Chapter 4.

Additional Demand and Supply

Topics/Applications

Key Topics

1. Allocating goods/resources via the price system and non price alternatives

2. Policies that affect market prices a. P ceiling, b. P floors, c. fees, d. Taxes

3. 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. How do markets allocate goods and resources?2. What are some nonmarket alternatives for

allocating goods and resources and their economic impacts?

3. 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 line2. Favored customers let sellers decide3. Issuing ration tickets or coupons

“Hidden” costs or problems with non-P rationing mechanisms

1. Queuing: cost of waiting in line2. Favored customers: bribes, hidden ‘service’

charges3. Ration coupons: often end up being

bought/sold legally or illegally (black market)

4. 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 importsImpacts:

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)

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)

$

Pw/o

Pw

Q1

t

D2 (w/tax)

D1(w/o tax)

Q

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)

P

a

D

QQ1

Cost

CSP1

= area under the D curve and above the price line= CS = ½ Q1 (a-P1)

Producer Surplus

Amount paid to sellers- Amount willing to sell for (cost)__________________________= producer surplus

Producer Surplus (graphically)

PS

Q

a Cost

PSp1

= area above the S curve and under the price line

= PS = ½ Q1 (P1 – a)

Market Equilibrium & NSW

P

CS

PS

S

D

QQe

Pe

NSW = net social welfare

= PS + CS

Max NSW P = Pe

NSW Impacts: Q & P

ΔNSW = Δ net social welfare= ΔPS + ΔCS= (a-c) + (-a-b)= -c-b= net welfare loss (deadweight loss)

P

Q

aPS

bc

S

D

CSP2

Pe

Q2 Q1

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

1/2a

Q

E0>1

E0=1

E0<1

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!

E QP

Q

x Q

Q

Q Pxd

x

xd

xd

xd

x x, . %%

. %

( . ) %

% .

8 64

8 643%

3% 8 64

25 92%

Elasticity Equation

=>

EQP0

%%

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

7.5 15Q

P=5-.5Q

Max TR

Cross Price Elasticity of Demand

E QPQ Pxd

Yx Y,

%%

+ Substitutes

- Complements

Income Elasticity

E QMQ Mxd

x,

%%

+ Normal Good

- Inferior Good

Elasticity of Supply

E QP

law of S

Q P

xs

xXS

x,

%%

0

Elasticity Summary

Elasticities can be used to estimate:

Q if P or P or I orTR if P

dx

x y

x

?