The Price System

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Price SystemThe Price System

• The market system, also called the The market system, also called the price price system,system, performs two important and performs two important and closely related functions : closely related functions :

• Price RationingPrice Rationing

• Resource AllocationResource Allocation


Price RationingPrice Rationing

• Price rationingPrice rationing is the is the process by which the process by which the market system allocates market system allocates goods and services to goods and services to consumers when quantity consumers when quantity demanded exceeds demanded exceeds quantity supplied.quantity supplied.



• A decrease in supply A decrease in supply creates a shortage at creates a shortage at PP00. Quantity demanded . Quantity demanded

is greater than quantity is greater than quantity supplied. Price will supplied. Price will begin to rise.begin to rise.

• The lower total supply The lower total supply is is rationed to those rationed to those who are willing and who are willing and able to payable to pay the higher the higher price.price.



• There is some price There is some price that will clear any that will clear any market.market.

• The price of a rare The price of a rare painting will eliminate painting will eliminate excess demand until excess demand until there is only one bidder there is only one bidder willing to buy the single willing to buy the single available painting.available painting.


Alternative Rationing MechanismsAlternative Rationing Mechanisms

• A price ceilingprice ceiling is a maximum price that sellers may charge for a good, usually set by government.

• QueuingQueuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services.



• Favored customersFavored 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.

• The problem with these alternatives is that The problem with these alternatives is that excess demand is created but not eliminated.excess demand is created but not eliminated.



• In 1974, the In 1974, the government used an government used an alternative rationing alternative rationing system to distribute the system to distribute the available supply of available supply of gasoline.gasoline.

• At an imposed price of At an imposed price of 57 cents per gallon, the 57 cents per gallon, the result was excess result was excess demand.demand.



• A A black marketblack market is a is a market in which illegal market in which illegal trading takes place at trading takes place at market-determined market-determined prices.prices.



• No matter how good the intentions of private No matter how good the intentions of private organizations and governments, it is very organizations and governments, it is very difficult to prevent the price system from difficult to prevent the price system from operating and to stop the willingness to pay operating and to stop the willingness to pay from asserting itself.from asserting itself.

• With favored customers and black markets, the With favored customers and black markets, the final distribution may be even more unfair than final distribution may be even more unfair than that which would result from simple price that which would result from simple price rationing.rationing.


Prices and the Allocation of ResourcesPrices and the Allocation of Resources

• Price changes resulting from shifts of demand in output Price changes resulting from shifts of demand in output markets cause profits to rise or fall.markets cause profits to rise or fall.

• Profits attract capital; losses lead to disinvestment.Profits attract capital; losses lead to disinvestment.

• Higher wages attract labor and encourage workers to Higher wages attract labor and encourage workers to acquire skills.acquire skills.

• At the core of the system, supply, demand, and prices in At the core of the system, supply, demand, and prices in input and output markets determine the allocation of input and output markets determine the allocation of resources and the ultimate combinations of things resources and the ultimate combinations of things produced.produced.


Supply and Demand Analysis:Supply and Demand Analysis:An Oil Import FeeAn Oil Import Fee

• At a world price of $18, At a world price of $18, imports are 5.9 million barrels imports are 5.9 million barrels per day.per day.

• The tax on imports causes an The tax on imports causes an increase in domestic production, increase in domestic production, and quantity imported falls.and quantity imported falls.


ElasticityElasticity

• Elasticity is a general concept that can be used Elasticity is a general concept that can be used to quantify the response in one variable when to quantify the response in one variable when another variable changes.another variable changes.

e lastic ity o f A w ith resp ec t to BA

B

%

%

• Price elasticity of demand Price elasticity of demand measures how measures how responsive consumers are to changes in the responsive consumers are to changes in the price of a product.price of a product.


Price Elasticity of DemandPrice Elasticity of Demand

• Measures the responsiveness of demand to changes in price.

• It is the ratio of the percentage change in quantity demanded to the percentage change in price.

• Its value is always negative, but stated in absolute terms.

• The value of the line of the slope and the value of elasticity are not the same.

p rice e las tic ity o f d em an d % ch an g e in q u an tity d em an d ed

ch an g e in p rice

%


Response to Price Changes

Responsive

Unresponsive

Proportional

Value of

Elasticity

> |1|

< |1|

= |1|

Characteristics of Demand ElasticityCharacteristics of Demand Elasticity

Type of Demand

Elastic

Inelastic

Unitary elastic

Magnitudes of Change

%Qd > %P

%Qd < %P

%Qd = %P

Type of Elasticity

Elastic

Inelastic

Substitutes Available

Many

Few


Type of Demand

Elastic

Inelastic

Inclination

Relatively Flat

Relatively Steep

Shape of Demand According to ElasticityShape of Demand According to Elasticity


Extreme ElasticitiesExtreme Elasticities

Elasticity Value

= 0

=

Type of Elasticity

Perfectly Inelastic

Perfectly Elastic

Substitutes Available

None

Infinite


Hypothetical Demand ElasticitiesHypothetical Demand Elasticitiesfor Four Productsfor Four Products

PRODUCT

% CHANGE IN PRICE

(%P)

Insulin 10% 0% 0 Perfectly inelastic

Basic telephone service 10% -1% -0.1 Inelastic

Beef 10% -10% -1 Unitary elastic

Bananas 10% -30% -3 Elastic

% CHANGE IN QUANTITY

DEMANDED

(%Qd)

ELASTICITY

(%Qd/%P)

Hypothetical Demand Elasticities for Four Products


Calculating Percentage ChangesCalculating Percentage Changes

• Elasticity is a Elasticity is a ratio of percentagesratio of percentages, and it involves , and it involves computing percentage changes.computing percentage changes.

% ch an g e in q u an tity d em an d ed x 1 0 0 %2Q Q

Q1

1

p rice e las tic ity o f d em an d

1 0 0 %

3 3 3 %3 0

..

• Using the values on the graph to compute elasticity, then:

% ch an g e in p rice x 1 0 0 %2P P

P1

1


Computing the Value of ElasticityComputing the Value of Elasticity

%

%

( ) /

( ) /

Q

P

Q QQ QP PP P

d

2 1

1 2

2 1

1 2

21 0 0 %

2

x

x 1 0 0 %

%

%( ) /

( ) /

. .Q

Pd

1 0 55 1 0 2

1 0 0 %

2 33 2 2

57 5 1 6 7

x

x 1 0 0 %

x 1 0 0 %

-12 .5

x 1 0 0 % =

6 6 .7 %

-4 0 .0 %

• The midpoint formula to compute elasticity is:


Interpreting the Value of ElasticityInterpreting the Value of Elasticity

• When = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded.

• When = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

Here is how to interpret two different values of elasticity:


Elasticity Changes along a Straight-Line Elasticity Changes along a Straight-Line Demand CurveDemand Curve

• Price elasticity of demand Price elasticity of demand decreases as we move decreases as we move downward along a linear downward along a linear demand curve.demand curve.

• Demand is elastic on the upper part of the demand curve and inelastic on the lower part.


Elasticity Changes along a Straight-Elasticity Changes along a Straight-Line Demand CurveLine Demand Curve

• Along the elastic range, Along the elastic range, elasticity values are elasticity values are greater than one.greater than one.

6.4

.29

• Along the inelastic range, Along the inelastic range, elasticity values are less elasticity values are less than one.than one.


Elasticity and Total RevenueElasticity and Total Revenue

• When demand is When demand is inelasticinelastic, price and total revenues are , price and total revenues are directlydirectly related. Price increases generate higher revenues.related. Price increases generate higher revenues.

• When demand is When demand is elasticelastic, price and total revenues are , price and total revenues are indirectlyindirectly related. Price increases generate lower revenues.related. Price increases generate lower revenues.

Type of Type of demanddemand Value of EValue of Edd

Change in quantity Change in quantity versus change in versus change in priceprice

Effect of an Effect of an increase in increase in price on total price on total revenuerevenue

Effect of a Effect of a decrease in price decrease in price on total revenueon total revenue

ElasticElastic Greater than Greater than 1.01.0

Larger percentage change Larger percentage change in quantityin quantity

Total revenue Total revenue decreasesdecreases

Total revenue Total revenue increasesincreases

InelasticInelastic Less than 1.0Less than 1.0 Smaller percentage Smaller percentage change in quantitychange in quantity

Total revenue Total revenue increasesincreases

Total revenue Total revenue decreasesdecreases

Unitary Unitary elasticelastic

Equal to 1.0Equal to 1.0 Same percentage change Same percentage change in quantity and pricein quantity and price

Total revenue Total revenue does not changedoes not change

Total revenue does Total revenue does not changenot change


Determinants of Demand ElasticityDeterminants of Demand Elasticity

• Availability of substitutes Availability of substitutes -- -- demand is more elastic when there demand is more elastic when there are more substitutes for the product.are more substitutes for the product.

• Importance of the item in the Importance of the item in the budget budget -- demand is more elastic -- demand is more elastic when the item is a more significant when the item is a more significant portion of the consumer’s budget.portion of the consumer’s budget.

• Time frame Time frame -- demand becomes -- demand becomes more elastic over time.more elastic over time.


Other Important ElasticitiesOther Important Elasticities

• Income elasticity of demandIncome elasticity of demand – measures the – measures the responsiveness of demand to changes in responsiveness of demand to changes in income.income.

in co m e e la stic ity o f d em an d % ch an g e in q u an tity d em an d ed

ch an g e in in co m e

%



• Cross-price elasticity of demand:Cross-price elasticity of demand: A A measure of the response of the quantity of one measure of the response of the quantity of one good demanded to a change in the price of good demanded to a change in the price of another good.another good.

cro ss - p rice e las tic ity o f d em an d % ch an g e in q u an tity o f d em an d ed

ch an g e in p rice o f

Y

X%



• Elasticity of supply:Elasticity of supply: A measure of the A measure of the response of quantity of a good supplied to a response of quantity of a good supplied to a change in price of that good. Likely to be change in price of that good. Likely to be positive in output markets.positive in output markets.

e lastic ity o f su p p ly % ch an g e in q u an tity su p p lied

ch an g e in p rice

%



• Elasticity of labor supply:Elasticity of labor supply: A measure of the A measure of the response of labor supplied to a change in the response of labor supplied to a change in the price of labor.price of labor.

e lastic ity o f lab o r su p p ly% ch an g e in q u an tity o f lab o r su p p lied

ch an g e in th e w ag e ra te

%

Date post:	31-Dec-2015
Category:	Documents
Upload:	basil-nash
View:	27 times
Download:	0 times

The Price System

Documents