4 Prepared by: Fernando Quijano and Yvonn Quijano 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The Price System,

C H

A P

T E

C

H A

P T

E RR

4

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Price System, Demand and Supply, and Elasticity

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair 2 of 42

The Price System:Rationing and Allocating Resources

• The market system, performs two important and closely related functions:

1. Resource allocation: the market system determines the allocation of resources among producers and the final mix of outputs.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


The Price System:Rationing and Allocating Resources

• The market system, performs two important and closely related functions:

2. Price rationing: the market system distributes goods and services on the basis of willingness and ability to pay.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Price Rationing

• A decrease in supply creates a shortage at the original price.

• The lower supply is rationed to those who are willing and able to pay the higher price.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Price Rationing

• 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.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Constraints on the Market

• A price ceiling is a maximum price that sellers may charge for a good, usually set by government.

• In 1974, the government set a price ceiling to distribute the available supply of gasoline.

• At an imposed price of 57 cents per gallon, the result was excess demand.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Alternative Rationing Mechanisms

• Queuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• 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.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• 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.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• The problem with rationing systems is that excess demand is created but not eliminated.

• 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.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Prices and the Allocation of Resources

• Price changes resulting from shifts of demand 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.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


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 under the price of labor.

• The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Elasticity

• Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

e lastic ity o f A w ith resp ec t to BAB

%%

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Price Elasticity of Demand

• A popular measure of elasticity isA popular measure of elasticity is price elasticity of demand price elasticity of demand measures how responsive measures how responsive consumers are to changes in the consumers are to changes in the price of a product.price of a product.

price e las tic ity o f d em an d % ch an g e in q u an tity d em an d ed

ch an g e in p rice

%

• The value of demand elasticity is always negative, but it is stated in absolute terms.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Types of Elasticity

Hypothetical Demand Elasticities for Four Products

PRODUCT

% CHANGE IN PRICE

(%P)

% CHANGE IN QUANTITY DEMANDED

(%QD)ELASTICITY(%QD %P)

Insulin +10% 0% 0.0 Perfectly inelastic

Basic telephone service +10% -1% -0.1 Inelastic

Beef +10% -10% -1.0 Unitarily elastic

Bananas +10% -30% -3.0 Elastic

• When the percentage change in quantity demanded is smaller than the percentage change in price, demand for that product is inelastic.

• When the percentage change in quantity demanded is larger than the percentage change in price, demand for that product is elastic.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Perfectly Elastic andPerfectly Inelastic Demand Curves

• When demand does not respond at all to a change in price, demand is perfectly inelastic.

• Demand is perfectly elastic when quantity demanded drops to zero at the slightest increase in price.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Calculating Elasticities

• Calculating percentage changes:

% ch ang e in q uan tity dem and ed x 1 00 %2Q QQ

1

1

% ch an ge in p rice x 1 0 0 %2P PP

1

1

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• Elasticity is a ratio of percentages.

p rice e las tic ity o f d em an d

1 00 %33 3%

3 0.

.

• Using the values on the graph to compute elasticity, using percentage changes yields the following result:

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• A more accurate way of computing elasticity than percentage changes is the midpoint formula:

%%

( ) /

( ) /

QP

Q QQ QP PP P

d

2 1

1 2

2 1

1 2

210 0%

2

x

x 10 0 %

%%

( ) /

( ) /

. .QPd

1 0 55 1 0 2

1 0 0 %

2 33 2 2

57 5 1 6 7

x

x 1 0 0 %

x 1 0 0 %

-12 .5

x 1 0 0 % =

6 6 .7 %-4 0 .0 %

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



Here is how to interpret two different values 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.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


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.

Type of demand Value of Ed

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

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

TR P Q

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity


Other Important Elasticities

• Income elasticity of demand – measures the responsiveness of demand to changes in income.

in co m e e la stic ity o f d em and % ch ang e in q uan tity d em and ed

ch ang e in inco m e

%

• Income elasticity of demand is positive for normal goods and negative for inferior goods.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• 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.

c ro ss - p rice e las tic ity o f d em an d % ch an g e in q u an tity o f d em an d ed

ch an g e in p rice o f

YX%

• Cross-price elasticity of demand is positive for substitutes and negative for complements.

C H

A P

T E

R 4

: Th

e Pr

ice S

yste

m, D

eman

d an

d Su

pply

, and

Ela

stici

tyC

H A

P T

E R

4:

The

Price

Sys

tem

, Dem

and

and

Supp

ly, a

nd E

last

icity



• 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.

e lastic ity o f su p p ly % ch an g e in q u an tity su p p lied

ch an g e in p rice

%

Documents

4 Prepared by: Fernando Quijano and Yvonn Quijano 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The Price System,