Unit 4

Chap.5 - Price Floors and Price Ceilings

Chap.6 - Elasticity

Government Intervention in Pricing

Price Floor Price is set higher than Market Equilibrium Surplus

Price Ceiling Price is set lower than Market Equilibrium Shortage

Example of Price Ceiling

Rent Controls in Large Cities

Maximum rent that can be charged is below market equilibrium

Seinfeld Episode

Example of Price Ceiling

Market Equilibrium: Qty supplied = Qty demanded at ???

Example of Price Ceiling

At Price Ceiling of $1,100, Qty demanded = ??? And Qty supplied = ???

Example of Price Ceiling

Rent Controls in Large Cities

Maximum rent that can be charged is below market equilibrium

Qty demanded increases Qty supplied decreases Shortage!!!

Example of Price Ceiling

When might rent controls be a good idea??

When do rent controls fail??

Example of Price Floor

Minimum Wage

Minimum wage that can be charged is above market equilibrium

Example of Price Floor

Market Equilibrium: Supply = Demand at ???

Example of Price Floor

At Price Floor of $7.25, Demand = ??? And Supply = ???

Example of Price Floor

Minimum Wage

Minimum wage that can be charged is above market equilibrium

Demand decreases Supply increases Surpus!!!

Law of Demand

The Law of Demand tells us that for an increase in price, there will be a decrease in quantity demanded, but it does not tell us by how much quantity demanded will decrease.

Elasticity of Demand

Price elasticity of demand measures the magnitude of change in quantity demanded due to a change in price – It tells us how much!

ED = % change in Quantity Demanded

% change in Price

Elasticity of Demand Equation

ED =Change in Price

Sum of Quantity

2

Change in Quantity

Sum of Price

2

Elasticity of Demand Example

If the price of Diet Coke increases from $2.50 to $3.00 for a 12 pack, then the quantity demanded will decrease from 1000 to 900 12 packs.

Elasticity of Demand Example

The percent change in quantity demanded is:

1000 - 900

1000 + 900

2

=100

1900

2

=100

950

= .11

Elasticity of Demand Example

The percent change in price is:

$3.00 - $2.50

$3.00+ $2.50

2

=$0.50

$5.50

2

=$0.50

$2.75

= .18

Elasticity of Demand Example

The ED will be equal to the percent change in quantity demanded divided by the percent change in price.

ED = .11 / .18 = .61

Elasticity of Demand Example

An ED of 0.61 means that every 1% change in price will result in a 0.61% change in quantity demanded.

For this example, a 1% increase in the price of a 12 pack of Coke leads to a 0.61% decrease in the sale of a 12 pack of Coke.

Elasticity When ED > 1

% change in Q > % change in P Demand is Elastic

When ED < 1 % change in Q < % change in P Demand is Inelastic

When ED = 1 % change in Q = % change in P Demand is Unit Elastic

Elasticity and Total Revenue

When demand is elastic Consumers are very price sensitive

An increase in price leads to a decrease in total revenue as many customers will no longer purchase this product.

A decrease in price leads to an increase in total revenue as many new customers will now buy this product.

Elasticity and Total Revenue

Let’s take a look at what happens to total revenue when price falls from $10 down to $5. Here, the price elasticity of demand is equal to 2.34.

Elasticity and Total Revenue

The decrease in price means less revenue gained for each of the first 60 units sold, or a decrease in revenue of $5 * 60 = -$300.

The decrease in price means more revenue gained by the sale of an additional 20 units (as sales increase from 60 to 80) at $5 * 20 = $100.

-$300

+$100

Elasticity and Total Revenue

When demand is inelastic Consumers are very price insensitive

An increase in price leads to an increase in total revenue as many customers will keep buying this product even at the higher price.

A decrease in price leads to a decrease in total revenue as your customers will now buy this product at a lower price.

Elasticity and Total Revenue

Let’s take a look at what happens to total revenue when price falls from $20 down to $15. Here, the price elasticity of demand is equal to 0.427.

Elasticity and Total Revenue

The decrease in price means less revenue gained for each of the first 20 units sold, or a decrease in revenue of $5 * 20 = -$100.

The decrease in price means more revenue gained by the sale of an additional 20 units (as sales increase from 20 to 40) at $15 * 20 = $300.

-$100

+$300

Elasticity and Total Revenue When demand is unit elastic

Consumers are price neutral An increase in price leads to no change in

total revenue as some customers will keep buying this product even at the higher price while some customers will stop buying the product.

A decrease in price leads to no change in total revenue as your current customers will now be paying a lower price, but this will be offset by the new customers you will gain who will start buying your product.

Elasticity of Demand Example

Calculate the price elasticity for the following. State whether the price elasticity of demand is elastic, unit elastic, or inelastic.

Will revenue rise, decline, or stay the same with the given change in price?

The price of a Boston Red Sox baseball game rises from $8 to $12 a game. The quantity of tickets sold falls from 160,000 tickets to 144,000.