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SUPPLY, DEMAND, AND GOVERNMENT POLICIES
• In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.
• While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.
• One of the roles of economists is to use their theories to assist in the development of policies.
PRICE CONTROLS: LIMITING PRICE MOVEMENTS
• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and floors.
PRICE CEILINGS & PRICE FLOORS
PRICE CEILING • A legally established maximum price at
which a good can be sold.
PRICE FLOOR• A legally established minimum price at
which a good can be sold.
•A government-set maximum price that can be charged for a good or service
•Upper Price Limit
PRICE CEILINGS (PC)
PRICE CEILINGS– NO EFFECT
$4
3
Quantity0
Price
Demand
Supply
Priceceiling
Equilibriumprice
100Equilibriumquantity
PRICE CEILING – WITH EFFECT
$3
Quantity0
Price
2
Demand
Supply
Equilibriumprice
Priceceiling
Shortage
125Quantitydemanded
75Quantitysupplied
• Since a Price Ceiling (Pc) should be placed below the equilibrium price, Pe, then Pe becomes illegal.
• Normally in a free market, adjustment will be through an increase in price, but here it is illegal.
PRICE CEILINGS (PC)
EFFECTS OF PRICE CEILINGS
An effective price ceiling creates ...
• Shortages because QD > QS.• Example: Gasoline shortage of the 1970s
• non-price rationing• Examples: Long lines, Discrimination by sellers
(Purchase will be limited to those able/willing to buy)
APPLICATION: LINES AT THE GAS PUMP
In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline.
What was responsible for the long gas lines?Economists blame government regulations that limited the price oil companies could charge for gasoline.
•A government-set minimum price that can be charged for a good or service
•Lower Price Limit
PRICE FLOORS
$3
Quantity0
Price
100Equilibriumquantity
Equilibriumprice
Demand
Supply
Pricefloor2
PRICE FLOORS – NO EFFECT
$3
Quantity0
Price
Equilibriumprice
Demand
Supply
Price floor$4
120Quantitysupplied
80Quantitydemanded
Surplus
PRICE FLOORS – WITH EFFECT
• A Price Floor (Pf) is placed above the equilibrium price, Pe, the government will penalize those who transact below the Price Floor (Pf) • To prevent the adjustment process to cause price to fall, government may buy the surplus, or sellers will have to absorb it.
PRICE FLOORS
EFFECTS OF PRICE FLOOR
• A price floor prevents supply and demand from moving toward the equilibrium price and quantity.
• When the market price hits the floor, it can fall no further, and the market price equals the floor price.
EFFECTS OF PRICE FLOOR
• An effective price floor causes . . .
• A surplus because QS >QD.
• Nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.
• Examples: The minimum wage, Agricultural price supports
APPLICATION: THE MINIMUM WAGE
• An important example of a price floor is the minimum wage.
• Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
THE MINIMUM WAGE
Quantity ofLabor
0
Wage
Equilibrium
wage
Labor demand
Labor supply
A Free Labor Market
Equilibriumemployment
Minimumwage
THE MINIMUM WAGE
Quantity ofLabor
0
Wage
Labor demand
Labor supply
Quantitysupplied
Quantitydemanded
Labor surplus(unemployment)
A Labor Market with a Minimum Wage
PRICE ELASTICITY OF DEMAND
Price Elasticity of Demand (Elasticity of Demand)
• Price Elasticity measures how much the quantity changes with a given change in price of the item.• Measure the strength of buyers responses to price
changes, in other words, the sensitivity of buyers towards the price changes.FORMULA:
d = % Quantity Demanded % Price
d = Q2 – Q1 x P1
Q1 P2 – P1
PRICE ELASTICITY OF DEMAND
Try this! Calculate the Price Elasticity of Demand for the following products:
• PRODUCT A – As the price change from $10 to 8, the quantity demanded change from 10 to 14.
• PRODUCT B – As the price change from $10 to 8, the quantity demanded change from 10 to 11.
• PRODUCT C – As the price change from $10 to 8, the quantity demanded change from 10 to 12.
INTERPRETATIONS
Product A, d = 2For Ed > 1, the demand is Elastic
Product B, d = 0.5For Ed < 1, the demand is Inelastic
Product C, d = 1For Ed = 1, the demand is Unit Elastic
PRICE ELASTICITY OF DEMAND
Price Elastic• Strong response to a price change.• Occurs when the % change in quantity is
greater than the % change in price (chg Q > chg P).• A small change in the price of the product
causes a large change in its quantity demanded.• Whenever the absolute value of price elasticity
of demand is greater than 1 (Ed > 1), demand is elastic. • Quantity demanded is “relatively
responsive”.
PRICE ELASTICITY OF DEMAND
Price Inelastic• Weak response to a price change.• Occurs when the % change in quantity is less
than the % change in price (chg Q < chg P)• A large change in the price of the product will
only cause a small change in its quantity demanded.• Whenever the absolute value of price
elasticity of demand is less than 1 (Ed < 1), demand is inelastic. • Quantity demanded “relatively
unresponsive”.
PRICE ELASTICITY OF DEMAND
Other level of elasticity.Unit Elastic Demand - A condition in which percentage changes in price equals to percentage changes in quantity demanded.2 Extreme Cases • Perfectly inelastic – A condition in which the
quantity demanded does not change as the price changes.
• Perfectly elastic demand - A condition in which a small percentage of change in price leads to an infinite percentage of change in the quantity demanded.
Price
Quantity Demanded
Unit Elastic Demand
DEGREES OF ELASTICITY
Inelastic DemandElastic Demand
Perfectly Inelastic Demand
Perfectly Elastic Demand
d > 1
d < 1
d = 1
d =0
d =
PRICE ELASTICITY OF DEMAND
Factors Affecting Price Elasticity of Demand1) Necessities vs. luxury goods• Strong response to price changes in luxury
goods.• Weak response to price changes in necessities.2) Substitutes• Strong response to price changes in products
with many substitutes or similar alternatives.• Weak response to price changes in products that
have few substitutes or similar alternatives.3) Proportion of income• Strong response to price changes in products
that require a greater proportion of income.• Weak response to price changes in products that
require a lesser proportion of income.
TEST YOUR UNDERSTANDING
• Insulin vs. Star Cruises• The prices of both of these goods rise by
20%. For which good does Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in demand. • A cruise is a luxury. If the price rises,
some people will forego it. • Lesson: Price elasticity is higher for luxuries
than for necessities.
DEMAND ELASTICITY & TOTAL REVENUE
Total Revenue TestPrice elasticity of demand can be estimated
by observing the change in total revenue that results from a price change (ceteris paribus).
The information on price elasticity of demand will be useful for the seller to adjust their selling price since it will affect the total revenue.
Three different scenarios to be considered– elastic, inelastic and unit elastic, which will result in a bigger gain in total revenue?
Total Revenue (TR) = Price (P) x Quantity (Q)
Price
D
RM30
10
RELATIONSHIP TO TOTAL REVENUE
DEMAND IS ELASTIC
Total Revenue RM20 x 10 = RM200If seller increases price to RM30New Total Revenue = RM30 x 5 = RM150 TR = RM50
RM20
5 Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)
Price
D
RM2
15
RELATIONSHIP TO TOTAL REVENUE (cont.)
DEMAND IS INELASTIC
Total Revenue RM1 x 15 = RM15If seller increases price to RM2New Total Revenue = RM2 x 10 = RM20 TR = RM5
RM1
10 Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)
Price
D
RM2
20
RELATIONSHIP TO TOTAL REVENUE (cont.)
DEMAND IS UNITARY ELASTIC
Total Revenue RM1 x 20 = RM20If seller increases price to RM2New Total Revenue = RM2 x 10 = RM20 TR = 0
RM1
10 Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)
Total Revenue Test - SummaryPrice cut and total revenue increases —
demand is elastic.Price cut and total revenue decreases —
demand is inelasticPrice cut and total revenue does not change
— demand is unit elastic
DEMAND ELASTICITY & TOTAL REVENUE
TEST YOUR UNDERSTANDING
List the factors that leads to inelastic demand.
1. Necessities 2. Few Substitutes3. Lesser proportion of income.
Interpret the coefficient of the price elasticity of demand, Ed = 1.5, and Ed = 0.7.
• A coefficient of 1.5 indicates that demand is elastic since the Ed > 1. This means, a relatively small change in price will result in large change in quantity demanded.
• A coefficient of 0.7 indicates that demand is inelastic since Ed < 1. This means that a relatively large change in price result in only small change in quantity demanded.
TEST YOUR UNDERSTANDING
For each of the following pairs of goods, which good has the more elastic demand and why.
a) Gasoline vs. Shell Gasoline
b) Cigarettes today vs. Cigarettes over the next year
c) Required textbooks vs. mystery novels
TEST YOUR UNDERSTANDING
How can the knowledge on elasticity of demand affects business firm’s pricing policy?
• Help firm decide whether to change prices in order to maximize their profit.
• If demand were relatively elastic, firm would know that lowering the price would expand the volume of sales, thus increasing total revenue.
• If demand were relatively inelastic, the firm would increase the price to increase total revenue (since buyer will not reduce their consumption or drop in sales is not much).
TEST YOUR UNDERSTANDING
How can the knowledge on elasticity of demand affects government’s tax policy?
Tax charges raise the price of the goods affected, governments tend to charge taxes on goods that have a relatively inelastic demand, i.e. petrol and tobacco.
If the government were to impose it on good or services which its demand is relatively elastic, a small increase in price caused by the tax would lead to a large drop in sales, thus may not raise revenue to government.
TEST YOUR UNDERSTANDING
PRICE ELASTICITY OF SUPPLY
DEFINITION:
Measures the sensitivity/responsiveness of the quantity supplied due to a change
in the price of a product or service.
Price (RM)
Quantity Demanded
Unitary Elastic SupplyPercentage change in price equals the percentage change in the quantity supplied.
DEGREE OF ELASTICITY
Inelastic SupplyA large percentage of change in the price of a good will only affect a small percentage of change of the quantity supplied.
Elastic SupplyA small percentage of change in the price of a good will lead to larger percentage of change in the quantity supplied.
Perfectly Inelastic Supply A percentage of change in price has no effect on the percentage of change in the quantity supplied.
Perfectly Elastic SupplyAn almost zero percentage of change in price brings a very large percentage of change in the quantity supplied.
ss > 1
ss < 1ss = 1ss =0
ss =
ELASTICITY OF SUPPLY
• Elastic• Inelastic• Unit/Unitary Elastic• Two extremes• Perfect elastic supply• Perfect inelastic supply
Mostly relevant and highlighted
PRICE ELASTICITY OF SUPPLY
• Whenever the absolute value of price elasticity of supply is greater than 1 (Es > 1), supply is elastic.
• The quantity supplied is “relatively responsive”.
• A small change in the price of the product will cause a large change in the quantity supplied for the product.
PRICE ELASTICITY OF SUPPLY
• Whenever the absolute value of price elasticity of supply is less than 1 (Es <1), demand is inelastic.
• The quantity supplied “relatively unresponsive”.
• A large change in the price of the product will cause a small change in the quantity supplied for the product.
DETERMINANTS FOR PRICE ELASTICITY OF SUPPLY
Factors Affecting Price Elasticity of Supply
1. Resource substitution possibilities
2. Time frame for the supply decision
Resource substitution possibilities
1. The ability of producers to alter input- the easier it is for producers to alter their input, the more elastic will the supply of the output/ product.
2. Storage Possibilities- the better the storability of resources, the more elastic is the price elasticity of supply
DETERMINANTS FOR PRICE ELASTICITY OF SUPPLY
Time frame for the supply decision
3. Time Horizon/Time to React
- the price elasticity of supply for most products is more elastic in the long-run than in the short-run.
- this is because longer time horizon gives producers more opportunity to alter their input and output of a good.
DETERMINANTS FOR PRICE ELASTICITY OF SUPPLY
TEST YOUR UNDERSTANDING
Differentiate between Law of Supply and Price Elasticity of Supply.
Law of Supply – Relationship between 2 variablesPrice and quantity - direct relationship.
Price Elasticity of Supply – The sensitivity of one variable (quantity) to change or respond as a result of the change in another variable.
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