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Chapter 4
Subtleties of the
Supply and Demand Model:
Price Floors, Price Ceilings, and Elasticity
Key Terms
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price control
price ceiling
price floor
rent control
minimum wage
price elasticity of
demand
unit-free measure
elastic demand
inelastic demand
perfectly inelastic
demand
• perfectly elastic
demand
• income elasticity of
• demand
• cross-price elasticity of
• demand
• price elasticity of
supply
• perfectly elastic supply
• perfectly inelastic
supply
Interference with Market Prices
Price Control: a government control or regulation
that sets or limits the price to be charged for a
particular good.
Two Broad Types of Price Controls:
• Price Floor
• Price Ceiling
Price Ceilings and Floors
Price Ceiling: a government price control that sets
the maximum allowable price for a good or a
service.
Example:
– Rent control: a government price control that
sets a maximum allowable rent to a house or
an apartment.
Price Ceilings and Floors
Price Floor: a government price control that sets
the minimum allowable price for a good or a
service.
Example:
– Minimum wage: a wage per hour below which
it is illegal to pay workers.
Side Effects of Price Ceilings
If the government sets the price ceiling below the
equilibrium price, a shortage will result.
Ways We Deal with Persistent Shortages:
• Coupons
• Long lines
• Reduction in the quality of the good sold
Figure 1: Effects of
a Maximum-Price Law
Figure 1: Effects of
a Maximum-Price Law
Side Effects of Price Floors
If the government sets the price floor above the
equilibrium price, a surplus will result.
Ways We Deal with Persistent Surpluses:
• Surpluses purchased by the government
• Surplus labor results in unemployment
Figure 2: Effects of
a Minimum-Price Law
(Top graph)
Figure 2: Effects of
a Minimum-Price Law
(Bottom Graph)
Elasticity of Demand
Price Elasticity of Demand: the percentage change
in the quantity demanded of a good divided by the
percentage change in the price
of that good.
Figure 3: Elasticity of Demand
In Figure 3, the top graph shows a demand curve
where an increase in the price from $20 to $22
results in a decrease in the quantity demanded
from 60 million barrels to 48 million barrels.
Figure 3:
Comparing
Different Sizes
of the Price
Elasticity of
Demand
Elasticity of Demand
Percentage
change in Qty.
demanded
48  60
 12

100 
100  20 percent
60
60
Percentage
22  20
2
change in price  20 100  20 100  10 percent
Elasticity of Demand
The price elasticity of demand for the top graph in
Figure 3 is:
Price Elasticity
of Demand
20%

 2  2
10%
Note: A price elasticity of demand of 2 implies that
a one percentage point increase in the price
results in a two percentage point decrease in the
quantity demanded.
Size of the Elasticity: High versus Low
We compare the demand curve found on the top
graph with the demand curve found on the bottom
graph on Figure 3. On the bottom graph, an
increase in the price from $20 to $22 results in a
decrease in the quantity demanded from 60 million
barrels to 57 million barrels.
Figure 3:
Comparing
Different Sizes
of the Price
Elasticity of
Demand
Size of the Elasticity: High versus Low
Percentage
change in Qty.
demanded
Percentage
change in price
57  60
3

100 
100  5 percent
60
60
22  20
2

100 
100  10 percent
20
20
Size of the Elasticity: High versus Low
The elasticity of demand for the top graph is:
Price Elasticity
of Demand
5%
1 1

 
10%
2 2
Note: A price elasticity of demand of 1/2 implies
that a one percentage point increase in the price
results in a one-half percentage point decrease in
the quantity demanded.
Size of the Elasticity: High versus Low
Note: The top graph in Figure 3 had a higher price
elasticity of demand (elasticity = 2) than the price
elasticity of demand for the bottom graph (elasticity
= 1/2). Hence, the demand curve on the top graph
is more sensitive to price changes than the
demand curve on the bottom graph.
Impact of a Change in
Supply on the Price of Oil
In the next slide, Figure 4 analyzes the effect of a
decrease in the supply of oil on the equilibrium
price of oil. The top graph features a demand
curve with a higher elasticity (elasticity = 2) than
the bottom graph (elasticity = ½).
Figure 4 : The
Importance of
the Size of the
Price Elasticity
of Demand
Impact of a Change in
Supply on the Price of Oil
Note: The same shift in the supply of oil to the
left (decrease by 14 million barrels) results in a
higher equilibrium price on the bottom graph,
where the demand curve has a lower price
elasticity (elasticity = ½) than in the top graph
(elasticity = 2).
Impact of a Change
in Supply on the Price of Oil
Figure 4A shows the daily crude oil prices in the
world since January 2006. The large fluctuations of
oil prices support the idea that demand for oil is
inelastic.
Figure 4A: World Oil and Gasoline Spot
Prices (Daily), January 2006-August 2007
Source: Department of Energy
Working with Demand Elasticities
The general formula that we will use for demand
elasticity (ed) will be:
Qd P Qd P
ed 



Qd
P
P Qd
Working with Demand Elasticities
An attractive feature of the price elasticity of
demand is that it is a unit-free measure; it allows
the comparison of the price elasticity of different
goods and different prices.
Unit-Free Measure: a measure that does not
depend on the unit of measurement.
Working with Demand Elasticities
Assume the price of rice rises by 10 cents, from 50
to 60 cents per pound, and the quantity demanded
falls from 20 to 19 tons. This implies a decrease of
1 ton per 10 cent increase in the price, or:
Elasticity of Demand:
Qd P  1 .10
1 1
ed 



 
Qd
P
20 .50
4 4
Working with Demand Elasticities
Similarly, assume the price of steak rises by $1,
from $5 to $6 per pound, and the quantity
demanded falls from 20 tons to 19 tons. This
implies a decrease of 1 ton per $1 increase in the
price, or:
Elasticity of Demand:
Qd P  1 1
1 1
ed 


  
Qd
P
20 5
4 4
Elasticity versus Slope
One common mistake made when dealing with
elasticity is to interchange the elasticity of the
demand curve with its slope. These concepts are
similar, but not the same.
Qd
Elasticity of demand =
ed 
P
Qd
P
Qd P


P Qd
slope
Elasticity versus Slope
Notes: The elasticity is a unit-free measure, while
the slope is not.
With a straight-line demand curve, the slope is
constant, while the elasticity varies at different
points in the line.
The Midpoint Formula
or
 Q2  Q1 


(Q2  Q1 ) / 2 

ed 
 P2  P1 


 ( P2  P1 ) / 2 
The Midpoint Formula
Recall Figure 4. If we use the midpoint formula to
calculate the elasticity on the top graph, the
elasticity of demand is:
60  48
20  22
ed 

 2.33
60  48 / 2 20  22 / 2
Talking About Elasticities
Elastic Demand – demand where the elasticity is
greater than one.
Inelastic Demand – demand where the elasticity is
less than one.
Unit Elastic Demand – demand where the elasticity
is exactly equal to one.
Talking About Elasticities
Perfectly Inelastic Demand – demand (or part
of the demand curve) where the price elasticity
is zero, indicating no response to a change in
price. A perfectly inelastic demand curve is a
vertical line.
Perfectly Elastic Demand – demand (or part of
the demand curve) where the price elasticity is
infinite, indicating an infinite response to a change
in price. A perfectly elastic demand curve is a
horizontal line.
Figure 6: Perfectly Elastic
and Perfectly Inelastic Demand
Revenue and the
Price Elasticity of Demand
Revenue of a firm
= (P X Q)
= (price of a good) X (quantity of the good sold)
Revenue and the
Price Elasticity of Demand
Example:
If people purchase 60 million barrels of oil at $20,
then the firm’s revenues equal:
Revenue
= 60 million X $20
= $1200 million = $1.2 billion
Revenue and the
Price Elasticity of Demand
Figure 7 shows that if the price increases in an
elastic demand curve, the firm revenues will
decrease. If the price increases in an inelastic
demand curve, the firm revenues will increase.
FIGURE 7:
Effects of an
Increase in the
Price of Oil on
Revenue
Revenue and the
Price Elasticity of Demand
If in the inelastic region of a straight-line demand
curve, an increase (a decrease) in the price will
result in an increase (a decrease) in revenues.
If in the elastic region of a straight-line demand
curve, an increase (a decrease) in the price will
result in a decrease (an increase) in revenues.
Figure 8: Revenue
and Elasticity of a
Straight-Line
Demand Curve
What Determines the Size
of the Price Elasticity of Demand?
Determinants of the Price Elasticity of Demand:
• Degree of substitutability
• Big-ticket versus little-ticket items
• Temporary versus permanent price change
• Differences in preferences
• Long-run versus short-run elasticity
Degree of Substitutability
Goods with a lot of substitutes have a high price
elasticity of demand.
Goods with few substitutes have a low price
elasticity of demand.
Big-Ticket versus Little-Ticket Items
If a good represents a large share fraction of
people’s income, then the price elasticity will
be high.
If a good represents a small share fraction of
people’s income, then the price elasticity will
be low.
Temporary versus
Permanent Price Change
If the price change is perceived to be temporary,
then the price elasticity of demand will be high.
If the price change is perceived to be permanent,
then the price elasticity of demand will be low.
Differences in Preferences
Some goods have varying price elasticity of
demand across different consumer groups.
Examples:
1) New smokers have a higher price elasticity of
demand for cigarettes than established
(addicted?) smokers.
2) Retired persons have a lower price elasticity
of demand for motor homes than persons in
the 18-26 age group.
Long Run vs. Short Run
The length of time elapsed since a price change
affects the price elasticity of demand.
Example:
If the price of gasoline rises, the price elasticity of
demand for gasoline may be lower for SUV owners
in the short run (just immediately after the price
change) than in the long run (when they can buy a
different car).
Income Elasticity of Demand
Income Elasticity of Demand: the percentage
change in the quantity demanded of a good
divided by the percentage change in income.
Income
Elasticity
of Demand
Income Elasticity of Demand
If the income elasticity of demand is positive (i.e.,
you buy more as income increases), then the good
is a normal good.
If the income elasticity of demand is negative (i.e.,
you buy less as income increases), then the good
is an inferior good.
Note: With income elasticity of demand, it is
incorrect to take the absolute value of the
computed elasticity.
Cross-Price Elasticity of Demand
Cross Price Elasticity of Demand: the percentage
change in the quantity demanded of a good
divided by the percentage change in the price of a
related good (a substitute or a complement).
Cross-Price Elasticity of Demand
If the cross-price elasticity of demand is positive
(i.e., you buy more as price of the other good
increases), then the two related goods are
substitutes.
If the cross-price elasticity of demand is negative
(i.e., you buy less as price of the other good
increases), then the two related goods are
complements.
Elasticity of Supply
Elasticity of Supply: the percentage change in the
quantity supplied of a good divided by the
percentage change in the price of a same good.
Price
Elasticity
of Supply
Elasticity of Supply
The general formula that we will use for price
elasticity of supply (es) will be:
Qs P Qs P
es 



Qs
P
P Qs
Elastic versus Inelastic Supply
Elastic Supply: supply where the price elasticity is
greater than one.
Inelastic Supply: supply where the price elasticity
is less than one.
Unit Elastic Supply: supply where the price
elasticity is exactly equal to one.
Perfectly Elastic versus
Perfectly Inelastic Supply
Perfectly Elastic Supply: supply where the price
elasticity is infinite, indicating an infinite response
to a change in price. A perfectly elastic supply
curve is a horizontal line.
Perfectly Elastic versus
Perfectly Inelastic Supply
Perfectly Inelastic Supply: supply where the price
elasticity is zero, indicating no response to a
change in price. A perfectly inelastic supply curve
is a vertical line.
Examples:
• The Mona Lisa
• Super Bowl Tickets
Figure 9: Perfectly Elastic
and Perfectly Inelastic Supply
Figure 10: Comparing Different
Sizes of the Price Elasticities of Supply
Figure 10: Comparing Different
Sizes of the Price Elasticities of Supply
Elastic vs. Inelastic Supply
In the next slide, Figure 11 shows that the same
shift in the demand for oil to the left results in a
lower equilibrium price in the bottom graph, where
the supply curve has a lower price elasticity than in
the top graph, which has a higher price elasticity.
Figure 11:
Importance of
Knowing the
Size of the
Price Elasticity
of Supply
Key Terms
•
•
•
•
•
•
•
•
•
•
price control
price ceiling
price floor
rent control
minimum wage
price elasticity of
demand
unit-free measure
elastic demand
inelastic demand
perfectly inelastic
demand
• perfectly elastic
demand
• income elasticity of
• demand
• cross-price elasticity of
• demand
• price elasticity of
supply
• perfectly elastic supply
• perfectly inelastic
supply