1. Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity
Chapter 4
Subtleties of the
Supply and Demand Model:
Price Floors, Price Ceilings, and Elasticity

2. Key Terms price control price ceiling price floor rent control
minimum wage
price elasticity of demand
unit-free measure
elastic demand
inelastic demand
perfectly inelastic demand
perfectly elastic demand
income elasticity of
demand
cross-price elasticity of
price elasticity of supply
perfectly elastic supply
perfectly inelastic supply

3. Interference with Market Prices
Price Control: a government control or regulation that sets or limits the price to be charged for a particular good.
Two Broad Types of Price Controls:
Price Floor
Price Ceiling

4. Price Ceilings and Floors
Price Ceiling: a government price control that sets the maximum allowable price for a good or a service.
Example:
Rent control: a government price control that sets a maximum allowable rent to a house or an apartment.

5. Price Ceilings and Floors
Price Floor: a government price control that sets the minimum allowable price for a good or a service.
Example:
Minimum wage: a wage per hour below which it is illegal to pay workers.

6. Side Effects of Price Ceilings
If the government sets the price ceiling below the equilibrium price, a shortage will result.
Ways We Deal with Persistent Shortages:
Coupons
Long lines
Reduction in the quality of the good sold

7. Figure 1: Effects of a Maximum-Price Law

8. Figure 1: Effects of a Maximum-Price Law

9. Side Effects of Price Floors
If the government sets the price floor above the equilibrium price, a surplus will result.
Ways We Deal with Persistent Surpluses:
Surpluses purchased by the government
Surplus labor results in unemployment

10. Figure 2: Effects of a Minimum-Price Law
(Top graph)

11. Figure 2: Effects of a Minimum-Price Law
(Bottom Graph)

12. Elasticity of Demand
Price Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in the price of that good.

13. Figure 3: Elasticity of Demand
In Figure 3, the top graph shows a demand curve where an increase in the price from $20 to $22 results in a decrease in the quantity demanded from 60 million barrels to 48 million barrels.

14. Figure 3: Comparing Different Sizes of the Price Elasticity of Demand

15. Elasticity of Demand Percentage change in Qty. demanded Percentage
change in price

16. Elasticity of Demand
The price elasticity of demand for the top graph in Figure 3 is:
Note: A price elasticity of demand of 2 implies that a one percentage point increase in the price results in a two percentage point decrease in the quantity demanded.
Price Elasticity
of Demand

17. Size of the Elasticity: High versus Low
We compare the demand curve found on the top graph with the demand curve found on the bottom graph on Figure 3. On the bottom graph, an increase in the price from $20 to $22 results in a decrease in the quantity demanded from 60 million barrels to 57 million barrels.

18. Figure 3: Comparing Different Sizes of the Price Elasticity of Demand

19. Size of the Elasticity: High versus Low
Percentage change in Qty. demanded
Percentage change in price

20. Size of the Elasticity: High versus Low
The elasticity of demand for the top graph is:
Note: A price elasticity of demand of 1/2 implies that a one percentage point increase in the price results in a one-half percentage point decrease in the quantity demanded.
Price Elasticity
of Demand

21. Size of the Elasticity: High versus Low
Note: The top graph in Figure 3 had a higher price elasticity of demand (elasticity = 2) than the price elasticity of demand for the bottom graph (elasticity = 1/2). Hence, the demand curve on the top graph is more sensitive to price changes than the demand curve on the bottom graph.

22. Impact of a Change in Supply on the Price of Oil
In the next slide, Figure 4 analyzes the effect of a decrease in the supply of oil on the equilibrium price of oil. The top graph features a demand curve with a higher elasticity (elasticity = 2) than the bottom graph (elasticity = ½).

23. Figure 4 : The Importance of the Size of the Price Elasticity of Demand

24. Impact of a Change in Supply on the Price of Oil
Note: The same shift in the supply of oil to the left (decrease by 14 million barrels) results in a higher equilibrium price on the bottom graph, where the demand curve has a lower price elasticity (elasticity = ½) than in the top graph (elasticity = 2).

25. Impact of a Change in Supply on the Price of Oil
Figure 4A shows the daily crude oil prices in the world since January The large fluctuations of oil prices support the idea that demand for oil is inelastic.

26. Figure 4A: World Oil and Gasoline Spot Prices (Daily), January 2006-August 2007
Source: Department of Energy

27. Working with Demand Elasticities
The general formula that we will use for demand elasticity (ed) will be:

28. Working with Demand Elasticities
An attractive feature of the price elasticity of demand is that it is a unit-free measure; it allows the comparison of the price elasticity of different goods and different prices.
Unit-Free Measure: a measure that does not depend on the unit of measurement.

29. Working with Demand Elasticities
Assume the price of rice rises by 10 cents, from 50 to 60 cents per pound, and the quantity demanded falls from 20 to 19 tons. This implies a decrease of 1 ton per 10 cent increase in the price, or:
Elasticity of Demand:

30. Working with Demand Elasticities
Similarly, assume the price of steak rises by $1, from $5 to $6 per pound, and the quantity demanded falls from 20 tons to 19 tons. This implies a decrease of 1 ton per $1 increase in the price, or:
Elasticity of Demand:

31. Elasticity versus Slope
One common mistake made when dealing with elasticity is to interchange the elasticity of the demand curve with its slope. These concepts are similar, but not the same.
Elasticity of demand =
slope

32. Elasticity versus Slope
Notes: The elasticity is a unit-free measure, while the slope is not.
With a straight-line demand curve, the slope is constant, while the elasticity varies at different points in the line.

33. The Midpoint Formula or

34. The Midpoint Formula
Recall Figure 4. If we use the midpoint formula to calculate the elasticity on the top graph, the elasticity of demand is:

35. Talking About Elasticities
Elastic Demand – demand where the elasticity is greater than one.
Inelastic Demand – demand where the elasticity is less than one.
Unit Elastic Demand – demand where the elasticity is exactly equal to one.

36. Talking About Elasticities
Perfectly Inelastic Demand – demand (or part of the demand curve) where the price elasticity is zero, indicating no response to a change in price. A perfectly inelastic demand curve is a vertical line.
Perfectly Elastic Demand – demand (or part of the demand curve) where the price elasticity is infinite, indicating an infinite response to a change in price. A perfectly elastic demand curve is a horizontal line.

37. Figure 6: Perfectly Elastic and Perfectly Inelastic Demand

39. Revenue and the Price Elasticity of Demand
Revenue of a firm
= (P X Q)
= (price of a good) X (quantity of the good sold)

40. Revenue and the Price Elasticity of Demand
Example:
If people purchase 60 million barrels of oil at $20, then the firm’s revenues equal:
Revenue = 60 million X $20
= $1200 million = $1.2 billion

41. Revenue and the Price Elasticity of Demand
Figure 7 shows that if the price increases in an elastic demand curve, the firm revenues will decrease. If the price increases in an inelastic demand curve, the firm revenues will increase.

42. FIGURE 7: Effects of an Increase in the Price of Oil on Revenue

43. Revenue and the Price Elasticity of Demand
If in the inelastic region of a straight-line demand curve, an increase (a decrease) in the price will result in an increase (a decrease) in revenues.
If in the elastic region of a straight-line demand curve, an increase (a decrease) in the price will result in a decrease (an increase) in revenues.

44. Figure 8: Revenue and Elasticity of a Straight-Line Demand Curve

46. What Determines the Size of the Price Elasticity of Demand?
Determinants of the Price Elasticity of Demand:
Degree of substitutability
Big-ticket versus little-ticket items
Temporary versus permanent price change
Differences in preferences
Long-run versus short-run elasticity

48. Degree of Substitutability
Goods with a lot of substitutes have a high price elasticity of demand.
Goods with few substitutes have a low price elasticity of demand.

49. Big-Ticket versus Little-Ticket Items
If a good represents a large share fraction of people’s income, then the price elasticity will be high.
If a good represents a small share fraction of people’s income, then the price elasticity will be low.

50. Temporary versus Permanent Price Change
If the price change is perceived to be temporary, then the price elasticity of demand will be high.
If the price change is perceived to be permanent, then the price elasticity of demand will be low.

51. Differences in Preferences
Some goods have varying price elasticity of demand across different consumer groups.
Examples:
New smokers have a higher price elasticity of demand for cigarettes than established (addicted?) smokers.
Retired persons have a lower price elasticity of demand for motor homes than persons in the age group.

52. Long Run vs. Short Run
The length of time elapsed since a price change affects the price elasticity of demand.
Example:
If the price of gasoline rises, the price elasticity of demand for gasoline may be lower for SUV owners in the short run (just immediately after the price change) than in the long run (when they can buy a different car).

53. Income Elasticity of Demand
Income Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in income.
Income
Elasticity
of Demand

55. Income Elasticity of Demand
If the income elasticity of demand is positive (i.e., you buy more as income increases), then the good is a normal good.
If the income elasticity of demand is negative (i.e., you buy less as income increases), then the good is an inferior good.
Note: With income elasticity of demand, it is incorrect to take the absolute value of the computed elasticity.

56. Cross-Price Elasticity of Demand
Cross Price Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in the price of a related good (a substitute or a complement).

57. Cross-Price Elasticity of Demand
If the cross-price elasticity of demand is positive (i.e., you buy more as price of the other good increases), then the two related goods are substitutes.
If the cross-price elasticity of demand is negative (i.e., you buy less as price of the other good increases), then the two related goods are complements.

58. Elasticity of Supply
Elasticity of Supply: the percentage change in the quantity supplied of a good divided by the percentage change in the price of a same good.
Price Elasticity
of Supply

59. Elasticity of Supply
The general formula that we will use for price elasticity of supply (es) will be:

60. Elastic versus Inelastic Supply
Elastic Supply: supply where the price elasticity is greater than one.
Inelastic Supply: supply where the price elasticity is less than one.
Unit Elastic Supply: supply where the price elasticity is exactly equal to one.

61. Perfectly Elastic versus Perfectly Inelastic Supply
Perfectly Elastic Supply: supply where the price elasticity is infinite, indicating an infinite response to a change in price. A perfectly elastic supply curve is a horizontal line.

62. Perfectly Elastic versus Perfectly Inelastic Supply
Perfectly Inelastic Supply: supply where the price elasticity is zero, indicating no response to a change in price. A perfectly inelastic supply curve is a vertical line.
Examples:
The Mona Lisa
Super Bowl Tickets

63. Figure 9: Perfectly Elastic and Perfectly Inelastic Supply

64. Figure 10: Comparing Different Sizes of the Price Elasticities of Supply

65. Figure 10: Comparing Different Sizes of the Price Elasticities of Supply

66. Elastic vs. Inelastic Supply
In the next slide, Figure 11 shows that the same shift in the demand for oil to the left results in a lower equilibrium price in the bottom graph, where the supply curve has a lower price elasticity than in the top graph, which has a higher price elasticity.

67. Figure 11: Importance of Knowing the Size of the Price Elasticity of Supply

68. Key Terms price control price ceiling price floor rent control
minimum wage
price elasticity of demand
unit-free measure
elastic demand
inelastic demand
perfectly inelastic demand
perfectly elastic demand
income elasticity of
demand
cross-price elasticity of
price elasticity of supply
perfectly elastic supply
perfectly inelastic supply