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• The market system, also called the The market system, also called the price price system,system, performs two important and performs two important and closely related functions : closely related functions :
• Price rationingPrice rationing is the is the process by which the process by which the market system allocates market system allocates goods and services to goods and services to consumers when quantity consumers when quantity demanded exceeds demanded exceeds quantity supplied.quantity supplied.
• A decrease in supply A decrease in supply creates a shortage at creates a shortage at PP00. Quantity demanded . Quantity demanded
is greater than quantity is greater than quantity supplied. Price will supplied. Price will begin to rise.begin to rise.
• The lower total supply The lower total supply is is rationed to those rationed to those who are willing and who are willing and able to payable to pay the higher the higher price.price.
• There is some price There is some price that will clear any that will clear any market.market.
• The price of a rare The price of a rare painting will eliminate painting will eliminate excess demand until excess demand until there is only one bidder there is only one bidder willing to buy the single willing to buy the single available painting.available painting.
Alternative Rationing MechanismsAlternative Rationing Mechanisms
• Favored customersFavored 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.
• The problem with these alternatives is that The problem with these alternatives is that excess demand is created but not eliminated.excess demand is created but not eliminated.
Alternative Rationing MechanismsAlternative Rationing Mechanisms
• In 1974, the In 1974, the government used an government used an alternative rationing alternative rationing system to distribute the system to distribute the available supply of available supply of gasoline.gasoline.
• At an imposed price of At an imposed price of 57 cents per gallon, the 57 cents per gallon, the result was excess result was excess demand.demand.
Alternative Rationing MechanismsAlternative Rationing Mechanisms
• A A black marketblack market is a is a market in which illegal market in which illegal trading takes place at trading takes place at market-determined market-determined prices.prices.
Alternative Rationing MechanismsAlternative Rationing Mechanisms
• No matter how good the intentions of private No matter how good the intentions of private organizations and governments, it is very organizations and governments, it is very difficult to prevent the price system from difficult to prevent the price system from operating and to stop the willingness to pay operating and to stop the willingness to pay from asserting itself.from asserting itself.
• With favored customers and black markets, the With favored customers and black markets, the final distribution may be even more unfair than final distribution may be even more unfair than that which would result from simple price that which would result from simple price rationing.rationing.
Prices and the Allocation of ResourcesPrices and the Allocation of Resources
• Price changes resulting from shifts of demand in output Price changes resulting from shifts of demand in output markets cause profits to rise or fall.markets cause profits to rise or fall.
• Profits attract capital; losses lead to disinvestment.Profits attract capital; losses lead to disinvestment.
• Higher wages attract labor and encourage workers to Higher wages attract labor and encourage workers to acquire skills.acquire skills.
• At the core of the system, supply, demand, and prices in At the core of the system, supply, demand, and prices in input and output markets determine the allocation of input and output markets determine the allocation of resources and the ultimate combinations of things resources and the ultimate combinations of things produced.produced.
Supply and Demand Analysis:Supply and Demand Analysis:An Oil Import FeeAn Oil Import Fee
• At a world price of $18, At a world price of $18, imports are 5.9 million barrels imports are 5.9 million barrels per day.per day.
• The tax on imports causes an The tax on imports causes an increase in domestic production, increase in domestic production, and quantity imported falls.and quantity imported falls.
• Elasticity is a general concept that can be used Elasticity is a general concept that can be used to quantify the response in one variable when to quantify the response in one variable when another variable changes.another variable changes.
e lastic ity o f A w ith resp ec t to BA
B
%
%
• Price elasticity of demand Price elasticity of demand measures how measures how responsive consumers are to changes in the responsive consumers are to changes in the price of a product.price of a product.
• Elasticity is a Elasticity is a ratio of percentagesratio of percentages, and it involves , and it involves computing percentage changes.computing percentage changes.
% ch an g e in q u an tity d em an d ed x 1 0 0 %2Q Q
Q1
1
p rice e las tic ity o f d em an d
1 0 0 %
3 3 3 %3 0
..
• Using the values on the graph to compute elasticity, then:
Elasticity Changes along a Straight-Line Elasticity Changes along a Straight-Line Demand CurveDemand Curve
• Price elasticity of demand Price elasticity of demand decreases as we move decreases as we move downward along a linear downward along a linear demand curve.demand curve.
• Demand is elastic on the upper part of the demand curve and inelastic on the lower part.
Elasticity and Total RevenueElasticity and Total Revenue
• When demand is When demand is inelasticinelastic, price and total revenues are , price and total revenues are directlydirectly related. Price increases generate higher revenues.related. Price increases generate higher revenues.
• When demand is When demand is elasticelastic, price and total revenues are , price and total revenues are indirectlyindirectly related. Price increases generate lower revenues.related. Price increases generate lower revenues.
Type of Type of demanddemand Value of EValue of Edd
Change in quantity Change in quantity versus change in versus change in priceprice
Effect of an Effect of an increase in increase in price on total price on total revenuerevenue
Effect of a Effect of a decrease in price decrease in price on total revenueon total revenue
ElasticElastic Greater than Greater than 1.01.0
Larger percentage change Larger percentage change in quantityin quantity
Total revenue Total revenue decreasesdecreases
Total revenue Total revenue increasesincreases
InelasticInelastic Less than 1.0Less than 1.0 Smaller percentage Smaller percentage change in quantitychange in quantity
Total revenue Total revenue increasesincreases
Total revenue Total revenue decreasesdecreases
Unitary Unitary elasticelastic
Equal to 1.0Equal to 1.0 Same percentage change Same percentage change in quantity and pricein quantity and price
Total revenue Total revenue does not changedoes not change
Total revenue does Total revenue does not changenot change
Determinants of Demand ElasticityDeterminants of Demand Elasticity
• Availability of substitutes Availability of substitutes -- -- demand is more elastic when there demand is more elastic when there are more substitutes for the product.are more substitutes for the product.
• Importance of the item in the Importance of the item in the budget budget -- demand is more elastic -- demand is more elastic when the item is a more significant when the item is a more significant portion of the consumer’s budget.portion of the consumer’s budget.
• Time frame Time frame -- demand becomes -- demand becomes more elastic over time.more elastic over time.
Other Important ElasticitiesOther Important Elasticities
• Income elasticity of demandIncome elasticity of demand – measures the – measures the responsiveness of demand to changes in responsiveness of demand to changes in income.income.
in co m e e la stic ity o f d em an d % ch an g e in q u an tity d em an d ed
Other Important ElasticitiesOther Important Elasticities
• Cross-price elasticity of demand:Cross-price elasticity of demand: A A measure of the response of the quantity of one measure of the response of the quantity of one good demanded to a change in the price of good demanded to a change in the price of another good.another good.
cro ss - p rice e las tic ity o f d em an d % ch an g e in q u an tity o f d em an d ed
Other Important ElasticitiesOther Important Elasticities
• Elasticity of supply:Elasticity of supply: A measure of the A measure of the response of quantity of a good supplied to a response of quantity of a good supplied to a change in price of that good. Likely to be change in price of that good. Likely to be positive in output markets.positive in output markets.
e lastic ity o f su p p ly % ch an g e in q u an tity su p p lied
Other Important ElasticitiesOther Important Elasticities
• Elasticity of labor supply:Elasticity of labor supply: A measure of the A measure of the response of labor supplied to a change in the response of labor supplied to a change in the price of labor.price of labor.
e lastic ity o f lab o r su p p ly% ch an g e in q u an tity o f lab o r su p p lied