Review: Actual Price, Equilibrium Price, and Market Forces

1. Review: Actual Price, Equilibrium Price, and Market Forces P S Surplus Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were _____, given that everything else relevant to the demand for beer remains the same? P* Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? D Shortage Q Q* Equilibrium:Quantity Demanded = Quantity Supplied Market Forces If Actual Price < Equilibrium Price If Actual Price > Equilibrium Price Quantity Demanded > Quantity Supplied Quantity Demanded < Quantity Supplied Shortage exists Surplus exists Market Forces: Actual Price equals Equilibrium Price Inventories fall Inventories rise Actual Price rises Actual Price falls Size of shortage decreases Size of surplus decreases  Until the equilibrium is reached and the actual price equals the equilibrium price 

2. Review: Shifts versus Movements Along Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were _____, given that everything else relevant to the demand for beer remains the same? Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? Equilibrium:Quantity Demanded = Quantity Supplied Shifts Movements along Change in something OTHER THAN the price of beer ITSELF Change in the price of beer ITSELF The slopes of the demand and supply curves for beer capture the effect of a change in the BEER PRICE itself; a change in the price of beer leads to a MOVEMENT ALONG the demand and supply curves for beer The demand curve for beer can SHIFT ONLY if something that affects demand OTHER THAN the BEER PRICE changes. The supply curve for beer can SHIFT ONLY if something that affects supply OTHER THAN the BEER PRICE changes.

3. Elasticity Project: Advice for the Vermonter The Vermonter is an AMTRAK train that travels from Washington, D.C. to St. Albans, VT, with continuing bus service to Montreal, Quebec. The following two individuals are considering ways to increase the revenues generated from Vermonter ticket sales. P Mr. A: “The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices.” Ms. B: “That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse.” 39.00 D Question: In general, what happens to the total revenue collected when the price falls? Q Total Revenues = Price  Quantity Demanded   Question: What additional information do we need to address this question?

4. Price Elasticity of Demand If the quantity demanded is very sensitive to the price If the quantity demanded is not very sensitive to the price  Demand is Elastic  Demand is Inelastic Unit Elastic  1 percent change in price causes the quantity demanded to change by more than 1 percent  1 percent change in price causes the quantity demanded to change by exactly 1 percent  1 percent change in price causes the quantity demanded to change by less than 1 percent  Price elasticity of demand greater than 1  Price elasticity of demand equals 1  Price elasticity of demand less than 1 Price Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the price Two Warnings: Elasticity always refers to percent changes; elasticity differs from the slope – more later. Inelastic demand means that the quantity demanded is not very sensitive to the price; it does not mean that the quantity demanded is not at all sensitive to the price. If the quantity demanded is not at all sensitive to the price we say that demand is perfectly inelastic.

5. Mr. A: “The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices.” Ms. B: “That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse.” Total Revenues = Price  Quantity Demanded Demand is Elastic Demand is Inelastic  If the quantity demanded is very sensitive to the price  If the quantity demanded is not very sensitive to the price  P Q TR = PQ rises  P Q TR = PQ falls

6. Farming Paradox Mr. A: “Good weather and bountiful harvests are bad for the farming community. Inclement weather and poor harvests are good because the total revenue collected by farmers will rise.” Mr. B: “You can't be serious. Have you gone crazy?" Wheat Market: 2010-2011 U.S. Springs Wheat Data By TOM POLANKEK And MARK PETERS Wall Street Journal – August 18, 2011 The U.S. Department of Agriculture quietly released estimates it usually keeps under wraps … Traders caught on to the new data set, posted on the USDA's web site, earlier this week and latched on to figures indicating that the size of the nation's prized fall wheat crop could be smaller than expected. …. prices have soared this week. Supplies of this wheat … have tightened since a historic drought hurt the spring harvest in states like Texas and Oklahoma. Question: Does the WSJ article cite any information suggesting that the supply curve shifted? Question: Does the WSJ article cite any information suggesting that the demand curve shifted? S2011 P 7.50 2011 Yes. No. S2010 7.00 6.50 6.00 5.50 2010 5.00 D Q 2,000 2,050 2,100 2,150 2,200

7. Demand is Elastic How are TR affected? Demand is Inelastic  If the quantity demanded is very sensitive to the price  If the quantity demanded is not very sensitive to the price TR = P × Q   Question: Is the demand for wheat elastic or inelastic?  P Q TR = PQ falls  P Q TR = PQ rises Inelastic This explains the farming paradox. Total Revenue in 2010 = 5.10  2,205 = $11,245.50 Total Revenue in 2011 = 7.45  2,000 = $14,900.00 Question: What affects the (price) elasticity of demand? Market for Insulin Question: Suppose that the price of insulin fell by 50 percent. What would happen to the quantity of insulin demanded? Price D The quantity demanded is not at all sensitive to the price. Perfectly inelastic. Question: Suppose our local hospital, Cooley-Dickinson, announced a special reduced price for appendectomies. What would happen to the quantity of appendectomies demanded? No substitutes for insulin or appendectomies. Perfectly inelastic. Warning: Inelastic does not mean perfectly inelastic. Not very sensitive ISN’T the same as not at all sensitive.. Insulin

8. Minimum Wage Legislation: A Price Floor Federal Minimum Wage = $7.25/hour Massachusetts Minimum Wage = $8.00/hour Market for Low Skilled Labor On January 1, 2015 the Massachusetts minimum wage will rise to $9.00/hour Wage Workers firms would hire S Unemployed 8.00 Workers seeking a job 4.00 D Workers Who is helped? Who is not helped? A Better Poverty Fighter Than Raising the Minimum Wage By Michael Saltsman WSJ Aug. 11, 2014 7:35 p.m. ET President Obama wants to raise the minimum wage to $10.10 from $7.25. But the Congressional Budget Office released a report in February estimating that this higher wage would eliminate 500,000 jobs. A Possible Justification Income Earned by Low Skilled Labor as a Group = w  L   Question: What information do we need to determine if the income earned by low skilled labor as a group rises of falls?

9. Wage Elasticity of Demand If the quantity demanded is very sensitive to the wage If the quantity demanded is not very sensitive to the wage  Demand is Elastic  Demand is Inelastic Unit Elastic  1 percent change in wage causes the quantity demanded to change by more than 1 percent  1 percent change in wage causes the quantity demanded to change by exactly 1 percent  1 percent change in wage causes the quantity demanded to change by less than 1 percent  Wage elasticity of demand greater than 1  Wage elasticity of demand equals 1  Wage elasticity of demand less than 1 Wage Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the wage Income Earned by Low Skilled Labor as a Group = w  L   w  L wL falls w  L wL rises

10. Hamermesh Empirical Study of Wage Elasticity Hamermesh. 1993. Labor Demand. Princeton and Chichester, U.K.: Princeton University Press.

11. Linear Demand Curves: Slope versus Elasticity “High” Price “Low” Price Price Price Increase in TR Decrease in TR Increase in TR P In net, TR falls In net, TR rises Decrease in TR P D D Q Quantity Q Quantity P P TR = P  Q falls TR = P  Q rises P Q P Q Q very sensitive to P Q not very sensitive to P Demand Elastic Demand Inelastic Slope and elasticity are not equivalent. Why? Price Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the price

12. Price Elasticity of Supply If the quantity supplied is very sensitive to the price If the quantity supplied is not very sensitive to the price  Supply is Elastic  Supply is Inelastic Price Elasticity of Supply = Percent change in the quantity supplied resulting from a 1 percent change in the price Claim: “Whenever the government imposes a tax, firms simply raise the price consumers pay by the amount of the tax and carry on business as usual.”