Chapter 4. Additional Demand and Supply Topics/Applications

Key Topics 1. Allocating goods/resources via the price system and non price alternatives 2. Policies that affect market prices a. P ceiling, b. P floors, c. fees, d. Taxes 3. Economic impacts of free market deviations (e.g. S, D, P, consumer & producer surplus)

Chapter 4 Objectives Upon completion of this chapter, you should understand and be able to answer these questions: 1. How do markets allocate goods and resources? 2. What are some nonmarket alternatives for allocating goods and resources and their economic impacts? 3. What are price ceilings, price floors, fees, and taxes and how do they impact markets?

The Role of Market Prices (i.e. markets): To ration or allocate goods and services (and resources) (solving the basic production problems of what, how, and for whom in the process).

P Rationing Example #1 S curve shifts to left (or D curve shifts to right)  Excess demand (i.e. shortage) exists at original price  Market P will rise to ration lower supply

Question Do the laws of S and D work to determine the price of an item if there is only ONE unit of that item to be sold?

“Buy land. They’ve stopped making it.” (Mark Twain) P S Q (land)

P Rationing Example #2 Extremely limited supply (e.g. Q S = 1)  P is D determined  P will rise until there is only 1 willing buyer

P Rationing Example #3 (resources) Suppose the demand for a product increases.  More profits to produce that product  Profits encourage firms to buy more capital, labor, etc.  Input prices influence what specific resources are used

Question Should the state of Iowa put a ‘cap’ on college tuition increases to make a University education more affordable to everyone?

P Constraint Example #1 – P Ceiling P Ceiling = max P sellers can charge (below equilibrium P) usually set by Gov’t Examples:gasoline (1970s), interest rates, rental rates, ATM fees Arguments for:P gouging is bad, not ‘fair’ or right to charge ‘exorbitant’ Ps, everyone should be able to buy necessities at ‘reasonable’ prices

P Constraint Example #1 – P Ceiling (cont’d) Problem: Excess D still exists  need to implement alternative rationing mechanisms such as: 1. Queuing  waiting in line 2. Favored customers  let sellers decide 3. Issuing ration tickets or coupons

“Hidden” costs or problems with non- P rationing mechanisms 1. Queuing: cost of waiting in line 2. Favored customers: bribes, hidden ‘service’ charges 3. Ration coupons: often end up being bought/sold legally or illegally (black market) 4. General: discourages both producers and consumers from making needed S and/or D adjustments

P Constraint Example #2 – P Floor P floor = min. P buyers must pay (above equilibrium P) Examples: minimum wage, ag P supports Arguments for: needed to keep producers in business, to generate ‘fair’ income levels Problem: excess S will be created (  e.g. surplus production, unemployment, etc.)

P Constraint Example #3 – Import Fee Fee = tax on imports Impacts:  P to U.S. consumers   Q d in U.S.  Q S in U.S.  Q of imports  Gov’t revenue

P Constraint example #4 (per unit tax on buyers) To buy Q 1 initially, buyers willing to pay P w/o. After tax, buyers willing to pay P w to keep the same total cost per unit. => Tax causes D curve to shift left (or down by amt of t) $ P w/o PwPw Q1Q1 t D 2 (w/tax) D 1 (w/o tax) Q

Economic Impacts of Deviations Away from Equilibrium CS=consumer surplus +PS=producer surplus __________________________________ =NSW (net social welfare)

Question Is there any product or service you currently buy that you consider to be a ‘really good’ deal for the money?

Consumer Surplus Amount willing to pay (value) - Amount have to pay (cost) ___________________________ =consumer surplus

Consumer Surplus (graphically) P a D Q Q1Q1 Cost CS P1P1 = area under the D curve and above the price line = CS = ½ Q 1 (a-P 1 )

Producer Surplus Amount paid to sellers - Amount willing to sell for (cost) __________________________ =producer surplus

Producer Surplus (graphically) P S Q a Cost PS p1p1 = area above the S curve and under the price line = PS = ½ Q 1 (P 1 – a)

Market Equilibrium & NSW P CS PS S D Q QeQe PePe NSW = net social welfare = PS + CS Max NSW  P = P e

NSW Impacts:  Q &  P ΔNSW=Δ net social welfare =ΔPS + ΔCS =(a-c) + (-a-b) =-c-b =net welfare loss (deadweight loss) P Q a PS b c S D CS P2P2 PePe Q2Q2 Q1Q1

Question Suppose your cumulative GPA increases from 3.00 to 3.30 after this semester. What was the ‘percentage increase’ in your cumulative GPA?

E 0 and Linear D Curve P a 1/2a Q E 0 >1 E 0 =1 E 0 <1

Factors Affecting Own Price Elasticity Available Substitutes – The more substitutes available for the good, the more elastic the demand. Time – Demand tends to be more inelastic in the short term than in the long term. – Time allows consumers to seek out available substitutes. Expenditure Share – Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

Uses of E 0 Calculate % change in P needed to bring about desired % change in Q sold Calculate % change in Q sold that will result from a given % change in P Predict how TR will Δ due to given % ΔP

Use of E 0 (Example) According to an FTC Report, AT&T’s own price elasticity of demand for long distance services is –8.64. If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

Answer Calls would increase by percent!

Elasticity Equation => Note: this is an equation with 3 variables => given values for 2 variables, can solve for value of 3 rd variable Example: %ΔQ = E 0 (%ΔP) Example: %ΔP = (%ΔQ)/E 0

Question If a firm wants to increase its dollar sales of a product, should it  P or  P?

Quote of the Day “Students of Economics need to be taught, in business, sometimes you should raise your price, and sometimes you should lower your price.” - CEO of Casey’s

E 0 and TR TR = P∙Q = total revenue (total $ sales) If E 0 elastic (# > 1)  little P   BIG Q    TR  little P   BIG Q    TR* (  P) If E 0 inelastic (# < 1)  BIG P   little Q    TR* (   P)  BIG P   little Q    TR

E 0 and TR (Example) Recall E 0 = -.25 at P=1 and Q=8 for P=5 -.5Q Given E 0 is inelastic  firm should be able to  TR by  P. PQdQd TR ($) * (= max TR)

Max TR Maximum R will be generated at midpoint of linear, down-sloping D curve P Q P=5-.5Q Max TR

Cross Price Elasticity of Demand +Substitutes - Complements

Income Elasticity +Normal Good -Inferior Good

Elasticity of Supply

Elasticity Summary Elasticities can be used to estimate: