Lecture notes_unit 3

(1)

Eco1001- Unit 3

Price Systems,

supply and

demand,

elasticity

(2)

The Price System – the invisible

hand

• _{The market system, also called the}

_price

system,

performs two important and closely

related functions :

2

• _{Price Rationing}

_{Price Rationing}

(3)

Resource allocation



_{Resource allocation:}

_{the market}

(4)

Price Rationing

2. Price rationing

is the process by

which the market system

distributes goods and services on

the basis of willingness and

ability to pay.

(5)

Price Rationing

• _{A decrease in supply creates a}

shortage at P

₀

. Quantity

demanded is greater than

quantity supplied. Price will

begin to rise.

• _{The lower total supply}

_{The lower total supply}

is

rationed to those

who are willing and

able to pay

(6)

Price Rationing

• _{There is some price that will clear}

any market.

6

• _{The price of a rare}

_{The price of a rare}

painting will eliminate

excess demand until

there is only one bidder

willing to buy the single

(7)

Alternative Rationing Mechanisms

• A

price ceiling

is a maximum price

that sellers may charge for a good,

usually set by government.

• Queuing

_Queuing

is a nonprice rationing

system that uses waiting in line as a

means of distributing goods and

(8)

Alternative Rationing Mechanisms

8

• Favored customers

_{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.

(9)

Alternative Rationing Mechanisms

• _{In 1974, the US government}

used an alternative rationing

system to distribute the

available supply of gasoline.

• _{At an imposed price of}

_{At an imposed price of}

57 cents per gallon, the

result was excess

(10)

Alternative Rationing Mechanisms

• _{Attempts to restrict prices often}

result in the evolution of a black

market.

• _A

_{black market}

_{is a market in}

which illegal trading takes place

at market-determined prices.

(11)

Alternative Rationing Mechanisms

• _{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

(12)

Prices and the Allocation of Resources

• _{Price changes resulting from shifts of demand 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.

(13)

13

o

f

42

Price Floors

• A

price floor

is a minimum price below which exchange is not

permitted.

• The most common example of a price floor is the

minimum

wage

, which is a floor set above the price of labour.

(14)

Supply and Demand Analysis:

An Oil Import Fee



_{At a world price of $18, imports}

are 5.9 million barrels per day.



_{The tax on imports causes an}

increase in domestic production,

and quantity imported falls.

(15)

Elasticity

• _{Elasticity is a general concept that can be used to quantify the}

response in one variable when another variable changes.

e l a s t i c i t y o f A w i t h r e s p e c t t o B

A

B



%



• Price elasticity of demand

_{Price elasticity of demand}

measures how

responsive consumers are to changes in the

(16)

Price Elasticity of Demand

16 • Measures the responsiveness of demand 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.

p r i c e e l a s t i c i t y o f d e m a n d

% c h a n g e i n q u a n t i t y d e m a n d e d

c h a n g e i n p r i c e



(17)

Response to

Price Changes

Responsive

Unresponsive

Proportional

Value of

Elasticity



> |1|



< |1|



= |1|

Characteristics of Demand Elasticity

Type of

Demand

Elastic

Inelastic

Unitary elastic

Magnitudes of

Change

%



Q

_d

>

%



P

%



Q

_d

<

%



P

%



Q

_d

=

%



P

(18)

Type of Demand

Elastic

Inelastic

Inclination

Relatively Flat

Relatively Steep

(19)

Extreme Elasticities

Elasticity Value



=

0 

=

∞

Type of Elasticity

Perfectly Inelastic

Perfectly Elastic

Substitutes Available

None

(20)

Hypothetical Demand Elasticities

for Four Products

20 PRODUCT

% CHANGE

IN PRICE

(%



P)

Insulin

10%

0%

0

Perfectly inelastic

Basic telephone service

10%

-1%

-0.1

Inelastic

Beef

10%

-10%

-1

Unitary elastic

Bananas

10%

-30%

-3

Elastic

% CHANGE IN

QUANTITY

DEMANDED

(%



Q

d

)

ELASTICITY

(%



Q

d

/%



P)

(21)

Calculating Percentage Changes

• _{Elasticity is a}

_{ratio of percentages}

_{, and it involves computing}

percentage changes.

% c h a n g e i n q u a n t i t y d e m a n d e d



Q

2 

Q

x 1 0 0 %

Q

1

1 p r i c e e l a s t i c i t y o f d e m a n d







 

1 0 0 %

3 3 3 %

.

3 0

.

• Using the values on the graph to

compute elasticity, then:

% c h a n g e i n p r i c e



P

2 

P

x 1 0 0 %

P

1

(22)

Computing the Value of Elasticity

22 %

%

(

) /

(

) /



Q

P

Q

P

d

_









2 1 1 2 2 1 1 2

2 1 0 0 %

2 x

x 1 0 0 %

%

(

) /

(

) /

.

_.



Q

P

d

_











 

1 0

5 5 1 0

2 1 0 0 %

2

3

2

5 7 5

_{1 6 7}

x

x 1 0 0 %

- 1

2 . 5

x 1 0 0 %

=

6 6 . 7 %

- 4 0 . 0 %

(23)

Interpreting the Value of Elasticity

• _When



= 0.2, a 10% increase in price leads to a 2%

decrease in quantity demanded.

• _When



= 2.0, a 10% increase in price leads to a 20%

decrease in quantity demanded.

(24)

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.

(25)

Elasticity Changes along a

Straight-Line Demand Curve

• _{Along the elastic range,}

elasticity values are greater

than one.



6.4 

.29

• Along the inelastic range,

_{Along the inelastic range,}

elasticity values are less

than one.

(26)

Elasticity and Total Revenue

• _{When demand is}

_inelastic

_{, price and total revenues are}

_directly

_related.

Price increases generate higher revenues.

• _{When demand is}

_elastic

_{, price and total revenues are}

_indirectly

_related.

Price increases generate lower revenues.

₂₆

Type of

demand

Value of E

dd

Change in quantity

versus change in

price

Effect of an

increase in

price on total

revenue

Effect of a

decrease in price

on total revenue

Elastic

Greater than

1.0

1.0 Larger percentage change

Larger percentage change

in quantity

Total revenue

decreases

Total revenue

increases

Inelastic

Less than 1.0

Smaller percentage

change in quantity

Total revenue

increases

Total revenue

decreases

Unitary

elastic

Equal to 1.0

Same percentage change

in quantity and price

Total revenue

does not change

Total revenue does

not change

(27)

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. While demand

is less elastic or inelastic if it represents a

relatively small part of the budget (salt)

• _{Time frame}

_{-- demand becomes more elastic over}

(28)

Other Important Elasticities

• _{Income elasticity of demand}

_{– measures the responsiveness of}

demand to changes in income.

28 i n c o m e e l a s t i c i t y o f d e m a n d

% c h a n g e i n q u a n t i t y d e m a n d e d

c h a n g e i n i n c o m e



(29)

Income elasticity

If income elasticity is The good is

Negative Inferior

Income elasticity can be either positive (

normal good

) or

negative (

inferior good

).

• Normal necessities

- If 0 < ε

_I

< 1, then quantity demanded

rises by smaller percentage than income or an increase in

income results in an increase in the quantity of the good

demanded by a lesser percentage;

• Luxuries

- if ε

_I

> 1 then quantity demanded rises by larger

(30)

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.

30 c r o s s - p r i c e e l a s t i c i t y o f d e m a n d

% c h a n g e i n q u a n t i t y o f d e m a n d e d

c h a n g e i n p r i c e o f



Y

X

(31)

Cross price elasticity

If cross-price elasticity is The goods are

Negative Complements

Cross-price elasticity can be either positive or

negative

.

•If ε

_xy

> 0, the two goods are

substitutes

-

• _{an increase in the price of Y induces a rise in}

the QD of good X.

• If ε

_xy

< 0, the two goods are

complements

.

•The greater the absolute value of the ε

_xy

the

(32)

Other Important Elasticities

• _{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.

32 e l a s t i c i t y o f s u p p l y

% c h a n g e i n q u a n t i t y s u p p l i e d

c h a n g e i n p r i c e



(33)

Elasticity of supply

A perfectly inelastic supply curve is vertical, where the price

elasticity of supply is zero.



_{For prices above a certain level, the supply curve becomes}

perfectly inelastic for some goods for which only a finite quantity

is available.



_{This is also true for a fisherman with no storage facilities, for}

(34)

Elasticity of supply

(35)

Elasticity of supply

(36)

Other Important Elasticities

• _{Elasticity of labor supply:}

_{A measure of the response of labor}

supplied to a change in the price of labor.

36 e l a s t i c i t y o f l a b o r s u p p l y

% c h a n g e i n q u a n t i t y o f l a b o r s u p p l i e d

c h a n g e i n t h e w a g e r a t e

