Working with Supply Working with Supply and Demandand Demand

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Government Government Intervention in Intervention in

MarketsMarkets

•Price CeilingsPrice Ceilings•Price FloorsPrice Floors

•TaxesTaxes

Government Government Intervention in Intervention in

MarketsMarkets

Price CeilingPrice Ceiling

A government-imposed A government-imposed maximum price in a maximum price in a

marketmarket

Price CeilingPrice Ceiling

Numberof Bottles ofMaple Syrup

Priceper

Bottle

6,0005,0004,000

D

S

$4.00

3.00

2.00

E

T

R V

Government Government Intervention in Intervention in

MarketsMarkets

When quantity supplied and When quantity supplied and quantity demanded differ, quantity demanded differ,

whichever of the two whichever of the two quantities is smaller, the quantities is smaller, the short side of the marketshort side of the market

will prevail.will prevail.

Government Government Intervention in Intervention in

MarketsMarkets

•A price ceiling creates a A price ceiling creates a shortage, increasing the shortage, increasing the time and trouble required time and trouble required to buy the good. to buy the good. •While the price While the price decreases, the opportunity decreases, the opportunity cost may rise.cost may rise.

Government Government Intervention in Intervention in

MarketsMarkets

Price FloorPrice Floor

A government-imposed A government-imposed minimum price in a minimum price in a

marketmarket

Price Floor Price Floor

Millionsof Pounds

Priceper

Pound

200180 220

$0.900.80

S

D

J

A

K

Government Government Intervention in Intervention in

MarketsMarkets•Price floor creates an excess Price floor creates an excess supply of a goodsupply of a good•To maintain a price floor, To maintain a price floor, government must prevent excess government must prevent excess supply from driving down the supply from driving down the market pricemarket price•In practice, government often In practice, government often does this by purchasing the does this by purchasing the excess supply itselfexcess supply itself

Government Government Intervention in Intervention in

MarketsMarkets

Excise TaxExcise Tax

A tax on a specific A tax on a specific good or service.good or service.

Excise TaxExcise Tax

Quantity

Priceper Unit

60 120

$1.50

.90

S

B

A

Excise TaxExcise Tax

An excise tax shifts the market An excise tax shifts the market supply curve upward by the supply curve upward by the amount of the tax. For each amount of the tax. For each quantity supplied, the new, quantity supplied, the new, higher supply curve tells us higher supply curve tells us firms’ firms’ grossgross price, and the price, and the

original, lower supply curve original, lower supply curve tells us the tells us the netnet price. price.

Excise TaxExcise Tax

Tickets(Millionsper Year)

Priceper

Ticket

10 11.3

$800

700730

S

S'

D

B

A

Excise TaxExcise Tax

•An Excise tax on a good An Excise tax on a good increases the price paid by increases the price paid by consumers, but decreases the consumers, but decreases the (net) price received by (net) price received by sellers.sellers.•Both buyers and sellers bear Both buyers and sellers bear part of the burden of paying part of the burden of paying taxes.taxes.

Price Elasticity of Price Elasticity of DemandDemand

•Calculating Price Elasticity of Calculating Price Elasticity of DemandDemand

•Elasticity and Straight-line Elasticity and Straight-line Demand CurvesDemand Curves

•Elasticity and Total ExpenditureElasticity and Total Expenditure•Categorizing Goods by ElasticityCategorizing Goods by Elasticity

•Determinants of ElasticityDeterminants of Elasticity•Using Price Elasticity of DemandUsing Price Elasticity of Demand

Price Elasticity of Price Elasticity of DemandDemand

•The sensitivity of The sensitivity of quantity demanded to quantity demanded to price price •The percentage change in The percentage change in quantity demanded caused quantity demanded caused by a 1 percent change in by a 1 percent change in priceprice P%

Q%E

D

D

Price Elasticity of Price Elasticity of DemandDemand

•A percentage change is A percentage change is usually usually defined as the defined as the change in a variable change in a variable divided by the starting, or divided by the starting, or base, valuebase, value•The The base valuebase value is always is always midway between the initial midway between the initial value and the new valuevalue and the new value

Price Elasticity of Price Elasticity of DemandDemand

Quantityof Laptops

C

Priceper

Laptop

100,000 200,000 300,000 400,000 500,000 600,000

$3,500

3,000

2,500

2,000

1,500

1,000

B

A

D

D

Elasticity and Elasticity and Straight-Line Straight-Line

Demand CurvesDemand Curves

•Elasticity of demand varies Elasticity of demand varies along a straight-line along a straight-line

demand curve. demand curve. •More specifically, demand More specifically, demand becomes more elastic as we becomes more elastic as we move upward and leftward.move upward and leftward.

Elasticity and Elasticity and Straight-Line Straight-Line

Demand CurvesDemand Curves

Quantity

Price

. . . and since equal quantitydecreases (horizontal arrows)are larger and largerpercentage decreases . . .

Since equal dollarincreases (vertical arrows)are smaller and smallerpercentage increases . . .

D

1

2

3

. . . demand becomesmore and more elasticas we move leftward andupward along a straightline demand curve.

Inelastic DemandInelastic Demand

Inelastic DemandInelastic Demand

A price elasticity of A price elasticity of demand between 0 and demand between 0 and

-1-1

Perfectly Inelastic Perfectly Inelastic DemandDemand

Perfectly Inelastic Perfectly Inelastic DemandDemand

A price elasticity of A price elasticity of demand equal to 0demand equal to 0

Perfectly Elastic Perfectly Elastic DemandDemand

Elastic DemandElastic Demand

A price elasticity of A price elasticity of demand less than -1demand less than -1

Extreme Cases of Extreme Cases of DemandDemand

aaa

Quantity

PriceperUnit

1

D

2

3

$4

20 40 60 80 100

(a)

Perfectly InelasticDemand

Quantity

PriceperUnit

D

20 40 60 80 100

(b)

1

2

3

$4Perfectly Elastic

Demand

Perfectly Elastic Perfectly Elastic DemandDemand

Perfectly (Infinitely) Perfectly (Infinitely) Elastic DemandElastic Demand

A price elasticity of A price elasticity of demand approaching demand approaching

minus infinityminus infinity

Unitary Elastic Unitary Elastic DemandDemand

Unitary Elastic Unitary Elastic DemandDemand

A price elasticity of A price elasticity of demand equal to -1demand equal to -1

Elasticity and Total Elasticity and Total ExpenditureExpenditure

• If demand is price If demand is price inelasticinelastic, , then total expenditure moves in then total expenditure moves in the same direction as price. the same direction as price. • If demand is If demand is elasticelastic, total , total spending moves in the opposite spending moves in the opposite direction from price. direction from price. • If demand is If demand is unitary elasticunitary elastic, , total expenditure remains the total expenditure remains the same as price changes.same as price changes.

Effects of Price Effects of Price Changes on Changes on ExpenditureExpenditure

Where Demand is: A price increase will: A price decrease will:

inelastic (|ED| < 1) increase expenditure decrease expenditureunitary elastic (|ED| = 1) cause no change in cause no change in

expenditure expenditureelastic (|ED| > 1) decrease expenditure increase expenditure

Effects of Price Effects of Price Changes on Changes on ExpenditureExpenditure

At any point on a demand curve, At any point on a demand curve, buyers’ total expenditures is the area buyers’ total expenditures is the area of a rectangle with width equal to of a rectangle with width equal to quantity demanded and height equal quantity demanded and height equal to price.to price.

Elasticity and Total Elasticity and Total ExpenditureExpenditure

Quantityof Laptops

Priceper

Laptop

100,000 200,000 300,000 400,000 500,000 600,000

$3,500

3,000

2,500

2,000

1,500

1,000

500D

B

A

Determinants of Determinants of Elasticity Elasticity

Short-run ElasticityShort-run Elasticity

An elasticity measured An elasticity measured just a short time after just a short time after

a price changea price change

Determinants of Determinants of Elasticity Elasticity

Specific Brands Narrow Categories Broad Categories

Tide Detergent –2.79 Transatlantic Air Travel –1.30 Recreation –1.09Tourism in Thailand –1.20

Pepsi –2.08 Ground Beef –1.02 Clothing –0.89Coke –1.71 Pork –0.78 Food –0.67

Milk –0.54 Imports –0.58Cigarettes –0.45 Transportation –0.56Electricity –0.40 to –0.50Beer –0.26Eggs –0.26Gasoline –0.20Oil –0.15

Long-run ElasticityLong-run Elasticity

Long-run ElasticityLong-run Elasticity

An elasticity measured An elasticity measured a year or more after a a year or more after a

price changeprice change

Short-run and Long-Short-run and Long-run Elasticityrun Elasticity

Short Run (a few months of less) Long Run (a year or more)

Use public transit more often Buy a more fuel-efficient carArrange a car pool Move closer to your jobGet a tune-up Switch to a job closer to homeDrive more slowly on the highway Move to a city where less driving is requiredEliminate unnecessary trips (use mail order and the Internet instead of driving to stores; locate goods by phone instead of driving around; shop for food less often and buy more each time)It there are two cars, use the more fuel-efficient one

Short-run and Long-Short-run and Long-run Elasticityrun Elasticity

•Easier to find substitutes for an Easier to find substitutes for an item in the long run than in the item in the long run than in the short runshort run•Thus, demand is more elastic in Thus, demand is more elastic in the long run than in the short the long run than in the short runrun•The more of their total budgets The more of their total budgets households spend on an item, households spend on an item, the more elastic the demand for the more elastic the demand for that itemthat item

Price Elasticity of Price Elasticity of DemandDemand

•The more The more elasticelastic the the demand curve, the more of demand curve, the more of an excise tax paid by an excise tax paid by sellerssellers•The more The more inelasticinelastic the the demand curve, the more of demand curve, the more of the tax paid by the tax paid by buyersbuyers

Price Elasticity of Price Elasticity of DemandDemand

Tickets(Millions per Year)

Priceper

Ticket

11.3

$830

730

S

S'D

B

A

Tickets(Millions per Year)

Priceper

Ticket

7.0 11.3

$730

S

S'

DAB

(a) (b)

Other Demand Other Demand ElasticitiesElasticities

•Income Elasticity of Income Elasticity of DemandDemand

•Cross-Price Elasticity Cross-Price Elasticity of Demandof Demand

Income Elasticity of Income Elasticity of DemandDemand

Income Elasticity of Income Elasticity of DemandDemand

The percentage change The percentage change demanded caused by a 1-demanded caused by a 1-percent change in incomepercent change in income

I%

Q%E

D

I

Income Elasticity of Income Elasticity of DemandDemand

Economic NecessityEconomic Necessity

A good with an income elasticity A good with an income elasticity of demand between 0 and 1of demand between 0 and 1

Economic LuxuryEconomic Luxury

A good with an income elasticity A good with an income elasticity of demand greater than 1of demand greater than 1

Cross-Price Elasticity Cross-Price Elasticity of Demandof Demand

Cross-Price Elasticity of Cross-Price Elasticity of DemandDemand

The percentage change in The percentage change in the the quantity the the quantity

demanded of one good demanded of one good caused by a 1-percent caused by a 1-percent change in the price of change in the price of

another goodanother good