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Semester 1 2010 ECON649/ECON991 Lecture 3.

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1 Semester ECON649/ECON991 Lecture 3

2 Class Test Next Week An in-class test will be held in the 1st 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.

3 Applications of Supply & Demand Analysis

4 Applications of Supply & Demand Analysis
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.

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.

6 Price Ceiling P = weekly rental rate We shall explore Pceiling 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 S P*= $300 PC= $200 D 500 QS 1400 QD Q of apartments

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?

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

9 Price Ceiling Certainly Pceiling 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.

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

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

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

13 Semester 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 Dlabour = Slabour

14 Semester Price Floor excess supply SL Suppose the govt imposes a price floor where minimum wage is set at Wmin QS W to Wmin & QD  excess supply of labour B C A Wmin W* DL E1 E* E2

15 Price Floor Semester 1 2010 SL
At Wmin, we have excess supply but wage rate not allowed to fall to bring about DL = SL Min-wage law has  wage rate for those who remain employed (i.e. who are part of E1) but Overall level of employment has  B C A Wmin W* DL E1 E* E2

16 Price Floor Semester 1 2010 Involuntary unemployment SL B C A Wmin W*
Min wage has created involuntary unemployment = distance BA Involuntary unemployment is comprised of BC + CA: BC = those laid off = the E* - E1 group and CA = an additional group of would-be workers (E2 – E*) drawn to the labour market in response to W from W*. B C A Wmin W* DL E1 E* E2

17 Semester Price Floor As W to Wmin  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.

18 Price Floor – Deadweight Loss
Weekly Wage AEW* = firms’ (consumer) surplus before price floor FW*E = workers’ (producer) surplus before price floor ABWmin = firms’ (consumer) surplus after price floor Note: W*HBWmin = Transfer of part of firms’ surplus to workers FWminBG = workers’ (producer) surplus after price floor GBE = deadweight loss to society SL A Deadweight loss B Wmin E H W* G DL F QD QS Employment

19 Price Elasticity, Income Elasticity & Cross Elasticity of Demand
Semester Price Elasticity, Income Elasticity & Cross Elasticity of Demand

20 Semester 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

21 Price Elasticity of Demand
Semester 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

22 Formulae for Calculating Price Elasticity of Demand
Semester 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

23 Semester 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.

24 Semester 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

25 1 slope Position on D Curve Point Formula Semester 1 2010
______________ slope Position on D Curve

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

27 Point Formula Now calculate elasticity where P=27, Q=6
Semester 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 Do not worry about the geometric method of calculating elasticity – it is not examinable. If you are interested in reading about it see McHarg.

28 Elasticity along a Demand Curve
Semester Elasticity along a Demand Curve Slope is constant, but elasticity is always changing due to different P/Q ratio. P E > 1 E = 1 P1 E < 1 So why would demand be more responsive to a price change when the price is high compared to when the price is low? Consider an example: AIRLINE TICKETS – if the cost to fly to Melbourne was $300 a ticket and then there was a 10% increase in price, you would expect demand to be very responsive to a price change, as there are many lower cost alternatives at this price – e.g. rail ($110), driving (fuel & accommodation costs), bus ($71) . If the cost were just $90 to fly to Melbourne, then demand is less likely to respond as much to a 10% price increase, as costs of alternatives are likely to still be higher, so there are fewer of them at this price. D Q1 Q

29 ARC Elasticity Formula
Semester ARC Elasticity Formula P 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 100 B 90 1,000,000 1,200,000 Q

30 ARC Elasticity Formula
Semester ARC Elasticity Formula P Calculating the change AB Reversing the direction of change BA A 100 B 90 1,000,000 1,200,000 Q

31 ARC Elasticity Formula
Semester 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

32 ARC Elasticity Formula
Semester 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 = ) Q= 200,000 ½ x (Q1 + Q2) = 2,200,000 ÷ 2 = 1,100,000 P= 10 ½ x (P1 + P2) = 190 ÷ 2 = 95 So E =( 200,000/1,100,000) ÷(10/95) = 1.727

33 Classifying Demand according to Price Elasticity of Demand
Semester 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 DEMAND IS UNITARY ELASTIC If |E| < 1  %Q < %P DEMAND IS INELASTIC

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

35 Limiting Cases for Price Elasticity of Demand
Semester Limiting Cases for Price Elasticity of Demand P Case 2: Perfectly Inelastic Demand |E| = 0 P but no Q D e.g. demand for insulin by diabetics – quantity demanded will not vary as price changes. Q

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

37 Semester 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”.

38 Factors Influencing Elasticity of Demand
Semester 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….. Availability of substitutes – the more substitutes available the more ELASTIC demand – as the easier it is to swap to a less expensive alternative. So it depends on how narrowly defined the good or service is. E.g. increase in the price of jeans – what are our alternatives? Cotton trousers, wool trousers, synthetic trousers, shorts, skirts, dresses – so more responsive to a price change. What about if the price of all trousers increased, are there any other alternatives? Demand would be less responsive to the price change (especially for men). E.g. increase in price of lamb, can swap to some other meat, e.g. chicken, beef, pork or even fish. So demand quite responsive to change in price (i.e. elastic). However what about substitutes for meat – nuts, eggs…. There are less available so if all meat prices increased demand will respond less to a change in price (i.e. less elastic). Importance of the item in your budget – we have discussed this before. The greater portion of your budget that the item takes up the more responsive is your demand to a change in price. E.g. increase in the price of a house, compared to an increase in the price of toothpaste. Time period – the more time you have the more responsive will be your demand as you have more time to seek out substitutes. Consider petrol price increases. If the price of petrol increases today, and your car in nearly empty then you still have to buy some petrol – but you might not fill the tank up full (in the hope the price might fall a little in the days ahead). However, if the price of petrol continues to remain high over a long period of time then you might change your spending on it in a much larger way – e.g. walk more often, catch public transport, buy a bike, buy a more fuel efficient car or convert your car to run on LPG gas instead. So in the long run demand is much more responsive to an increase in price.

39 Factors Influencing Elasticity of Demand
Semester 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. Availability of substitutes – the more substitutes available the more ELASTIC demand – as the easier it is to swap to a less expensive alternative. So it depends on how narrowly defined the good or service is. E.g. increase in the price of jeans – what are our alternatives? Cotton trousers, wool trousers, synthetic trousers, shorts, skirts, dresses – so more responsive to a price change. What about if the price of all trousers increased, are there any other alternatives? Demand would be less responsive to the price change (especially for men). E.g. increase in price of lamb, can swap to some other meat, e.g. chicken, beef, pork or even fish. So demand quite responsive to change in price (i.e. elastic). However what about substitutes for meat – nuts, eggs…. There are less available so if all meat prices increased demand will respond less to a change in price (i.e. less elastic). Importance of the item in your budget – we have discussed this before. The greater portion of your budget that the item takes up the more responsive is your demand to a change in price. E.g. increase in the price of a house, compared to an increase in the price of toothpaste. Time period – the more time you have the more responsive will be your demand as you have more time to seek out substitutes. Consider petrol price increases. If the price of petrol increases today, and your car in nearly empty then you still have to buy some petrol – but you might not fill the tank up full (in the hope the price might fall a little in the days ahead). However, if the price of petrol continues to remain high over a long period of time then you might change your spending on it in a much larger way – e.g. walk more often, catch public transport, buy a bike, buy a more fuel efficient car or convert your car to run on LPG gas instead. So in the long run demand is much more responsive to an increase in price.

40 Factors Influencing Elasticity of Demand
Semester Factors Influencing Elasticity of Demand Share of expenditure on the good in the consumer’s 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. Availability of substitutes – the more substitutes available the more ELASTIC demand – as the easier it is to swap to a less expensive alternative. So it depends on how narrowly defined the good or service is. E.g. increase in the price of jeans – what are our alternatives? Cotton trousers, wool trousers, synthetic trousers, shorts, skirts, dresses – so more responsive to a price change. What about if the price of all trousers increased, are there any other alternatives? Demand would be less responsive to the price change (especially for men). E.g. increase in price of lamb, can swap to some other meat, e.g. chicken, beef, pork or even fish. So demand quite responsive to change in price (i.e. elastic). However what about substitutes for meat – nuts, eggs…. There are less available so if all meat prices increased demand will respond less to a change in price (i.e. less elastic). Importance of the item in your budget – we have discussed this before. The greater portion of your budget that the item takes up the more responsive is your demand to a change in price. E.g. increase in the price of a house, compared to an increase in the price of toothpaste. Time period – the more time you have the more responsive will be your demand as you have more time to seek out substitutes. Consider petrol price increases. If the price of petrol increases today, and your car in nearly empty then you still have to buy some petrol – but you might not fill the tank up full (in the hope the price might fall a little in the days ahead). However, if the price of petrol continues to remain high over a long period of time then you might change your spending on it in a much larger way – e.g. walk more often, catch public transport, buy a bike, buy a more fuel efficient car or convert your car to run on LPG gas instead. So in the long run demand is much more responsive to an increase in price.

41 Factors Influencing Elasticity of Demand
Semester 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. Availability of substitutes – the more substitutes available the more ELASTIC demand – as the easier it is to swap to a less expensive alternative. So it depends on how narrowly defined the good or service is. E.g. increase in the price of jeans – what are our alternatives? Cotton trousers, wool trousers, synthetic trousers, shorts, skirts, dresses – so more responsive to a price change. What about if the price of all trousers increased, are there any other alternatives? Demand would be less responsive to the price change (especially for men). E.g. increase in price of lamb, can swap to some other meat, e.g. chicken, beef, pork or even fish. So demand quite responsive to change in price (i.e. elastic). However what about substitutes for meat – nuts, eggs…. There are less available so if all meat prices increased demand will respond less to a change in price (i.e. less elastic). Importance of the item in your budget – we have discussed this before. The greater portion of your budget that the item takes up the more responsive is your demand to a change in price. E.g. increase in the price of a house, compared to an increase in the price of toothpaste. Time period – the more time you have the more responsive will be your demand as you have more time to seek out substitutes. Consider petrol price increases. If the price of petrol increases today, and your car in nearly empty then you still have to buy some petrol – but you might not fill the tank up full (in the hope the price might fall a little in the days ahead). However, if the price of petrol continues to remain high over a long period of time then you might change your spending on it in a much larger way – e.g. walk more often, catch public transport, buy a bike, buy a more fuel efficient car or convert your car to run on LPG gas instead. So in the long run demand is much more responsive to an increase in price.

42 Price Elasticity of Demand and Total Revenue
Semester 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 buyer’s viewpoint this is consumer expenditure

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

44 Impact of P on TR Semester 1 2010 P A P2 B P1 C Q2 Q1 Q Consider P
Loss = CBQ1Q2 Impact of P on TR Gain = P2ACP1 Unchanged = P1CQ20 P Consider P when |E| > 1 (%Q > %P) TR1 at P1, Q1 = P1BQ10 TR2 at P2, Q2 = P2AQ20 TR1 > TR2 negative positive impact on impact on TR via Q TR via P  TR falls A P2 B P1 C Consider a numerical example: Q1 = 5 P1 = 30 Q2 = 2 P2 = 33 10% increase in price from $30 to $33. What is % fall in Q? =(5-2)/5 = 60% Occurs because numbers for Q are small, while for P are large. Q2 Q1 Q

45 Impact of P on TR Semester 1 2010 Consider P when |E| < 1
Loss = CBQ1Q2 Gain = P2ACP1 Consider P when |E| < 1 (%Q < %P) TR1 at P1, Q1 = P1BQ10 TR2 at P2, Q2 = P2AQ20 TR2 > TR1 negative positive impact on impact on TR via Q TR via P  TR increases Unchanged = P1CQ20 P A P2 B P1 C P1 = 3 Q1 = 50 P2 = 5 Q2 = 45 % increase in P = 67% % fall in Q = 10% Q2 Q1

46 Impact of P on TR Semester 1 2010 P Mid-point on D curve E = 1 A P2 B
Loss = CBQ1Q2 Impact of P on TR Gain = P2ACP1 Unchanged = P1CQ20 P Consider P when |E| = 1 (%Q = %P) TR1 at P1, Q1 = P1BQ10 TR2 at P2, Q2 = P2AQ20 TR2 = TR1 negative positive impact on = impact on TR via Q TR via P  TR does not change Mid-point on D curve E = 1 A P2 B P1 C P1 = 8 Q1 = 20 P2 = 10 Q2 = 15 % increase in P = 25% % fall in Q = 25% Q2 Q1 Q

47 Semester Impact of P on TR Having information relating to any two of the following lines will permit you to determine the third situation: |E| > 1, |E| = 1, |E| < 1 price  or price  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

48 Summary of Impact of P on TR
Semester 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 %P = %Q %P > %Q

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.

50 Cross-Elasticity of Demand
XEA = 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.

51 Cross-Elasticity of Demand
period Q of gas P of electricity 1 19 $0.45 2 21 $0.55

52 Cross-Elasticity of Demand
Semester 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. Substitutes – e.g. different brands of pens; black pens and blue pens; pens and pencils Complements – e.g. pen and paper; petrol and car; memory card and digital camera; computer and software Unrelated – e.g. pen and rice; shoes and printers; biscuits and staplers. XE assists in identifying competitors and in making production and pricing decisions.

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. EY = %QD %Y

54 Income Elasticity of Demand
period Q Income p.w. 1 6 $285 2 7 $315

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 EY 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 EY coefficients (e.g. second-hand clothes)

56 The Price Elasticity of Supply
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.

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

58 The Price Elasticity of Supply
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

59 The Price Elasticity of Supply
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.

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

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

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

63 REQUIRED READING Next week’s lecture: Per-Unit Taxes
Semester REQUIRED READING Next week’s lecture: Per-Unit Taxes Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 5(pp ) Production and Costs Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 6

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


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