Download Ch.4

Chapter 4
Working with
Supply and Demand
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
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
2
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
3
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
4
Price Ceilings
• Figure 1 A Price Ceiling in the Market for Maple Syrup
5. With a black market,
the lower quantity sells
for a higher price than initially.
Price per
Bottle
3. and decreases the
quantity supplied
S
T
$4.00
3.00
2.00
R
4. The result is a shortage
– the distance between
R and V
E
V
2. increases the
quantity demanded
D
1. A price ceiling lower than
the equilibrium price…
40,000 50,000 60,000
Number of Bottles of
Maple Syrup per Period
5
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
6
Price Floors
• Figure 2 A Price Floor in the Market for Nonfat Dry Milk
Price
per
Pound
1.A price floor higher
than the equilibrium
price . . .
2. decreases quantity
demanded…
3.and increases
quantity supplied
S
J
K
$0.81
A
0.65
4. the result is a surplus
(distance between K and J)
D
180
200
220
Millions of Pounds
7
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
8
The Elasticity Approach
• Price elasticity of demand (ED)
– percentage change in quantity
demanded divided by percentage change
in price
% Q D
ED 
% P
9
Price Elasticity of Demand
• Negative
• Percentage change in quantity
demanded for each 1% change in price
• The greater the ED the more sensitive
quantity demanded is to price
• Percentage Change
– Use the midpoint formula
• Change in variable divided by the average
10
Calculating Price Elasticity of Demand
• %Change in Price
( P1  P0 )
%P 
 P1  P0 
 2 
• %Change in Quantity demanded
(Q1  Q0 )
% Q D 
 Q1  Q0 
 2 
11
Calculating Price Elasticity of Demand
• Figure 3 Using the Midpoint Formula for Elasticity
Price
Per
Avocado
$1.50
3. Elasticity of demand for the
move from A to B is
20% / 40% = 0.5
A
B
1.00
1. Using the midpoint
formula, the percentage drop
in price is $0.50/$1.25
= 0.40 or 40% …
4,500
5,500
2. and the percentage rise
in quantity is 1,000 / 5,000
= 0.2 or 20%.
Quantity of
Avocados per week
12
Types of Demand Curves
• Perfectly inelastic demand: ED=0
• Inelastic demand: ED between 0 and 1
• 1% rise in price will cause quantity
demanded to fall by less than 1%
• Perfectly elastic demand:
– ED approaching infinity
• Elastic demand: ED >1
• a 1% rise in price will cause quantity
demanded to fall by more than 1%
• Unit elastic demand: ED=1
13
Types of Demand Curves
• Figure 4 Categories of Demand Curves
b) Inelastic Demand
a) Perfectly Inelastic Demand
P
P
D
$11
$11
9
9
D
Price
rises
by 20%
Price
rises
100
Quantity doesn’t change
Q
95 105
Q
Quantity falls by less than 20%
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Types of Demand Curves
• Figure 4 Categories of Demand Curves
c) Elastic Demand
d) Perfectly Elastic Demand
P
P
Consumers will buy
any quantity at $9,
none at a higher price
D
$11
D
9
$9
Price
rises
by 20%
85
115
Q
100
Q
Quantity falls by more than 20%
15
Elasticity and Straight-Line Demand Curves
• Figure 5 How Elasticity Changes along a Straight-Line Demand
Price
$2,000
Each time P
drops by
$500, the
%ΔP is larger
A
B
1,500
Elasticity falls as we
move rightward along
a straight-line demand
curve
C
1,000
D
15,000
25,000 35,000
Each time Q rises by another 10,000, the
%ΔQ is smaller.
Quantity
of Laptops
16
Elasticity and Straight-Line Demand Curves
• Demand becomes less elastic (ED gets
smaller) as we move downward and
rightward.
• Demand becomes more elastic (ED
increases) as we move upward and
leftward
17
Elasticity and Total Revenue
• Total Revenue TR=PxQ
• Inelastic Demand (ED < 1)
• total revenue moves in same direction as
price
• Elastic Demand (ED > 1)
• total revenue moves in opposite direction
from price
• Unitary elastic demand
• total revenue remains the same as price
changes
18
Elasticity and Total Revenue
• Figure 6 Elasticity and Total Revenue
a) Inelastic Demand
b) Elastic Demand
P
$11
P
B
$11
B
A
9
A
9
D
D
95 105
Q
85
115
Q
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Determinants of Elasticity
1.
2.
3.
4.
•
Availability of substitutes
Necessities vs. Luxuries
Importance in the Buyer’s Budget
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
20
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%
21
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
%QD
EY 
%Income
22
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
23
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)
E xy 
%QDx
%Py
• Substitutes: Exy >0
• Complements: Exy <0
24
Price Elasticity of Supply
• Percentage change in quantity of a good
supplied, caused by a 1% change in the
price of the good
%QS
ES 
%P
• The more easily suppliers can switch to
alternate goods, the more elastic the supply
25
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
26
An Excise Tax on Sellers - Airlines
• Figure 7 A Tax on Sellers Shifts the Supply Curve Upward
SAfter Tax
Price per
Ticket
S1
A’
$360
300
A
10
with a $60 tax, the
airlines must get $60 more
than before to supply any
given number of tickets.
Millions of
Tickets per Year
27
An Excise Tax on Sellers - Airlines
• Figure 8 The Effect of an Excise Tax Imposed on Sellers
Price per
Ticket
After the tax
Safter tax
$360
340
B
300
Buyers pay $40 of the tax
Sellers pay $20 of the tax
S1
A
Before the tax
D
7.5
10
Millions of
Tickets per Year
28
An Excise Tax on Buyers
• Figure 9 A Tax on Buyers Shifts the Demand Curve Downward
Price per
Ticket
A
$300
with a $60 tax imposed on buyers
they must be charged $60 less
than before to demand any
given number of tickets.
A’
240
D1
D After Tax
10
Millions of
Tickets per Year
29
An Excise Tax on Buyers
• Figure 10 The Effect of an Excise Tax Imposed on Buyers
Price per
Ticket
Buyers pay $40 of the tax
Sellers pay $20 of the tax
S
$340
A
Before the tax
300
C
280
D1
After the tax
D After Tax
7.5
10
Millions of
Tickets per Year
30
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
31
The War on Drugs
• Figure 11a The War on Drugs
Price per
Unit
S1
A
P1
D1
Q1
Quantity
32
The War on Drugs
• Figure 11b The War on Drugs
Price per
Unit
S2
B
S1
P2
A
P1
D1
Q2 Q1
Quantity
33
The War on Drugs
• Figure 11c The War on Drugs
Price per
Unit
S1
A
P1
P3
C
D1
D2
Q3
Q1
Quantity
34
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
35
How Scholarships Increase College Tuition
• Figure 12 A Subsidy for Students Attending College
Price per
Year
S1
B
$31,000
A
25,000
21,000
D After Subsidy
D1
4
4.8
Number of Students
Attending College
(millions)
36