Transcript Price Elasticity of Demand

Lecture 2. The Elasticity of Supply and
Demand
•
•
•
•
What are elasticities of supply and demand?
How do short-run and long-run elasticities differ?
Applications of supply, demand and elasticity.
What are the effects of government intervention
– price controls?
Reading: chapter 2
1
Elasticities of Supply and Demand
• Not only are we concerned with what direction
price and quantity will move when the market
changes, but we are concerned about how much
they change
• Elasticity gives a way to measure by how much
a variable will change with the change in another
variable
• Specifically, it gives the percentage change in
one variable resulting from a one percent
change in another
2
Warm-up exercise
•
People buy greeting cards and roses
throughout the year. As Valentine’s Day
approaches, however, cards and roses
become necessities. The demand for both
products jump and we expect the prices of
both products to jump. The price of roses,
however, always increases more sharply than
the price of greeting cards. Why?
3
Price Elasticity of Demand
• Measures the sensitivity of quantity
demanded to price changes
– It measures the percentage change in the
quantity demanded of a good that results from
a one percent change in price
% Q D
E 
% P
D
P
4
Price Elasticity of Demand
• The price elasticity of demand can also be written as:
Q Q P Q
E 

P P Q P
D
P
•
Since quantity demanded and price are negatively related,
we drop the negative sign.
• e.g. the price elasticity of demand of 0.5 means that every
1% increase in price leads to a 0.5% decrease in quantity
demanded.
5
Price Elasticity of Demand
• The primary determinant of price elasticity of demand is
the availability of substitutes
– Many substitutes, demand is price elastic
• Can easily move to another good with price
increases
– Few substitutes, demand is price inelastic
• Necessities vs. discretionary expenditure
. . . Basic food vs. restaurant meals
• Budget share
. . . salt vs. car
• Time horizon
6
Price Elasticity of Demand
E
D
P
Q Q
P Q


P P
Q P
• Looking at a linear demand curve, the slope of the
curve is constant, but as we move along the curve, P
and Q will change;
so price elasticity along a linear demand curve is not
constant
– The top portion of a linear demand curve is elastic
• Price is high and quantity small
– The bottom portion of a linear demand curve is
inelastic
• Price is low and quantity high
7
Price Elasticity of a Linear Demand Curve
Q Q P Q
E 

P P Q P
The top portion of demand curve is elastic
Price is high and quantity small
The bottom portion of demand curve is inelastic
Price is low and quantity high
D
P
Price
4
EP = 
Elastic
Ep = 1
2
Inelastic
0
4
8
Q
Ep = 0
8
• Two extreme cases of demand curves
– Infinitely elastic demand: horizontal demand curve
– Completely inelastic demand: vertical demand curve
9
Infinitely Elastic Demand
Price
EP = 
D
P*
Quantity
10
Completely Inelastic Demand
Price
D
EP = 0
Q*
Quantity
11
Other Demand Elasticities
• Income Elasticity of Demand
– Measures how much quantity demanded
changes with a change in income
Q/Q I Q
EI 

I/I Q I
12
Other Demand Elasticities
• Cross-Price Elasticity of Demand
– Measures the percentage change in the
quantity demanded of one good that results
from a one percent change in the price of
another good
EQb Pm
Qb Qb Pm Qb


Pm Pm Qb Pm
13
EQb Pm
Qb Qb

Pm Pm
• Complements: Cars and Tires
– Price of cars increases, quantity demanded of tires decreases
• Cross-price elasticity of demand is negative
• Substitutes: Butter and Margarine
– Price of butter increases, quantity of margarine demanded increases
• Cross-price elasticity of demand is positive
14
Price Elasticity of Supply
• Measures the sensitivity of quantity
supplied given a change in price
– Measures the percentage change in quantity
supplied resulting from a 1 percent change in
price
%Q S
E 
% P
S
P
15
Point vs. Arc Elasticities
• Point elasticity of demand
– Price elasticity of demand at a particular point
on the demand curve
• Arc elasticity of demand
– Price elasticity of demand calculated over a
range of prices
E
D
P
P 

Q






P  Q 

16
Short-Run Versus Long-Run
Elasticity
• Price elasticity varies with the amount of
time consumers have to respond to a price
• Short-run demand and supply curves often
look very different from their long-run
counterparts
17
Short-Run Versus Long-Run
Elasticity
• Demand
– In general, demand is much more price elastic
in the long run
• Consumers take time to adjust consumption habits
• Demand might be linked to another good that
changes slowly
• More substitutes are usually available in the long
run
18
Gasoline: Short-Run and Long-Run
Demand Curves
Price
DSR
• People cannot easily
adjust consumption in
the short run.
• In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
19
• Demand and Durability
– For some durable goods, demand is more
elastic in the short run
– If goods are durable, then when price
increases, consumers choose to hold on to
the good instead of replacing it
– But in long run, older durable goods will have
to be replaced
20
Short-Run Versus Long-Run
Elasticity
• Income elasticity also varies with the
amount of time consumers have to
respond to an income change
– For most goods and services, income
elasticity is larger in the long run
– When income changes, it takes time to adjust
spending
21
Short-Run Versus Long-Run Supply Elasticity
Most goods and services:
Long-run price elasticity of supply is greater than short-run price elasticity of
supply
Price
SSR
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.
Quantity
22
Short-Run vs. Long-Run
Elasticity – An Application
• Demand and supply are more elastic in the
long run
• In the very short run, supply is completely
inelastic
– E.g. Weather may destroy part of the fixed
supply, decreasing supply
• Demand is relatively inelastic as well
• Price increases significantly
23
An Example - Coffee
S’
S
Price
A freeze or drought
decreases the supply
of coffee
Price increases
significantly due to
inelastic supply and
demand
P1
P0
D
Q1
Q0
Quantity
24
Elasticity: An Application
• During the 1980’s and 1990’s, the market
for wheat went through changes that had
great implications for American farmers
and US agricultural policy
• Using the supply and demand curves for
wheat, we can analyze what occurred in
this market
25
Elasticity: An Application
• Supply: QS = 1800 + 240P
• Demand: QD = 3550 – 266P
• At equilibrium: QS = QD
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million
bushels
26
Elasticity: An Application
• We can find the elasticities of demand and
supply at these points
P QD
3.46
E 

(266)  .035
Q P
2, 630
D
P
P QS
3.46
E 

(240)  .032
Q P
2, 630
S
P
27
Elasticity: An Application
• If the price of wheat rose to $4.00/bushel
due to decrease in supply
QD  3,550  (266)(4.00)  2, 486
4.00
E 
(266)  0.43
2, 486
D
P
28
Effects of Price Controls
• Markets are rarely free of government
intervention
– Imposed taxes and granted subsidies
– Price controls
• Price controls usually hold the price above
or below the equilibrium price
29
Policy 1: price ceiling
• Price ceiling: a legal maximum on the price
(to be effective, it has to be lower than the
equilibrium price)
• Examples: price ceiling on gasoline;
rent control
• Objectives of the price control: promotion of
equity (or to satisfy voters?)
• What are the likely outcomes of the policy?
30
Effects of Price Ceiling
Price
S
• Price is regulated to
be no higher than Pmax
• Quantity supplied
falls and quantity
demanded increases
• A shortage results
P0
Pmax
Shortage
QS
Q0
D
QD Quantity
31
Effects of Price Ceiling
• Excess demand sometimes takes the form
of queues
– Lines at gas stations during shortage
• Sometimes get curtailments and supply
rationing
– Natural gas shortage of the mid ’70’s
• Producers/suppliers typically lose, but
some consumers gain. Some consumers
lose.
32
Price Controls and
Natural Gas Shortages
• In 1954, the federal government began
regulating the wellhead price of natural
gas
• In 1962, the ceiling prices that were
imposed became binding and shortages
resulted
33
Price Controls and
Natural Gas Shortages
• Price controls created an excess demand
of 7 trillion cubic feet
• Price regulation was a major component of
US energy policy in the 1960s and 1970s,
and it continued to influence the natural
gas markets in the 1980s
34
Questions for discussion
• What are the problems with rent control?
• Who will lose and who will gain?
• What do you think are better alternatives
to rent control?
35
A Rent Control
Search time increases
Rent (dollars per unit per month)
Black market may develop
S
b
24
e
20
Rent
ceiling
a
16
Housing
shortage
12
0
44
D
72
100
150
Quantity (thousands of units per month)
36
Policy 2: price floor
• Price floor: a legal minimum on the price
that can be charged (to be effective, it
has to be higher than the equilibrium
price)
• Example: minimum wage
• Objectives of the price control: promotion
of equity (or to satisfy voters?)
• what will be the impact on youth workers?
37
Policy 2: price floor
Without the price floor, the
market equilibrium is (p, q).
With the price floor at pmin,
there is excess supply of
qS - qD.
Price
supply
As a result, unemployed
young workers may rise.
pmin
and some may willing to
accept lower (illegal) wage
rate in order to work
p
pill
demand
qD
q
qS
Quantity
38