SUPPLY AND DEMAND INTERACTIONS

OPERATION OF A FREE MARKET SYSTEM  Choosing how to best handle scarce resources is a challenge for many markets. Decisions have to be made:  What products and services are these resources going to produce?  Who will receive these products and services when they are available?  These questions can be answered by the price system technique.

 The price system is the technique by which scarce resources are allocated to the production of those products and services that provide the greatest return to the resource owner.  In this way, the system of prices, rents, wages, and interest organizes economic activity.

 The greatest return on investment drives production and service. People will seek highest paying jobs. Buildings are rented under circumstances that provide the highest return

The price system has two distinct advantages in allocating resources: 1. It is efficient in allowing thousands of individuals to cooperate in making economic decisions, and 2. It transmits information to buyers and sellers which assists consumers in allocating their limited income to various purchases and encourages sellers to adopt the least costly and most efficient means of production.

1. People are unaware they are involved but their decision making, often based on prices and price changes, influence the markets and in-turn the prices for goods and services. 2. If information is not transmitted then shortages and surpluses tend to persist

 The free-market system and its establishment of prices through the interaction of demand and supply provides insight into the concept of value.  What is the value of a diamond ring?  a new car?  a glass of water?

 The only indicator of value is the marketplace and what someone is willing to spend to get a product/service.

ELASTICITY  The law of downward-sloping demand states that, all other factors remaining constant, the quantity demanded of a product increases as the price falls.  Price elasticity of demand measures the extent to which the quantity of a product demanded responds to a change in price.  Price Elasticity of Demand Coefficient =

 Ex. If a 10% cut in the price of an item brought about a 20% increase in the quantity demanded the elasticity coefficient would be 20/10 = 2.0  Essentially, we need to consider how sensitive consumers are to the changes in price.

 Elastic demand is one in which a price change brings about a greater than proportional change in the quantity that consumers demand.  % Δ Q s > % Δ P thus E s > 1  Ex. A small increase in the price of chocolate bars will likely have a large impact in the number of bars sold.

If a supplier is not able to adjust supply readily when the price changes, the supply is referred to as inelastic. % Δ Q s < % Δ P thus E s < 1  Milk has an inelastic demand curve as price changes have little impact on the amount of milk sold.

 Unitary elastic supply is one in which a price change brings about a proportional change in the quantity supplied.  % Δ Q s = % Δ P thus E s = 1

CHARACTERISTICS THAT AFFECT ELASTICITY 1. Luxury or necessity 2. The number of close substitutes 3. Percentage of budget spent on the product 4. Length of time since price change

TOTAL REVENUE APPROACH TO PRICE ELASTICITY OF DEMAND  The total amount of money that people spend on a product is referred to as Total Revenue.  TR = P x Q d  If the demand for a product is elastic, any decrease in price will increase total revenue; conversely any increase in price will decrease total revenue. when PTR P

If the demand for a product is inelastic, any decrease in price will decrease total revenue; conversely any increase in price will increase total revenue. when When the elasticity of demand is unitary, any change in price leaves total revenue unchanged. PTR P

SPECIAL CASES OF PRICE ELASTICITY OF DEMAND  There are two special cases of a demand curve where the price and quantity demanded are not inversely related.  The first is where the price is set and the quantity demanded is unlimited, a perfectly elastic demand (E d = ∞).  An example of a perfectly elastic demand curve is when U.S. citizens were required to sell all their gold to the government at a price of $35 an ounce.

 In the 1930’s the US govt instituted the Gold Reserve Act. The act changed the nominal price of gold from $20.67 per ounce to $35. This price change incentivized foreign investors to export their gold to the United States, while simultaneously devaluing the U.S. dollar in an attempt to spark inflation. The increase in gold reserves due to the price change as well as the confiscation clause resulted in a large accumulation of gold in the Federal Reserve and U.S. Treasury. The increase in the moneymoney

 The second is where a certain quantity is demanded and any price will be paid to acquire that amount, a perfectly inelastic demand (E d = 0).  This curve may reflect the demand for a necessary drug in which individuals will pay any price to acquire it.

 Last year, ipilimumab, also known as MDX-010 and MDX-101, marketed as Yervoy was approved by the Food and Drug Administration (FDA) for the treatment of metastatic melanoma. The benefit in survival over and above standard treatment arms was 3.7 months in previously treated patients and 2.1 months in previously untreated patients. The cost: $120,000 for 4 doses.

PRICE ELASTICITY OF SUPPLY  The law of upward-sloping supply states that, all other factors remaining constant, the quantity supplied of a product increases as the price increases.  Price elasticity of supply measures the extent to which the quantity of a product supplied responds to a change in price.  Price Elasticity of Supply Coefficient =

 If the coefficient is greater than one, supply is elastic, if it is less than one it is inelastic and if the coefficient is equal to one the supply is unitary elastic.  Three major characteristics help determine price elasticity of supply: 1. Time 2. Ability to store product 3. Ability to substitute during production

1. The longer the time allowed to adjust to price changes the more likely it is to increase production. If the price of green peppers stays constant farmers will be able to adjust production. If prices increase the farmer will produce more green peppers. 2. Some items are perishable and cannot be stored for long or are expensive to store, their elasticity of supply is inelastic. They have to be sold no matter the price. 3. Shifting production to make alternative products in response to price changes affects elasticity of supply. If the switch is easy it is elastic, if not it is inelastic.

OTHER TYPES OF ELASTICITY  Income elasticity measures the responsiveness of the change in quantity demanded to changing income levels.  Products with negative income elasticity are inferior goods.  Products with positive income elasticity are normal goods.

 Cross-elasticity of demand measures the impact that changes in the price of one product have on the quantity demanded of another product. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good.  Products with negative cross-elasticity are complementary.  Products with positive cross-elasticity are substitutes.