Lecture 4 Working with Supply and Demand

Lecture 4 Working with Supply and Demand • • Price Ceilings, Price Floors Price Elasticity of Demand Elasticity and Total Revenue Determinants of price elasticity of demand Income Elasticity of Demand Cross-Price Elasticity of Demand Determinants of price elasticity of supply 1

Price Ceilings • Government-imposed maximum price that prevents the price of a good from rising above a certain level in a market • Short side of the Market – Smaller of quantity supplied and quantity demanded at a particular price – When quantity supplied and quantity demanded differ, short side of market will prevail • Price ceiling creates a shortage and increases the time and trouble required to buy the good – While the price decreases, the opportunity cost may rise • Black Market – A market created by unintended consequences of government intervention • Goods are sold illegally at a price above the legal ceiling 2

Figure 1: A Price Ceiling in the Market for Maple Syrup 5. With a black market, the lower quantity sells for a higher price than initially. Price per Bottle 3. and decreases quantity supplied. 4. The result is a shortage – the distance between S R and V. T $4. 00 3. 00 R 2. 00 E V 2. increases quantity demanded D 40, 000 50, 000 60, 000 1. A price ceiling lower than the equilibrium price. . . Number of Bottles of Maple Syrup per Period 3

Price Floors • Government imposed minimum amount below which price is not permitted to fall – Price floors for agricultural goods are commonly called price support programs • When sellers produce more of the good than buyers want at the price floor – Remaining goods become a surplus that no one wants at the imposed price • Government responds by maintaining price floors – Uses taxpayer dollars to buy up entire excess supply of the good in question – Prevents excess supply from doing what it would ordinarily do • Drive price down to its equilibrium value 4

Figure 2: A Price Floor in the Market for Nonfat Dry Milk Price per Pound 2. decreases quantity demanded. . . 1. A price floor higher than the equilibrium price. . . $0. 81 3. and increases quantity supplied. S J K A 0. 65 4. The result is a surplus the – distance between K and J – which government must buy. D 180 200 220 Millions of Pounds 5

Limiting Surplus • A price floor creates a surplus of goods – In order to maintain price floor, government must prevent surplus from driving down market price • Government often accomplishes this goal by purchasing surplus with taxpayers dollars. USDA spent $500 million to buy 636 million pounds of surplus nonfat dry milk. • Price floors often get government deeply involved in production decisions – Rather than leaving them to the market – Example: U. S. government developed a complicated management system to control the production and sale of milk to manufacturers and processors. 6

Benefits and costs of price floor for diary product • Benefits: help farmer when they are in need. Many farmers who benefit from price floors are wealthy or powerful who don’t need assistance. • Costs: (1) taxpayers’ money (2) consumers pay higher price ($10. 4 billion from 1986 to 2001) (3) cost of health effect (calcium and protein deficiencies) More cost effective if given directly to those truly in need. 7

The Problem with Rate Change • For a particular good, when price rises by $1, quantity demanded falls by 500 units period. (1)chocolate bars purchases in U. S. (2)private jets purchased in U. S. • Rate of change of quantity demanded compared to the change in price is not a good measure of price sensitivity – Doesn’t tell whether a change in price or a change in quantity demanded is a relatively large or relatively small change • Relative means compared to value of price or quantity before change 8

The Elasticity Approach • Elasticity approach improves on the problems with rate of change – By comparing percentage change in quantity demanded with percentage change in price • Price elasticity of demand (ED) for a good is percentage change in quantity demanded divided by percentage change in price – Will virtually always be a negative number – Tells us percentage change in quantity demanded for each 1% increase in price • Price elasticity of demand tells us percentage change in quantity demanded caused by a 1% rise in price as we move along a demand curve from one point to another 9

Calculating Price Elasticity of Demand • When calculating elasticity base value for percentage changes in price or quantity is always midway between initial value and new value – When price changes from any value P 0 to any other value P 1, we define the percentage change in price as – When quantity demanded changes from Q 0 to Q 1, percentage change is calculated as 10

Figure 3: Calculating Price Elasticity of Demand Price per Laptop $3, 500 3, 000 D C 2, 500 2, 000 1, 500 1, 000 B A D 100, 000 200, 000 300, 000 400, 000 500, 000 600, 000 Quantity of Laptops 11

An Example: Calculating Price Elasticity of Demand • Now let’s calculate an elasticity of demand for laptop computers using data in Figure 3 from point A to point B • Use percentage changes for price and quantity to calculate price elasticity of demand (ED) 12

Elasticity and Straight-Line Demand Curves • As we move upward and leftward along a straight-line demand curve – Same absolute increment in price will correspond to smaller and smaller percentage increments in price • Because base price used to calculate percentage changes keeps rising • As we move upward and leftward along a straight-line demand curve – Same absolute decrease in quantity corresponds to larger and larger percentage decreases in quantity • As we move upward and leftward by equal distances, percentage change in quantity rises – Percentage change in price falls • Elasticity of demand varies along a straight-line demand curve – Demand becomes more elastic as we move upward and leftward 13

Calculating Price Elasticity of Demand from Point C to Point D 14

Figure 4: Elasticity and Straight-Line Demand Curves Price Since equal dollar increases (vertical arrows) are smaller and smaller percentage increases. . . 3 2 and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases. . . 1 demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve. D Quantity 15

Categorizing Goods by Elasticity • Inelastic Demand – Price elasticity of demand between 0 and -1 |% Change in Quantity Demanded| < |% Change in Price| • Perfectly Inelastic Demand: Price elasticity of demand equal to 0 Examples: – Drug ‘insulin’ for diabetics to control their blood sugar. No substitutes. ‘Antibiotics’. – Addicts. Necessities. 16

Categorizing Goods by Elasticity • Elastic Demand – Price elasticity of demand with absolute value > 1 |% Change in Quantity Demanded| > |% Change in Price| • Examples: Luxury goods • Perfectly (infinitely) Elastic Demand – Price elasticity of demand approaching minus infinity • Unitary Elastic Demand – Price elasticity of demand equal to -1 17

Figure 5: Extreme Cases of Demand (a) Price per Unit (b) Price per Unit D $4 3 2 $4 Perfectly Inelastic Demand 1 3 Perfectly Elastic Demand 2 D 1 20 40 60 80 100 Quantity 18

Elasticity and Total Revenue • Total revenue (TR) of all firms in the market is defined as • TR = P x Q • When two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes – Applying this to total revenue • % Change in TR = % Change in Price + % Change in Quantity Demanded • Assume demand is unitary elastic and Q rises by 10% – % Change in TR = 10% + (-10%) = 0 19

Elasticity and Total Revenue • If demand is inelastic, a 10% rise in price will cause quantity demanded to fall by less than 10% – % change in TR = 10% + (something less negative than – 10%) > 0 • If demand is elastic, so that Q falls by more than 10% – TR will fall • % Change in TR = 10% + (something more negative than -10%) < 0 20

Elasticity and Total Revenue • Where demand is inelastic, total revenue moves in same direction as price • Where demand is elastic, total revenue moves in opposite direction from price • Where demand is unitary elastic, total revenue remains the same as price changes • At any point on a demand curve sellers’ total revenue (buyers’ total expenditure) is the area of a rectangle – Width equal to quantity demanded – Height equal to price 21

Figure 6: Elasticity and Total Expenditure Price per Laptop $3, 500 3, 000 2, 500 2, 000 1, 500 1, 000 2. At point B, revenue is $750 million. 1. At point A , where price is $1, 000 and 600, 000 laptops are demanded, revenue is $600 million. 3. Moving from A to B, expenditure increases, so demand must be inelastic over that range. B A D 500 100, 000 200, 000 300, 000 400, 000 500, 000 600, 000 Quantity of Laptops 22

Table: Some Short-Run Price Elasticities of Demand Specific Brands Narrow Categories Tide Detergent -2. 79 Transatlantic Travel -1. 3 Pepsi -2. 08 Tourism in Thailand -1. 2 Coke -1. 71 Ground Beef -1. 02 Pork -0. 78 Milk -0. 54 Cigarettes -0. 45 Electricity -0. 40 to -0. 50 Beer -0. 26 Eggs -0. 26 Gasoline -0. 20 Oil -0. 15 Broad Categories Recreation -1. 09 Clothing -0. 89 Food -0. 67 Imports -0. 58 Transportation -0. 56 23

Availability of Substitutes • Demand is more elastic – If close substitutes are easy to find and buyers can cut back on purchases of the good in question • Demand is less elastic – If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question 24

Narrowness of Market • More narrowly we define a good, easier it is to find substitutes – More elastic is demand for the good • More broadly we define a good – Harder it is to find substitutes and the less elastic is demand for the good • Different things are assumed constant when we use a narrow definition compared with a broader definition 25

Necessities vs. Luxuries • The more “necessary” we regard an item, the harder it is to find a substitute – Expect it to be less price elastic • The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute – Expect it to be more price elastic 26

Table: Adjustments after a rise in the price of gasoline Short Run (a few months Long Run (a year or or few) more) Use public transit more often Arrange a car pool Drive more slowly on the highway Eliminate unnecessary trips If there are two cars, use the more fuel-efficient one Buy a more fuel-efficient car Move closer to your job Switch to a job closer to home Mover to a city where less driving is required 27

Time Horizon • Short-run elasticity – Measured a short time after a price change • Long-run elasticity – Measured a year or more after a price change • Usually easier to find substitutes for an item in the long run than in the short run – Therefore, demand tends to be more elastic in the long run than in the short run 28

Importance in the Buyer’s Budget • The more of their total budgets that households spend on an item – The more elastic is demand for that item – Example: housing, transatlantic air travel • The less of their total budgets that households spend on an item – The less elastic is demand for that item – Example: salt 29

Using Price Elasticity of Demand: The War on Drugs • Every year U. S. Government spends about $20 billion on efforts to restrict the supply of drugs • Figure 9(a) – Market for heroin without government intervention • Figure 9(b) – Result of government efforts to restrict supply (current policy) • Figure 9(c) – Results of an effective policy of reducing demand 30

Figure 7 a: The War on Drugs (a) Price per Unit S 1 P 1 A D 1 Quantity 31

Figure 7 b: The War on Drugs (b) Price per Unit S 2 B S 1 P 2 P 1 A D 1 Q 2 Q 1 Quantity A rise in price will increase the total expenditure of drug users. Many drug users Support themselves through crime. Total revenue for illegal drug industry increases too. 32

Figure 7 c: The War on Drugs (c) Price per Unit S 1 A P 1 P 3 C D 2 D 1 Q 3 Q 1 Quantity Heavier advertisement against drug use, and greater availability of treatment Centers for addicts. 33

Income Elasticity of Demand • Percentage change in quantity demanded divided by the percentage change in income – With all other influences on demand—including the price of the good—remaining constant • Interpret this number as percentage increase in quantity demanded for each 1% rise in income 34

Income Elasticity of Demand • Income elasticities vs. price elasticities of demand – Price elasticity of demand • Measures effect of change in price of good – Assumes that other influences on demand, including income, remain unchanged – Income elasticity • Measures effect on demand we would observe if income changed and all other influences on demand—including price of the good—remained the same • Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant 35

Income Elasticity of Demand • Another difference between price and income elasticity of demand – Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another – Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price • While a price elasticity is virtually always negative – Income elasticity can be positive or negative – Normal goods and Inferior goods 36

Some Income Elasticities Narrow Categories Income Elasticities Broad Categories Income Elasticities Fresh fruit Computers Transatlantic Air Travel College Education Cigarettes Chicken Pork Fresh Vegetables Tooth Extraction Ground Beef Bread Potatoes 1. 99 1. 71 1. 4 0. 55 0. 50 0. 42 0. 34 0. 26 -0. 13 ~ 0. 47 -0. 20 -0. 42 -0. 81 Imports Transportation Recreation Clothing Food 2. 73 1. 79 1. 07 1. 02 0. 60 -0. 85 37

Income and Spending on Economic Necessities and Economic Luxuries Income Spending on Food Percent of Spending on % of income Income Spent on Transportation spend on Food Transportation $10, 000 $6, 000 60% $1, 000 10% $20, 000 $96, 000 48% $2, 800 14% $40, 000 $15, 360 38% $7, 840 20% $80, 000 $24, 576 30% $21, 952 27% 38

Income Elasticity of Demand • Economic necessity – Good with an income elasticity of demand between 0 and 1 • Economic luxury – Good with an income elasticity of demand greater than 1 • An implication follows from these definitions – As income rises, proportion of income spent on economic necessities will fall • While proportion of income spent on economic luxuries will rise • But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior – Not by our judgment of a good’s importance to human survival – Example: Cigarettes 39

Cross-Price Elasticity of Demand • Cross-price elasticity of demand – Percentage change in quantity demanded of one good caused by a 1% change in price of another good • While all other influences on demand remain unchanged • While the sign of the cross-price elasticity helps us distinguish substitutes (positive) and complements (negative) among related goods • Its size tells us how closely the two goods are related – A large absolute value for EXZ suggests that the two goods are close substitutes or complements – While a small value suggests a weaker relationship 40

Some Cross-Price Elasticities Products Cross-Price Elasticity Margarine with price of butter Pepsi with price of Coke with price of Pepsi Ground beef with price of poultry Electricity with price of natural gas Theater with price of all other lively arts Entertainment with price of food 1. 53 0. 80 0. 61 0. 24 0. 20 0. 12 -0. 72 41

Price Elasticity of Supply • Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good – With all other influences on supply held constant 42

Price Elasticity of Supply • When do we expect supply to be price elastic, and when do we expect it to be price inelastic? – Ease with which suppliers can find profitable activities that are alternatives to producing the good in question • Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily (produce orange to orange juice) – When can we expect suppliers to have easy alternatives? Depends on » Nature of the good itself (Envelope v. s. microprocessor chips) » Narrowness of the market definition—especially geographic narrowness (the market of orange in Iowa v. s. the market of orange in U. S. A. ) » Time horizon—longer we wait after a price change, greater the supply response to a price change 43

Price Elasticity of Supply • Extreme cases of supply elasticity – Perfectly inelastic supply curve is a vertical line • Many markets display almost completely inelastic supply curves over very short periods of time • Example: the supply of fresh-caught tuna – Perfectly elastic supply curve is a horizontal line The supply of IBM Stock when the price of IBM stock at Pacific Stock Exchange rises even the tiniest bit above the price in other markets 44

Figure 8: Extreme Cases of Supply (a) (b) Price per Unit S P 2 Perfectly Inelastic Supply Perfectly Elastic Supply S P 1 Quantity per Period 45

The Tax on Airline Travel: Taxes and Market Equilibrium • A tax on a particular good or service is called an excise tax – Shifts market supply curve upward by amount of tax • For each quantity supplied, the new, higher curve tells us firms’ gross price, and the original, lower curve tells us the net price • Who really pays excise taxes? – Buyers and sellers share in the payment of an excise tax • Called tax shifting – Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers) 46

Figure 9 a: The Tax on Airline Travel Price per Ticket (a) 4. and then find the minimum price needed for the market to supply that quantity. SBefore Tax $300 $260 1. One way to use the supply curve is to start with the price. . . 3. But another way is to start with a quantity. . . A 7 10 Millions of Tickets per Year 2. and then find the quantity supplied at that price. 47

Figure 9 b: The Tax on Airline Travel Price per Ticket (b) SAfter Tax $360 A' $300 SBefore Tax A 3. But another way is to start with a quantity. . . 10 Millions of Tickets per Year 4. and then find the minimum price needed for the market to supply that quantity. 48

Figure 10: Effect of Excise Tax on Airlines 2. The $60 tax shifts the supply curve up by $60. Price per Ticket SAfter Tax B $340 3. In the new equilibrium, buyers pay $340. $300 SBefore Tax A 1. Before the tax, the supply curve is SBefore Tax and the price is $300. $280 4. And, net of the tax, sellers receive $280. D Millions of Tickets per Year 49

Tax Incidence and Demand Elasticity • In most cases excise tax will be shared by both buyer and seller – For a given supply curve, the more elastic is demand, the more of an excise tax is paid by sellers – The more inelastic is demand, the more of the tax is paid by buyers 50

Figure 11: Tax Incidence and Demand Elasticity (a) Price per Ticket $360 $300 (b) Price per SAfter Tax Ticket SAfter Tax SBefore Tax D SBefore Tax B A 10 $300 Millions of Tickets per Year B A 2 D Millions of 10 Tickets per Year 51

Tax Incidence and Supply Elasticity • Although there are extreme cases of supply elasticity, in general the following is true – For a given demand curve, the more elastic is supply, the more of an excise tax is paid by buyers – The more inelastic is supply, the more of the tax is paid by sellers 52

Figure 12: Tax Incidence and Supply Elasticity (a) Price per Ticket (b) SBefore and After Tax Price per Ticket $360 $300 A $240 B SAfter Tax A $300 D 10 Millions of Tickets per Year SBefore Tax D 8 10 Millions of Tickets per Year 53

Health Insurance and the Market for Health Care • Health insurance has definite benefits to our society • Our current health care system keeps patients from facing the full opportunity cost of their health care decisions – Can cause people to over consume health care • Health insurance reduces buyers’ incentives to monitor their health care expenditures closely or to shop around for high-quality low-cost care 54

Figure 14: The Market For Health Care With Coinsurance Price per DAfter Insurance Examination $100 S DBefore Insurance B 70 50 A 100, 000 150, 000 Examinations per Year 55