1 What are elasticities of supply and demand? How do short-run and long-run elasticities differ? Applications of supply, demand and elasticity. What are.

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• What are elasticities of supply and demand?• How do short-run and long-run elasticities differ?• Applications of supply, demand and elasticity.• What are the effects of government intervention

– price controls?

Reading: chapter 2

Lecture 2. The Elasticity of Supply and Demand

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Elasticities of Supply and Demand• Not only are we concerned with what direction

price and quantity will move when the market changes, but we are concerned about how much they change

• Elasticity gives a way to measure by how much a variable will change with the change in another variable

• Specifically, it gives the percentage change in one variable resulting from a one percent change in another

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Warm-up exercise

• People buy greeting cards and roses throughout the year. As Valentine’s Day approaches, however, cards and roses become necessities. The demand for both products jump and we expect the prices of both products to jump. The price of roses, however, always increases more sharply than the price of greeting cards. Why?

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Price Elasticity of Demand

• Measures the sensitivity of quantity demanded to price changes– It measures the percentage change in the

quantity demanded of a good that results from a one percent change in price

P

QE DDP

%

%

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Price Elasticity of Demand• The price elasticity of demand can also be written as:

P

Q

Q

P

PP

QQE D

P

• Since quantity demanded and price are negatively related, we drop the negative sign.

• e.g. the price elasticity of demand of 0.5 means that every 1% increase in price leads to a 0.5% decrease in quantity demanded.

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Price Elasticity of Demand• The primary determinant of price elasticity of demand is t

he availability of substitutes– Many substitutes, demand is price elastic

• Can easily move to another good with price increases

– Few substitutes, demand is price inelastic• Necessities vs. discretionary expenditure

. . . Basic food vs. restaurant meals• Budget share

. . . salt vs. car• Time horizon

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Price Elasticity of Demand

• Looking at a linear demand curve, the slope of the curve is constant, but as we move along the curve, P and Q will change;

so price elasticity along a linear demand curve is not constant– The top portion of a linear demand curve is elastic

• Price is high and quantity small

– The bottom portion of a linear demand curve is inelastic

• Price is low and quantity high

P

Q

Q

P

PP

QQE D

P

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Price Elasticity of a Linear Demand Curve

Q

Price

4

8

2

4

Ep = 1

Ep = 0

EP =

Elastic

Inelastic

The top portion of demand curve is elastic Price is high and quantity small

The bottom portion of demand curve is inelasticPrice is low and quantity high

P

Q

Q

P

PP

QQE D

P

0

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• Two extreme cases of demand curves

– Infinitely elastic demand: horizontal demand curve– Completely inelastic demand: vertical demand curve

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Infinitely Elastic Demand

DP*

Quantity

Price

EP =

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Completely Inelastic Demand

Quantity

Price

Q*

D

EP = 0

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Other Demand Elasticities

• Income Elasticity of Demand– Measures how much quantity demanded

changes with a change in income

I

Q

Q

I

I/I

Q/Q EI

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Other Demand Elasticities

• Cross-Price Elasticity of Demand– Measures the percentage change in the

quantity demanded of one good that results from a one percent change in the price of another good

m

b

b

m

mm

bbPQ P

Q

Q

P

PP

QQE

mb

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• Complements: Cars and Tires– Price of cars increases, quantity demanded of tires decreases

• Cross-price elasticity of demand is negative

• Substitutes: Butter and Margarine– Price of butter increases, quantity of margarine demanded increases

• Cross-price elasticity of demand is positive

b m

b bQ P

m m

Q QE

P P

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Price Elasticity of Supply

• Measures the sensitivity of quantity supplied given a change in price– Measures the percentage change in quantity

supplied resulting from a 1 percent change in price

P

QE SSP

%

%

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Point vs. Arc Elasticities• Point elasticity of demand

– Price elasticity of demand at a particular point on the demand curve

• Arc elasticity of demand– Price elasticity of demand calculated over a

range of prices

QP

PQE D

P

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Short-Run Versus Long-Run Elasticity

• Price elasticity varies with the amount of time consumers have to respond to a price

• Short-run demand and supply curves often look very different from their long-run counterparts

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Short-Run Versus Long-Run Elasticity

• Demand– In general, demand is much more price elastic

in the long run• Consumers take time to adjust consumption habits• Demand might be linked to another good that

changes slowly• More substitutes are usually available in the long

run

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Gasoline: Short-Run and Long-Run Demand Curves

DSR

DLR

• People cannot easily adjust consumption in the short run.• In the long run, people tend to drive smaller and more fuel efficient cars.

Quantity of Gas

Price

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• Demand and Durability– For some durable goods, demand is more

elastic in the short run– If goods are durable, then when price

increases, consumers choose to hold on to the good instead of replacing it

– But in long run, older durable goods will have to be replaced

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Short-Run Versus Long-Run Elasticity

• Income elasticity also varies with the amount of time consumers have to respond to an income change– For most goods and services, income

elasticity is larger in the long run– When income changes, it takes time to adjust

spending

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SSR

Quantity

Price

Short-Run Versus Long-Run Supply Elasticity

SLR

Due to limitedcapacity, firmsare limited by

output constraintsin the short run.

In the long run, theycan expand.

Most goods and services:Long-run price elasticity of supply is greater than short-run price elasticity of supply

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Short-Run vs. Long-Run Elasticity – An Application

• Demand and supply are more elastic in the long run

• In the very short run, supply is completely inelastic– E.g. Weather may destroy part of the fixed

supply, decreasing supply

• Demand is relatively inelastic as well

• Price increases significantly

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D

P0

S

Q0 Quantity

PriceA freeze or drought

decreases the supplyof coffee

S’

Q1

An Example - Coffee

Price increases significantly due to inelastic supply and

demand

P1

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Elasticity: An Application

• During the 1980’s and 1990’s, the market for wheat went through changes that had great implications for American farmers and US agricultural policy

• Using the supply and demand curves for wheat, we can analyze what occurred in this market

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Elasticity: An Application• Supply: QS = 1800 + 240P• Demand: QD = 3550 – 266P• At equilibrium: QS = QD

1800 + 240P = 3550 – 266P506P = 1750

P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million bushels

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Elasticity: An Application

• We can find the elasticities of demand and supply at these points

3.46( 266) .035

2,630D DP

QPE

Q P

3.46(240) .032

2,630S SP

QPE

Q P

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Elasticity: An Application

• If the price of wheat rose to $4.00/bushel due to decrease in supply

3,550 (266)(4.00) 2,486DQ

4.00( 266) 0.43

2,486DPE

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Effects of Price Controls

• Markets are rarely free of government intervention– Imposed taxes and granted subsidies– Price controls

• Price controls usually hold the price above or below the equilibrium price

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Policy 1: price ceiling• Price ceiling: a legal maximum on the price

(to be effective, it has to be lower than the equilibrium price)

• Examples: price ceiling on gasoline; rent control

• Objectives of the price control: promotion of equity (or to satisfy voters?)

• What are the likely outcomes of the policy?

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D

Effects of Price Ceiling

Quantity

Price

P0

Q0

S

Pmax

• Price is regulated to be no higher than Pmax• Quantity supplied falls and quantity demanded increases• A shortage results

QS

QD

Shortage

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Effects of Price Ceiling

• Excess demand sometimes takes the form of queues– Lines at gas stations during shortage

• Sometimes get curtailments and supply rationing– Natural gas shortage of the mid ’70’s

• Producers/suppliers typically lose, but some consumers gain. Some consumers lose.

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Price Controls andNatural Gas Shortages

• In 1954, the federal government began regulating the wellhead price of natural gas

• In 1962, the ceiling prices that were imposed became binding and shortages resulted

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Price Controls andNatural Gas Shortages

• Price controls created an excess demand of 7 trillion cubic feet

• Price regulation was a major component of US energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s

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Questions for discussion• What are the problems with rent control?

• Who will lose and who will gain?

• What do you think are better alternatives to rent control?

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A Rent Control

Quantity (thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

0 44 72 100 150

12

16

20

24

D

S

Housingshortage

Rentceiling a

b

e

Search time increases

Black market may develop

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Policy 2: price floor• Price floor: a legal minimum on the price

that can be charged (to be effective, it has to be higher than the equilibrium price)

• Example: minimum wage• Objectives of the price control: promotion

of equity (or to satisfy voters?)• what will be the impact on youth workers?

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Policy 2: price floor

Price

Quantity

demand

supply

q

p

With the price floor at pmin, there is excess supply of qS - qD.

pminAs a result, unemployed young workers may rise.

and some may willing to accept lower (illegal) wage rate in order to work

qSqD

Without the price floor, the market equilibrium is (p, q).

pill