Transcript Chapter 4. - Iowa State University

Chapter 4.
Additional Demand
and Supply
Topics/Applications
Key Topics
1.
2.
Allocating goods/resources via the price
system and non price alternatives
Policies that affect market prices
a.
b.
c.
d.
3.
P ceiling,
P floors,
fees,
Taxes
Economic impacts of free market deviations
(e.g. S, D, P, consumer & producer surplus)
Chapter 4 Objectives
Upon completion of this chapter, you should
understand and be able to answer these questions:
1.
2.
3.
How do markets allocate goods and resources?
What are some nonmarket alternatives for
allocating goods and resources and their economic
impacts?
What are price ceilings, price floors, fees, and
taxes and how do they impact markets?
The Role of Market Prices
(i.e. markets):
 To
ration or allocate goods and
services (and resources)
(solving the basic production
problems of what, how, and for
whom in the process).
P Rationing Example #1
S curve shifts to left (or D curve shifts
to right)
 Excess demand (i.e. shortage) exists at
original price
 Market P will rise to ration lower supply

Question
 Do
the laws of S and D work to
determine the price of an item if
there is only ONE unit of that item
to be sold?
“Buy land. They’ve stopped making
it.” (Mark Twain)
P
S
Q (land)
P Rationing Example #2

Extremely limited supply (e.g. QS = 1)
P
is D determined
 P will rise until there is only 1 willing
buyer
P Rationing Example #3 (resources)
Suppose the demand for a product
increases.
 More profits to produce that product
 Profits encourage firms to buy more capital,
labor, etc.
 Input prices influence what specific
resources are used

Question
 Should
the state of Iowa put a ‘cap’
on college tuition increases to
make a University education more
affordable to everyone?
P Constraint Example #1 – P Ceiling
P Ceiling = max P sellers can charge (below
equilibrium P) usually set by Gov’t
Examples: gasoline (1970s), interest rates,
rental rates, ATM fees
Arguments for: P gouging is bad, not ‘fair’ or
right to charge ‘exorbitant’ Ps, everyone
should be able to buy necessities at
‘reasonable’ prices
P Constraint Example #1 – P Ceiling
(cont’d)
Problem: Excess D still exists  need to
implement alternative rationing mechanisms
such as:
1. Queuing  waiting in line
2. Favored customers  let sellers decide
3. Issuing ration tickets or coupons
“Hidden” costs or problems with non-P
rationing mechanisms
1.
2.
3.
4.
Queuing: cost of waiting in line
Favored customers: bribes, hidden ‘service’
charges
Ration coupons: often end up being
bought/sold legally or illegally (black
market)
General: discourages both producers and
consumers from making needed S and/or D
adjustments
P Constraint Example #2 – P Floor




P floor = min. P buyers must pay (above
equilibrium P)
Examples: minimum wage, ag P supports
Arguments for: needed to keep producers in
business, to generate ‘fair’ income levels
Problem: excess S will be created ( e.g.
surplus production, unemployment, etc.)
P Constraint Example #3
– Import Fee
Fee = tax on imports
Impacts:
 P to U.S. consumers   Qd in U.S.
 QS in U.S.
 Q of imports
 Gov’t revenue
P Constraint example #4 (per unit tax
on buyers)
$
Pw/o
t
Pw
D1(w/o tax)
D2 (w/tax)
Q1
Q
To buy Q1 initially, buyers willing to pay Pw/o. After tax,
buyers willing to pay Pw to keep the same total cost per
unit.
=> Tax causes D curve to shift left (or down by amt of t)
Economic Impacts of Deviations Away
from Equilibrium
CS
=
consumer surplus
+ PS
=
producer surplus
__________________________________
=
NSW (net social welfare)
Question
 Is
there any product or service you
currently buy that you consider to
be a ‘really good’ deal for the
money?
Consumer Surplus
Amount willing to pay (value)
- Amount have to pay (cost)
___________________________
= consumer surplus
Consumer Surplus (graphically)
= area under the D curve and above the price line
= CS = ½ Q1 (a-P1)
P
a
P1
CS
D
Cost
Q1
Q
Producer Surplus
Amount paid to sellers
- Amount willing to sell for (cost)
__________________________
= producer surplus
Producer Surplus (graphically)
= area above the S curve and under the price line
= PS = ½ Q1 (P1 – a)
P
S
p1
a
PS
Cost
Q
Market Equilibrium & NSW
P
S
CS
NSW = net social welfare
Pe
= PS + CS
PS
D
Max NSW  P = Pe
Q
Qe
NSW Impacts: Q & P
P
P2
Pe
CS
a
PS
S
b
c
D
Q
Q1
Δ net social welfare
=
ΔPS + ΔCS
=
(a-c) + (-a-b)
=
-c-b
=
net welfare loss (deadweight loss)
Q2
ΔNSW
=
Question
 Suppose
your cumulative GPA
increases from 3.00 to 3.30 after
this semester. What was the
‘percentage increase’ in your
cumulative GPA?
E0 and Linear D Curve
P
a
E0>1
E0=1
1/2a
E0<1
Q
Factors Affecting Own Price
Elasticity



Available Substitutes
– The more substitutes available for the good, the
more elastic the demand.
Time
– Demand tends to be more inelastic in the short
term than in the long term.
– Time allows consumers to seek out available
substitutes.
Expenditure Share
– Goods that comprise a small share of consumer’s
budgets tend to be more inelastic than goods for
which consumers spend a large portion of their
incomes.
Uses of E0

Calculate % change in P needed to bring
about desired % change in Q sold

Calculate % change in Q sold that will result
from a given % change in P

Predict how TR will Δ due to given % ΔP
Use of E0 (Example)
According to an FTC Report, AT&T’s
own price elasticity of demand for long
distance services is –8.64.
 If AT&T lowered price by 3 percent,
what would happen to the volume of
long distance telephone calls routed
through AT&T?

Answer

Calls would increase by 25.92 percent!
EQ , P
x
x
% Qxd
 8.64 
% Px
% Qxd
8.64 
3%
3% x ( 8.64)  % Qxd
% Qxd  25.92%
Elasticity Equation
=>
% Q
E0 
% P
Note: this is an equation with 3 variables => given
values for 2 variables, can solve for value of 3rd
variable
Example: %ΔQ = E0(%ΔP)
Example: %ΔP = (%ΔQ)/E0
Question
 If
a firm wants to increase its dollar
sales of a product, should it P or
P?
Quote of the Day

“Students of Economics need to be taught, in
business, sometimes you should raise your
price, and sometimes you should lower your
price.”
- CEO of Casey’s
E0 and TR
TR = P∙Q = total revenue (total $ sales)
If E0 elastic (# > 1)
 little P  BIG Q  TR
 little P  BIG Q  TR* (P)
If E0 inelastic (# < 1)
 BIG P  little Q  TR* ( P)
 BIG P  little Q  TR
E0 and TR (Example)
Recall E0 = -.25 at P=1 and Q=8 for P=5 - .5Q
Given E0 is inelastic  firm should be able to TR by P.
P
Qd
TR ($)
1
8
8.00
2
6
12.00
2.50
7.5
18.75* (= max TR)
Max TR
Maximum R will be generated at midpoint of
linear, down-sloping D curve
P
5.00
2.50
Max TR
P=5-.5Q
7.5
15
Q
Cross Price Elasticity of Demand
EQ , P 
x
+ Substitutes
- Complements
Y
d
% Qx
% PY
Income Elasticity
EQ
x
,M

+
Normal Good
-
Inferior Good
d
% Qx
% M
Elasticity of Supply
% Qx
EQ , P 
% Px
law of S   0
s
S
X
x
Elasticity Summary

Elasticities can be used to estimate:
Qd if Px or Py or I or  ?
x
TRif Px