ii.) Price controls and government policies effect on the market Lecture Three i.) Elasticity ii.) Price controls and government policies effect on the market Professor Chris Wimmer Oct 26 2007

Elasticity Elasticity measures the responsiveness of demand or supply to one of its determinants or factors We need this tool to help us find new equilibrium price and quantity when a shift or movement occurs

Price elasticity of demand This measure of how much quantity demanded changes with a change in price Price elasticity of demand = % Δ quantity demanded / % Δ price = Q2-Q1/Q1 x 100 / P2-P1/P1 x 100 Let’s do some examples

Elasticity factors Close substitutes – Products with close substitutes will have very elastic demands Necessities - Necessities will have inelastic demands vs. luxuries Market definition – more narrow defined markets have more elastic demand e.g. Porsche vs. cars Time horizon – Longer time horizons have more elastic demand – this is because of time to change

Midpoint method Sometimes calculating elasticity on a curve gives different answers depending what direction you go on the line Midpoint formula eliminates this problem see pg. 92 Not all demand curves have constant elasticity. Straight lines do not!

Types of demand curves Elastic – elasticity is greater than one These curves are usually a little flat Unit Elastic – elasticity = 1 Inelastic – elasticity is less than one These curves are usually steep Lets draw them

Revenue Revenue is the amount of money a firm makes before subtracting costs You can calculate it by P x Q Changes in price change the revenue depending on the elasticity of demand

Elasticity and revenue If the demand is elastic then price and revenue move in opposite directions If the demand is inelastic then price and revenue move in the same direction If the demand is unit elastic then revenue stays constant as price changes These are generalizations but typically true

Other demand elasticities Income elasticity of demand – change in quantity demanded as income changes I E D = % Δ quantity demanded / % Δ income Cross-price elasticity of demand (CPED) – change in the quantity of product 1 from a change in the price of product 2 C P E D - % Δ quantity demanded of product 1 / % Δ price of product 2 Compliments are – ve CPED, substitutes are + ve CPED

Elasticity of Supply This measures how the supply of a good changes as prices changes Price elasticity of supply = %Δ quantity supplied / % Δ price Or = Qs2 – Qs1/Qs1 x 100 / P2-P1/P1 x 100 Let’s try calculating elasticity of supply

Elasticity and supply curves Let’s draw an elastic supply curve, an inelastic supply curve, and a unit elastic supply curve

Revenue, demand and supply Let’s work on some examples of shifts in supply, demand, supply and demand to see what happens to revenue under different situations

Farmer’s Crops Is a large harvest a good thing if it is only for one farmer? What about for all farmers?

ii.) Price controls and government policies effect on the market When the market functions properly it always provides the most efficient allocation of goods But it does not always provide the most equitable (equal) allocation between citizens This is when sometimes the government is needed

Price ceilings If the government feels that prices are too high, they can impose a price ceiling A price ceiling is binding if it is below the market price A price ceiling is not binding if it is above market price

See pg. 115

Price floors In other situations, the government may help a particular product or industry by setting a price floor Trade sometimes will make this choice a bad one. Why?

Taxes The government mostly taxes to raise income for the country so they can spend money where needed Sometimes taxes are used as an incentive What goods are the best for the government to tax, elastic or inelastic demands?

Tax incidence Tax incidence refers to how much of the tax is paid by buyers and how much is paid by sellers

If we tax the buyers If buyers are taxed they will buy less of a product because they are paying a higher price even if to two different places. The sellers and buyers will end up sharing the tax burden

What if the sellers are taxed Much like if the buyers are taxed the sellers are receiving less of the profit from the sale price because they have to include the tax Thus we see by both graphs that a tax on sellers or buyers has the same effect

Elasticity and taxes The burden of the tax will be paid by the person with a less elastic curve The elasticity can be seen as the likelihood of the buyer or seller to exit the market

Homework Pg. 132  134 Q# 2, 3, 4, 5, 6, 7 Pr# 1, 2, 3, 4, 6, 7, 8, 10, 11