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1 ECON649/ECON991 Lecture 3

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2 Class Test Next Week An in-class test will be held in the 1 st hour of your week 4 lecture. You MUST attend the lecture in which you are enrolled to undertake the test. It will cover material from lectures and textbook readings in weeks The test will consist of 30 multiple choice questions and will be 45mins in duration. You MUST bring 2 pencils (2B is best), an eraser and your student ID card to the test.

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3 Applications of Supply & Demand Analysis

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4 So far we have assumed that S & D are the only forces at work. Now consider different forms of government intervention within the S & D framework.

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5 Price Ceiling Price ceiling = legally enforceable maximum price, imposed by the government in the belief that the market equilibrium price is too high. Proponents claim ceilings help the poor.

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6 Price Ceiling We shall explore P ceiling in the context of rent control. Suppose market in equilibrium (P*=300) Suppose govt imposes maximum rental rate of $200 p.w. QD P and QS excess D = 900 apartments D S P*= $300 PC= $200 P = weekly rental rate Q of apartments 500 QS 1400 QD

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7 Price Ceiling We have excess demand but price is not (legally) allowed to increase to restore D = S Need non-price rationing device Who would you rent to? –Poorest members of society?

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8 Price Ceiling Rational self-interested landlords favour those with: –High income –Secure employment –Good history as a tenant and discriminate against: –Low income-earners (= the poor) –Jobless

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9 Price Ceiling Certainly P ceiling has made apartments more affordable BUT only those lucky enough to rent an apartment (from the 500) will benefit. The rest of would-be renters (= 900 of them) are not helped. They are willing and able to rent at $200 but apartments are just not available.

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10 Price Ceiling Landlords may –Accept side-payments (= bribes) –Impose extra charges Extra to rent the key Extra to rent curtains etc.

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11 Price Ceiling May also see: quality of apartments over time (repair costs but rents fixed) development of black market = illegal market to circumvent rent control

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12 Price Ceiling – Deadweight Loss AEP* = consumer surplus before price ceiling FP*E = producer surplus before price ceiling ABGP C = consumer surplus after price ceiling Note: P*HGP C = Transfer of part of producer surplus to consumers FP C G = producer surplus after price ceiling GBE = deadweight loss to society D S P*= $300 P C = $200 P = weekly rental rate Q of apartments 500 QS 1400 QD Deadweight loss A B G E F H

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13 Price Floor Price Floor = legally enforceable minimum price, imposed by govt in the belief that P* (where D=S) is too low. We often see price floors in the labour market where the objective is to provide an adequate wage via minimum-wage laws. In a freely competitive labour market the equilibrium wage rate and quantity of labour employed will be W*, E* where D labour = S labour

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14 Price Floor Suppose the govt imposes a price floor where minimum wage is set at W min. QS W to W min & QD excess supply of labour W min BCA SLSL DLDL 0 E1E1 E* W* E2E2 excess supply

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15 Price Floor At W min, we have excess supply but wage rate not allowed to fall to bring about D L = S L Min-wage law has wage rate for those who remain employed (i.e. who are part of E 1 ) but Overall level of employment has SLSL DLDL 0 E1E1 E* W* W min BCA E2E2

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16 Price Floor Min wage has created involuntary unemployment = distance BA Involuntary unemployment is comprised of BC + CA: BC = those laid off = the E* - E 1 group and CA = an additional group of would-be workers (E 2 – E*) drawn to the labour market in response to W from W*. SLSL DLDL 0 E1E1 E* W* W min BCA E2E2 Involuntary unemployment

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17 Price Floor As W to W min labour relatively less attractive to employers Employers may react by: –using more capital in place of labour –employing only close family –increase skill standards – apprenticeships and other on-job training schemes –may attempt to compensate themselves for having to pay higher wages by changing work conditions.

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18 Price Floor – Deadweight Loss AEW* = firms (consumer) surplus before price floor FW*E = workers (producer) surplus before price floor ABW min = firms (consumer) surplus after price floor Note: W*HBW min = Transfer of part of firms surplus to workers FW min BG = workers (producer) surplus after price floor GBE = deadweight loss to society DLDL SLSL W* W min Weekly Wage Employment QDQS Deadweight loss A B G E F H

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19 Price Elasticity, Income Elasticity & Cross Elasticity of Demand

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20 Elasticity Via the Law of Demand we can see that as P QD but how responsive is QD to P? If P 20% will QD by exactly 20% or >20% or <20%? We need a measure of responsiveness which brings us to the concept of elasticity. We will consider the following types of elasticity: –Price elasticity –Cross elasticity –Income elasticity

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21 Price Elasticity of Demand =measure of responsiveness of QD to a change in price, ceteris paribus =proportional change in QD ____________________________________________________________________ proportional change in P =% QD= effect _______________ ____________ % P cause (ceteris paribus requires just one cause) We convert this ratio into a number (called a coefficient) and refer to this number as the price elasticity of demand

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22 Formulae for Calculating Price Elasticity of Demand Point formula Designed to measure elasticity at a single point on the D curve Suitable where we observe small proportional changes in P and Q

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23 Point Formula Because of the Law of Demand, the price elasticity of demand coefficient will always be a negative number. So we do not need to include the negative sign when discussing price elasticity of demand.

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24 Point Formula Elasticity depends on both slope of D curve and position on D curve. The equation P=a-bQ is a general equation for a linear negatively sloped D curve where: -b = slope = P/ Q

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25 Point Formula 1 ______________ slope Position on D Curve

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26 Point Formula Suppose D curve is given by P = 81 – 9Q Calculate elasticity where P = 18, Q = 7 ( P/ Q = -9)

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27 Point Formula Now calculate elasticity where P=27, Q=6 We see that along given D curve we have constant slope (=-9 here), but at different positions on the curve we have different price elasticity values

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28 Elasticity along a Demand Curve Q P D E = 1 E > 1 E < 1 Slope is constant, but elasticity is always changing due to different P/Q ratio. P1P1 Q1Q1

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29 ARC Elasticity Formula At times we may see changes in price and quantity demanded that span a whole section or arc of a given D curve. Suppose we wanted to determine price elasticity over the arc A to B A B Q P ,000,0001,200,000

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30 ARC Elasticity Formula Calculating the change A B Reversing the direction of change B A A B Q P ,000,0001,200,000

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31 ARC Elasticity Formula Can see that it makes a difference whether you calculate A B or B A We avoid this difficulty by using a modified arc formula called the mid-point formula

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32 ARC Elasticity Formula With this formula, the average P and average Q values are used in place of the original or starting values. This formula will yield same elasticity coefficient whether change from A B or B A (i.e. E = )

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33 Classifying Demand according to Price Elasticity of Demand We classify demand according to the absolute or numerical value of elasticity. If |E| > 1 % Q > % P we say that DEMAND IS ELASTIC If |E| = 1 % Q = % P we say that DEMAND IS UNITARY ELASTIC If |E| < 1 % Q < % P we say that DEMAND IS INELASTIC

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34 Limiting Cases for Price Elasticity of Demand There are several limiting cases or extremes. Case 1: Perfectly Elastic Demand |E| = P infinitely large Q D Q P

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35 Limiting Cases for Price Elasticity of Demand Case 2: Perfectly Inelastic Demand |E| = 0 P but no Q D Q P

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36 Limiting Cases for Price Elasticity of Demand Case 3: Unitary elastic demand |E| = 1 all along the D curve D Q P

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37 NOTE: When economists say that demand is inelastic, they do not mean perfectly inelastic. Rather they are referring to a situation where |E| < 1 (i.e. where % Q < % P) If they wish to consider the case of perfectly inelastic demand they call it perfectly inelastic demand.

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38 Factors Influencing Elasticity of Demand Price elasticity depends primarily on the level of price –At a high price, QD tends to be elastic –At a low price QD tends to be less responsive to P There are a number of other important factors which influence the responsiveness of QD to a change in price…..

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39 Factors Influencing Elasticity of Demand Availability of substitutes The more substitutes available the more elastic is demand; the fewer substitutes available the less elastic demand will be. The number of substitutes available depends on how we define the market for the product. The more narrowly defined a market is the more substitutes there are available.

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40 Factors Influencing Elasticity of Demand Share of expenditure on the good in the consumers budget The greater the fraction of your budget that the item takes up the more responsive your demand will be to a change in price, i.e. your demand will be more elastic. The less of your budget that the item takes up the less responsive your demand will be to a change in price, i.e. your demand will be more inelastic.

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41 Factors Influencing Elasticity of Demand Length of time involved The more time that passes the more elastic your demand becomes. As you have more time to seek out substitutes, or newly created substitutes become available. The less time that has passed the less elastic your demand. Necessities versus Luxuries Goods that are luxuries have more elastic demand than goods that are necessities.

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42 Price Elasticity of Demand and Total Revenue An important practical application of elasticity is to show how changes in the price of a product affect overall spending on that product. Overall spending = price x quantity purchased From sellers perspective this is total revenue (TR) From buyers viewpoint this is consumer expenditure

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43 Price Elasticity of Demand and Total Revenue When price changes, TR may increase, decrease or remain unchanged. The impact on TR depends on: a)Whether demand is elastic, unitary or inelastic and b)Whether price increases or decreases

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44 Impact of P on TR Consider P when |E| > 1 (% Q > % P) TR 1 at P 1, Q 1 = P 1 BQ 1 0 TR 2 at P 2, Q 2 = P 2 AQ 2 0 TR 1 > TR 2 negative positive impact on TR via Q TR via P TR falls P Q Q1Q1 Q2Q2 P1P1 P2P2 0 B A Loss = CBQ 1 Q 2 Gain = P 2 ACP 1 Unchanged = P 1 CQ 2 0 C

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45 Impact of P on TR Consider P when |E| < 1 (% Q < % P) TR 1 at P 1, Q 1 = P 1 BQ 1 0 TR 2 at P 2, Q 2 = P 2 AQ 2 0 TR 2 > TR 1 negative positive impact on TR via Q TR via P TR increases P Q1Q1 Q2Q2 P1P1 P2P2 0 B A Loss = CBQ 1 Q 2 Gain = P 2 ACP 1 Unchanged = P 1 CQ 2 0 C

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46 Impact of P on TR Consider P when |E| = 1 (% Q = % P) TR 1 at P 1, Q 1 = P 1 BQ 1 0 TR 2 at P 2, Q 2 = P 2 AQ 2 0 TR 2 = TR 1 negative positive impact on = impact on TR via Q TR via P TR does not change P Q Q1Q1 Q2Q2 P1P1 P2P2 0 B A Loss = CBQ 1 Q 2 Gain = P 2 ACP 1 Unchanged = P 1 CQ 2 0 Mid-point on D curve E = 1 C

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47 Impact of P on TR Having information relating to any two of the following lines will permit you to determine the third situation: i.|E| > 1, |E| = 1, |E| < 1 ii.price or price iii.TR or TR or TR unchanged e.g. knowing that price and |E| = 1 TR will be unchanged knowing that price and TR |E| > 1

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48 Summary of Impact of P on TR |E| > 1|E| = 1|E| < 1 P %P < %Q TR %P = %Q TR no change %P > %Q TR P %P < %Q TR %P = %Q TR no change %P > %Q TR

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49 Cross-Elasticity of Demand Cross-elasticity provides a measure of extent to which two products are related to one another. X-elasticity measures the responsiveness of the demand for one good to a change in the price of another good, ceteris paribus.

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50 Cross-Elasticity of Demand XE A = proportional in demand for good A proportional in price of good B = % QD of good A % P of good B Sellers of commodities are keen to know the effect on the demand for their product when the price of related product changes.

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51 Cross-Elasticity of Demand period Q of gas P of electricity 119$ $0.55

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52 Cross-Elasticity of Demand When two products are substitutes (i.e. products that are used as replacements for each other as they have the same purpose) the XE coefficient will be positive. Goods that are complements (i.e. products that are used together) have negative XE coefficients. If two goods are unrelated then their XE coefficient will be equal to zero. e.g. a decrease in the price of DVD players causes the consumption of DVDs to increase a negative XE of demand for DVDs; so goods are complements.

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53 Income Elasticity of Demand This measures the responsiveness of the demand for a given product to a change in consumer income (Y), ceteris paribus. Y-elasticity is measured as the proportional change in demand divided by a proportional change in consumer income. E Y = % QD % Y

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54 Income Elasticity of Demand period QIncome p.w. 16$285 27$315

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55 Income Elasticity of Demand When a change in income causes demand to move in the same direction, the item is classified as a normal good. Normal goods have positive E Y coefficients (e.g. new cars) When the demand for a good and income move in the opposite directions, the good is called an inferior good. Inferior goods have negative E Y coefficients (e.g. second-hand clothes)

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56 Price elasticity of supply: The responsiveness of the quantity supplied to a change in price. Measured by dividing the percentage change in the quantity supplied of a product by the percentage change in price. The Price Elasticity of Supply

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57 Note: (i) The elasticity of supply will always be positive as price and quantity supplied always move in the same direction. (ii) Q represents quantity supplied. The Price Elasticity of Supply

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58 Determinants of the price elasticity of supply: 1.Availability of resources. 2.Capacity of production – excess or at full capacity? 3.Time involved to change production levels. 4.Short-run or long-run The Price Elasticity of Supply

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59 The polar cases of perfectly inelastic and perfectly elastic supply: -The perfectly inelastic supply curve is a vertical line. -The perfectly elastic supply curve is a horizontal line. The Price Elasticity of Supply

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60 The Price Elasticities of Supply: Hubbard et al., Table 4.5 Hubbard, Garnett, Lewis and OBrien: Essentials of Economics © 2010 Pearson Australia

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61 The Price Elasticities of Supply: Hubbard et al., Table 4.5 continued Hubbard, Garnett, Lewis and OBrien: Essentials of Economics © 2010 Pearson Australia

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62 REQUIRED READING This weeks lecture: Price Ceilings and Price Floors Hubbard, Garnett, Lewis & OBrien, Essentials of Economics Chapter 5(pp & pp ) Hubbard, Garnett, Lewis & OBrien, Microeconomics, Appendix to Chapter 5 – available as a free download from the unit web page. Elasticity Hubbard, Garnett, Lewis & OBrien, Essentials of Economics Chapters 4 & 5(pp )

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63 REQUIRED READING Next weeks lecture: Per-Unit Taxes Hubbard, Garnett, Lewis & OBrien, Essentials of Economics Chapter 5(pp ) Production and Costs Hubbard, Garnett, Lewis & OBrien, Essentials of Economics Chapter 6

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64 Solutions to D & S Exercises Demand Supply P* = ? Q* = P* = Q* = ? Supply P* = Q* = ? P* = ? Q* = ? = indeterminate

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