this way,
the demand schedule is derived from the willingness to pay of the four possible buyers.
• Here is the demand curve that corresponds to
the earlier demand schedule. Note the
relationship between the height of the demand
curve and the buyers’ willingness to pay.
• At any quantity, the price shows the
willingness to pay of the marginal buyer, the
buyer who would leave the market first if the
price were any higher. At a quantity of 4
albums, for instance, the demand curve has a
height of $50, the price that Ringo (the
marginal buyer) is willing to pay for an album.
• At a quantity of 3 albums, the demand curve
has a height of $70, the price that George (who
is now the marginal buyer) is willing to pay.

• Consumer Surplus- the price is $80 (or slightly

above), and the quantity demanded is 1. Note
that the area above the price and below the
demand curve equals $20.
How a lower price raises Consumer Surplus
• Because buyers always want to pay less for the goods they
buy, a lower price makes buyers of a good better off. But how
much does buyers’ well-being rise in response to a lower
price? We can use the concept of consumer surplus to answer
this question precisely.
• In panel (a), consumer surplus at a price of P1 is the area of
triangle ABC.
• Now suppose that the price falls from P1 to P2 , as shown in
panel (b).
• The consumer surplus now equals area ADF.

The increase in consumer surplus attributable to the lower

price is the area BCFD. This increase in consumer surplus is
composed of two parts.
a. Rectangle BCED: the increase in consumer surplus of
existing buyers (the reduction in the amount they pay); it
equals the area of the.
b. Triangle CEF: some new buyers enter the market because
they are now willing to buy the good at the lower price. As a
What does Consumer Surplus measure?
• Our goal in developing the concept of consumer surplus is to make normative judgments about
the desirability of market outcomes. Now that you have seen what consumer surplus is, let’s
consider whether it is a good measure of economic well-being.
• Consumer surplus is a good measure of economic well-being if policymakers want to respect
the preferences of buyers.
• In some circumstances, policymakers might choose not to care about consumer surplus
because they do not respect the preferences that drive buyer behavior. For example, drug
addicts are willing to pay a high price for drugs. From the standpoint of society, willingness to
pay in this instance is not a good measure of the buyers’ benefit, and consumer surplus is not
a good measure of economic well-being, because addicts are not looking after their own best
interests.
• In most markets, however, consumer surplus does reflect economic well-being. Economists
normally presume that buyers are rational when they make decisions and that their
preferences should be respected.
Practical Applications
1. Seasonal Discounts on Clothing: Imagine you're shopping for a new jacket, and you're willing to pay up to $200 for it
because it's a style you love and need for the upcoming winter. When you go to the store, you find the jacket on sale for
$150. Your consumer surplus is $50 because you were prepared to pay more than the sale price.
2. Early Bird Movie Tickets: Say a movie theater offers discounted tickets for the first show of the day. You value seeing a
new film at $15 because of the entertainment it provides, but with the early bird special, you only pay $10. Your consumer
surplus is $5.
3. Bulk Buying: A grocery store offers a discount if you buy in bulk. A single bottle of olive oil costs $10, but if you buy a
pack of six, it's $50. If you were willing to pay the full price of $60 for six (because you use it regularly), the bulk discount
gives you a consumer surplus of $10.
4. Last-Minute Travel Deals: You're planning a trip and are willing to spend $500 on a flight. A week before your trip, you
find a last-minute deal for $300. The $200 you save is your consumer surplus.
5. Electronic Gadgets Post-Holiday Sales: You've been eyeing a new smartphone that costs $800, and you've saved up
enough to buy it at that price. After the holiday season, the price drops to $650 due to a sale. By purchasing the phone at
the lower price, your consumer surplus is $150.
6. Subscription Services: A streaming service offers a yearly subscription for $100, but you value the service at $150
because of the wide range of shows and convenience. By subscribing, your consumer surplus for the year is $50.
7. Coupon Savings: If you have a coupon that saves you $2 on a loaf of bread that you were willing to pay full price for,
your consumer surplus is $2 each time you use a coupon.
8. Early Adoption of Technology: You're willing to pay a high price for the latest smartphone because being an early
adopter is valuable to you. Over time, the price of the smartphone decreases as new models are released. Late adopters
who buy the phone at the reduced price receive a greater consumer surplus than early adopters, as they get the same
phone for a lower price.
9. Energy-Efficient Appliances: You're in the market for a new refrigerator and are willing to pay a premium for one that is
energy-efficient, expecting to spend up to $1200. You find an energy-efficient model on sale for $900. The consumer
surplus here is not just the $300 saved but also the future savings on energy bills due to the efficiency of the appliance.
Producer Surplus
Topics to be covered:

• Concept of Producer Surplus: Cost & Willingness to Sell

• Using the Supply Curve to Measure Producer Surplus
• How a higher price raises Producer Surplus
Producer Surplus: Willingness to Sell
• Definition: the amount a seller is paid for a good minus the seller’s cost

• Imagine now that you are a homeowner, and you need to get your house painted. You turn to four
sellers of painting services: Mary, Frida, Georgia, and Grandma.
• You decide to take bids from the four painters and auction off the job to the painter who will do the
work for the lowest price.
• Each painter is willing to take the job if the price she would receive exceeds her cost of doing the
work.
• Here the term cost should be interpreted as the painters’ opportunity cost: It includes the painters’
out-of-pocket expenses (for paint, brushes, and so on) as well as the value that the painters place
on their own time.
• cost is a measure of her willingness to sell her services.
• When Price Received < Seller’s Willingness to Sell(Cost); Seller would not sell
• When Price Received > Seller’s Willingness to Sell(Cost); Seller would be eager to sell
• When Price Received > Seller’s Willingness to Sell(Cost); Seller would be indifferent to Sell

• When you take bids from the painters, the price might start off high, but it quickly falls as the
painters compete for the job.
• Once Grandma has bid $600 (or slightly less), she is the sole remaining bidder. Grandma is happy
to do the job for this price, because her cost is only $500.
• Mary, Frida, and Georgia are unwilling to do the job for less than $600. Note that the job goes to
the painter who can do the work at the lowest cost.
• What benefit does Grandma receive from getting the job? Because she is willing to do the work for
$500 but gets $600 for doing it, we say that she receives producer surplus of $100.
Using the Supply curve to measure Producer Surplus
• Just as consumer surplus is closely related to the demand curve, producer surplus is closely
related to the supply curve. To see how, let’s continue our example.
• We begin by using the costs of the four painters to find the supply schedule for painting
services.
Buyers Price Quantity Demanded
Mary, Frida, Georgia, More than $900 4
Grandma
Frida, Georgia, Grandma 800-900 3
Georgia, Grandma 600-800 2
Grandma 500-600 1
None Less than 500 0

• If the price is below $500, none of the four painters is willing to do the job, so the quantity
supplied is zero. If the price is between $500 and $600, only Grandma is willing to do the job,
so the quantity supplied is 1. If the price is between $600 and $800, Grandma and Georgia are
willing to do the job, so the quantity supplied is 2, and so on.
• In this way, the supply schedule is derived from the costs of the four painters.
• Note that the height of the supply
curve is related to the sellers’ costs.

• At any quantity, the price given by

the supply curve shows the cost of
the marginal seller, the seller who
would leave the market first if the
price were any lower. At a quantity
of 4 houses, for instance, the supply
curve has a height of $900, the cost
that Mary (the marginal seller)
incurs to provide her painting
services.
• At a quantity of 3 houses, the supply
curve has a height of $800, the cost
that Frida (who is now the marginal
seller) incurs.
• Because the supply curve reflects
sellers’ costs, we can use it to
measure producer surplus.
How a higher price raises Producer Surplus
• You will not be surprised to hear that sellers always want to
receive a higher price for the goods they sell. But how much
does sellers’ well-being rise in response to a higher price?
The concept of producer surplus offers a precise answer to
this question.
• In panel (a), the price is P1, and producer surplus is the area
of triangle ABC.
• Now suppose that the price increases from P1 to P2 , as
shown in panel (b).
• The producer surplus now equals area ADF.

The increase in producer surplus is composed of two parts.

a. Rectangle BCED: the increase in producer surplus of
existing sellers (they now get more for what they sell);
b. Triangle CEF: Some new sellers enter the market because
they are now willing to produce the good at the higher price,
resulting in an increase in the quantity supplied from Q1 to
Q2.
Deadweight Loss of Taxation

Topics to be covered:

Concept of Deadweight Loss of Tax

Determinants of Deadweight Loss of Tax: Elasticity Vs Inelasticity
Deadweight Loss of Tax & tax revenue as tax vary: Laffer’s curve
Deadweight Loss of Taxation
HOW A TAX AFFECTS MARKET PARTICIPANTS
• The benefit received by buyers in a market is measured by consumer
surplus—the amount buyers are willing to pay for the good minus the
amount they actually pay for it.
• The benefit received by sellers in a market is measured by producer surplus
—the amount sellers receive for the good minus their costs.
• Tax places a wedge between the price buyers pay and the price sellers
receive.
• Because of this tax wedge, the quantity sold falls below the level that would
be sold without a tax, consumer surplus & producer surplus also decrease.
• What about the third interested party, the government? If T is the size of the
tax and Q is the quantity of the good sold, then the government gets total
tax revenue of T *Q. It can use this tax revenue to provide services, such as
roads, police, and public education, or to help the needy. Keep in mind,
however, that this benefit actually accrues not to government but to those on
whom the revenue is spent.
• government’s tax revenue is represented by the rectangle between the
supply and demand curves.
• The height of this rectangle is the size of the tax, T, and the width of the
rectangle is the quantity of the good sold, Q. Because a rectangle’s area is
its height times its width, this rectangle’s area is T* Q, which equals the tax
revenue.
Welfare before tax and after tax
1. Without a tax, the price and quantity are found at the
intersection of the supply and demand curves. The price is P1, and
the quantity sold is Q1.
• consumer surplus = A + B + C.
• producer surplus= D + E + F.
• Total surplus, = A + B + C + D + E + F.

2. Now consider welfare after the tax is enacted.

• The price paid by buyers rises from P1 to PB, so consumer
surplus= area A.
• The price received by sellers falls from P1 to PS, so producer
surplus= area
• The quantity sold falls from Q1 to Q2, and
• the government collects tax revenue equal to the area B + D.
• total surplus is area A B D F.
• The area C + E measures the size of the deadweight
loss.
Deadweight loss C+E
• the tax makes buyers and sellers worse off and the government better off.
• The change in total welfare includes the change in consumer surplus (which is negative), the
change in producer surplus (which is also negative), and the change in tax revenue (which is
positive).
• When we add these three pieces together, we find that total surplus in the market falls by the
area C + E.
• Thus, the losses to buyers and sellers from a tax exceed the revenue raised by the
government.
• The fall in total surplus that results when a tax (or some other policy) distorts a market
outcome is called the deadweight loss.
• When a tax raises the price to buyers and lowers the price to sellers, it gives buyers an
incentive to consume less and sellers an incentive to produce less than they otherwise would.
• As buyers and sellers respond to these incentives, the size of the market shrinks below its
optimum.
• Thus, because taxes distort incentives, they cause markets to allocate resources inefficiently.
Determinants of Deadweight loss
• What determines whether the deadweight loss from a tax is large or small?
• The answer is the price elasticities of supply and demand, which measure how much the
quantity supplied and quantity demanded respond to changes in the price.
• A tax has a deadweight loss because it induces buyers and sellers to change their behavior.
The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers
the price received by sellers, so they produce less.
• The elasticities of supply and demand measure how much sellers and buyers respond to the
changes in the price and, therefore, determine how much the tax distorts the market outcome.
• Hence, the greater the elasticities of supply and demand, the greater the deadweight loss of a
tax.
Deadweight loss & tax revenue as tax vary
• Here we consider what happens to the deadweight loss and tax revenue when the size of a tax
changes.
• As the size of a tax, the deadweight loss grows larger and larger.
• Indeed, the deadweight loss of a tax rises even more rapidly than the size of the tax. The
reason is that the deadweight loss is an area of a triangle, and an area of a triangle depends
on the square of its size. If we double the size of a tax, for instance, the base and height of the
triangle double, so the deadweight loss rises by a factor of 4. If we triple the size of a tax, the
base and height triple, so the deadweight loss rises by a factor of 9.
• The government’s tax revenue is the size of the tax times the amount of the good sold. As
Figure 8-6 shows, tax revenue equals the area of the rectangle between the supply and
demand curves. For the small tax in panel (a), tax revenue is small. As the size of a tax rises
from panel (a) to panel (b), tax revenue grows. But as the size of the tax rises further from
panel (b) to panel (c), tax revenue falls because the higher tax drastically reduces the size of
the market. For a very large tax, no revenue would be raised, because people would stop
buying and selling the good altogether.
Laffer’s Curve
• HOW DEADWEIGHT LOSS AND TAX REVENUE
VARY WITH THE SIZE OF A TAX.
• Panel (a) shows that as the size of a tax grows
larger, the deadweight loss grows larger.
• Panel (b) shows that tax revenue first rises, then
falls. This relationship is sometimes called the
Laffer curve.