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Hall & Leiberman; Economics: Principles And Applications, 2004 1 Working with Demand and Supply Price Ceilings Government-imposed maximum price that prevents.

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Presentation on theme: "Hall & Leiberman; Economics: Principles And Applications, 2004 1 Working with Demand and Supply Price Ceilings Government-imposed maximum price that prevents."— Presentation transcript:

1 Hall & Leiberman; Economics: Principles And Applications, Working with Demand and Supply 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 prevails Price ceiling creates a shortage –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

2 Hall & Leiberman; Economics: Principles And Applications, Figure 1: A Price Ceiling in the Market for Maple Syrup 60,00050,00040,000 T E V R D S $ increases quantity demanded 3.and decreases quantity supplied. 4.The result is a shortage – the distance between R and V. Number of Bottles of Maple Syrup per Period Price per Bottle 1.A price ceiling lower than the equilibrium price... 5.With a black market, the lower quantity sells for a higher price than initially.

3 Hall & Leiberman; Economics: Principles And Applications, 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

4 Hall & Leiberman; Economics: Principles And Applications, Figure 2: A Price Floor in the Market for Nonfat Dry Milk 2.decreases quantity demanded $ K J S D A 4.The result is a surplus the – distance between K and J – which government must buy. Millions of Pounds Price per Pound 1.A price floor higher than the equilibrium price... 3.and increases quantity supplied.

5 Hall & Leiberman; Economics: Principles And Applications, Limiting Surplus A price floor creates a surplus of goods –In order to maintain price floor, government must prevent surplus from driving down market price Government often accomplishes this goal by purchasing surplus with taxpayers dollars Price floors often get government deeply involved in production decisions –Rather than leaving them to the market

6 Hall & Leiberman; Economics: Principles And Applications, Suppliers perspective A producer considers increasing his price Is it a good idea? Higher price means more revenue per unit output BUT… Lower units of quantity sold (downward sloping demand).

7 Hall & Leiberman; Economics: Principles And Applications, The Demand Schedule Demand for Maple Syrup Price (per bottle)Quantity Demanded (bottles per month) $1.0075,000 $2.0060,000 $3.0050,000 $4.0035,000 $5.0020,000

8 Hall & Leiberman; Economics: Principles And Applications, The Demand Schedule Demand for Maple Syrup Price (per bottle) Quantity Demanded (bottles per month) Revenue (price times quantity) $1.0075,000$75,000 $2.0060,000$12,000 $3.0050,000$150,000 $4.0035,000$140,000 $5.0020,000$100,000

9 Hall & Leiberman; Economics: Principles And Applications, The Problem with Rate Change Rate of change of quantity demanded compared to the change in price is not a good measure of price sensitivity –Doesnt tell whether a change in price or a change in quantity demanded is a relatively large or relatively small change Relative means compared to value of price or quantity before change

10 Hall & Leiberman; Economics: Principles And Applications, The Elasticity Approach Elasticity approach improves on the problems with rate of change –By comparing percentage change in quantity demanded with percentage change in price Price elasticity of demand (E D ) for a good is percentage change in quantity demanded divided by percentage change in price –Will virtually always be a negative number –Tells us percentage change in quantity demanded for each 1% increase in price Price elasticity of demand tells us percentage change in quantity demanded caused by a 1% rise in price as we move along a demand curve from one point to another

11 Hall & Leiberman; Economics: Principles And Applications, 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 price changes from any value P 0 to any other value P 1, we define the percentage change in price as –When quantity demanded changes from Q 0 to Q 1, percentage change is calculated as

12 Hall & Leiberman; Economics: Principles And Applications, Figure 3: Calculating Price Elasticity of Demand Quantity of Laptops C Price per Laptop 100,000200,000300,000400,000500,000600,000 $3,500 3,000 2,500 2,000 1,500 1,000 B A D D

13 Hall & Leiberman; Economics: Principles And Applications, An Example: Calculating Price Elasticity of Demand Now lets calculate an elasticity of demand for laptop computers using data in Figure 3 from point A to point B Use percentage changes for price and quantity to calculate price elasticity of demand (E D )

14 Hall & Leiberman; Economics: Principles And Applications, 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 Why? As we move upward and leftward along a straight-line demand curve –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

15 Hall & Leiberman; Economics: Principles And Applications, Figure 4: Elasticity and Straight- Line Demand Curves Quantity Price and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases... Since equal dollar increases (vertical arrows) are smaller and smaller percentage increases D demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve.

16 Hall & Leiberman; Economics: Principles And Applications, Categorizing Goods by Elasticity Inelastic Demand –Price elasticity of demand between 0 and -1 |% Change in Quantity Demanded| < |% Change in Price| Perfectly Inelastic Demand –Price elasticity of demand equal to 0

17 Hall & Leiberman; Economics: Principles And Applications, Categorizing Goods by Elasticity Elastic Demand –Price elasticity of demand with absolute value > 1 |% Change in Quantity Demanded| > |% Change in Price| Perfectly (infinitely) Elastic Demand –Price elasticity of demand approaching minus infinity Unitary Elastic Demand –Price elasticity of demand equal to -1

18 Hall & Leiberman; Economics: Principles And Applications, Figure 5: Extreme Cases of Demand D Perfectly Inelastic Demand (a) Quantity Price per Unit $ (b) D Quantity $4 Price per Unit Perfectly Elastic Demand

19 Hall & Leiberman; Economics: Principles And Applications, Elasticity and Total Revenue Total revenue (TR) of all firms in the market is defined as TR = P x Q When two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes –Applying this to total revenue % Change in TR = % Change in Price + % Change in Quantity Demanded Assume demand is unitary elastic and Q rises by 10% –% Change in TR = 10% + (-10%) = 0

20 Hall & Leiberman; Economics: Principles And Applications, Elasticity and Total Revenue If demand is inelastic, a 10% rise in price will cause quantity demanded to fall by less than 10% –% change in TR = 10% + (something less negative than –10%) > 0 If demand is elastic, so that Q falls by more than 10% –TR will fall % Change in TR = 10% + (something more negative than -10%) < 0

21 Hall & Leiberman; Economics: Principles And Applications, Elasticity and Total Revenue Where demand is inelastic, total revenue moves in same direction as price Where demand is elastic, total revenue moves in opposite direction from price Where demand is unitary elastic, total revenue remains the same as price changes At any point on a demand curve sellers total revenue (buyers total expenditure) is the area of a rectangle –Width equal to quantity demanded –Height equal to price

22 Hall & Leiberman; Economics: Principles And Applications, Figure 6: Elasticity and Total Expenditure B A D 3.Moving from A to B, expenditure increases, so demand must be inelastic over that range. 1.At point A, where price is $1,000 and 600,000 laptops are demanded, revenue is $600 million. 2.At point B, revenue is $750 million. Quantity of Laptops 100,000200,000300,000400,000500,000600,000 $3,500 3,000 2,500 2,000 1,500 1, Price per Laptop

23 Hall & Leiberman; Economics: Principles And Applications, Availability of Substitutes Demand is more elastic –If close substitutes are easy to find and buyers can cut back on purchases of the good in question Demand is less elastic –If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question

24 Hall & Leiberman; Economics: Principles And Applications, Narrowness of Market More narrowly we define a good, easier it is to find substitutes –More elastic is demand for the good More broadly we define a good –Harder it is to find substitutes and the less elastic is demand for the good Different things are assumed constant when we use a narrow definition compared with a broader definition

25 Hall & Leiberman; Economics: Principles And Applications, Necessities vs. Luxuries The more necessary we regard an item, the harder it is to find a substitute –Expect it to be less price elastic The less necessary (luxurious) we regard an item, the easier it is to find a substitute –Expect it to be more price elastic

26 Hall & Leiberman; Economics: Principles And Applications, Time Horizon Short-run elasticity –Measured a short time after a price change Long-run elasticity –Measured a year or more after a price change Usually easier to find substitutes for an item in the long run than in the short run –Therefore, demand tends to be more elastic in the long run than in the short run

27 Hall & Leiberman; Economics: Principles And Applications, Importance in the Buyers Budget The more of their total budgets that households spend on an item –The more elastic is demand for that item The less of their total budgets that households spend on an item –The less elastic is demand for that item

28 Hall & Leiberman; Economics: Principles And Applications, Using Price Elasticity of Demand: The War on Drugs Every year U.S. Government spends about $20 billion on efforts to restrict the supply of drugs Figure 9(a) –Market for heroin without government intervention Figure 9(b) –Result of government efforts to restrict supply (current policy) Figure 9(c) –Results of an effective policy of reducing demand

29 Hall & Leiberman; Economics: Principles And Applications, Figure 7a: The War on Drugs P1P1 Q1Q1 D1D1 A S1S1 Quantity Price per Unit (a)

30 Hall & Leiberman; Economics: Principles And Applications, Figure 7b: The War on Drugs B (b) Q1Q1 S2S2 P2P2 Q2Q2 P1P1 D1D1 S1S1 Quantity Price per Unit A

31 Hall & Leiberman; Economics: Principles And Applications, Figure 7c: The War on Drugs P1P1 Q1Q1 D1D1 A S1S1 Quantity Price per Unit C D2D2 Q3Q3 P3P3 (c)

32 Hall & Leiberman; Economics: Principles And Applications, Using Price Elasticity of Demand: Mass Transit Elasticity studies show that long-run demand for mass transit is inelastic –Therefore, a rise in fare would increase revenues However, most cities do not raise transit fares due to –Desire to provide low-income households with affordable transportation –Desire to manage traffic congestion –Desire to limit air pollution in the city An increase in fares would increase revenue –Would also decrease ridership and require the city to sacrifice these other goals

33 Hall & Leiberman; Economics: Principles And Applications, Using Price Elasticity of Demand: An Oil Crisis For the past five decades, Middle East has been a geopolitical hot spot Both military and economic government agencies ask What if questions –If an event in the Middle East were to disrupt oil supplies, what would happen to the price of oil on world markets? Flipping the elasticity equation like so Tells us percentage rise in price that would bring about a 1 percent decrease in quantity demanded –Enables us to make reasonable forecasts about the impact of various events on oil prices Once we have established our forecasted oil prices we can then use that data to examine effect that higher oil prices would have on many broader issues –Effect on U.S. inflation rate –Effect on number of flights offered by U.S. airlines

34 Hall & Leiberman; Economics: Principles And Applications, Income Elasticity of Demand Percentage change in quantity demanded divided by the percentage change in income –With all other influences on demandincluding the price of the goodremaining constant Interpret this number as percentage increase in quantity demanded for each 1% rise in income

35 Hall & Leiberman; Economics: Principles And Applications, Income Elasticity of Demand Income elasticities vs. price elasticities of demand –Price elasticity of demand Measures effect of change in price of good –Assumes that other influences on demand, including income, remain unchanged –Income elasticity Measures effect on demand we would observe if income changed and all other influences on demandincluding price of the goodremained the same Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant

36 Hall & Leiberman; Economics: Principles And Applications, Income Elasticity of Demand Another difference between price and income elasticity of demand –Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another –Income elasticity tells us relative shift in demand curveincrease in quantity demanded at a given price While a price elasticity is virtually always negative –Income elasticity can be positive or negative

37 Hall & Leiberman; Economics: Principles And Applications, Income Elasticity of Demand Economic necessity –Good with an income elasticity of demand between 0 and 1 Economic luxury –Good with an income elasticity of demand greater than 1 An implication follows from these definitions –As income rises, proportion of income spent on economic necessities will fall While proportion of income spent on economic luxuries will rise But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior –Not by our judgment of a goods importance to human survival

38 Hall & Leiberman; Economics: Principles And Applications, Cross-Price Elasticity of Demand Cross-price elasticity of demand –Percentage change in quantity demanded of one good caused by a 1% change in price of another good While all other influences on demand remain unchanged While the sign of the cross-price elasticity helps us distinguish substitutes and complements among related goods Its size tells us how closely the two goods are related –A large absolute value for E XZ suggests that the two goods are close substitutes or complements –While a small value suggests a weaker relationship

39 Hall & Leiberman; Economics: Principles And Applications, Price Elasticity of Supply Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good –With all other influences on supply held constant

40 Hall & Leiberman; Economics: Principles And Applications, Price Elasticity of Supply When do we expect supply to be price elastic, and when do we expect it to be price inelastic? –Ease with which suppliers can find profitable activities that are alternatives to producing the good in question Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily –When can we expect suppliers to have easy alternatives? Depends on »Nature of the good itself »Narrowness of the market definitionespecially geographic narrowness »Time horizonlonger we wait after a price change, greater the supply response to a price change

41 Hall & Leiberman; Economics: Principles And Applications, Price Elasticity of Supply Extreme cases of supply elasticity –Perfectly inelastic supply curve is a vertical line Many markets display almost completely inelastic supply curves over very short periods of time –Perfectly elastic supply curve is a horizontal line

42 Hall & Leiberman; Economics: Principles And Applications, Figure 8: Extreme Cases of Supply S (a) Quantity per Period Price per Unit P1P1 P2P2 S (b) Quantity per Period Price per Unit Perfectly Inelastic Supply Perfectly Elastic Supply

43 Hall & Leiberman; Economics: Principles And Applications, The Tax on Airline Travel: Taxes and Market Equilibrium A tax on a particular good or service is called an excise tax –Shifts market supply curve upward by amount of tax For each quantity supplied, the new, higher curve tells us firms gross price, and the original, lower curve tells us the net price Who really pays excise taxes? –Buyers and sellers share in the payment of an excise tax Called tax shifting –Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers)

44 Hall & Leiberman; Economics: Principles And Applications, Figure 9a: The Tax on Airline Travel $300 $260 7 S Before Tax A Millions of Tickets per Year Price per Ticket (a) 10 1.One way to use the supply curve is to start with the price... 2.and then find the quantity supplied at that price. 3.But another way is to start with a quantity... 4.and then find the minimum price needed for the market to supply that quantity.

45 Hall & Leiberman; Economics: Principles And Applications, Figure 9b: The Tax on Airline Travel $360 S After Tax A' 10 (b) 3.But another way is to start with a quantity... 4.and then find the minimum price needed for the market to supply that quantity. Millions of Tickets per Year Price per Ticket $300 S Before Tax A

46 Hall & Leiberman; Economics: Principles And Applications, Figure 10: Effect of Excise Tax on Airlines $340 $300 Millions of Tickets per Year Price per Ticket D A B $ The $60 tax shifts the supply curve up by $ In the new equilibrium, buyers pay $ And, net of the tax, sellers receive $ Before the tax, the supply curve is S Before Tax and the price is $300. S After Tax S Before Tax

47 Hall & Leiberman; Economics: Principles And Applications, Tax Incidence and Demand Elasticity In most cases excise tax will be shared by both buyer and seller –For a given supply curve, the more elastic is demand, the more of an excise tax is paid by sellers –The more inelastic is demand, the more of the tax is paid by buyers

48 Hall & Leiberman; Economics: Principles And Applications, Figure 11: Tax Incidence and Demand Elasticity $ D A D A B B Millions of Tickets per Year Price per Ticket (a) $360 S After Tax S Before Tax S After Tax S Before Tax (b) Price per Ticket Millions of Tickets per Year

49 Hall & Leiberman; Economics: Principles And Applications, Tax Incidence and Supply Elasticity Although there are extreme cases of supply elasticity, in general the following is true –For a given demand curve, the more elastic is supply, the more of an excise tax is paid by buyers –The more inelastic is supply, the more of the tax is paid by sellers

50 Hall & Leiberman; Economics: Principles And Applications, Figure 12: Tax Incidence and Supply Elasticity $300 $240 $360 $ D A D A B (a) Millions of Tickets per Year Price per Ticket (b) Price per Ticket Millions of Tickets per Year S Before and After Tax S After Tax S Before Tax

51 Hall & Leiberman; Economics: Principles And Applications, The Market For Food Shrinking and unstable incomes are problems for farmers The market for farm goods would reach an equilibrium if it were allowed to do so But farming seems to be special –Notion of small family farm has tremendous political appeal –Farmers have banded together to form powerful and effective government lobbies Result has been continual government interference with supply and demand in agricultural markets around the world

52 Hall & Leiberman; Economics: Principles And Applications, Figure 13: The Market For Food P1P1 Q1Q1 D S Old Technology Q2Q2 P2P2 A B P1P1 Q1Q1 D A B Q2Q2 P2P2 S New Technology (a)(b) Quantity of Food Price per Unit of Food Quantity of Food S Bad Weather S Good Weather

53 Hall & Leiberman; Economics: Principles And Applications, Health Insurance and the Market for Health Care Health insurance has definite benefits to our society Our current health care system keeps patients from facing the full opportunity cost of their health care decisions –Can cause people to over consume health care Health insurance reduces buyers incentives to monitor their health care expenditures closely or to shop around for high-quality low-cost care

54 Hall & Leiberman; Economics: Principles And Applications, Figure 14: The Market For Health Care With Coinsurance Examinations per Year Price per Examination 150,000100,000 B A D After Insurance D Before Insurance S $


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