Chapter 5

Second Edition

Chapter 5 Chapter 5

Elasticity and Its Elasticity and Its ApplicationsApplications

Chapter OutlineChapter Outline

The Elasticity of Demand The Elasticity of Supply Using Elasticities for Quick Predictions

(Optional) Takeaway Appendix 1: Using Excel to Calculate

Elasticities Appendix 2: Other Types of Elasticities

2

Elasticity of DemandElasticity of Demand

We know there is an inverse relationship between price and quantity demanded.

But how much does quantity demanded change when price changes?


Elasticity of demand - a measure of how responsive the quantity demanded is to a change in price• more responsive equals more elastic.

The slope of the demand curve is related to the elasticity of demand.

Let’s see how this works.

4


price

QuantityDemand I (less elastic)

Demand E(more elastic)

10095

40

$50

20

a

bc

Price ↑ from $40 to $50:•a → b less responsive•a → c more responsive

5

Determinants of the Elasticity of DemandDeterminants of the Elasticity of Demand

Ease in finding substitutes ***• Easier → greater elasticity

Time required to adjust to price changes• Long term → more substitutes → greater elasticity

The definition of the commodity• Narrow definition → more substitutes → greater

elasticity• Example: Coffee vs. specific brand

Necessities versus Luxuries Share of budget devoted to the good.

• Larger share → greater elasticity

6

Determinants of the Elasticity of DemandDeterminants of the Elasticity of Demand

Summary of Determinants of Elasticity of Summary of Determinants of Elasticity of DemandDemand

Less Elastic More Elastic

Fewer Substitutes More Substitutes

Short Run (less time) Long Run (more time)

Necessities Luxuries

Small Part of Budget Large Part of Budget

Mathematics of Demand ElasticityMathematics of Demand Elasticity

Elasticity of demand is always negative, so we typically drop the negative sign and use absolute value instead.

If the |Ed| < 1, the demand curve is inelastic. If the |Ed| > 1, the demand curve is elastic. If the |Ed| = 1, the demand curve is unit elastic.

Calculating the Elasticity of DemandCalculating the Elasticity of Demand

Elasticity measures the responsiveness of quantity demanded to changes in price.

Usually interpreted using the absolute value:

P%

Q%

pricein change Percentage

demandedquantity in change PercentageE demand of Elasticity

demanded

d

ElasticUnit 1E

Inelastic1E

Elastic1E

d

d

d

9

Calculating the Elasticity: Midpoint MethodCalculating the Elasticity: Midpoint Method

We use the midpoint as the base:

)/2P(PPP

2/)QQ(QQ

price Averagepricein Change

quantity Averagedemandedquantity in Change

Price%

Q%E

beforeafter

beforeafter

beforeafter

beforeafter

demandedd

Let’s work an example.10


Given:

What does this number mean?

0.6 22.0

33.1

45106080

)/204(500405

2/)00102(00102

Ed

Price Quantity Demanded

Point a $40 100

Point b $50 20

11

A firm’s revenues are equal to price per unit times quantity sold.• Revenue = Price x Quantity

The elasticity of demand directly influences revenues when the price of the good changes.

Total Revenue and the Elasticity of DemandTotal Revenue and the Elasticity of Demand

Total Revenue and Elasticity of DemandTotal Revenue and Elasticity of Demand

Inelastic Demand Elastic Demand

QuantityQuantity

Price

Demand

Demand

40 40

$50 $50

10095

Price

100 20

dQ%% PdQ%% P

↓TR due to ↓Qd ↑TR due to ↑P

Result: ↑TR Result: ↓TR

13

Total Revenue and the Elasticity of DemandTotal Revenue and the Elasticity of Demand

Knowing the value of the elasticity allows us to understand what happens to total revenue when the price changes.

If…directions oppositein move TR and PP%Q%1E dd

We can use diagrams to see how this works.

14

direction samein move TR and PP%Q%1E dd

constant is TRP%Q%1E dd

Total Revenue and Elasticity of Demand: Total Revenue and Elasticity of Demand: SummarySummary

Summary: Total revenue and Ed

15

How the American Farmer has Worked Himself Out of a Job:

•Increased agricultural productivity has the supply of food BUT the supply of farmers….

•And their revenues because the demand for most agricultural products is inelastic.

Applications of Elasticity of Demand Applications of Elasticity of Demand

Try it!Try it!

• Which is more elastic, the demand for computers or the demand for Dell computers? Why?

• The elasticity of demand for eggs has been estimated to be 0.1. If the price of eggs increases by 10%, what will happen to total revenue of egg producers?

To next To next Try it! Try it!

Try it!Try it!

If a fashionable clothing store raised its prices by 25 percent, what does that tell you about the store’s estimate of the elasticity of demand for its products?a) They think it’s elasticb) They think it’s inelastic


The Elasticity of SupplyThe Elasticity of Supply

Elasticity of supply – measures how responsive the quantity supplied is to the a change in price.• more responsive equals more elastic.

The slope of the supply curve is related to the elasticity of supply.

Let’s see how this works.

19

Quantity

Price per Unit

Elasticity of Supply Captures the Sensitivity of Quantity Supplied to Changes in Price

Inelastic Supply

Elastic Supply

$40

80…Causes a Small Increase in Quantity Supplied if Supply is Inelastic

$50The Same Price Increase

85

…Causes a Big Increase in Quantity Supplied if Supply is Elastic

170

The Elasticity of SupplyThe Elasticity of Supply

Determinants of the ElasticityDeterminants of the Elasticityof Supplyof Supply

How much per-unit costs ↑ as production ↑ • Greater ↑ in per unit costs → ↓ elasticity of

supply.• Examples:

Elasticity of supply tends to be low for raw materials like oil and coal.

Elasticity of supply tends to greater for manufactured goods

Local supply is more elastic than the global supply. Why?

21

Determinants of the ElasticityDeterminants of the Elasticityof Supplyof Supply

Consider two polar casesPicasso painting Toothpicks

PricePrice

QuantityQuantity

Perfectly elastic supplyPerfectly inelastic supply

22

If the Es < 1, the supply curve is inelastic.

If the Es > 1, the supply curve is elastic.

If the Es = 1, the supply curve is unit elastic.

23

Mathematics of Supply ElasticityMathematics of Supply Elasticity

Determinants of the Elasticity of Supply: Determinants of the Elasticity of Supply: SummarySummary

Primary Factors Determining the Elasticity of Supply

Less Elastic More Elastic

Difficult to increase production at constant unit cost (e.g., some raw materials)

Easy to increase production at constant unit cost. (e.g., some manufactured goods)

Large share of market for inputs

Small share of market for inputs

Global supply Local supply

Short-run Long-run

24

Calculating the Elasticity of SupplyCalculating the Elasticity of Supply

Measure of the responsiveness of quantity supplied to a change in price

Computed by

P%

Q%

price in change Percentage

suppliedquantity in change PercentageE supply of Elasticity

supplied

s

25


Again, we use the midpoint as the base

)/2P(PPP

2/)QQ(QQ

price Averageprice in Change

quantity Averagesuppliedquantity in Change

Price%

Q%E

beforeafter

beforeafter

beforeafter

beforeafter

supplieds

26

Applications of Supply Elasticity: Gun Applications of Supply Elasticity: Gun Buyback ProgramsBuyback Programs

Gun buyback programs• Several cities in the U.S. have spent millions of

dollars buying guns with “no questions asked”.

• Objective Reduce the number of guns on the streets in order to… Lower crime rates.

Principles of economics predict these programs are unlikely to reduce the number of guns on the streets of these cities. Why?

27


Demand for guns will increase. Guns will be imported to sell to the police. People will sell old, low quality guns Result

• The supply of guns is perfectly elastic to the city.

Price of guns does not increase

• No fewer, but higher quality, guns are on the streets.

Let’s use our model to see this.28


Price of low quality guns

Quantity of gunstraded

Supply of old, lowquality guns (perfectlyelastic)

Demand w/buyback

$84

1,000

Demand w/o buyback

6,000

Increase in supply = buyback

29

TakeawayTakeaway

Elasticities of demand and supply help us quantify…• The effects of shifts in the demand and supply

curves.• How revenues respond to changes in price

along a demand curve

You should know how to calculate these elasticities using data on prices and quantities.

30

Second Edition

End of Chapter 5End of Chapter 5

Second Edition

Chapter 6 Chapter 6

Taxes and SubsidiesTaxes and Subsidies


Commodity Taxes Subsidies

33

Commodity TaxesCommodity Taxes

We will emphasize the following:1. Who ultimately pays the tax is not dependent

on who writes the check

2. Who ultimately pays the tax does depend on the relative elasticities of supply and demand.

3. Commodity taxation raises revenue and creates lost gains from trade (deadweight loss)

Let’s look at each of these in turn.34

Who Ultimately Pays the TaxWho Ultimately Pays the Tax

Assume a 1$ per basket tax on apples. Government can collect the tax in two

ways:• From the seller • From the buyer

It doesn’t matter which way is chosen.

Let’s use our model to analyze each.

35

Commodity Tax Collected From the SellerCommodity Tax Collected From the Seller

Price of Apples (per basket)

Quantity ofApples (baskets)

Supply w/tax

Supply w/o tax

Commodity tax = $11.Supply shifts up by $12.Seller wants to charge $33.At $3: Qd < Qs → surplus4.Price ↓ → Qd ↑and Qs ↓ → 500Result:Seller’s net price = $1.65Buyer’s net price = $2.65Burden of the tax

• Buyer - $0.65• Seller - $0.35

$1

$4

3

2

1

500 700 1,250

1.65

2.65

Demand

400

36

Commodity Tax Collected From the BuyerCommodity Tax Collected From the Buyer



Supply

Commodity tax = $11.Buyer wants to pay $1.002.Demand shifts down by $13.At $1: Qd > Qs → shortage4.Price ↑→ ↑Qs and Qd ↓ → ↑Qs → 500Result:Buyer’s net price = $2.65Seller’s net price = $1.65Burden of the tax

• Buyer - $0.65• Seller - $0.35

$1

$4

3

2

1

500 700 1,250

2.65

1.65

Demand w/o tax

Demand w/tax

200

37

The Burden of the Tax Depends on the The Burden of the Tax Depends on the Relative Elasticities of Demand and SupplyRelative Elasticities of Demand and Supply

The Wedge shortcut• Tax wedge – a vertical line measuring the

difference between the price paid by buyers and the price received by sellers.

• This tool simplifies our analysis• The output where the wedge “fits” between the

demand and supply curves tells us… the after tax price consumers pay the after tax price that sellers receive.

Let’s go to our model now.38

Using the Tax WedgeUsing the Tax Wedge



Supply

$4

3

2

1

500 700 1,250

2.65

1.65

Demand

200

Tax Wedge = $1

Price buyers pay

Price sellersreceive

39

The Burden of the Tax Depends of the The Burden of the Tax Depends of the Elasticities of Supply and DemandElasticities of Supply and Demand

An elastic demand curve means that buyers can substitute

An elastic supply curve means that workers and capital can easily find work in another industry

Result• When demand is more elastic than supply, buyers

pay less of the tax• When supply is more elastic than demand, sellers

pay less of the tax• In other words elasticity = escape

Let’s use the model to show this40


Case I: Demand is more elastic than supplyPrice

Quantity

Supply

DemandTaxWedge

Qno taxQw/tax

Pno tax

Price receivedby sellers

Price paidby buyers

Result:Most of the tax is paidBy sellers

41


Case II: Supply is more elastic than demandPrice

Quantity

Supply

Demand

TaxWedge

Qno taxQw/tax

Pno tax


Price paidby buyers

Result:Most of the tax is paidBy buyers

42

BACK TO

SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

SEE THE SEE THE INVISIBLEINVISIBLE HANDHANDThis pleasure boat seems like a good thing to tax…

Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods like pleasure boats with a sales price above $100,000. Expected tax revenue? $9 billion. Reality?

•Sales of boats Sales of boats down 52.7%;down 52.7%;• Net Net loss of 30,000 jobsloss of 30,000 jobs;;• The federal government paid out > $7 The federal government paid out > $7 million more in unemployment benefits to million more in unemployment benefits to those workers those workers than it collected in luxury than it collected in luxury tax revenuestax revenues.

The federal luxury tax was repealed in 1993.The federal luxury tax was repealed in 1993.

Health Insurance Mandates and Tax Health Insurance Mandates and Tax AnalysisAnalysis

Suppose government mandates that firms buy health insurance for its workers.• Think of this as a tax on labor.

Who actually pays for the health insurance?• Depends which is more elastic: supply or

demand • That is, which is easier:

For firms to escape the tax by not employing? For workers to escape the tax by not working?

44

Health Insurance Mandates and Tax Health Insurance Mandates and Tax AnalysisAnalysis

Firms can escape the tax in lots of ways• Substitute capital for labor.• Move operations overseas.• Close up shop.

It is more difficult for workers to escape the tax• Most workers will work at a lower wage• The cost of leaving the labor force is high

Conclusion: demand is more elastic than supply

Result: most of the tax is paid by workers.

45

Who Pays the Cigarette Tax?Who Pays the Cigarette Tax?

Because nicotine is addictive, demand is inelastic.

Taxes are imposed by states. A manufacture can easily

escape these taxes by selling…• Overseas• Other states

Conclusion: Supply elasticity is very high Result: most of tax is paid by buyers.

46

Who Pays the Cigarette TaxWho Pays the Cigarette Tax

An interesting test• If buyers pay almost all of the tax, the after tax

price paid by sellers must be equal in all states.

• This table shows that is the case.

Year 2000

Tax per Pack

After tax price paid by buyers

After tax price receivedby sellers

South Carolina $0.07 $3.35 $3.28

New Jersey $2.57 $6.45 $3.88

47

A Commodity Tax Raises Revenues A Commodity Tax Raises Revenues and Creates Lost Gains From Tradeand Creates Lost Gains From Trade Lost gains from trade = deadweight loss Tax increases reduce consumer and

producer surplus

Let’s use our model to show this.

48

A Commodity Tax Raises Revenues A Commodity Tax Raises Revenues and Creates Lost Gains From Tradeand Creates Lost Gains From Trade

PricePrice

QQ

No Tax With Tax

700700

$2.00$2.00

Consumersurplus

Producersurplus

500

Tax wedge

$2.65

$1.65

Consumer surplus

Producersurplus

Governmentrevenue

Deadweightloss

DD

SS

49

Try it!Try it!

What is the tax revenue that the government collects from the tax on gadgets?a)$350b)$450c)$100d)$550


A Commodity Tax Raises Revenues and A Commodity Tax Raises Revenues and Creates Lost Gains From TradeCreates Lost Gains From Trade

Elasticities of demand and supply determine consumer and producer surplus• The greater these elasticities, the greater will

be the deadweight loss


51

Qw/ tax


Case I: Elastic Demand

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Tax Revenue

Qno tax

Deadweightloss

52

Qw/ tax


Case II: Inelastic Demand

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Tax Revenue

Qno tax

Deadweightloss

Note: Tax rate and Tax revenue are the same as before.Deadweight loss is much smaller.

53

Tax Revenue

Qw/ tax


Case III: Elastic Supply

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Qno tax

Deadweightloss

54

Tax Revenue

Qw/ tax


Case IV: Inelastic Supply

Supply

Price

Quantity

Demand

Pno tax

Pw/tax

Tax wedge

Qno tax

Deadweightloss

Note: Tax rate and Tax revenue are the same as before.Deadweight loss is smaller.

55

Try it!Try it!


• Suppose that the government taxes insulin producers $50 per dose produced. Who is likely to pay this tax?

• Although the government taxes almost everything, would the government rather tax items that have relatively inelastic or relatively or relatively elastic demands and supplies? Why?

SubsidiesSubsidies

A subsidy is a reverse tax Important facts about commodity subsidies

1. Who gets the subsidy does not depend on who gets the check from the government.

2. Who benefits from the subsidy does depend on the relative elasticities of demand and supply.

3. Subsidies…1. Are paid for by taxpayers2. Result in inefficient increases in trade (deadweight

loss) We can use the same wedge shortcut as

before.Let’s use our model to analyze subsidies.

57

SubsidiesSubsidiesPrice of apples

Per basket

Quantity of apples(baskets)

Demand

Supply

3

$4

2

1

700 900

Price receivedBy sellers = $2.40

Price paidBy buyers = $1.40

Subsidywedge

Deadweightloss

58

Taxes and Subsidies ComparedTaxes and Subsidies Compared

Whoever Bears the Burden of the Tax Receives the Benefits of a Subsidy

Price

Quantity

Supply

Demand

subsidywithQ

Subsidywedge

Taxwedge


Price paidby buyers

Price paidby buyers


subsidy notax noP

taxwithQ

subsidy notax noQ

Benefitof subsidyon sellers

Burdenof tax onsellers

59

Try it!Try it!Who benefits most from the large agricultural water subsidy? Farmers in California’s Central Valley typically pay $20-$30 an acre-foot for water that costs $200-$500 an acre-footHint: which is more elastic: demand or supply for cotton?

•California cotton suppliers •California cotton buyers


King Cotton and the Deadweight Loss of King Cotton and the Deadweight Loss of Water SubsidiesWater Subsidies

Quantityof Cotton

DemandFor CaliforniaCotton

Supply of California Cotton

Price of Cotton

Qw/subsidy

WorldMarketprice

Qno subsidy

Subsidy wedge

PriceSellersreceive Total subsidy payments

received by farmers

Can you see why sellers ofCotton lobby for subsidies, not buyers?

61

Wage SubsidiesWage Subsidies

Edmund Phelps – Nobel Prize winner• Wage subsidies can be used to increase

employment of low wage workers.• Although costly, they may reduce

Welfare payments. Crime Drug dependency “Rational defeatism”

• A better alternative to the minimum wage.

Let’s analyze a wage subsidy program.62

Wage SubsidiesWage Subsidies

Wage

Quantityof labor

Demandfor labor

Market wage= $10.50

Supply of Labor

Qm

SubsidyWedge = $4

Qs

Wage received by

workers$12

$8

Wage paidby firms

Cost to taxpayers

63

Try it!Try it!

• The U.S. government subsidizes college education in the form of Pell grants and lower-cost government Stafford loans. How do these subsidies affect the price of college education? Which is relatively more elastic: supply or demand? Who benefits the most from these subsidies: suppliers (colleges) or demanders of education (students)?


Try it!Try it!

If demand of some good is more elastic than supply and a tax is imposed on the consumption of the good, who will bear more of the burden of the tax?a)Producers, because consumers have a greater ability to change their behavior in response to the tax.b)Both parties will share the burden equally.c)Consumers, because they pay the tax out of pocket.d)The government, because the tax will cause less of the good to be produced and consumed.


TakeawayTakeaway

Taxes decrease the quantity traded. Subsidies increase the quantity traded. The burden of the tax and the benefit of the

subsidy do not depend on who sends or receives the government check.

The side of the market that is more elastic will escape more of the tax and receive less of the benefit of the subsidy.

The greater the elasticity of demand or supply the greater will be the deadweight loss.

66

Second Edition


Second Edition

Chapter 8 Chapter 8 Price Ceilings and FloorsPrice Ceilings and Floors


Price Ceilings Rent Control (optional section) Arguments for Price Controls Price Floors

69

IntroductionIntroduction

August 1971 – President Nixon imposed wage and price controls in the U.S.• Made it illegal to trade at a higher price even if

both buyer and seller agreed to the higher price.

• Supposed to be in effect for 90 days

• Had lasting effects for over 10 years

We will show how price controls… • Affect a single market

• Delink some markets and link other markets in ways that are counterproductive.

70

Price CeilingsPrice Ceilings

Price ceiling – a maximum price allowed by law

Five important effects1. Shortages

2. Reductions in product quality

3. Wasteful lines and other search costs

4. A loss in gains from trade

5. A misallocation of resources

Let’s look at each one in turn.71

ShortagesShortages

When the price ceiling is below the market price…• Quantity demanded is greater than quantity

supplied: Qd > Qs

We call this a shortage

• A shortage is different from scarcity Scarcity is reflected in the market price Shortage is due only to a price ceiling

The lower the ceiling price is below the market price, the greater the shortage

72

ShortagesShortages

Shortages appeared soon after prices were frozen in 1971• ↑ demand for housing → ↑ demand for

materials (inputs) needed to build houses• Normally this would result in ↑ price of inputs

→ a signal to produce more inputs.

With fixed prices, this signal was missing.• Shortages of inputs: lumber, steel bars, toilets

and other materials were common.

Let’s use our model to examine a price ceiling.73

Price Ceilings Create ShortagesPrice Ceilings Create Shortages

Price of gasolineper gallon

Quantity

Demand

Supply

Market Equilibrium

Controlled Price(ceiling)

Qs Qd

Shortage

74

ShortagesShortages

A shortage of vinyl in 1973 forced Capitol Records to melt down slow sellers so they could keep pressing Beatle’s albums.

75

Reductions in QualityReductions in Quality

One way to evade price controls is to lower quality• Printing books on lower quality paper

• Shrinking 2” x 4” lumber to 15/8” x 35/8”

• Fewer coats of paint on new automobiles• Some newspapers switched to a smaller font size.

76


Another way to lower quality is to reduce service

With a surplus of buyers, sellers have less of an incentive to give good service.

•Full service gas stations disappeared in 1973.•Owners would close whenever they wanted to

take a break.77


The great matzo ball debate

In 1972 George Meany, AFL-CIO boss complained that his favorite soup, Mrs. Adlers, had shrunk from 4 to 3 matzo balls!

The chairman of the wage and price commission had his staff count the number of balls in many can’s of Mrs. Adler’s soup.

78

Wasteful Lines and Other Search CostsWasteful Lines and Other Search Costs

There are other ways of paying for gas• Some buyers might

try bribing the station owners

• Another way is to be willing to wait in line.

• Time waiting in line is also a cost. How long will the line get?

Let’s answer this question using our model.

79

TotalValue ofWastedtime

Wasteful Lines and Other Search CostsWasteful Lines and Other Search Costs

Quantity

Demand

SupplyMarket Equilibrium

Controlled Price = 1

(ceiling)

Qs Qd

Shortage

Willingness topay for Qs = $3


At the controlled price:Quantity supplied = Qs

Buyers are willing to pay $3/gallonLine will grow until the time cost per gallon $3 - $1 = $2.00/gallon

80

Wasted Time and Other Search CostsWasted Time and Other Search Costs

What’s the difference between paying a bribe and waiting in line?• Waiting in line is more wasteful!

A bribe goes to the station owner. Time waiting in line is lost; it benefits no

one.

81

Lost Gains From TradeLost Gains From Trade

Deadweight loss – total of lost consumer and producer surplus when not all mutually profitable gains from trade are exploited.

As long as

there are mutually profitable trades that can be made.

Price ceilings create a deadweight loss

acceptto willingare sellers

pay to willingare

consumers P P

Let’s go to our model again.82

TotalValue ofWastedtime

Price Ceilings: Reduce Gains From TradePrice Ceilings: Reduce Gains From Trade

Quantity

Demand

Supply

Market Equilibrium


(ceiling)

Qs Qd

Shortage

$3


Market price

Lostproducersurplus

Lostconsumersurplus

BB

A

A + B = Lost gainsfrom trade

83

Misallocation of ResourcesMisallocation of Resources

When prices are controlled, resources do not flow to their highest valued uses.• Example: When it gets cold in the Northeast,

the demand for heating oil goes up. If the price is allowed to rise…

• There is a greater incentive to produce more heating oil.• The incentive to consume less heating oil increases.• This provides a signal for more heating oil to be delivered

to Maine instead of California. If the price is fixed…

• Swimming pools in California are heated• Homes in Maine are cold


84

Misallocation of ResourcesMisallocation of Resources

Quantity

Demand

Supply

Controlled Price

(ceiling)

Qs Qd

Shortage

$3

Price($)

Highest-valueduses

Lower-valueduses

Least-valueduses

Price control prevents highest valued usesfrom outbidding lower valued uses.Result: some oil flows to lower valued uses

85

The Loss From Random AllocationThe Loss From Random Allocation

Let’s ignore wasteful time and search costs The maximum CS is the area between the

demand curve and the controlled price up to the quantity supplied with the controlled price.

Because the good is not necessarily allocated to the highest values uses…• Consumer surplus will be less

• How much less?

• Let’s do some reasonable calculations

86

The Loss From Random AllocationThe Loss From Random Allocation

Best case scenario• Buyers with the highest valued uses get in line

first. Worst case scenario

• All goods are allocated to the lowest value uses. Random allocation scenario

• Let’s assume that goods are allocated randomly with equal probabilities for each user.

• Suppose: Highest price any buyer is willing to pay = $30; controlled price = $6.

• Average price consumers would be willing to pay = ½ ($30) + ½ ($6) = $18

87

The Loss From Random Allocation: Best The Loss From Random Allocation: Best Case ScenarioCase Scenario

Quantity

Demand

Supply


(ceiling)

Qs Qd

Shortage



Best Case Scenario:Buyers with the highest valued uses get the goodsCS = total green area

Highest-valueduses

88

The Loss From Random Allocation: Worst The Loss From Random Allocation: Worst Case ScenarioCase Scenario

Quantity

Demand

Supply


(ceiling)

Qs Qd

Shortage



Worst Case Scenario:Buyers with lower valued uses get the goods.CS = total green area

Loss to random allocation

Lower-valueduses

89

The Loss From Random Allocation: Equal The Loss From Random Allocation: Equal Probability ScenarioProbability Scenario

Quantity

Demand

Supply


(ceiling)

Qs Qd

Shortage



Equal Probability Scenario:Av price = $18CS = total green area

Loss due to random allocation

AveragePrice = $18

90

The End of Price ControlsThe End of Price Controls

Controls on most prices were lifted by April 1974

Controls on oil prices continued in some form over the next 7 years.• “Old oil”-“New oil” and wasteful gaming

Controls on oil prices ended on the morning of President Reagan’s inauguration day January 20, 1981

Oil price ↓ over the next several years No shortages of oil have occurred since.

91

Try it!Try it!

• Nixon’s price controls set price ceilings below the market price. What would have happened if the price ceilings had been set above the market prices?

• Under price controls, why were the shortages of oil in some local markets much more severe than in others?


Try it!Try it!

• Shortages in the former Soviet Union were very common, but why were there also surpluses of some goods at some times and places?


Price FloorsPrice Floors

Price floor – a minimum price allowed by law

Price floors create:1. Surpluses

2. Lost gains from trade (deadweight loss)

3. Wasteful increases in quality

4. A misallocation of resources

94

SurplusesSurpluses

A good example of a price floor is the minimum wage

Workers with very low productivity are most affected by the minimum wage.• Least experienced• Least educated or trained

Low-skilled teenagers are most affected.

Let’s use the labor market model to analyze the minimum wage.

95

Minimum Wage Creates a SurplusMinimum Wage Creates a Surplus

Demand for labor

Supply of labor

Marketwage

Wage($/hr)

Quantityof labor(unskilled)

Market employment

Minimumwage

QsQd

Labor surplus(unemployment)

96

Minimum Wage Creates Lost Gains From Minimum Wage Creates Lost Gains From TradeTrade

Demand for labor

Supply of labor

Marketwage

Wage($/hr)

Quantityof labor(unskilled)

Market employment

Minimumwage

QsQd

Labor surplus(unemployment)

Lost gains from trade(deadweight loss) = lost consumer surplus + lost producer surplus

97

Minimum WageMinimum Wage

Hotly debated in the U.S. • 93.9% of workers < 25 years earn more than

the minimum wage• At best, the minimum wage raises the wages

of some teenagers and young workers whose wages would have increased anyway as they became more skilled.

• At worst, increases in the price of hamburgers can create some teenage unemployment.

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Minimum WageMinimum Wage

A large increase in the minimum wage will cause serious unemployment

Test Case: Puerto Rico, 1938• Congress set the first minimum wage at $0.25/hr.

Average wage in U.S. = $0.625/hr

• Congress forgot to exempt Puerto Rico Average wage in Puerto Rico = $0.03 to $0.04/hr

• Puerto Rican firms went bankrupt → devastating unemployment

• Puerto Rican politicians begged for exemption

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Minimum Wages in FranceMinimum Wages in France

Firms in France are reluctant to hire• Minimum wage is higher than in the U.S.• Labor laws make it very difficult to fire workers

Younger workers are affected the most• Less productive• Risk of hiring is greater

Result:• Unemployment among workers < 25 yrs old

was 23% in 2005.

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Try it!Try it!

• The European Union guaranteed its farmers that the price of butter will stay above a floor. The floor price is often above the market equilibrium price. What do you think has been the result of this?

• The U.S. has set a price floor above the equilibrium price. Has this led to shortages or surpluses? How do you think the U.S. government has dealt with this?


TakeawayTakeaway

You should be able to explain the effects of price ceilings to your uncle.

You should be able to draw a diagram showing the price ceiling, label the shortage, wasteful losses, and the lost gains from trade.

You should understand why a price ceiling reduces product quality and misallocates resources.

You should be able to a similar analysis for price floors.

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Second Edition


Documents

Chapter 5