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Understanding Economics
5th edition
by Mark Lovewell
Copyright © 2009 by McGraw-Hill Ryerson
Limited. All rights reserved.
Chapter 3
Competitive Dynamics and Government
Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.
Learning Objectives
After this chapter, you will be able to:
comprehend price elasticity of demand, its relation to other
demand elasticities, and its impact on sellers’ revenues
2. understand the price elasticity of supply and the links
between production periods and supply
3. identify how price elasticities of demand and supply
determine the impact of an excise tax on consumers and
producers
4. explain how governments use price controls to override the
“invisible hand” of competition
1.
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Elastic and Inelastic Demand (a)

Price elasticity of demand shows how responsive
consumers are to price changes.
 elastic demand means % change in quantity demanded is
more than % change in price
 inelastic demand means % change in quantity demanded
is less than % change in price
 unit-elastic demand means % change in quantity demand
equals % change in price
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Elastic and Inelastic Demand (b)
Figure 3.1 Page 58
Inelastic Demand Curve
for Ice cream Cones
2.40
2.40
20%
2.00
D1
1.60
50%
1.20
0.80
0.40
0
500
1000
Quantity Demanded
(cones per winter month)
Price ($ per cone)
Price ($ per cone)
Elastic Demand Curve
for Ice Cream Cones
20%
2.00
D2
1.60
10%
1.20
0.80
0.40
0
500
1000
Quantity Demanded
(cones per summer month)
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1800 2000
Perfectly Elastic and Perfectly
Inelastic Demand (a)


Perfectly elastic demand means a constant price and a
horizontal demand curve.
Perfectly inelastic demand means a constant quantity
demanded and a vertical demand curve.
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Perfectly Elastic and Perfectly Inelastic Demand (b)
Figure 3.2 Page 59
Perfectly Inelastic
Demand Curve
for Insulin
D3
1.60
0
D4
Price ($ per tonnes)
Price ($ per tonnes)
Perfectly Elastic
Demand Curve
for Soybeans
0
Quantity Demanded
(tonnes)
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1000
Quantity Demanded
(litres)
Total Revenue and the Price
Elasticity of Demand (a)



A price change causes total revenue to change in the
opposite direction when demand is elastic.
A price change causes total revenue to change in the
same direction when demand is inelastic.
A price change does not affect total revenue when
demand is unit-elastic.
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Revenue Changes with Elastic Demand
Figure 3.3 Page 60
Price ($ to rent a video)
Demand Curve for Videos
5
4
A
3
2
D
B
C
1
0
500
1000
1500
Quantity Demanded (videos rented each day)
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Revenue Changes with Inelastic Demand
Figure 3.4 Page 61
Price ($ per ride)
Demand Curve for Amusement Park Rides
5
4
3
E
2
F
1
0
2000
4000
D
G
6000
8000
10 000
Quantity Demanded (riders each day)
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Total Revenue and the Price Elasticity of Demand (b)
Figure 3.5 Page 62
Demand Elasticity and Changes in Total Revenue
Price
Change
Change in
Total Revenue
Elastic Demand
up
down
down
up
Inelastic Demand
up
down
up
down
Unit-Elastic Demand
up
down
unchanged
unchanged
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Determinants of the Price
Elasticity of Demand

There are four determinants:
 portion of consumer incomes (products with smaller
portions more inelastic)
 access to substitutes (products with more substitutes
more elastic)
 necessities versus luxuries (more inelastic for necessities
and more elastic for luxuries)
 time (more elastic with the passage of time)
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Calculating Price Elasticity of
Demand
 A numerical value for price elasticity of demand (ed) is
found by taking the ratio of the changes in quantity
demanded and in price, each divided by its average
value.
 In mathematical terms:
ed =
ΔQd ÷ average Qd
Δprice ÷ average price
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Elasticity and a Linear Demand
Curve (a)
 A linear demand curve has a different price elasticity
(ed) at every point.
 At high prices, the change in quantity demanded
(price) is relatively large (small) relative to average
quantity demanded (price), giving a large ed.
 At low prices, the change in quantity demand (price) is
relatively small (large) relative to average quantity
demanded, giving a small ed.
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Elasticity and a Linear Demand
Curve (b)
Figure 3.6 Page 64
Market Demand Curve for Sodas
Market Demand Schedules
for Sodas
5
4
3
2
1
0
Quantity
Demanded
0
1
2
3
4
5
9.00
2.33
1.00
0.43
0.11
Price ($ per soda)
Price
Elasticity
of Demand
($ per
(ed)
soda) (millions of sodas)
Price
5
ed > 1
4
3
ed = 1
2
ed < 1
1
0
1
2
3
4
Quantity Demanded
(millions of sodas)
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5
Income Elasticity
 Income elasticity (ei) is the responsiveness of a
product’s quantity demanded to changes in consumer
income.
 In mathematical terms:
ei = ΔQd ÷ average Qd
ΔI ÷ average I
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Cross-Price Elasticity
 Cross-price elasticity (ei) is the responsiveness of the
quantity demanded of one product (x) to a change in
price of another (y).
 In mathematical terms:
exy = ΔQd ÷ average Qd
ΔPy ÷ average Py
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Elastic and Inelastic Supply

Price elasticity of supply measures the responsiveness
of quantity supplied to price changes.
 Elastic supply means % change in quantity supplied is
more than % change in price.
 Inelastic supply means % change in quantity supplied is
less than % change in price.
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Elastic and Inelastic Supply
Figure 3.7, Page 67
Inelastic Supply Curve
For Tomatoes
4
S1
3
50%
2
100%
1
0
100 000
Price ($ per kilogram)
Price ($ per kilogram)
Elastic Supply Curve
for Tomatoes
120000
Quantity Supplied
(kilograms per year)
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4
S2
3
50%
2
1
0
20%
100 000 120 000
Quantity Supplied
(kilograms per year)
Perfectly Elastic and Perfectly
Inelastic Supply


Perfectly elastic supply means a constant price and a
horizontal supply curve.
Perfectly inelastic supply means a constant quantity
supplied and a vertical supply curve.
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Time and the Price Elasticity of
Supply (a)

Price elasticity of supply changes over three
production periods:
 Supply is perfectly inelastic in the immediate run.
 Supply is either elastic or inelastic in the short run.
 Supply is perfectly elastic for a constant-cost industry
and very elastic for an increasing-cost industry in the
long run.
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Time and the Price Elasticity of Supply (b)
Figure 3.8, Page 68 (continued in part (e))
Price ($ per kilogram)
S1
0
750 000
Short-Run
Supply Elasticity
For Strawberries
Price ($ per kilograms)
Immediate-Run
Supply Elasticity
for Strawberries
S2
2.50
2.00
0
Quantity Supplied
(kilograms per month)
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9
11
Quantity Supplied
(millions of kilograms per year)
Time and the Price Elasticity of
Supply (c)
 If strawberries are produced in a constant-cost
industry:
 A higher price of strawberries raises production but not
resource prices.
 As new businesses enter the industry in the long run
due to a higher price of strawberries, this price is
gradually pushed back down to its original level.
 Therefore the long-run supply curve for a constant-cost
industry is perfectly elastic.
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Time and the Price Elasticity of
Supply (d)
 If strawberries are produced in a increasing-cost
industry:
 A higher price of strawberries raises production and also
resource prices.
 As new businesses enter the industry in the long run
due to a higher price of strawberries, this price is
gradually pushed back down to its lowest possible level,
but this level is higher than it was originally.
 Therefore the long-run supply curve for an increasingcost industry is very elastic.
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Time and the Price Elasticity of Supply (e)
Figure 3.8, Page 68 (continued from part (b))
Price ($ per kilograms)
Long-Run Supply Elasticity
S4
S3
2.00
Increasingcost Industry
0
Quantity Supplied
(millions of kilograms per decade)
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Constantcost Industry
Calculating Price Elasticity of
Supply
 A numerical value for price elasticity of supply (es) is
found by taking the ratio of the changes in quantity
supplied and in price, each divided by its average
value.
 In mathematical terms:
es =
ΔQs ÷ average Qs
Δprice ÷ average price
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Excise Taxes (a)
 An excise tax is a tax on a particular product expressed
as a dollar amount per unit of quantity.
 Such a tax creates a new supply curve (S1) seen by
consumers. It is vertically above the initial supply
curve (S0) seen by producers.
 The reason for this difference is that the price as seen by
consumers is now higher than that seen by producers.
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Excise Taxes (b)
 The after-tax price for consumers is found where S1
crosses the demand curve. The after-tax equilibrium
price for producers is the corresponding price on S0.
 The total tax paid by consumers is found by multiplying
their tax-induced price rise by after-tax quantity.
 Similarly, the total tax paid by consumers is found by
multiplying their corresponding price drop by after-tax
quantity.
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The Impact of an Excise Tax
Figure 3.9, page 71
The Impact of an Excise Tax
Market Demand and Supply
Curves For Strawberries
4.00
Price
3.00
S1
3.50
Quantity
Quantity
Demanded
Supplied
($ per
(D)
(S0)
(S1)
tonne)
(millions of tonnes)
3.00
2.50
2.00
1.50
1.00
5
7
9
11
13
13
11
9
7
5
9
7
5
3
1
Price ($ per kg)
b
a
2.50
S0
$1
A
2.00
B
c
d
1.50
1.00
D
0.50
0
1
3
5
7
9
11
13
Quantity (millions of kg per year)
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15
The Effect of Elasticity
 For a given supply curve, the more elastic the demand
curve the greater the proportion of an excise tax paid
by producers.
 For a given demand curve, the more elastic the supply
curve the greater the proportion of an excise tax paid
by consumers.
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Excise Taxes and Demand Elasticity
Figure 3.10, page 72
Elastic Demand
Inelastic Demand
S1
S1
S0
b
b
S0
2.25
2.00
c
A
D
B
1.25
a
2.75
$1
d
Price ($ per kg)
Price ($ per kg)
a
$1
A
c
2.00
B
1.75
d
D
6
9
Quantity (millions of kg per year)
8
9
Quantity (millions of kg per year)
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Excise Taxes and Supply Elasticity
Figure 3.11, page 73
Elastic Supply
Inelastic Supply
S1
S0
b
S1
b
2.75
$1
A
2.00
1.75
$1
B
S0
c
d
D
6
Price ($ per kg)
Price ($ per kg)
a
a
2.25
2.00
A
B
1.25
d
9
Quantity (millions of kg per year)
c
8
D
9
Quantity (millions of kg per year)
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Price Controls

A price floor is a minimum price set above the
equilibrium price.
 It results in a surplus in the market.

A price ceiling is a maximum price set below the
equilibrium price.
 It results in a shortage in the market.
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Agricultural Price Supports

Price supports for agricultural goods are an example of
a price floor.
 They help overcome unstable agricultural prices.
 Farmers win from these supports.
 Consumers and taxpayers lose from these supports.
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Reasons for Price Supports
Figure 3.12, page 74
Market Demand and Supply
Curves for Wheat
Market Demand and Supply
Schedules for Wheat
140
Price
120
S1
S0
Quantity
Quantity
Demanded
Supplied
($ per
(D)
(S0)
(S1)
tonne)
(millions of tonnes)
$140
120
100
80
60
10
11
12
13
14
14
13
12
11
10
12
11
10
9
8
Price ($ per tonne)
b
100
a
80
60
D
40
20
0
1
2 3 4
5
6
7
8
9 10 11 12 13 14
Quantity (millions of tonnes per year)
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Effects of Price Supports
Figure 3.14, page 76
Market Demand and Supply Curves
for Milk
Market Demand and Supply
Schedules for Milk
$1.30
Quantity Quantity
Demanded Supplied
(D)
(S)
(millions of litres)
59
62
1.10
60
60
0.90
61
58
S
Price ($ per litre)
Price
($ per
litre)
surplus
1.30
1.10
.90
A price floor
creates
a surplus.
.70
0
58
59
60
D
61
Quantity
(millions of litres per year)
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62
Rent Controls

Rent controls are an example of a price ceiling.
 They keep down prices of controlled rental
accommodation.
 Some (especially middle-class) tenants win from these
controls.
 Other (especially poorer) tenants lose from these
controls.
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Effects of Rent Controls
Figure 3.15, page 77
Market Demand and Supply
Curves for Units
Market Demand and Supply
Schedules for Units
Price
($ rent
per
month)
Quantity
Quantity
Demanded
Supplied
(D)
(S)
(units rented per month)
$700
1700
2500
500
2000
2000
300
2300
1500
Price ($ per unit)
S
700
A price ceiling
creates
a shortage.
500
300
shortage
0
1500
2000 2300 2500
Quantity
(units rented per month)
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D
Prophet of Capitalism’s Doom

According to Karl Marx’s theory of exploitation:
 a product’s price is based on the amount of labour that
goes into producing it
 capitalists cut costs by minimizing workers’ wages and
by maximizing the length of the workday
 capitalists keep any surplus value, which is the excess of
their revenues over their costs
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Marx’s Theory of Exploitation
Figure A, Page 84
Creation of Surplus Value
Creation of Surplus Value
$50 Wage
$30 Wage
Daily Wage
$50
$30
Materials and
machine wear
and tear (M)
$10
$10
Surplus Value (SV)
$20
$40
Total Value
$80
$80
Exploitation Rate
2
4
(SV/W)
5
3
Value produced ($ per day)
(when producing 2 shirts or 1 suit)
80
60
W = 30
W = 50
W = 10
40
20
0
M = 10
SV = 10
SV = 40
$50
$30
Daily Wage
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The Economic Role of
Government
 Besides intervening in private markets, Canadian
governments have an independent role.
 Government programs include payments to adults
with children, retirement funds for the elderly,
unemployment insurance, welfare, higher education
subsidies, free health care and schooling, and
subsidized public housing.
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Federal Spending
 The main federal spending programs are:
 transfer payments to seniors (the Seniors Benefit)
 tax credits to low-income parents (the Child Tax Credit)
 transfer payments to the unemployed (Employment
Insurance)
 pensions (the Quebec and Canada Pension Plans)
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Provincial and Territorial Spending
 The responsibilities of provincial and territorial
governments include:
 health care
 subsidies for post-secondary education
 welfare services
 The federal government pays a portion of these costs
through the Canada Health and Social Transfer
(CHST).
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Government Expenditures
Figure A, Page 87
Federal (2006)
($ billions)
Goods and services
Transfers to
Persons
Businesses
Nonresidents
Provinces and local
Debt charges
Provincial (2006)
($ billions)
58.2
75.9
3.8
4.4
55.9
31.5
Goods and services
Transfers to
Persons
Businesses
Governments
Debt charges
229.8
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186.1
38.2
9.8
47.3
28.3
309.7
Local (2006)
($ billions)
Goods and services
Transfers to
Persons
Businesses
Provinces
Debt Charges
98.2
3.2
1.7
0.1
3.6
106.8
Taxation (a)
 Canadian governments use five main types of taxation:
 Personal income taxes are levied by both federal and
provincial governments, and are based on four marginal
federal tax rates (15%, 22%, 26%, and 29%).
 Sales taxes are levied by both federal and provincial
governments, and are charged as a percentage of price
on a wide range of products.
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Taxation (b)
 Excise taxes are levied by both federal and provincial
governments, and are usually charged as a dollar amount
per unit of quantity on particular products.
 Property taxes are charged by local governments on
buildings and land.
 Corporate income taxes are paid by corporations to both
federal and provincial governments as a percentage of
annual profits.
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Tax Revenues for All Levels of Government (2006)
Figure B, Page 88
Personal income taxes
Sales and excise taxes
Property taxes
Corporate income taxes
Miscellaneous taxes
Percent of
Gross Domestic Product
Percent of
Total Taxes
12.1
9.3
2.9
3.6
5.2
36.3
28.2
8.8
10.9
15.7
33.1
100.0
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Government Taxes and the Canadian Economy
Figure C, Page 88
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Debates over Government’s Role (a)
 Taxes have increased significantly as a proportion of
the total Canadian economy over the past few decades.
 Critics argue that taxes and some spending programs
reduce productive activity.
 Critics also contend that many government programs
are inequitable, and hampered by administrative
problems.
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Debates Over Government’s Role (b)
 Supporters of government admit that public spending
and taxation are not as effective as they could be. But
they argue that these problems need to be seen in
perspective, given that private markets are also subject
to a variety of flaws.
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Chapter 3
The End
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