Download Chapter 4 - Working with Supply and Demand

Econ 101:
Microeconomics
Chapter 4:
Working with Supply and
Demand: Part 1
Why Government Would Like to
Control Prices?

Government intervenes to regulate prices – Price Control.

Why?
• Equilibrium:
•
•

•
Quantity Demanded = Quantity Supplied
Buyers would always like to pay less if they could
Sellers would always like to get more money from what they
sell
Price Control
•
•
Upper Limit – Price Ceilings
Lower Limit – Price Floors
Hall & Leiberman;
Economics: Principles
2
Price Ceilings



Government-imposed maximum price that prevents the price of
a good from rising above a certain level in a market
Short side of the Market
•
•
Price ceiling creates a shortage and increases the time and
trouble required to buy the good
•

Smaller of quantity supplied and quantity demanded at a particular
price
When quantity supplied and quantity demanded differ, short side of
market will prevail
While the price decreases, the opportunity cost may rise
Black Market
•
A market created by unintended consequences of government
intervention
•
Goods are sold illegally at a price above the legal ceiling
Hall & Leiberman;
Economics: Principles
3
Figure 1: A Price Ceiling
5. With a black market, the
lower quantity sells for a
higher price than initially.
p
3. and decreases
quantity supplied.
4. The result is a shortage
– the distance between
S
R and V.
T
R
E
V
2. increases quantity
demanded
D
Q
1. A price ceiling lower than
the equilibrium price . . .
Hall & Leiberman;
Economics: Principles
4
Example: Market for Apartments
(millions)
Monthly Rent
Q Demanded
Q Supplied
1,400
1.6
2.4
1,300
1.7
2.3
1,200
1.8
2.2
1,100
1.9
2.1
1,000
2.0
2.0
900
2.1
1.9
800
2.2
1.8
700
2.3
1.7
600
2.4
1.6
Equilibrium
Price Ceiling
Housing shortage of 400,000 apartments caused by price ceiling
Hall & Leiberman;
Economics: Principles
5
Price Floors

Government imposed minimum amount below which price is
not permitted to fall
•

When sellers produce more of the good than buyers want at the
price floor
•

Price floors for agricultural goods are commonly called price
support programs
Remaining goods become a surplus that no one wants at the
imposed price
Government responds by maintaining price floors
•
•
Uses taxpayer dollars to buy up entire excess supply of the good
in question
Prevents excess supply from doing what it would ordinarily do
•
Drive price down to its equilibrium value
Hall & Leiberman;
Economics: Principles
6
Figure 2: A Price Floor
p
2. decreases quantity
demanded . . .
1. A price floor higher
than the equilibrium
price . . .
3. and increases
quantity supplied.
S
J
K
A
4. The result is a surplus
the – distance between
K and J – which
government must buy.
D
Q
Hall & Leiberman;
Economics: Principles
7
Example: Market for Butter
(millions of pounds)
Price of Butter
Q Demanded
Q Supplied
1.40
8.0
14.0
1.30
8.5
13.0
1.20
9.0
12.0
1.10
9.5
11.0
1.00
10.0
10.0
0.90
10.5
9.0
0.80
11.0
8.0
0.70
11.5
7.0
0.60
12.0
6.0
Price Ceiling
Equilibrium
Butter surplus of 3 million pounds caused by price floor
Hall & Leiberman;
Economics: Principles
8
The Problem with Rate Change

Recall the “Law of Demand”:
• Other things equal, when the price of a good rises
the quantity demanded of the good falls
• When price rises, does quantity demanded fall a
“little” or a “lot”?
• How can we measure degree of responsiveness
of quantity demanded to price changes?
Hall & Leiberman;
Economics: Principles
9
Figure 3: The Problem with Rate Change
p
p
D
D
Q
Q
It seems to be related to slope:
• Relative flat demand – big response of Q to change in p
• Relative steep demand- small response of Q to change in p
Hall & Leiberman;
Economics: Principles
10
Q
p
The Problem with Rate Change

This suggests using either the slope of the reciprocal of
the slope of demand as a measure of the
responsiveness of Q to changes in p.
•
Q
Reciprocal of the slope =
p
“Change in Q / change in p”
• Have a problem with this measure of responsiveness
•
•
This sign of the ration
Different units of measure
Hall & Leiberman;
Economics: Principles
11
The Elasticity Approach

By comparing percentage change in quantity
demanded with percentage change in price we can
get more informative measure of responsiveness.

(own price) elasticity of demand =
Q
% Change in Q demanded % Q D base Q


ED 
p
% Change in p
% p
base p
Hall & Leiberman;
Economics: Principles
12
Calculating Price Elasticity of Demand

When calculating elasticity “base value” for percentage
changes in price or quantity is always midway between
initial value and new value
p1  p0 

p
% Change in Price 

base p  p1  p0 
2
• When quantity demanded changes from Q0 to Q1,
percentage change is calculated as
Q1  Q0 

Q
% Change in Quantity Demanded 

base Q Q1  Q0 
2
Hall & Leiberman;
Economics: Principles
13
Calculating Price Elasticity of Demand

(own price) elasticity of demand =
Q
% Change in Q demanded % Q D base Q


ED 
p
% Change in p
% p
base p
Q1  Q0  Q1  Q0   2 Q1  Q0  Q1  Q0 


p

p
p

p

2
 1 0   1 0    p1  p0   p1  p0 
Hall & Leiberman;
Economics: Principles
14
Example of an Elasticity Calculation
p
B
1.75
A
1.50
D
72
80
Q
Two points: A(80, 1.5) and B(72, 1.75)
ED 
Q1  Q0  / Q1  Q0 
 72  80  /  72  80 

 0.684
 p1  p0  /  p1  p0  1.75  1.50  / 1.75  1.50 
Hall & Leiberman;
Economics: Principles
15
Elasticity and Straight-Line Demand
Curves

As we move upward and leftward along a straight-line
demand curve
•

• Because base price used to calculate percentage changes keeps rising
As we move upward and leftward along a straight-line
demand curve
•

Same absolute decrease in quantity corresponds to larger
and larger percentage decreases in quantity
As we move upward and leftward by equal distances,
percentage change in quantity rises
•

Same absolute increment in price will correspond to smaller
and smaller percentage increments in price
Percentage change in price falls
Elasticity of demand varies along a straight-line demand
curve
•
Demand becomes more elastic as we move upward and leftward
Hall & Leiberman;
Economics: Principles
16
Figure 5: Elasticity and Straight-Line
Demand Curves
Since equal dollar increases (vertical
arrows) are smaller and smaller
percentage increases . . .
Price
3
2
and since equal quantity decreases
(horizontal arrows) are larger and
larger percentage decreases . . .
1
demand becomes more and more
elastic as we move leftward and
upward along a straight-line
demand curve.
D
Quantity
Hall & Leiberman;
Economics: Principles
17
Categorizing Goods by Elasticity

Now return to the example of an elasticity
ED  0.684

What does this number mean?
• Negative sign
• Along demand curve price and quantity changes are
always of opposite signs, so own price elasticities of
demand are always negative.
• Warning: do not think in terms of absolute values
Hall & Leiberman;
Economics: Principles
18
Categorizing Goods by Elasticity

Inelastic Demand
%Q  %p
p
 0  ED  1
Q

Elastic Demand
%Q  %p 
p
ED  1
Q
p

Unit Elastic Demand
%Q  %p 
Hall & Leiberman;
Economics: Principles
ED  1
Q
19
Extreme Cases of Demand

Perfectly Inelastic Demand
p
%Q  0 ED  0
Q
p

Perfectly Elastic Demand
%p  0  ED  
Hall & Leiberman;
Economics: Principles
Q
20