1 lecture 4 working with supply and demand price ceilings, price floors price elasticity of demand...
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Lecture 4 Working with Supply and Demand
• Price Ceilings, Price Floors
• Price Elasticity of Demand
• Elasticity and Total Revenue
• Determinants of price elasticity of demand
• Income Elasticity of Demand
• Cross-Price Elasticity of Demand
• Determinants of price elasticity of supply
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
60,00050,00040,000
TE
VR
D
S
$4.00
3.00
2.002. increases quantity
demanded
3. and decreases quantity supplied.
4. The result is a shortage – the distance between R and V.
Number of Bottles of Maple Syrup per Period
Price per Bottle
1. A price ceiling lower than the equilibrium price . . .
5. With a black market, the lower quantity sells for a higher price than initially.
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
2. decreases quantity demanded . . .
200180 220
$0.81
0.65
K J
S
D
A
4. The result is a surplus the – distance between K and J – which government must buy.
Millions of Pounds
Price per
Pound
1. A price floor higher than the equilibrium price . . .
3. and increases quantity supplied.
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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. USDA spent $500 million to buy 636 million pounds of surplus nonfat dry milk.
• Price floors often get government deeply involved in production decisions– Rather than leaving them to the market– Example: U.S. government developed a complicated
management system to control the production and sale of milk to manufacturers and processors.
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Benefits and costs of price floor for diary product
• Benefits: help farmer when they are in need. Many farmers who benefit from price floors are
wealthy or powerful who don’t need assistance.• Costs: (1) taxpayers’ money (2) consumers pay higher price ($10.4 billion from 1986 to 2001) (3) cost of health effect (calcium and protein
deficiencies)More cost effective if given directly to those truly in need.
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The Problem with Rate Change
• For a particular good, when price rises by $1, quantity demanded falls by 500 units per period.
(1)chocolate bars purchases in U.S. (2)private jets purchased in U.S.• 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
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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
10
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
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Figure 3: Calculating Price Elasticity of Demand
Quantity of Laptops
C
Price per Laptop
100,000 200,000 300,000 400,000 500,000 600,000
$3,500
3,000
2,500
2,000
1,500
1,000
B
A
D
D
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An Example: Calculating Price Elasticity of Demand
• Now let’s calculate an elasticity of demand for laptop computers using data in Figure 3 from point A to point B
percent 2.18 or ,182.0000,550
000,100
2)000,600000,500()000,600000,500(
DemandedQuantity in Change %
• Use percentage changes for price and quantity to calculate price elasticity of demand (ED)
percent 40.0 or ,400.0250,1$
500$
2)000,1$500,1($)000,1$500,1($
Price in Change %
46.0400.0
182.0ED
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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
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Calculating Price Elasticity of Demand from Point C to Point D
33.415.4%
66.7%-Demand of Elasticity
%4.15,154.0250,3$
$3,000)-($3,500Demanded Pricein Change %
% 7.66or ,667.0
2)000,200000,100()000,200000,100(
DemandedQuantity in Change %
or
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Figure 4: Elasticity and Straight-Line Demand Curves
Quantity
Price
and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases . . .
Since equal dollar increases (vertical arrows) are smaller and smaller percentage increases . . .
1
2
3
D
demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve.
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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 0Examples: – Drug ‘insulin’ for diabetics to control their
blood sugar. No substitutes. ‘Antibiotics’.– Addicts. Necessities.
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Categorizing Goods by Elasticity
• Elastic Demand– Price elasticity of demand with absolute value > 1
|% Change in Quantity Demanded| > |% Change in Price|
• Examples: Luxury goods• 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
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Figure 5: Extreme Cases of Demand
D
Perfectly Inelastic Demand
(a)
Quantity
Price per
Unit
1
2
3
$4
20 40 60 80 100
(b)
D
Quantity20 40 60 80 100
1
2
3
$4
Price per
Unit
Perfectly Elastic Demand
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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
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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
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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
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Figure 6: Elasticity and Total Expenditure
B
A
D
3. Moving from A to B, expenditure increases, so demand must be inelastic over that range.
1. At point A , where price is $1,000 and 600,000 laptops are demanded, revenue is $600 million.
2. At point B, revenue is $750 million.
Quantity of Laptops
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
Price per
Laptop
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Table: Some Short-Run Price Elasticities of Demand
Specific Brands
Narrow Categories
Broad Categories
Tide Detergent -2.79
Pepsi -2.08
Coke -1.71
Transatlantic Travel -1.3
Tourism in Thailand -1.2
Ground Beef -1.02
Pork -0.78
Milk -0.54
Cigarettes -0.45
Electricity -0.40 to -0.50
Beer -0.26
Eggs -0.26
Gasoline -0.20
Oil -0.15
Recreation -1.09
Clothing -0.89
Food -0.67
Imports -0.58
Transportation -0.56
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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
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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
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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
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Table: Adjustments after a rise in the price of gasoline
Short Run (a few months or few)
Long Run (a year or more)
Use public transit more often
Arrange a car pool
Drive more slowly on the highway
Eliminate unnecessary trips
If there are two cars, use the more fuel-efficient one
Buy a more fuel-efficient car
Move closer to your job
Switch to a job closer to home
Mover to a city where less driving is required
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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
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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– Example: housing, transatlantic air travel
• The less of their total budgets that households spend on an item– The less elastic is demand for that item– Example: salt
30
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
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Figure 7a: The War on Drugs
P1
Q1
D1
A
S1
Quantity
Price per Unit
(a)
32
Figure 7b: The War on Drugs
B
(b)
Q1
S2
P2
Q2
P1
D1
S1
Quantity
Price per Unit
A
A rise in price will increase the total expenditure of drug users. Many drug users Support themselves through crime.Total revenue for illegal drug industry increases too.
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Figure 7c: The War on Drugs
P1
Q1
D1
A
S1
Quantity
Price per Unit
C
D2
Q3
P3
(c)
Heavier advertisement against drug use, and greater availability of treatment Centers for addicts.
34
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
35
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
36
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 – Normal goods and Inferior goods
37
Some Income Elasticities
Narrow Categories Income
Elasticities
Broad
Categories
Income
Elasticities
Fresh fruit
Computers
Transatlantic Air Travel
College Education
Cigarettes
Chicken
Pork
Fresh Vegetables
Tooth Extraction
Ground Beef
Bread
Potatoes
1.99
1.71
1.4
0.55
0.50
0.42
0.34
0.26
-0.13 ~ 0.47
-0.20
-0.42
-0.81
Imports
Transportation
Recreation
Clothing
Food
2.73
1.79
1.07
1.02
0.60-0.85
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Income and Spending on Economic Necessities and Economic Luxuries
Income Spending on Food
Percent of Income Spent on Food
Spending on
Transportation
% of income spend on Transportation
$10,000 $6,000 60% $1,000 10%
$20,000 $96,000 48% $2,800 14%
$40,000 $15,360 38% $7,840 20%
$80,000 $24,576 30% $21,952 27%
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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 – Example: Cigarettes
40
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 (positive) and complements (negative) 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
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Some Cross-Price Elasticities
Products Cross-Price Elasticity
Margarine with price of butter
Pepsi with price of Coke
Coke with price of Pepsi
Ground beef with price of poultry
Electricity with price of natural gas
Theater with price of all other lively arts
Entertainment with price of food
1.53
0.80
0.61
0.24
0.20
0.12
-0.72
42
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
43
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 (produce orange to orange juice)
– When can we expect suppliers to have easy alternatives? Depends on
» Nature of the good itself (Envelope v.s. microprocessor chips)» Narrowness of the market definition—especially geographic
narrowness (the market of orange in Iowa v.s. the market of orange in U.S.A.)
» Time horizon—longer we wait after a price change, greater the supply response to a price change
44
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
• Example: the supply of fresh-caught tuna
– Perfectly elastic supply curve is a horizontal line
The supply of IBM Stock when the price of IBM stock at Pacific Stock Exchange rises even the tiniest bit above the price in other markets
45
Figure 8: Extreme Cases of Supply
S
(a)
Quantity per Period
Price per
Unit
P1
P2 S
(b)
Quantity per Period
Price per
Unit
Perfectly Inelastic Supply
Perfectly Elastic Supply
46
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)
47
Figure 9a: The Tax on Airline Travel
$300
$260
7
SBefore Tax
A
Millions of Tickets per Year
Price per Ticket
(a)
101. One way to use the supply curve is to start with the price . . . 2. and then find the quantity
supplied at that price.
3. But another way is to start with a quantity . . .
4. and then find the minimum price needed for the market to supply that quantity.
48
Figure 9b: The Tax on Airline Travel
$360
SAfter Tax
A'
10
(b)
3. But another way is to start with a quantity . . .
4. and then find the minimum price needed for the market to supply that quantity.
Millions of Tickets per Year
Price per Ticket
$300
SBefore Tax
A
49
Figure 10: Effect of Excise Tax on Airlines
$340
$300
Millions of Tickets per Year
Price per Ticket
D
A
B
$280
2. The $60 tax shifts the supply curve up by $60.
3. In the new equilibrium, buyers pay $340.
4. And, net of the tax, sellers receive $280.
1. Before the tax, the supply curve is SBefore Tax and the price is $300.
SAfter Tax
SBefore Tax
50
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
51
Figure 11: Tax Incidence and Demand Elasticity
$300 $300
10 102
D
A DA
B
B
Millions of Tickets per Year
Price per Ticket
(a)
$360
SAfter Tax
SBefore Tax
SAfter Tax
SBefore Tax
(b)
Price per Ticket
Millions of Tickets per Year
52
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
53
Figure 12: Tax Incidence and Supply Elasticity
$300
$240
$360
$300
10 108
D
A
D
A
B
(a)
Millions of Tickets per Year
Price per Ticket
(b)
Price per Ticket
Millions of Tickets per Year
SBefore and After Tax
SAfter Tax
SBefore Tax
54
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
55
Figure 14: The Market For Health Care With Coinsurance
Examinations per Year
Price per Examination
150,000100,000
B
A
DAfter Insurance
DBefore Insurance
S$100
70
50