Chapter 4: Working with Supply and Demand: Part 1 Econ 101: Microeconomics Chapter 4: Working with Supply and Demand: Part 1

Why Government Would Like to Control Prices? Government intervenes to regulate prices – Price Control. Why? Equilibrium: Quantity Demanded = Quantity Supplied Buyers would always like to pay less if they could Sellers would always like to get more money from what they sell Price Control Upper Limit – Price Ceilings Lower Limit – Price Floors Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 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 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 1: A Price Ceiling 5. With a black market, the lower quantity sells for a higher price than initially. Q p 3. and decreases quantity supplied. 4. The result is a shortage – the distance between R and V. S T E R V 2. increases quantity demanded D 1. A price ceiling lower than the equilibrium price . . . Hall & Leiberman; Economics: Principles And Applications, 2004

Example: Market for Apartments (millions) Monthly Rent Q Demanded Q Supplied 1,400 1.6 2.4 1,300 1.7 2.3 1,200 1.8 2.2 1,100 1.9 2.1 1,000 2.0 900 800 700 600 Equilibrium Price Ceiling Housing shortage of 400,000 apartments caused by price ceiling Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 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 Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Figure 2: A Price Floor p 2. decreases quantity demanded . . . 3. and increases quantity supplied. 1. A price floor higher than the equilibrium price . . . S K J A 4. The result is a surplus the – distance between K and J – which government must buy. D Q Hall & Leiberman; Economics: Principles And Applications, 2004

Example: Market for Butter (millions of pounds) Price of Butter Q Demanded Q Supplied 1.40 8.0 14.0 1.30 8.5 13.0 1.20 9.0 12.0 1.10 9.5 11.0 1.00 10.0 0.90 10.5 0.80 0.70 11.5 7.0 0.60 6.0 Price Ceiling Equilibrium Butter surplus of 3 million pounds caused by price floor Hall & Leiberman; Economics: Principles And Applications, 2004

The Problem with Rate Change Recall the “Law of Demand”: Other things equal, when the price of a good rises the quantity demanded of the good falls When price rises, does quantity demanded fall a “little” or a “lot”? How can we measure degree of responsiveness of quantity demanded to price changes? Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 3: The Problem with Rate Change D D Q Q It seems to be related to slope: Relative flat demand – big response of Q to change in p Relative steep demand- small response of Q to change in p Hall & Leiberman; Economics: Principles And Applications, 2004

The Problem with Rate Change This suggests using either the slope of the reciprocal of the slope of demand as a measure of the responsiveness of Q to changes in p. Reciprocal of the slope = “Change in Q / change in p” Have a problem with this measure of responsiveness This sign of the ration Different units of measure Hall & Leiberman; Economics: Principles And Applications, 2004

The Elasticity Approach By comparing percentage change in quantity demanded with percentage change in price we can get more informative measure of responsiveness. (own price) elasticity of demand = Hall & Leiberman; Economics: Principles And Applications, 2004

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 quantity demanded changes from Q0 to Q1, percentage change is calculated as Hall & Leiberman; Economics: Principles And Applications, 2004

Calculating Price Elasticity of Demand (own price) elasticity of demand = Hall & Leiberman; Economics: Principles And Applications, 2004

Example of an Elasticity Calculation B 1.75 A 1.50 D 72 80 Q Two points: A(80, 1.5) and B(72, 1.75) Hall & Leiberman; Economics: Principles And Applications, 2004

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 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 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 5: Elasticity and Straight-Line Demand Curves Since equal dollar increases (vertical arrows) are smaller and smaller percentage increases . . . Quantity Price and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases . . . 3 2 1 demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve. D Hall & Leiberman; Economics: Principles And Applications, 2004

Categorizing Goods by Elasticity Now return to the example of an elasticity What does this number mean? Negative sign Along demand curve price and quantity changes are always of opposite signs, so own price elasticities of demand are always negative. Warning: do not think in terms of absolute values Hall & Leiberman; Economics: Principles And Applications, 2004

Categorizing Goods by Elasticity Inelastic Demand Elastic Demand Unit Elastic Demand p Q p Q p Q Hall & Leiberman; Economics: Principles And Applications, 2004

Extreme Cases of Demand Perfectly Inelastic Demand Perfectly Elastic Demand p Q p Q Hall & Leiberman; Economics: Principles And Applications, 2004