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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. Figure 3: The Problem with Rate ChangeD 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

11. 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

12. 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

13. 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

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

15. Example of an Elasticity CalculationB
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

16. 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

17. 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

18. 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

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

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