Download Chapter 5

The Price System and Supply
and Demand
Chapter 5
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The Price System:
Rationing and Allocating Resources
The price system performs two important and
closely related functions in a society with
unregulated markets:
Price Rationing
Resource Allocation
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Price Rationing
Price rationing is the process by which the
market system allocates goods and services to
consumers when quantity demanded exceeds
quantity supplied.
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Price Rationing in the Market for
Lobsters (Figure 5.1)
 In 2001 the market
for lobsters is in
equilibrium. At $10
per kg the quantity
demanded and
quantity supplied are
both 20 million kg.
 The initial equilibrium
is at point C.
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Price Rationing in the Market for
Lobsters cont. (Figure 5.1)
 In 2002 a large part
of the lobstering
waters are closed.
 The supply curve
shifts to the left.
 Now, at point A, we
have an excess
demand of 10
million kg.
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Price Rationing in the Market for
Lobsters cont. (Figure 5.1)
 The reduced supply
causes the price to rise.
 The market’s price
rationing function
becomes apparent as
the quantity supplied
increases and the
quantity demanded
decreases as we move
from A to B.
 Finally a new equilbrium
is established at $13.75
and 16 million kg.
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Governments or firms may use
alternative allocation methods:




Price ceilings
Queuing
Favoured customers
Ration coupons
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Alternative Allocation Methods:
A price ceiling is a maximum price that sellers
may charge for a good, usually established by
government.
Queuing is a nonprice rationing system that
uses waiting in line as a means of distributing
goods and services.
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Excess demand created by a ceiling price
for Tickle Me Elmo dolls in 1996 (Figure 5.3)
 If the price had
been set from
supply and demand
it would have been
about $100.
 At $35 demand
exceeded supply
and an alternative
rationing system
had to be used.
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Alternative Allocation Methods
(cont.):
Favoured 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.
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Black Markets
The problem with these alternatives is that they
do not eliminate the excess demand for the
products.
Despite best efforts of governments and firms
black market can emerge.
A black market is a market in which illegal
trading takes place at market-determined prices.
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The Canadian Farm Crisis
The use of subsidies in the form of price floors
(minimum guaranteed prices) by U.S. and
European governments has distorted world
markets.
Canadian producers who do not enjoy the same
level of subsidy are at a disadvantage despite
being as efficient as their counterparts.
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Agricultural Policy and the Prairie
Farm Crisis (Figure 5.4a)
 A price support or price
floor at Ps will create a
surplus of wheat q1q2 and
increase income (P*Q)
from P0q0 to P2q2.
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Agricultural Policy and the Prairie
Farm Crisis (Figure 5.4b)
 If a surplus is dumped on
world markets the world
price will fall. The
incomes of those
participating in world
markets before the
dumping fall from P0wq0w
to P1wqrw.
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Agricultural Policy and the Prairie
Farm Crisis (Figure 5.4c)
 A policy that combines
restrictions on imports
and a price support will
result in a dramatic
expansion of the
agricultural sector in a
country implementing
these policies. In this
example output of wheat
grows from q10 to q13
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Supply and Demand Analysis:
The Price of Gasoline (Figure 5.5a)
 The market is in
equilibrium in February
1999 with the spot price
at US$11.53, and 76
million barrels a day
purchased and sold.
 A shift in supply or
demand is required for
an increase in price.
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Supply and Demand Analysis:
The Price of Gasoline (Figure 5.5b)
 At a meeting in March 1999,
OPEC members agree to cut
production by 4 million
barrels to improve revenue.
 This shifts the supply curve
to S1 and causes consumers
to bid the price up to US$34
by November.
 The increased price also
leads to movement along the
supply curve from B to C and
movement along the demand
curve from A to B to reach
the new equilibrium.
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Supply and Demand Analysis:
The Price of Gasoline (Figure 5.5c)
 By February 2000, OPEC
increases supply slightly,
but demand also has
increased.
 The new equilibrium is
at a higher quantity but
the same price.
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Elasticity
Elasticity is a general concept that can be used
to quantify the response in one variable when
another variable changes.
If some variable, A, changes in response to a
change in another variable, B, then:
Elasticity of A with respect B = % change in A
% change in B
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Price Elasticity of Demand
The price elasticity of demand is the ratio of the
percentage change in quantity demanded to the
percentage change in price.
 Price Elasticity of Demand = % change in quantity demanded
% change in price
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Perfectly Inelastic Demand
Perfectly inelastic demand is demand in which
quantity demanded does not respond at all to a
change in price.
An example could be the demand for insulin.
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Inelastic Demand
Inelastic demand is demand that responds
somewhat, but not a great deal, to changes in
price. Inelastic demand always has a numerical
value between zero minus one.
An example would be the demand for housing
or telephone service.
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Unitary Elasticity
Unitary elasticity is a demand relationship in
which the percentage change in quantity of a
product demanded is the same as the
percentage change in price.
The elasticity is always equal to minus one.
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Elastic Demand
Elastic demand is a demand relationship in
which the percentage change in quantity
demanded is larger in absolute value than the
percentage change in price.
The demand elasticity has an absolute value
greater than one.
An example could be the demand for bananas
or any other product for which there are close
substitutes.
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Perfectly Elastic Demand
Perfectly elastic demand is demand in which
quantity demanded drops to zero at the
slightest increase in price.
An example could be the demand for wheat on
the world market, or any other good that can
only be sold at a predetermined price.
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Demand Curves and Elasticity
P
P
Perfectly elastic
P
D
D
Q
Q
Relatively elastic
D
P
D
Q
Perfectly inelastic
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Q
Relatively inelastic
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Calculating Elasticity Using the
Midpoint Formula
The midpoint formula is a more precise way of
calculating percentages using the value halfway
between P1 and P2 for the base in calculating
the percentage change in price, and the value
halfway between Q1 and Q2 as the base for
calculating the percentage change in quantity
demanded.
Using the initial values of P and Q as the base to
calculate percentages is misleading.
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Midpoint Formula
Price elasticity of demand =
% change in quantity demanded
% change in price
% change in quantity demanded = change in quantity demanded x 100
(Q1 + Q2) / 2
= Q2 - Q1
x 100
(Q1 + Q2) / 2
% change in price = change in price x 100
(P1 + P2) / 2
= P2 - P1
x 100
(P1 + P2) / 2
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Elasticity Changes Along a StraightLine Demand Curve (Figure 5.8)
 Demand is quite
elastic from A to
B and quite
inelastic from C to
D.
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Calculating Price Elasticity From A to B
% change in quantity demanded = Q2 - Q1
x 100
(Q1 + Q2) / 2
=
4-2
x 100 = 66.7%
(4 + 2) / 2
% change in price = P2 - P1
x 100
(P1 + P2) / 2
= 9 - 10
x 100 = - 10.5%
(9 +10) / 2
Elasticity of demand = % change in quantity demanded = 66.7% = - 6.4
% change in price
-10.5%
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Calculating Price Elasticity From C to D
% change in quantity demanded = Q2 - Q1
x 100
(Q1 + Q2) / 2
= 18 - 16
x 100 = 11.7%
(18 + 16) / 2
% change in price = P2 - P1
x 100
(P1 + P2) / 2
= 2-3
x 100 = - 40%
(3 +2) / 2
Elasticity of demand = % change in quantity demanded = 11.7% = - 0.294
% change in price
-40%
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Elasticity and Total Revenue
Effect of a price increase on a product with
inelastic demand:
P x Qd = TR
Effect of a price increase on a product with
elastic demand:
P x Qd = TR
Effect of a price cut on a product with elastic
demand:
P x Qd = TR
Effect of price cut on a product with inelastic
demand:
P x Qd = TR
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Relationship Between Elasticity and
Total Revenue (Figure 5.9)
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Determinants of Demand Elasticity
Availability of substitutes
When substitutes are not readily available, demand is
likely to be less elastic.
The importance of being unimportant
When an item represents a small proportion of our
total budget, demand is likely to be less elastic.
The time dimension
In the longer run, demand is likely to become more
elastic, or responsive, because households make
adjustments over time.
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Other Important Elasticities
Income elasticity of demand
Measures the responsiveness of demand with respect
to changes in income
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
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Other Important Elasticities (cont.)
Elasticity of supply
A measure of the response of the quantity of a good
supplied to a change in the price of that good. Likely
to be positive in output markets
Elasticity of labour supply
A measure of the response of labour supplied to a
change in the price of labour. Can be negative or
positive
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Review Concepts and Terms
 black market
 cross-price elasticity of
demand
 elastic demand
 elasticity
 elasticity of labour supply
 elasticity of supply
 favoured customers
 income elasticity of demand
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
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

inelastic demand
midpoint formula
perfectly elastic demand
perfectly inelastic demand
price ceiling
price elasticity of demand
price rationing
queuing
ration coupons
unitary elasticity
Copyright 2002, Pearson Education Canada