Chapter 4 Working with Supply and Demand ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 Government Intervention in Markets Excess demand –Quantity demanded exceeds quantity supplied –Sellers - short side of the market Excess supply –Quantity supplied exceeds quantity demanded –Buyers - short side of the market

3 Government Intervention in Markets Shortage –Excess demand not eliminated by a rise in price Surplus –Excess supply not eliminated by a fall in price When quantity supplied and quantity demanded differ, the short side of the market will prevail

4 Price Ceilings A government imposed maximum price –Prevents the price from rising above a certain level Creates a shortage Unintended consequences –Black market illegal price above the ceiling –Long lines, higher prices

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

6 Price Floors A government imposed minimum price –prevents the price from falling below a certain level Creates a surplus –that no one wants at the imposed price the government buys the excess supply

7 Price Floors $ K J S D A Millions of Pounds Price per Pound Figure 2 A Price Floor in the Market for Nonfat Dry Milk 1.A price floor higher than the equilibrium price decreases quantity demanded… 3.and increases quantity supplied 4. the result is a surplus (distance between K and J)

8 Problems with the Rate of Change Price elasticity of demand –Measures the sensitivity of quantity demanded to a change in price Problems with the rate of change (slope) –Not a good measure of elasticity Depends on the units of measurement Significance of a change in price or quantity

9 The Elasticity Approach Price elasticity of demand (E D ) –percentage change in quantity demanded divided by percentage change in price

10 Price Elasticity of Demand Negative Percentage change in quantity demanded for each 1% change in price The greater the E D the more sensitive quantity demanded is to price Percentage Change –Use the midpoint formula Change in variable divided by the average

11 Calculating Price Elasticity of Demand %Change in Price %Change in Quantity demanded

12 Calculating Price Elasticity of Demand Figure 3 Using the Midpoint Formula for Elasticity Quantity of Avocados per week Price Per Avocado A B 4,5005,500 $ Using the midpoint formula, the percentage drop in price is $0.50/$1.25 = 0.40 or 40% … 2. and the percentage rise in quantity is 1,000 / 5,000 = 0.2 or 20%. 3. Elasticity of demand for the move from A to B is 20% / 40% = 0.5

13 Types of Demand Curves Perfectly inelastic demand: E D =0 Inelastic demand: E D between 0 and 1 1% rise in price will cause quantity demanded to fall by less than 1% Perfectly elastic demand: –E D approaching infinity Elastic demand: E D >1 a 1% rise in price will cause quantity demanded to fall by more than 1% Unit elastic demand: E D =1

14 Types of Demand Curves Figure 4 Categories of Demand Curves P Q100 9 $11 D Price rises Quantity doesn’t change a) Perfectly Inelastic Demand P Q105 9 $11 D Price rises by 20% Quantity falls by less than 20% b) Inelastic Demand 95

15 Types of Demand Curves Figure 4 Categories of Demand Curves P Q115 9 $11 D Price rises by 20% Quantity falls by more than 20% c) Elastic Demand 85 P Q100 $9 Consumers will buy any quantity at $9, none at a higher price d) Perfectly Elastic Demand D

16 Elasticity and Straight-Line Demand Curves Figure 5 How Elasticity Changes along a Straight-Line Demand $2,000 Price 1,500 1,000 15,00025,000 35,000 D Quantity of Laptops A B C Each time P drops by $500, the %ΔP is larger Each time Q rises by another 10,000, the %ΔQ is smaller. Elasticity falls as we move rightward along a straight-line demand curve

17 Elasticity and Straight-Line Demand Curves Demand becomes less elastic (E D gets smaller) as we move downward and rightward. Demand becomes more elastic (E D increases) as we move upward and leftward

18 Elasticity and Total Revenue Total Revenue TR=PxQ Inelastic Demand (E D < 1) total revenue moves in same direction as price Elastic Demand (E D > 1) total revenue moves in opposite direction from price Unitary elastic demand total revenue remains the same as price changes

19 Elasticity and Total Revenue Figure 6 Elasticity and Total Revenue P Q105 9 $11 D a) Inelastic Demand 95 P Q115 9 $11 D b) Elastic Demand 85 A B A B