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Slides by: John & Pamela Hall
ECONOMICS 3e / HALL & LIEBERMANWORKING WITH SUPPLY AND DEMAND© 2005 South-Western/Thomson Learning
Working with Supply and Demand
2
Price Ceilings
• Government-imposed maximum price that prevents the price of a good from rising above a certain level in a market
• Short side of the Market– Smaller of quantity supplied and quantity demanded at a particular
price– When quantity supplied and quantity demanded differ, short side of
market will prevail• Price ceiling creates a shortage and increases the time
and trouble required to buy the good– While the price decreases, the opportunity cost may rise
• Black Market– A market created by unintended consequences of government
intervention• Goods are sold illegally at a price above the legal ceiling
3
Figure 1: A Price Ceiling in the Market for Maple Syrup
Numberof Bottles ofMaple Syrup
Price
perBottle
5,000
E
D
S
3.00
T$4.00
R
6,0004,000
V2.00
4
Price Floors
• Government imposed minimum amount below which price is not permitted to fall– Price floors for agricultural goods are commonly called price
support programs
• When sellers produce more of the good than buyers want at the price floor – Remaining goods become a surplus that no one wants at the
imposed price
• Government responds by maintaining price floors – Uses taxpayer dollars to buy up entire excess supply of the good
in question– Prevents excess supply from doing what it would ordinarily do
• Drive price down to its equilibrium value
5
Figure 2: A Price Floor in the Market for Nonfat Dry Milk
Millions
of Pounds
Price
perPound
200
0.80
S
D
A
220180
K$0.90
J
6
Limiting Surplus
• A price floor creates a surplus of goods– In order to maintain price floor, government
must prevent surplus from driving down market price
• Government often accomplishes this goal by purchasing surplus with taxpayers dollars
• Price floors often get government deeply involved in production decisions– Rather than leaving them to the market
7
The Problem with Rate Change
• Rate of change of quantity demanded compared to the change in price is not a good measure of price sensitivity– Doesn’t tell whether a change in price or a
change in quantity demanded is a relatively large or relatively small change
• Relative means compared to value of price or quantity before change
8
The Elasticity Approach
• Elasticity approach improves on the problems with rate of change – By comparing percentage change in quantity demanded with percentage
change in price
• Price elasticity of demand (ED) for a good is percentage change in quantity demanded divided by percentage change in price
– Will virtually always be a negative number– Tells us percentage change in quantity demanded for each 1%
increase in price• Price elasticity of demand tells us percentage change in quantity
demanded caused by a 1% rise in price as we move along a demand curve from one point to another
P%Q%E
D
D
9
Calculating Price Elasticity of Demand
• When calculating elasticity base value for percentage changes in price or quantity is always midway between initial value and new value– When price changes from any value P0 to any other value P1, we
define the percentage change in price as
2
)(
)( Price in Change %
PPPP
01
01
– When quantity demanded changes from Q0 to Q1, percentage change is calculated as
2
)_( DemandedQuantity in Change %
01
01
QQQQ
10
Figure 3: Calculating Price Elasticity of Demand
11
An Example: Calculating Price Elasticity of Demand
• Now let’s calculate an elasticity of demand for laptop computers using data in Figure 3 from point A to point B
percent 2.18 or ,182.0000,550
000,100
2)000,600000,500()000,600000,500(
DemandedQuantity in Change %
• Use percentage changes for price and quantity to calculate price elasticity of demand (ED)
percent 40.0 or ,400.0250,1$
500$
2)000,1$500,1($)000,1$500,1($
Price in Change %
46.0400.0
182.0ED
12
Elasticity and Straight-Line Demand Curves
• As we move upward and leftward along a straight-line demand curve – Same absolute increment in price will correspond to smaller and
smaller percentage increments in price• Because base price used to calculate percentage changes keeps rising
• As we move upward and leftward along a straight-line demand curve – Same absolute decrease in quantity corresponds to larger and
larger percentage decreases in quantity• As we move upward and leftward by equal distances,
percentage change in quantity rises– Percentage change in price falls
• Elasticity of demand varies along a straight-line demand curve– Demand becomes more elastic as we move upward and leftward
13
Figure 4: Elasticity and Straight-Line Demand Curves
14
Categorizing Goods by Elasticity
• Inelastic Demand– Price elasticity of demand between 0 and -1
1.0 Price in Change %
DemandedQuantity in Change % DemandInelastic
|% Change in Quantity Demanded| < |% Change in Price|
• Perfectly Inelastic Demand– Price elasticity of demand equal to 0
15
Categorizing Goods by Elasticity
• Elastic Demand– Price elasticity of demand with absolute value > 1
|% Change in Quantity Demanded| > |% Change in Price|
• Perfectly (infinitely) Elastic Demand– Price elasticity of demand approaching minus infinity
• Unitary Elastic Demand– Price elasticity of demand equal to -1
1 Price in Change %
DemandedQuantity in Change % DemandElastic
16
Figure 5: Extreme Cases of Demand
17
Elasticity and Total Revenue
• Total revenue (TR) of all firms in the market is defined as
• TR = P x Q
• When two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes– Applying this to total revenue
• % Change in TR = % Change in Price + % Change in Quantity Demanded
• Assume demand is unitary elastic and Q rises by 10% – % Change in TR = 10% + (-10%) = 0
18
Elasticity and Total Revenue
• If demand is inelastic, a 10% rise in price will cause quantity demanded to fall by less than 10%– % change in TR = 10% + (something less
negative than –10%) > 0
• If demand is elastic, so that Q falls by more than 10%– TR will fall
• % Change in TR = 10% + (something more negative than -10%) < 0
19
Elasticity and Total Revenue
• Where demand is inelastic, total revenue moves in same direction as price
• Where demand is elastic, total revenue moves in opposite direction from price
• Where demand is unitary elastic, total revenue remains the same as price changes
• At any point on a demand curve sellers’ total revenue (buyers’ total expenditure) is the area of a rectangle – Width equal to quantity demanded – Height equal to price
20
Figure 6: Elasticity and Total Expenditure
Quantity of Laptops
Price per
Laptop
A
D
100,000 200,000 300,000 400,000 500,000 600,000
$3,500
3,000
2,500
2,000
1,500
1,000
500
B
21
Availability of Substitutes
• Demand is more elastic– If close substitutes are easy to find and buyers
can cut back on purchases of the good in question
• Demand is less elastic – If close substitutes are difficult to find and
buyers can not cut back on purchases of the good in question
22
Narrowness of Market
• More narrowly we define a good, easier it is to find substitutes– More elastic is demand for the good
• More broadly we define a good– Harder it is to find substitutes and the less
elastic is demand for the good
• Different things are assumed constant when we use a narrow definition compared with a broader definition
23
Necessities vs. Luxuries
• The more “necessary” we regard an item, the harder it is to find a substitute– Expect it to be less price elastic
• The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute– Expect it to be more price elastic
24
Time Horizon
• Short-run elasticity– Measured a short time after a price change
• Long-run elasticity– Measured a year or more after a price change
• Usually easier to find substitutes for an item in the long run than in the short run– Therefore, demand tends to be more elastic in the long
run than in the short run
25
Importance in the Buyer’s Budget
• The more of their total budgets that households spend on an item– The more elastic is demand for that item
• The less of their total budgets that households spend on an item– The less elastic is demand for that item
26
Using Price Elasticity of Demand: The War on Drugs
• Every year U.S. Government spends about $20 billion on efforts to restrict the supply of drugs
• Figure 9(a)– Market for heroin without government intervention
• Figure 9(b)– Result of government efforts to restrict supply (current
policy)
• Figure 9(c)– Results of an effective policy of reducing demand
27
Figure 7: The War on Drugs
Quantity
Price per Unit
P1
Q1
D1
A A
S1
Quantity
Price per Unit
Q1
D1
S1
Quantity
Price per Unit
P1
Q1
S1
D1
(a) (b) (c)
AP1
Q3
P3
D2
C
Q2
B
S2
P2
28
Using Price Elasticity of Demand: Mass Transit
• Elasticity studies show that long-run demand for mass transit is inelastic– Therefore, a rise in fare would increase revenues
• However, most cities do not raise transit fares due to– Desire to provide low-income households with
affordable transportation– Desire to manage traffic congestion– Desire to limit air pollution in the city
• An increase in fares would increase revenue– Would also decrease ridership and require the city to
sacrifice these other goals
29
Using Price Elasticity of Demand: An Oil Crisis
• For the past five decades, Middle East has been a geopolitical hot spot• Both military and economic government agencies ask “What if” questions
– If an event in the Middle East were to disrupt oil supplies, what would happen to the price of oil on world markets?
• Flipping the elasticity equation like so
DemandedQuantity in Change %
Price in Change %1
ED
• Tells us percentage rise in price that would bring about a 1 percent decrease in quantity demanded– Enables us to make reasonable forecasts about the impact of various
events on oil prices• Once we have established our forecasted oil prices we can then use that
data to examine effect that higher oil prices would have on many broader issues– Effect on U.S. inflation rate– Effect on number of flights offered by U.S. airlines
30
Income Elasticity of Demand
• Percentage change in quantity demanded divided by the percentage change in income– With all other influences on demand—including the
price of the good—remaining constant
Income in Change %
DemandedQuantity in change %EY
• Interpret this number as percentage increase in quantity demanded for each 1% rise in income
31
Income Elasticity of Demand
• Income elasticities vs. price elasticities of demand– Price elasticity of demand
• Measures effect of change in price of good – Assumes that other influences on demand, including income,
remain unchanged
– Income elasticity • Measures effect on demand we would observe if income
changed and all other influences on demand—including price of the good—remained the same
• Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant
32
Income Elasticity of Demand
• Another difference between price and income elasticity of demand– Price elasticity measures sensitivity of demand
to price as we move along a demand curve from one point to another
– Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price
• While a price elasticity is virtually always negative– Income elasticity can be positive or negative
33
Income Elasticity of Demand
• Economic necessity– Good with an income elasticity of demand between 0 and 1
• Economic luxury– Good with an income elasticity of demand greater than 1
• An implication follows from these definitions– As income rises, proportion of income spent on economic
necessities will fall• While proportion of income spent on economic luxuries will rise
• But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior – Not by our judgment of a good’s importance to human survival
34
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand– Percentage change in quantity demanded of one good caused by a 1%
change in price of another good • While all other influences on demand remain unchanged
Z of Price in Change %
Demanded X ofQuantity in Change %EXZ
• While the sign of the cross-price elasticity helps us distinguish substitutes and complements among related goods• Its size tells us how closely the two goods are related
– A large absolute value for EXZ suggests that the two goods are close substitutes or complements
– While a small value suggests a weaker relationship
35
Price Elasticity of Supply
• Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good– With all other influences on supply held constant
Price in Change %
SuppliedQuantity in Change %ES
36
Price Elasticity of Supply
• When do we expect supply to be price elastic, and when do we expect it to be price inelastic? – Ease with which suppliers can find profitable activities
that are alternatives to producing the good in question• Supply will tend to be more elastic when suppliers can switch
to producing alternate goods more easily– When can we expect suppliers to have easy alternatives?
Depends on
» Nature of the good itself
» Narrowness of the market definition—especially geographic narrowness
» Time horizon—longer we wait after a price change, greater the supply response to a price change
37
Price Elasticity of Supply
• Extreme cases of supply elasticity– Perfectly inelastic supply curve is a vertical line
• Many markets display almost completely inelastic supply curves over very short periods of time
– Perfectly elastic supply curve is a horizontal line
38
Figure 8: Extreme Cases of Supply
39
The Tax on Airline Travel: Taxes and Market Equilibrium
• A tax on a particular good or service is called an excise tax– Shifts market supply curve upward by amount of tax
• For each quantity supplied, the new, higher curve tells us firms’ gross price, and the original, lower curve tells us the net price
• Who really pays excise taxes?– Buyers and sellers share in the payment of an excise
tax• Called tax shifting
– Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers)
40
Figure 9: The Tax on Airline Travel
41
Figure 10: Effect of Excise Tax on Airlines
42
Tax Incidence and Demand Elasticity
• In most cases excise tax will be shared by both buyer and seller– For a given supply curve, the more elastic is
demand, the more of an excise tax is paid by sellers
– The more inelastic is demand, the more of the tax is paid by buyers
43
Figure 11: Tax Incidence and Demand Elasticity
44
Tax Incidence and Supply Elasticity
• Although there are extreme cases of supply elasticity, in general the following is true– For a given demand curve, the more elastic is
supply, the more of an excise tax is paid by buyers
– The more inelastic is supply, the more of the tax is paid by sellers
45
Figure 12: Tax Incidence and Supply Elasticity
46
The Market For Food
• Shrinking and unstable incomes are problems for farmers
• The market for farm goods would reach an equilibrium if it were allowed to do so
• But farming seems to be special– Notion of small family farm has tremendous political
appeal– Farmers have banded together to form powerful and
effective government lobbies• Result has been continual government
interference with supply and demand in agricultural markets around the world
47
Figure 13: The Market For Food
Quantity of Food
Price per
Unit ofFood
P1
Q1
D
Sold technology
A
(a)
(b)
Quantityof Food
Price perUnit ofFood
D
SBad Weather
AP1
Q1 2
B
SGoodWeather
P2
Q
Snewtechnology
P2 B
Q2
48
Health Insurance and the Market for Health Care
• Health insurance has definite benefits to our society
• Our current health care system keeps patients from facing the full opportunity cost of their health care decisions– Can cause people to over consume health care
• Health insurance reduces buyers’ incentives to monitor their health care expenditures closely or to shop around for high-quality low-cost care
49
Figure 14: The Market For Health Care With Coinsurance
Examinations per Year
Price
per
Examination
100,000
A
Dbefore insurance
S
50
150,000
B
Dafter insurance
$100
70
