Transcript Document 7674284

The Price System
4.1
The market system, also called the price system, performs two
important and closely related functions:
• Price Rationing
• Resource Allocation
Price rationing is the process by which the market system
allocates goods and services to consumers when quantity
demanded exceeds quantity supplied.
Price Rationing
A.
4.2
The market is initially in equilibrium at Price
Po .
A. a decrease in supply (what might cause
this?) creates a shortage at P0. Quantity
demanded is greater than quantity
supplied. Price will rise.
OR
B.
B. an increase in demand (what might cause
this?) creates a shortage at Po. Quantity
demanded is greater than quantity
supplied. Price will rise.
In both cases, the quantity is rationed to those
who are willing and able to pay the higher
price.
Price Rationing
4.3
• There is some price that will
clear any market.
• The price of a rare painting
will eliminate excess demand
until there is only one bidder
willing to buy the single
available painting.
Price Ceilings
4.4
• When a maximum price for a product or service is set
(generally this is done by the government)
• Why? Because the equilibrium price appears to be “unfair”
• Consequences for the market?
• An alternative to price rationing is needed to allocate the
available quantity:
Alternative Rationing Mechanisms
• Queuing is a nonprice rationing system that uses
waiting in line as a means of distributing goods
and services.
• Favored 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 are the hidden costs that
increase the effective price above the maximum price
allowed.
4.5
Example of Price Ceiling
4.6
• In 1974, the government used
an alternative rationing
system to distribute the
available supply of gasoline.
• At an imposed price of 57
cents per gallon (price
ceiling), the result was excess
demand.
Alternative Rationing Mechanisms
• A black market is a market in
which illegal trading takes place
at market-determined prices.
4.7
Alternative Rationing Mechanisms
4.8
• No matter how good the intentions of private organizations
and governments, it is very difficult to prevent the price
system from operating and to stop the willingness to pay
from asserting itself.
• With favored customers and black markets, the final
distribution may be even more unfair than that which would
result from simple price rationing.
Price Floors
4.9
• Some times it is believed that the equilibrium price of a good
or service is too low.
• The government steps in and imposes a minimum price in the
market
Examples and Consequences:
Prices and the Allocation of Resources
4.10
When markets are allowed to work:
• Changes in price resulting from shifts of demand and supply in
output markets cause profits to rise or fall.
• Profits attract capital; losses lead to disinvestment.
• Higher wages attract labor and encourage workers to acquire
skills.
• At the core of the system, supply, demand, and prices in input
and output markets determine the allocation of resources and
the ultimate combinations of things produced.
Application of Demand and Supply
Oil Import Fee
• At a world price of $18, imports are
5.9 million barrels per day.
4.11
• The tax on imports causes an increase in
domestic production, and quantity
imported falls.
Consumer and Producer Surplus
4.12
Consumer surplus is the
difference between the
maximum amount a person is
willing to pay for a good and
its current market price.
Consumer surplus
measurement is a key
element in cost-benefit
analysis.
Consumer and Producer Surplus
4.13
Producer surplus is the difference
between the maximum amount a
producer is willing to accept to
supply a good and its current
market price.
Markets Maximize the Sum of
Producer and Consumer Surplus
4.14
• Total producer and consumer
surplus is highest where
supply and demand curves
intersect at equilibrium.
• Consumers receive benefits in
excess of what they pay and
producers receive
compensation in excess of
costs.
Deadweight Loss from Market Intervention:
Price Ceiling
4.15
Elasticity
4.16
Some questions:
• If a firm wants to increase its total revenues (“sales”), should
it raise price or lower price?
• Why is a bumper crop often bad news for farmers?
• How would a tax on cigarettes affect the number of teenage
smokers compared to adult smokers?
• Why do policies that limit the supply of illegal drugs often
increase property crime?
4.17
Elasticity
Elasticity is a general concept that can be used to quantify the
response in one variable when another variable changes.
Elasticity of A with respect to B
%A

%B
We can measure the responsiveness of quantity demanded to
changes in price, income, or prices of related goods.
Price Elasticity of Demand:
%QD

%P
Elasticity
Price Elasticity of Demand:
%QD

%P
• Measures the responsiveness of quantity demanded 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.
4.18
Why this formula?
• Price elasticity of demand quantifies (in %) how
quantity demanded changes will price changes.
• Law of Demand tells us that if Price increases 
quantity demanded will decrease, but not by how
much
How much? Depends on the demand curve.
• If it is steep  small change in Qd
• If it is flat  large change in Qd
• But, can’t use slope as a measure of elasticity: it is
sensitive to the units of measurement.
4.19
Elasticity
4.20
%QD
D 
%P
P
Elasticity is a ratio of
percent changes. We are
interested in knowing whether
quantity demanded changes
by relatively more or relatively
less than the price change.
$4
$3
10
20
Qd
How to Calculate Percent Changes
3 possibilities:
1.
X1  X 0
%X 
X0
2.
X1  X 0
%X 
X1
3.
X1  X 0
%X 
( X1  X 0 )
2
Midpoint formula
We will use formula #3
4.21
Elasticity using Mid-Point Formula
P
Q1  Q0
Q1  Q0
%QD
2
D 

P1  P0
%P
P1  P0
2
$4
$3
10
20
Qd
4.22
Interpreting Elasticity
Price elasticity of demand must always be negative, due to the
Law of Demand (demand curves always have negative slope)
 we often work with the absolute value
1. | D | < 1  demand is said to be “inelastic”
2. | D | > 1  demand is said to be “elastic”
3. | D | = 1  demand is said to be “unitary elastic”
4.23
Interpreting Elasticity (con’t)
4. | D | = 0  demand is said to be “perfectly inelastic”
5. | D | =   demand is said to be “perfectly elastic”
4.24
4.25
Hypothetical Demand Elasticities
for Four Products
Hypothetical Demand Elasticities for Four Products
PRODUCT
Insulin
Basic telephone service
Beef
Bananas
% CHANGE
IN PRICE
(%  P)
10%
10%
10%
10%
% CHANGE IN
QUANTITY
DEMANDED
(%  Qd)
0%
-1%
-10%
-30%
ELASTICITY
(%  Qd/%  P)
0
-0.1
-1
-3
Perfectly inelastic
Inelastic
Unitary elastic
Elastic
Interpreting the Value of Elasticity
Here is how to interpret two different values of
elasticity:
• When |D|= 0.2, a 10% increase in price leads to
a 2% decrease in quantity demanded.
• When |D|= 2.0, a 10% increase in price leads to
a 20% decrease in quantity demanded.
4.26
Elasticity Changes along a Straight-Line Demand
Curve
• Price elasticity of demand
decreases as we move
downward along a linear
demand curve.
• Demand is elastic on the
upper part of the demand
curve and inelastic on the
lower part.
4.27
Elasticity Changes along a Straight-Line
Demand Curve
4.28
• Along the elastic range,
elasticity values are greater
than one.
 6.4
 .29
• Along the inelastic range,
elasticity values are less
than one.
4.29
Elasticity and Total Revenue
Type of
demand
Elastic
Value of d
Change in quantity
versus change in price
Effect of an
Effect of a decrease
increase in price in price on total
on total revenue revenue
Greater than
1.0
Larger percentage change
in quantity demanded
Total revenue
decreases
Total revenue
increases
Total revenue
increases
Total revenue
decreases
Total revenue
does not change
Total revenue does
not change
|%Q| > |%P|
Inelastic
Less than 1.0
Smaller percentage
change in quantity
demanded
|%Q| < |%P|
Unitary
elastic
Equal to 1.0
Same percentage change
in quantity and price
|%Q| = |%P|
Elasticity and Total Revenue
When demand is inelastic, price and total revenues are positively related.
Price increases generate higher revenues.
When demand is elastic, price and total revenues are negatively related.
Price increases generate lower revenues.
Some questions and Answers:
•If a firm wants to increase its total revenues (“sales”), should it raise
price or lower price?
•Why is a bumper crop often bad news for farmers?
•How would a tax on cigarettes affect the number of teenage smokers
compared to adult smokers?
•Why do policies that limit the supply of illegal drugs often increase
property crime?
4.30
Determinants of Demand Elasticity
• Availability of substitutes -- demand is more
elastic when there are more substitutes for the
product.
• Importance of the item in the budget --
demand is more elastic when the item is a more
significant portion of the consumer’s budget.
• Time frame -- demand becomes more elastic
over time.
4.31
Other Important Elasticities
4.32
• Income elasticity of demand – measures the responsiveness
of demand to changes in income.
Income Elasticity of Demand:
What values can this ratio take on?
%QD

%I
Other Important Elasticities
• Cross-price elasticity of demand: A measure of the
response of the quantity of one good demanded to a change
in the price of another good.
% QDB
Cross-Price Elasticity of Demand: 
% P A
If A and B are substitutes:
If A and B are complements:
4.33
Other Important Elasticities
4.34
• Elasticity of supply: A measure of the response of quantity
of a good supplied to a change in price of that good. Likely
to be positive in output markets.
Price Elasticity of Supply:
%QS

%P