Demand & Supply Dr. Alok Kumar Pandey

Agenda for Discussion Cross elasticity Market Demand and Market Supply Bandwagon Effect Impact of Tax Price Elasticity and Tax Incidence Price Ceilings and Price Floors

Cross-Price Elasticity of Demand Responsiveness of D for one good to changes in P of another good %∆ in demand for one good divided by %∆ in price of another good If positive: substitutes If negative: complements If zero: unrelated

Market Demand and Market Supply Market demand schedule Market demand curve Market supply schedule Market supply curve

Summing individual D curves to derive market 2 4 6 Price dX (a) X 2 4 6 dY (b) Y 2 Quantity 4 6 dZ (c) Z 2 6 12 4 dX+dY+dZ=D (d) Market Market demand curve is the horizontal sum of individual demand curves

Bandwagon Effect Individual demand is influenced by number of other households consuming a commodity The greater the number of households consuming a commodity Key to marketing most toys and clothing is to create a bandwagon effect Results in market demand curve shifting outward

Impact of Tax How do taxes affect the economic well-being of market participants? It does not matter whether a tax on a good is levied on buyers or sellers of the good. The price paid by buyers rises, and the price received by sellers falls.

The Effects of a Tax Price Demand Supply Price buyers pay Price sellers receive Quantity with tax Size of tax Price without tax Quantity Quantity

How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks.

How a Tax Affects Market Participants Tax Revenue T = the size of the tax Q = the quantity of the good sold T  Q = the government’s tax revenue

Tax Revenue Price Demand Supply Quantity with tax Price buyers pay Price sellers receive Tax revenue (T × Q) Size of tax (T) Quantity without tax Quantity sold (Q) Quantity

How a Tax Affects Market Participants The change in total welfare includes: The change in consumer surplus, The change in producer surplus, and The change in tax revenue. The losses to buyers and sellers exceed the revenue raised by the government. This fall in total surplus is called the deadweight loss.

Price Elasticity and Tax Incidence Decrease in S by the amount of tax Tax incidence Consumers : high P Producers: net-of-tax receipt

Price Elasticity and Tax Incidence The more price elastic the D: The more tax producers pay The less tax consumers pay The more elastic the S: The less tax producers pay The more tax consumers pay

Effects of price elasticity of D on tax incidence (a) Less elastic demand (b) More elastic demand Price 1.15 1.00 0.95 Price 1.05 1.00 0.85 0.20 Tax St St D 0.20 Tax S D’ S Millions of ounces per day 10 9 10 7 The more elastic the D curve, the more tax is paid by producers (lower net-of-tax receipt)

Effects of price elasticity of S on tax incidence (a) More elastic supply (b) Less elastic supply St” Price 1.15 1.00 0.95 0.20 Tax Price 1.05 1.00 0.85 St’ S” D’’ D’’ 0.20 Tax S’ quantity 10 8 10 9 The more elastic the S curve, the more tax is paid by consumers as a higher price.

Price Ceilings A price ceiling establishes a maximum price that sellers are legally permitted to charge. Example: rent control When a price ceiling keeps the price of a good below the market equilibrium, there will be both direct and indirect effects. (Direct effect) A shortage: the quantity demanded will exceed the quantity supplied. Waiting lines may develop. (Indirect effects) Quality deterioration and changes in other non-price factors that are favorable to sellers & unfavorable to buyers.

The Impact of a Price Control Price (rent) Rental housing market Consider the rental housing market where the price (rent) P0 would bring the quantity of rental units demanded into balance with the quantity supplied. S A price ceiling like P1 imposes a price below market equilibrium … P0 causing quantity demanded QD … to exceed quantity supplied QS … Price ceiling P1 resulting in a shortage. Shortage Because prices are not allowed to direct the market to equilibrium, non-price elements will become more important in determining where the scarce goods go. D Quantity of housing units QS QD

Effects of Rent Control Shortages and black markets will develop. The future supply of housing will decline. The quality of housing will deteriorate. Inefficient use of housing will result.

Price Floor A price floor establishes a minimum legal price for the good or service. Example: minimum wage When a price floor keeps the price of a good above the market equilibrium, it will lead to both direct and indirect effects. (Direct effect) A surplus: sellers will want to supply a larger quantity than buyers are willing to purchase. (Indirect effects) Changes in non-price factors that are favorable to buyers and unfavorable to sellers.

The Impact of a Price Floor S A price floor like P1 imposes a price above market equilibrium … Surplus P1 Price floor causing quantity supplied Qs … to exceed quantity demanded QD … resulting in a surplus. P0 Because prices are not allowed to direct the market to equilibrium, non-price elements of exchange will become more important in determining where scarce goods go. D Quantity QD QS

Minimum Wage: An Example of a Price Floor When the minimum wage is set above the market equilibrium for low-skill labor, the following will occur: Direct effect: Reduces employment of low-skilled labor. Indirect effects: Reduction in non-wage component of compensation Less on-the-job training

Employment and the Minimum Wage Price (wage) Low-skill labor market Excess supply S Consider the market for low-skill labor where a price (wage) of 5.00 could bring the quantity of labor demanded into balance with the quantity supplied. 7.25 Minimum wage level 5.00 A minimum wage (price floor) of 7.25 would increase the wages of low-skill labor, but employment will decline from E0 to E1 . Those who lose their jobs will be pushed into either unemployment or less preferred employment. D Quantity (employment) E1 E0

Case Study: Does the Minimum Wage Help the Poor? While increasing the minimum wage will increase the wages of low-skill workers, their on-the-job training opportunities, non-wage benefits, working conditions, and employment will decline. Who earns minimum wage? Most minimum wage workers are young and / or only working part-time. Fewer than are from families with incomes below the poverty line.

HOME ASSIGNMENT – MANAGERIAL ECONOMICS Date of Submission: 27/06/2008 Note: Copying will award zero marks. After last date of submission student will loose 25% of Marks. Maximum word limit for each question is 500 words.

HOME ASSIGNMENT – MANAGERIAL ECONOMICS Question 1: Write the role of government in the developing economy. Question 2: Write a note on invisible hand principle. Question 3: Explain in brief the relevance of Price ceiling and Price Floor. Question 4: Explain the concept of PPF.