1. 1 What are elasticities of supply and demand? How do short-run and long-run elasticities differ? Applications of supply, demand and elasticity. What are the effects of government intervention – price controls? Reading: chapter 2 Lecture 2. The Elasticity of Supply and Demand

2. 2 Elasticities of Supply and Demand Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change Elasticity gives a way to measure by how much a variable will change with the change in another variable Specifically, it gives the percentage change in one variable resulting from a one percent change in another

3. 3 Warm-up exercise People buy greeting cards and roses throughout the year. As Valentine’s Day approaches, however, cards and roses become necessities. The demand for both products jump and we expect the prices of both products to jump. The price of roses, however, always increases more sharply than the price of greeting cards. Why?

4. 4 Price Elasticity of Demand Measures the sensitivity of quantity demanded to price changes –It measures the percentage change in the quantity demanded of a good that results from a one percent change in price

5. 5 Price Elasticity of Demand The price elasticity of demand can also be written as: Since quantity demanded and price are negatively related, we drop the negative sign. e.g. the price elasticity of demand of 0.5 means that every 1% increase in price leads to a 0.5% decrease in quantity demanded.

6. 6 Price Elasticity of Demand The primary determinant of price elasticity of demand is the availability of substitutes –Many substitutes, demand is price elastic Can easily move to another good with price increases –Few substitutes, demand is price inelastic Necessities vs. discretionary expenditure... Basic food vs. restaurant meals Budget share... salt vs. car Time horizon

7. 7 Price Elasticity of Demand Looking at a linear demand curve, the slope of the curve is constant, but as we move along the curve, P and Q will change; so price elasticity along a linear demand curve is not constant –The top portion of a linear demand curve is elastic Price is high and quantity small –The bottom portion of a linear demand curve is inelastic Price is low and quantity high

8. 8 Price Elasticity of a Linear Demand Curve Q P rice 4 8 2 4 E p = 1 E p = 0 E P =  Elastic Inelastic The top portion of demand curve is elastic Price is high and quantity small The bottom portion of demand curve is inelastic Price is low and quantity high 0

9. 9 Two extreme cases of demand curves –Infinitely elastic demand: horizontal demand curve –Completely inelastic demand: vertical demand curve

10. 10 Infinitely Elastic Demand D P*P* Quantity Price E P = 

11. 11 Completely Inelastic Demand Quantity Price Q*Q* D E P = 0

12. 12 Other Demand Elasticities Income Elasticity of Demand –Measures how much quantity demanded changes with a change in income

13. 13 Other Demand Elasticities Cross-Price Elasticity of Demand –Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good

14. 14 Complements: Cars and Tires –Price of cars increases, quantity demanded of tires decreases Cross-price elasticity of demand is negative Substitutes: Butter and Margarine –Price of butter increases, quantity of margarine demanded increases Cross-price elasticity of demand is positive

15. 15 Price Elasticity of Supply Measures the sensitivity of quantity supplied given a change in price –Measures the percentage change in quantity supplied resulting from a 1 percent change in price

16. 16 Point vs. Arc Elasticities Point elasticity of demand –Price elasticity of demand at a particular point on the demand curve Arc elasticity of demand –Price elasticity of demand calculated over a range of prices

17. 17 Short-Run Versus Long-Run Elasticity Price elasticity varies with the amount of time consumers have to respond to a price Short-run demand and supply curves often look very different from their long-run counterparts

18. 18 Short-Run Versus Long-Run Elasticity Demand –In general, demand is much more price elastic in the long run Consumers take time to adjust consumption habits Demand might be linked to another good that changes slowly More substitutes are usually available in the long run

19. 19 Gasoline: Short-Run and Long-Run Demand Curves D SR D LR People cannot easily adjust consumption in the short run. In the long run, people tend to drive smaller and more fuel efficient cars. Quantity of Gas Price

20. 20 Demand and Durability –For some durable goods, demand is more elastic in the short run –If goods are durable, then when price increases, consumers choose to hold on to the good instead of replacing it –But in long run, older durable goods will have to be replaced

21. 21 Short-Run Versus Long-Run Elasticity Income elasticity also varies with the amount of time consumers have to respond to an income change –For most goods and services, income elasticity is larger in the long run –When income changes, it takes time to adjust spending

22. 22 S SR Quantity Price Short-Run Versus Long-Run Supply Elasticity S LR Due to limited capacity, firms are limited by output constraints in the short run. In the long run, they can expand. Most goods and services: Long-run price elasticity of supply is greater than short-run price elasticity of supply

23. 23 Short-Run vs. Long-Run Elasticity – An Application Demand and supply are more elastic in the long run In the very short run, supply is completely inelastic –E.g. Weather may destroy part of the fixed supply, decreasing supply Demand is relatively inelastic as well Price increases significantly

24. 24 D P0P0 S Q0Q0 Quantity Price A freeze or drought decreases the supply of coffee S’ Q1Q1 An Example - Coffee Price increases significantly due to inelastic supply and demand P1P1

25. 25 Elasticity: An Application During the 1980’s and 1990’s, the market for wheat went through changes that had great implications for American farmers and US agricultural policy Using the supply and demand curves for wheat, we can analyze what occurred in this market

26. 26 Elasticity: An Application Supply: Q S = 1800 + 240P Demand: Q D = 3550 – 266P At equilibrium: Q S = Q D 1800 + 240P = 3550 – 266P 506P = 1750 P = $3.46 per bushel Q = 1800 + (240)(3.46) = 2630 million bushels

27. 27 Elasticity: An Application We can find the elasticities of demand and supply at these points

28. 28 Elasticity: An Application If the price of wheat rose to $4.00/bushel due to decrease in supply

29. 29 Effects of Price Controls Markets are rarely free of government intervention –Imposed taxes and granted subsidies –Price controls Price controls usually hold the price above or below the equilibrium price

30. 30 Policy 1: price ceiling Price ceiling: a legal maximum on the price (to be effective, it has to be lower than the equilibrium price) Examples: price ceiling on gasoline; rent control Objectives of the price control: promotion of equity (or to satisfy voters?) What are the likely outcomes of the policy?

31. 31 D Effects of Price Ceiling Quantity P rice P0P0 Q0Q0 S P max Price is regulated to be no higher than P max Quantity supplied falls and quantity demanded increases A shortage results QSQS QDQD Shortage

32. 32 Effects of Price Ceiling Excess demand sometimes takes the form of queues –Lines at gas stations during shortage Sometimes get curtailments and supply rationing –Natural gas shortage of the mid ’70’s Producers/suppliers typically lose, but some consumers gain. Some consumers lose.

33. 33 Price Controls and Natural Gas Shortages In 1954, the federal government began regulating the wellhead price of natural gas In 1962, the ceiling prices that were imposed became binding and shortages resulted

34. 34 Price Controls and Natural Gas Shortages Price controls created an excess demand of 7 trillion cubic feet Price regulation was a major component of US energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s

35. 35 Questions for discussion What are the problems with rent control? Who will lose and who will gain? What do you think are better alternatives to rent control?

36. 36 A Rent Control Quantity (thousands of units per month) Rent (dollars per unit per month) 04472100 150 12 16 20 24 D S Housing shortage Rent ceiling a b e Search time increases Black market may develop

37. 37 Policy 2: price floor Price floor: a legal minimum on the price that can be charged (to be effective, it has to be higher than the equilibrium price) Example: minimum wage Objectives of the price control: promotion of equity (or to satisfy voters?) what will be the impact on youth workers?

38. 38 Policy 2: price floor Price Quantity demand supply q p With the price floor at p min, there is excess supply of q S - q D. p min As a result, unemployed young workers may rise. and some may willing to accept lower (illegal) wage rate in order to work qSqS qDqD Without the price floor, the market equilibrium is (p, q). p ill