Working with Supply and Demand

1. Working with Supply and Demand

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 • Smaller of quantity supplied and quantity demanded at a particular price • When quantity supplied and quantity demanded differ, short side of market will prevail • Price ceiling creates a shortage and increases the time and trouble required to buy the good • 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

3. S Price per Bottle T $4.00 V R 2.00 E 3.00 D 4,000 6,000 Number 5,000 of Bottles of Maple Syrup Figure 1: A Price Ceiling in the Market for Maple Syrup

4. Price Floors • Government imposed minimum amount below which price is not permitted to fall • Price floors for agricultural goods are commonly called price support programs • When sellers produce more of the good than buyers want at the price floor • 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

5. Price per Pound S K $0.90 J 0.80 A D 180 220 200 Millions of Pounds Figure 2: A Price Floor in the Market for Nonfat Dry Milk

6. Limiting Surplus • A price floor creates a surplus of goods • In order to maintain price floor, government must prevent surplus from driving down market price • Government often accomplishes this goal by purchasing surplus with taxpayers dollars • Price floors often get government deeply involved in production decisions • Rather than leaving them to the market

7. The Problem with Rate Change • Rate of change of quantity demanded compared to the change in price is not a good measure of price sensitivity • Doesn’t tell whether a change in price or a change in quantity demanded is a relatively large or relatively small change • Relative means compared to value of price or quantity before change

8. The Elasticity Approach • Elasticity approach improves on the problems with rate of change • By comparing percentage change in quantity demanded with percentage change in price • Price elasticity of demand (ED) for a good is percentage change in quantity demanded divided by percentage change in price • Will virtually always be a negative number • Tells us percentage change in quantity demanded for each 1% increase in price • Price elasticity of demand tells us percentage change in quantity demanded caused by a 1% rise in price as we move along a demand curve from one point to another

9. 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 • When price changes from any value P0 to any other value P1, we define the percentage change in price as • When quantity demanded changes from Q0 to Q1, percentage change is calculated as

10. Figure 3: Calculating Price Elasticity of Demand

11. An Example: Calculating Price Elasticity of Demand • Now let’s calculate an elasticity of demand for laptop computers using data in Figure 3 from point A to point B • Use percentage changes for price and quantity to calculate price elasticity of demand (ED)

12. Elasticity and Straight-Line Demand Curves • As we move upward and leftward along a straight-line demand curve • Same absolute increment in price will correspond to smaller and smaller percentage increments in price • 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 • 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

13. Figure 4: Elasticity and Straight-Line Demand Curves

14. Categorizing Goods by Elasticity • Inelastic Demand • Price elasticity of demand between 0 and -1 |% Change in Quantity Demanded| < |% Change in Price| • Perfectly Inelastic Demand • Price elasticity of demand equal to 0

15. Categorizing Goods by Elasticity • Elastic Demand • Price elasticity of demand with absolute value > 1 |% Change in Quantity Demanded| > |% Change in Price| • Perfectly (infinitely) Elastic Demand • Price elasticity of demand approaching minus infinity • Unitary Elastic Demand • Price elasticity of demand equal to -1

16. Figure 5: Extreme Cases of Demand

17. Elasticity and Total Revenue • Total revenue (TR) of all firms in the market is defined as • TR = P x Q • When two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes • Applying this to total revenue • % Change in TR = % Change in Price + % Change in Quantity Demanded • Assume demand is unitary elastic and Q rises by 10% • % Change in TR = 10% + (-10%) = 0

18. Elasticity and Total Revenue • If demand is inelastic, a 10% rise in price will cause quantity demanded to fall by less than 10% • % change in TR = 10% + (something less negative than –10%) > 0 • If demand is elastic, so that Q falls by more than 10% • TR will fall • % Change in TR = 10% + (something more negative than -10%) < 0

19. Elasticity and Total Revenue • Where demand is inelastic, total revenue moves in same direction as price • Where demand is elastic, total revenue moves in opposite direction from price • Where demand is unitary elastic, total revenue remains the same as price changes • At any point on a demand curve sellers’ total revenue (buyers’ total expenditure) is the area of a rectangle • Width equal to quantity demanded • Height equal to price

20. Price per Laptop $3,500 3,000 2,500 B 2,000 1,500 A 1,000 D 500 Quantity 100,000 200,000 300,000 400,000 500,000 600,000 of Laptops Figure 6: Elasticity and Total Expenditure

21. Availability of Substitutes • Demand is more elastic • If close substitutes are easy to find and buyers can cut back on purchases of the good in question • Demand is less elastic • If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question

22. Narrowness of Market • More narrowly we define a good, easier it is to find substitutes • More elastic is demand for the good • More broadly we define a good • Harder it is to find substitutes and the less elastic is demand for the good • Different things are assumed constant when we use a narrow definition compared with a broader definition

23. Necessities vs. Luxuries • The more “necessary” we regard an item, the harder it is to find a substitute • Expect it to be less price elastic • The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute • Expect it to be more price elastic

24. Time Horizon • Short-run elasticity • Measured a short time after a price change • Long-run elasticity • Measured a year or more after a price change • Usually easier to find substitutes for an item in the long run than in the short run • Therefore, demand tends to be more elastic in the long run than in the short run

25. Importance in the Buyer’s Budget • The more of their total budgets that households spend on an item • The more elastic is demand for that item • The less of their total budgets that households spend on an item • The less elastic is demand for that item

26. Using Price Elasticity of Demand: The War on Drugs • Every year U.S. Government spends about $20 billion on efforts to restrict the supply of drugs • Figure 9(a) • Market for heroin without government intervention • Figure 9(b) • Result of government efforts to restrict supply (current policy) • Figure 9(c) • Results of an effective policy of reducing demand

27. (a) (b) (c) Price Price Price S 2 per per per Unit Unit Unit B S S S 1 1 1 P 2 A A A P P P 1 1 1 C P 3 D D D 1 1 1 D 2 Q Q Q Q Q 1 3 1 2 1 Quantity Quantity Quantity Figure 7: The War on Drugs

28. Using Price Elasticity of Demand: Mass Transit • Elasticity studies show that long-run demand for mass transit is inelastic • Therefore, a rise in fare would increase revenues • However, most cities do not raise transit fares due to • Desire to provide low-income households with affordable transportation • Desire to manage traffic congestion • Desire to limit air pollution in the city • An increase in fares would increase revenue • Would also decrease ridership and require the city to sacrifice these other goals

29. Using Price Elasticity of Demand: An Oil Crisis • For the past five decades, Middle East has been a geopolitical hot spot • Both military and economic government agencies ask “What if” questions • If an event in the Middle East were to disrupt oil supplies, what would happen to the price of oil on world markets? • Flipping the elasticity equation like so • Tells us percentage rise in price that would bring about a 1 percent decrease in quantity demanded • Enables us to make reasonable forecasts about the impact of various events on oil prices • Once we have established our forecasted oil prices we can then use that data to examine effect that higher oil prices would have on many broader issues • Effect on U.S. inflation rate • Effect on number of flights offered by U.S. airlines

30. Income Elasticity of Demand • Percentage change in quantity demanded divided by the percentage change in income • With all other influences on demand—including the price of the good—remaining constant • Interpret this number as percentage increase in quantity demanded for each 1% rise in income

31. Income Elasticity of Demand • Income elasticities vs. price elasticities of demand • Price elasticity of demand • Measures effect of change in price of good • Assumes that other influences on demand, including income, remain unchanged • Income elasticity • Measures effect on demand we would observe if income changed and all other influences on demand—including price of the good—remained the same • Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant

32. Income Elasticity of Demand • Another difference between price and income elasticity of demand • Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another • Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price • While a price elasticity is virtually always negative • Income elasticity can be positive or negative

33. Income Elasticity of Demand • Economic necessity • Good with an income elasticity of demand between 0 and 1 • Economic luxury • Good with an income elasticity of demand greater than 1 • An implication follows from these definitions • As income rises, proportion of income spent on economic necessities will fall • While proportion of income spent on economic luxuries will rise • But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior • Not by our judgment of a good’s importance to human survival

34. Cross-Price Elasticity of Demand • Cross-price elasticity of demand • Percentage change in quantity demanded of one good caused by a 1% change in price of another good • While all other influences on demand remain unchanged • While the sign of the cross-price elasticity helps us distinguish substitutes and complements among related goods • Its size tells us how closely the two goods are related • A large absolute value for EXZ suggests that the two goods are close substitutes or complements • While a small value suggests a weaker relationship

35. Price Elasticity of Supply • Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good • With all other influences on supply held constant

36. Price Elasticity of Supply • When do we expect supply to be price elastic, and when do we expect it to be price inelastic? • Ease with which suppliers can find profitable activities that are alternatives to producing the good in question • Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily • When can we expect suppliers to have easy alternatives? Depends on • Nature of the good itself • Narrowness of the market definition—especially geographic narrowness • Time horizon—longer we wait after a price change, greater the supply response to a price change

37. Price Elasticity of Supply • Extreme cases of supply elasticity • Perfectly inelastic supply curve is a vertical line • Many markets display almost completely inelastic supply curves over very short periods of time • Perfectly elastic supply curve is a horizontal line

38. Figure 8: Extreme Cases of Supply

39. The Tax on Airline Travel: Taxes and Market Equilibrium • A tax on a particular good or service is called an excise tax • Shifts market supply curve upward by amount of tax • For each quantity supplied, the new, higher curve tells us firms’ gross price, and the original, lower curve tells us the net price • Who really pays excise taxes? • Buyers and sellers share in the payment of an excise tax • Called tax shifting • Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers)

40. Figure 9: The Tax on Airline Travel

41. Figure 10: Effect of Excise Tax on Airlines

42. Tax Incidence and Demand Elasticity • In most cases excise tax will be shared by both buyer and seller • For a given supply curve, the more elastic is demand, the more of an excise tax is paid by sellers • The more inelastic is demand, the more of the tax is paid by buyers

43. Figure 11: Tax Incidence and Demand Elasticity

44. Tax Incidence and Supply Elasticity • Although there are extreme cases of supply elasticity, in general the following is true • For a given demand curve, the more elastic is supply, the more of an excise tax is paid by buyers • The more inelastic is supply, the more of the tax is paid by sellers

45. Figure 12: Tax Incidence and Supply Elasticity

46. The Market For Food • Shrinking and unstable incomes are problems for farmers • The market for farm goods would reach an equilibrium if it were allowed to do so • But farming seems to be special • Notion of small family farm has tremendous political appeal • Farmers have banded together to form powerful and effective government lobbies • Result has been continual government interference with supply and demand in agricultural markets around the world

47. (a) (b) Price per Price per S old Unit of Unit of S technology Bad Food Food Weather S new S technology Good A A Weather P P 1 1 B P P B 2 2 D D Q Q Quantity Q Quantity Q 1 2 2 1 of Food of Food Figure 13: The Market For Food

48. Health Insurance and the Market for Health Care • Health insurance has definite benefits to our society • Our current health care system keeps patients from facing the full opportunity cost of their health care decisions • Can cause people to over consume health care • Health insurance reduces buyers’ incentives to monitor their health care expenditures closely or to shop around for high-quality low-cost care

49. after insurance D Price per Examination $100 B S 70 Dbefore insurance 50 A 150,000 Examinations 100,000 per Year Figure 14: The Market For Health Care With Coinsurance