Ch04 - wps.prenhall.com

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Prepared by: Fernando QuijanoPrepared by: Fernando Quijanoand Yvonn Quijanoand Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Price System, Demand and Supply, and Elasticity

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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair 2 of 42

The Price System:Rationing and Allocating Resources

• The market system, performs two important and closely related functions:

1. Resource allocation: the market system determines the allocation of resources among produces and the final mix of outputs.

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The Price System:Rationing and Allocating Resources

• The market system, performs two important and closely related functions:

2. Price rationing: the market system distributes goods and services on the basis of willingness and ability to pay.

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Price Rationing

• A decrease in supply creates a shortage at the original price.

• The lower supply is rationed to those who are willing and able to pay the higher price.

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Price Rationing

• There is some price that will clear any market.

• The price of a rare painting will eliminate excess demand until there is only one bidder willing to buy the single available painting.

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Constraints on the Market

• A price ceiling is a maximum price that sellers may charge for a good, usually set by government.

• In 1974, the government set a price ceiling to distribute the available supply of gasoline.

• At an imposed price of 57 cents per gallon, the result was excess demand.

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Alternative Rationing Mechanisms

• Queuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services.

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• Favored customers are those who receive special treatment from dealers during situations when there is excess demand.

• Ration coupons are tickets or coupons that entitle individuals to purchase a certain amount of a given product per month.

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• Attempts to restrict prices often result in the evolution of a black market.

• A black market is a market in which illegal trading takes place at market-determined prices.

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• The problem with rationing systems is that excess demand is created but not eliminated.

• No matter how good the intentions of private organizations and governments, it is very difficult to prevent the price system from operating and to stop the willingness to pay from asserting itself.

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Prices and the Allocation of Resources

• Price changes resulting from shifts of demand cause profits to rise or fall.

• Profits attract capital; losses lead to disinvestment.

• Higher wages attract labor and encourage workers to acquire skills.

• At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.

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Price Floors

• A price floor is a minimum price below which exchange is not permitted.

• The most common example of a price floor is the minimum wage, which is a floor set under the price of labor.

• The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded.

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Supply and Demand Analysis:An Oil Import Fee

• At a world price of $18, imports are 5.9 million barrels per day.

• The tax on imports causes an increase in domestic production, and quantity imported falls.

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Supply and Demandand Market Efficiency

• Supply and demand curves can be used to illustrate the idea of market efficiency, an important aspect of “normative economics.”

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Consumer Surplus

• Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price.

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Consumer Surplus

• Some consumers are willing to pay as much as $5 each for hamburgers.

• Since the price is only $2.50, they receive a consumer surplus of $2.50.

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Consumer Surplus

• Others are willing to pay something less than $5.00 but more than $2.50.

• Consumer surplus is the area below the demand curve and above the price level.

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Producer Surplus

• Producer surplus is the difference between the maximum amount a producer is willing to accept to supply a good and its current market price.

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Producer Surplus

• Some producers are willing to accept as little as 75 cents each for hamburgers.

• Since the price is $2.50, they receive a producer surplus of $1.75 per hamburger.

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Producer Surplus

• Others producers are willing to receive something less than $5.00 but higher than 75 cents.

• Producer surplus is the area above the supply curve and below the price level.

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Markets Maximize the Sum of Producer and Consumer Surplus

• Total producer and consumer surplus is highest where supply and demand curves intersect at equilibrium.

• Consumers receive benefits in excess of what they pay and producers receive compensation in excess of costs.

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Markets Maximize the Sum of Producer and Consumer Surplus

• If the market produces too little, say 4 million instead of 7 million hamburgers per month, total producer and consumer surplus is reduced. This reduction (triangle ABC) is called a deadweight loss.

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Potential Causes of Deadweight Loss From Under- and Overproduction

• Deadweight losses can occur from under- and overproduction.

• If the market produces 10 million instead of 7 million hamburgers per month, the cost of production rises above the willingness of consumers to pay, resulting in a deadweight loss.

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Elasticity

• Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

elasticity of A with respect t o BA

B=

%

%

∆∆

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Price Elasticity of Demand

•• A popular measure of elasticity isA popular measure of elasticity isprice elasticity of demand price elasticity of demand measures how responsive measures how responsive consumers are to changes in the consumers are to changes in the price of a product.price of a product.

price elasticity of demand % change in quantity demanded

change in price=

%

• The value of demand elasticity is

always negative, but it is stated in

absolute terms.

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Slope and Elasticity

• The value of the slope of the demand curve and the value of elasticity are not the same.

• Unlike the value of the slope, the value of elasticity is a useful measure of responsiveness.

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Slope and Elasticity

• Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical.

231slope1055−==−− 231slope1608080−==−−

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Types of Elasticity

Elastic

Unitarily elastic

Inelastic

Perfectly inelastic

-3.0-30%+10%Bananas

-1.0-10%+10%Beef

-0.1-1%+10%Basic telephone service

0.00%+10%Insulin

ELASTICITY(%∆∆∆∆QD dddd %∆∆∆∆P)

% CHANGE IN QUANTITY DEMANDED

(%∆∆∆∆QD)

% CHANGE IN PRICE

(%∆∆∆∆P)PRODUCT

Hypothetical Demand Elasticities for Four Products

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Perfectly Elastic andPerfectly Inelastic Demand Curves

• When demand does not respond at all to a change in price, demand is perfectly inelastic.

• Demand is perfectly elasticwhen quantity demanded drops to zero at the slightest increase in price.

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Calculating Elasticities

• Calculating percentage changes:

% change in quantity demanded x 100%2=−Q QQ

1

1

% change in price x 100%2=−P PP

1

1

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• Elasticity is a ratio of percentages.

price elasticity of demand =+−

= −100%

33 3%30

..

• Using the values on the

graph to compute

elasticity, using

percentage changes

yields the following

result:

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• A more accurate way of computing elasticity than percentage changes is the midpoint formula:

%

%( ) /

( ) /

∆∆Q

P

Q Q

Q QP PP P

d =

−+

−+

2 1

1 2

2 1

1 2

2100%

2

x

x 100%

%

%( ) /

( ) /

. .∆∆Q

Pd =

−+

−+

= = −

10 55 10 2

100%

2 33 2 2

57 5 167

x

x 100%

x 100%

-12.5

x 100% =

66.7%

-40.0%

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Here is how to interpret two different values of elasticity:

• When ε = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded.

• When ε = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

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Elasticity Changes along aStraight-Line Demand Curve

• Price elasticity of demand decreases as we move downward along a straight line demand curve.

• Demand is elastic in the upper range and inelastic in the lower range of the line.

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Elasticity Changes along a Straight-Line Demand Curve

• Along the elastic range, elasticity values are greater than one.

− 6.4

− .29 • Along the inelastic range, elasticity values are less than one.

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Elasticity and Total Revenue

• When demand is inelastic, price and total revenues are directly related. Price increases generate higher revenues.

• When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues.

Total revenue does not change

Total revenue does not change

Same percentage change in quantity and price

Equal to 1.0Unitary elastic

Total revenue decreases

Total revenue increases

Smaller percentage change in quantity

Less than 1.0Inelastic

Total revenue increases

Total revenue decreases

Larger percentage change in quantity

Greater than 1.0

Elastic

Effect of a decrease in price on total revenue

Effect of an increase in price on total revenue

Change in quantity versus change in priceValue of Ed

Type of demand

TR P Q= ×

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The Determinants ofDemand Elasticity

• Availability of substitutes -- demand is more elastic when there are more substitutes for the product.

• Importance of the item in the budget -- demand is more elastic when the item is a more significant portion of the consumer’s budget.

• Time dimension -- demand becomes more elastic over time.

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C H

A P

T E

R 4

: Th

e Pr

ice

Syst

em, D

eman

d an

d Su

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, and

Ela

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4:

The

Pric

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stem

, Dem

and

and

Supp

ly, a

nd E

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ticity

ticity


Other Important Elasticities

• Income elasticity of demand –measures the responsiveness of demand to changes in income.

income elasticity of demand % change in quantity demanded

change in income=

%

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C H

A P

T E

R 4

: Th

e Pr

ice

Syst

em, D

eman

d an

d Su

pply

, and

Ela

sC

H A

P T

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4:

The

Pric

e Sy

stem

, Dem

and

and

Supp

ly, a

nd E

las

ticity

ticity



• Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good.

cross - price elasticity of demand % change in quantity of demanded

change in price of =

YX%

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C H

A P

T E

R 4

: Th

e Pr

ice

Syst

em, D

eman

d an

d Su

pply

, and

Ela

sC

H A

P T

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4:

The

Pric

e Sy

stem

, Dem

and

and

Supp

ly, a

nd E

las

ticity

ticity



• Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.

elasticity of supply % change in quantity supplied

change in price=

%

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C H

A P

T E

R 4

: Th

e Pr

ice

Syst

em, D

eman

d an

d Su

pply

, and

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H A

P T

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4:

The

Pric

e Sy

stem

, Dem

and

and

Supp

ly, a

nd E

las

ticity

ticity



• Elasticity of labor supply: A measure of the response of labor supplied to a change in the price of labor.

elasticity of labor supply% change in quantity of labor supplied

change in the wage rate=

%

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C H

A P

T E

R 4

: Th

e Pr

ice

Syst

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eman

d an

d Su

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, and

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P T

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4:

The

Pric

e Sy

stem

, Dem

and

and

Supp

ly, a

nd E

las

ticity

ticity


Review Terms and Concepts

black marketblack market

consumer surplusconsumer surplus

crosscross--price elasticity of price elasticity of demanddemand

deadweight lossdeadweight loss

elastic demandelastic demand

elasticityelasticity

elasticity of labor supplyelasticity of labor supply

elasticity of supplyelasticity of supply

favored customersfavored customers

price floorprice floor

price rationingprice rationing

producer surplusproducer surplus

queuingqueuing

ration couponsration coupons

unitary elasticityunitary elasticity

income elasticity of income elasticity of demanddemand

inelastic demandinelastic demand

midpoint formulamidpoint formula

minimum wageminimum wage

perfectly elastic demandperfectly elastic demand

perfectly inelastic perfectly inelastic demanddemand

price ceilingprice ceiling

price elasticity of price elasticity of demanddemand

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Ch04 - wps.prenhall.com

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