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CHAPTER
4
The Price System, Demand
and Supply, and Elasticity
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Price System
• The market system, also called the price
system, performs two important and
closely related functions :
• Price Rationing
• Resource Allocation
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Price Rationing
• Price rationing is the
process by which the
market system allocates
goods and services to
consumers when quantity
demanded exceeds
quantity supplied.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Price Rationing
• A decrease in supply
creates a shortage at
P0. Quantity demanded
is greater than quantity
supplied. Price will
begin to rise.
• The lower total supply
is rationed to those
who are willing and
able to pay the higher
price.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Price Rationing
• There is some price
that will clear any
market.
• The price of a rare
painting will eliminate
excess demand until
there is only one bidder
willing to buy the single
available painting.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Alternative Rationing Mechanisms
• A price ceiling is a maximum price
that sellers may charge for a good,
usually set by government.
• Queuing is a nonprice rationing
system that uses waiting in line as a
means of distributing goods and
services.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Alternative Rationing Mechanisms
• Favored customers are those who receive
special treatment from dealers during
situations when there is excess demand.
• Ration coupons are tickets or coupons that
entitle individuals to purchase a certain
amount of a given product per month.
• The problem with these alternatives is that
excess demand is created but not eliminated.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Alternative Rationing Mechanisms
• In 1974, the
government used an
alternative rationing
system to distribute the
available supply of
gasoline.
• At an imposed price of
57 cents per gallon, the
result was excess
demand.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Alternative Rationing Mechanisms
• A black market is a
market in which illegal
trading takes place at
market-determined
prices.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Alternative Rationing Mechanisms
• No matter how good the intentions of private
organizations and governments, it is very
difficult to prevent the price system from
operating and to stop the willingness to pay
from asserting itself.
• With favored customers and black markets, the
final distribution may be even more unfair than
that which would result from simple price
rationing.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Prices and the Allocation of Resources
• Price changes resulting from shifts of demand in output
markets cause profits to rise or fall.
• Profits attract capital; losses lead to disinvestment.
• Higher wages attract labor and encourage workers to
acquire skills.
• At the core of the system, supply, demand, and prices in
input and output markets determine the allocation of
resources and the ultimate combinations of things
produced.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Supply and Demand Analysis:
An Oil Import Fee
• At a world price of $18,
imports are 5.9 million barrels
per day.
© 2002 Prentice Hall Business Publishing
• The tax on imports causes an
increase in domestic production,
and quantity imported falls.
Principles of Economics, 6/e
Karl Case, Ray Fair
Elasticity
• Elasticity is a general concept that can be used
to quantify the response in one variable when
another variable changes.
% A
elasticity of A with respect to B 
% B
• Price elasticity of demand measures how
responsive consumers are to changes in the
price of a product.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Price Elasticity of Demand
• Measures the responsiveness of demand to
changes in price.
• It is the ratio of the percentage change in
quantity demanded to the percentage change
in price.
% change in quantity demanded
price elasticity of demand 
% change in price
• Its value is always negative, but stated in
absolute terms.
• The value of the line of the slope and the
value of elasticity are not the same.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Characteristics of Demand Elasticity
Value of
Elasticity
Type of
Demand
Magnitudes of
Change
Response to
Price Changes
 > |1|
Elastic
%Qd > %P
Responsive
 < |1|
Inelastic
%Qd < %P
Unresponsive
 = |1|
Unitary elastic
%Qd = %P
Proportional
© 2002 Prentice Hall Business Publishing
Type of
Elasticity
Substitutes
Available
Elastic
Many
Inelastic
Few
Principles of Economics, 6/e
Karl Case, Ray Fair
Shape of Demand According to Elasticity
Type of Demand
Inclination
Elastic
Relatively Flat
Inelastic
Relatively Steep
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Extreme Elasticities
Elasticity Value
Type of Elasticity
Substitutes Available
=0
Perfectly Inelastic
None
=
Perfectly Elastic
Infinite
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Hypothetical Demand Elasticities
for Four Products
Hypothetical Demand Elasticities for Four Products
PRODUCT
% CHANGE
IN PRICE
(% P)
Insulin
Basic telephone service
Beef
Bananas
© 2002 Prentice Hall Business Publishing
10%
10%
10%
10%
% CHANGE IN
QUANTITY
DEMANDED
(% Qd)
0%
-1%
-10%
-30%
ELASTICITY
(% Qd/% P)
0
-0.1
-1
-3
Principles of Economics, 6/e
Perfectly inelastic
Inelastic
Unitary elastic
Elastic
Karl Case, Ray Fair
Calculating Percentage Changes
• Elasticity is a ratio of percentages, and it involves
computing percentage changes.
P2  P1
% change in price 
x 100%
P1
Q2  Q1
% change in quantity demanded 
x 100%
Q1
• Using the values on the graph to
compute elasticity, then:
 100%
price elasticity of demand 
  3.0
 33.3%
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Computing the Value of Elasticity
• The midpoint formula to
compute elasticity is:
Q2  Q1
x 100%
%  Qd (Q1  Q2 ) / 2

P2  P1
% P
x 100%
( P1  P2 ) / 2
10  5
5
x 100%
x 100%
%  Qd (5  10) / 2
66.7%
7
.
5


=
  167
.
2 3
-1
% P
-40.0%
x 100%
x 100%
( 3  2) / 2
2.5
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Interpreting the Value of Elasticity
Here is how to interpret two different
values of elasticity:
• When  = 0.2, a 10% increase in price
leads to a 2% decrease in quantity
demanded.
• When  = 2.0, a 10% increase in price
leads to a 20% decrease in quantity
demanded.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Elasticity Changes along a Straight-Line
Demand Curve
• Price elasticity of demand
decreases as we move
downward along a linear
demand curve.
• Demand is elastic on the
upper part of the demand
curve and inelastic on the
lower part.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Elasticity Changes along a StraightLine Demand Curve
• Along the elastic range,
elasticity values are
greater than one.
 6.4
 .29
© 2002 Prentice Hall Business Publishing
• Along the inelastic range,
elasticity values are less
than one.
Principles of Economics, 6/e
Karl Case, Ray Fair
Elasticity and Total Revenue
Value of Ed
Change in quantity
versus change in
price
Effect of an
increase in
price on total
revenue
Effect of a
decrease in price
on total revenue
Elastic
Greater than
1.0
Larger percentage change
in quantity
Total revenue
decreases
Total revenue
increases
Inelastic
Less than 1.0
Smaller percentage
change in quantity
Total revenue
increases
Total revenue
decreases
Unitary
elastic
Equal to 1.0
Same percentage change
in quantity and price
Total revenue
does not change
Total revenue does not
change
Type of
demand
•
When demand is inelastic, price and total revenues are directly
related. Price increases generate higher revenues.
•
When demand is elastic, price and total revenues are indirectly
related. Price increases generate lower revenues.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Determinants of Demand Elasticity
• Availability of substitutes --
demand is more elastic when there
are more substitutes for the product.
• Importance of the item in the
budget -- demand is more elastic
when the item is a more significant
portion of the consumer’s budget.
• Time frame -- demand becomes
more elastic over time.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Other Important Elasticities
• Income elasticity of demand – measures the
responsiveness of demand to changes in
income.
% change in quantity demanded
income elasticity of demand 
% change in income
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Other Important Elasticities
• Cross-price elasticity of demand: A
measure of the response of the quantity of one
good demanded to a change in the price of
another good.
% change in quantity of Y demanded
cross- price elasticity of demand 
% change in price of X
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Other Important Elasticities
• Elasticity of supply: A measure of the
response of quantity of a good supplied to a
change in price of that good. Likely to be
positive in output markets.
% change in quantity supplied
elasticity of supply 
% change in price
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Other Important Elasticities
• Elasticity of labor supply: A measure of the
response of labor supplied to a change in the
price of labor.
% change in quantity of labor supplied
elasticity of labor supply 
% change in the wage rate
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair