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 Get the government involved in production decisions –Rather than leaving them to the market

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

20 Determinants of Elasticity 1.Availability of substitutes 2.Necessities vs. Luxuries 3.Importance in the Buyer’s Budget 4.Time Horizon The demand is more price elastic: –close substitutes are easy to find –The less of a “necessity” (luxurious) –The more of total budgets spent on good –The longer the time horizon

21 Two Practical Examples 1.Elasticity and Mass Transit long-run demand for mass transit is inelastic An increase in fares –would increase revenue –would decrease ridership 2.Elasticity and an Oil Crisis to bring about 1% percent decrease in world oil demand oil prices would have to rise by 6.67%

22 Income Elasticity of Demand Percentage change in quantity demanded divided by the percentage change in income –percentage increase in quantity demanded for each 1% rise in income

23 Income Elasticity of Demand Differences –Price elasticity of Demand sensitivity of demand to price as we move along a demand curve virtually always negative –Income elasticity of Demand relative shift in demand curve positive or negative

24 Cross-Price Elasticity of Demand Percentage change in quantity demanded of one good (x) caused by a 1% change in the price of another good (y) Substitutes: E xy >0 Complements: E xy <0

25 Price Elasticity of Supply Percentage change in quantity of a good supplied, caused by a 1% change in the price of the good The more easily suppliers can switch to alternate goods, the more elastic the supply

26 Taxes and Market Equilibrium Excise tax - tax on a specific good –to raise the price and discourage the use –A tax collected from sellers shifts the supply curve upward by the amount of the tax –A tax collected from buyers shifts the demand curve downward The part of the tax paid by each side of the market is the same whether the tax is imposed on buyers or imposed on sellers

27 An Excise Tax on Sellers - Airlines Figure 7 A Tax on Sellers Shifts the Supply Curve Upward S1S1 S After Tax $ Price per Ticket Millions of Tickets per Year A A’ with a $60 tax, the airlines must get $60 more than before to supply any given number of tickets.

28 An Excise Tax on Sellers - Airlines Figure 8 The Effect of an Excise Tax Imposed on Sellers S1S1 S after tax $ Price per Ticket Millions of Tickets per Year A B Before the tax After the tax Buyers pay $40 of the tax Sellers pay $20 of the tax 340 D 7.5

29 An Excise Tax on Buyers Figure 9 A Tax on Buyers Shifts the Demand Curve Downward $ Price per Ticket Millions of Tickets per Year A’ A D1D1 D After Tax with a $60 tax imposed on buyers they must be charged $60 less than before to demand any given number of tickets.

30 An Excise Tax on Buyers Figure 10 The Effect of an Excise Tax Imposed on Buyers Price per Ticket Millions of Tickets per Year A D1D1 D After Tax Before the tax S C 280 $ After the tax Buyers pay $40 of the tax Sellers pay $20 of the tax 280 $340

31 The War on Drugs Figure 11(a) - Market for heroin without government intervention Figure 11(b) - Result of government efforts to restrict supply (current policy) –Price rises; –Total expenditure increases Figure 11(c) - Results of an effective policy of reducing demand –Price falls; –Total expenditure falls

32 The War on Drugs P1P1 Q1Q1 D1D1 A S1S1 Quantity Price per Unit Figure 11a The War on Drugs

33 The War on Drugs B Q1Q1 S2S2 P2P2 Q2Q2 P1P1 D1D1 S1S1 Quantity Price per Unit A Figure 11b The War on Drugs

34 The War on Drugs P1P1 Q1Q1 D1D1 A S1S1 Quantity Price per Unit C D2D2 Q3Q3 P3P3 Figure 11c The War on Drugs

35 How Scholarships Increase College Tuition A subsidy gives dollars to the buyer or seller when a unit is sold. –The results for buyers and sellers are the same whether the subsidy is paid out to buyers or to sellers. –Colleges - get more for each student who attends –Students - pay less Higher tuition - a call for greater subsidies. Greater subsidies - lead to higher tuition

36 How Scholarships Increase College Tuition Figure 12 A Subsidy for Students Attending College $31, Price per Year Number of Students Attending College (millions) D1D1 S1S1 A 25,000 21,000 4 B D After Subsidy