Chapter 4 Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity

1. Chapter 4 Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity

2. price control price ceiling price floor rent control minimum wage price elasticity of demand unit-free measure elastic demand inelastic demand perfectly inelastic demand perfectly elastic demand income elasticity of demand cross-price elasticity of demand price elasticity of supply perfectly elastic supply perfectly inelastic supply Key Terms

3. Interference with Market Prices Price Control:a government control or regulation that sets or limits the price to be charged for a particular good. Two Broad Types of Price Controls: • Price Floor • Price Ceiling

4. Price Ceilings and Floors Price Ceiling: a government price control that sets the maximum allowable price for a good or a service. Example: • Rent control: a government price control that sets a maximum allowable rent to a house or an apartment.

5. Price Ceilings and Floors Price Floor: a government price control that sets the minimum allowable price for a good or a service. Example: • Minimum wage: a wage per hour below which it is illegal to pay workers.

6. Side Effects of Price Ceilings If the government sets the price ceiling below the equilibrium price, a shortage will result. Ways We Deal with Persistent Shortages: • Coupons • Long lines • Reduction in the quality of the good sold

7. Figure 1: Effects ofa Maximum-Price Law

8. Figure 1: Effects of a Maximum-Price Law

9. Side Effects of Price Floors If the government sets the price floor above the equilibrium price, a surplus will result. Ways We Deal with Persistent Surpluses: • Surpluses purchased by the government • Surplus labor results in unemployment

10. Figure 2: Effects of a Minimum-Price Law (Top graph)

11. Figure 2: Effects of a Minimum-Price Law (Bottom Graph)

12. Elasticity of Demand Price Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in the price of that good.

13. Figure 3: Elasticity of Demand In Figure 3, the top graph shows a demand curve where an increase in the price from $20 to $22 results in a decrease in the quantity demanded from 60 million barrels to 48 million barrels.

14. Figure 3: Comparing Different Sizesof the Price Elasticity of Demand

15. Percentage change in price Elasticity of Demand Percentage change in Qty. demanded

16. The price elasticity of demand for the top graph in Figure 3 is: Note: A price elasticity of demand of 2 implies that a one percentage point increase in the price results in a two percentage point decrease in the quantity demanded. Price Elasticity of Demand Elasticity of Demand

17. Size of the Elasticity: High versus Low We compare the demand curve found on the top graph with the demand curve found on the bottom graph on Figure 3. On the bottom graph, an increase in the price from $20 to $22 results in a decrease in the quantity demanded from 60 million barrels to 57 million barrels.

18. Figure 3: Comparing Different Sizesof the Price Elasticity of Demand

19. Size of the Elasticity: High versus Low Percentage change in Qty. demanded Percentage change in price

20. The elasticity of demand for the top graph is: Note: A price elasticity of demand of 1/2 implies that a one percentage point increase in the price results in a one-half percentage point decrease in the quantity demanded. Size of the Elasticity: High versus Low Price Elasticity of Demand

21. Size of the Elasticity: High versus Low Note: The top graph in Figure 3 had a higher price elasticity of demand (elasticity = 2) than the price elasticity of demand for the bottom graph (elasticity = 1/2). Hence, the demand curve on the top graph is more sensitive to price changes than the demand curve on the bottom graph.

22. Impact of a Change in Supply on the Price of Oil In the next slide, Figure 4 analyzes the effect of a decrease in the supply of oil on the equilibrium price of oil. The top graph features a demand curve with a higher elasticity (elasticity = 2) than the bottom graph (elasticity = ½).

23. Figure 4 : The Importance of the Size of the Price Elasticity of Demand

24. Impact of a Change inSupply on the Price of Oil Note: The same shift in the supply of oil to theleft (decrease by 14 million barrels) results in a higher equilibrium price on the bottom graph, where the demand curve has a lower price elasticity (elasticity = ½) than in the top graph (elasticity = 2).

25. Figure 4A shows the daily crude oil prices in the world since January 2006. The large fluctuations of oil prices support the idea that demand for oil is inelastic. Impact of a Change in Supply on the Price of Oil

26. Figure 4A: World Oil and Gasoline Spot Prices (Daily), January 2006-August 2007 Source: Department of Energy

27. Working with Demand Elasticities The general formula that we will use for demand elasticity (ed) will be:

28. Working with Demand Elasticities An attractive feature of the price elasticity of demand is that it is a unit-free measure; it allows the comparison of the price elasticity of different goods and different prices. Unit-Free Measure: a measure that does not depend on the unit of measurement.

29. Working with Demand Elasticities Assume the price of rice rises by 10 cents, from 50 to 60 cents per pound, and the quantity demanded falls from 20 to 19 tons. This implies a decrease of 1 ton per 10 cent increase in the price, or: Elasticity of Demand:

30. Working with Demand Elasticities Similarly, assume the price of steak rises by $1, from $5 to $6 per pound, and the quantity demanded falls from 20 tons to 19 tons. This implies a decrease of 1 ton per $1 increase in the price, or: Elasticity of Demand:

31. Elasticity versus Slope One common mistake made when dealing with elasticity is to interchange the elasticity of the demand curve with its slope. These concepts are similar, but not the same. Elasticity of demand = slope

32. Elasticity versus Slope Notes: The elasticity is a unit-free measure, while the slope is not. With a straight-line demand curve, the slope is constant, while the elasticity varies at different points in the line.

33. The Midpoint Formula or

34. Recall Figure 4. If we use the midpoint formula to calculate the elasticity on the top graph, the elasticity of demand is: The Midpoint Formula

35. Talking About Elasticities Elastic Demand – demand where the elasticity is greater than one. Inelastic Demand – demand where the elasticity is less than one. Unit Elastic Demand – demand where the elasticity is exactly equal to one.

36. Talking About Elasticities Perfectly Inelastic Demand – demand (or part of the demand curve) where the price elasticity is zero, indicating no response to a change in price. A perfectly inelastic demand curve is a vertical line. Perfectly Elastic Demand – demand (or part of the demand curve) where the price elasticity is infinite, indicating an infinite response to a change in price. A perfectly elastic demand curve is a horizontal line.

37. Figure 6: Perfectly Elasticand Perfectly Inelastic Demand

39. Revenue and thePrice Elasticity of Demand Revenue of a firm = (P X Q) = (price of a good) X (quantity of the good sold)

40. Revenue and thePrice Elasticity of Demand Example: If people purchase 60 million barrels of oil at $20, then the firm’s revenues equal: Revenue = 60 million X $20 = $1200 million = $1.2 billion

41. Revenue and thePrice Elasticity of Demand Figure 7 shows that if the price increases in an elastic demand curve, the firm revenues will decrease. If the price increases in an inelastic demand curve, the firm revenues will increase.

42. FIGURE 7: Effects of an Increase in the Price of Oil on Revenue

43. Revenue and thePrice Elasticity of Demand If in the inelastic region of a straight-line demand curve, an increase (a decrease) in the price will result in an increase (a decrease) in revenues. If in the elastic region of a straight-line demand curve, an increase (a decrease) in the price will result in a decrease (an increase) in revenues.

44. Figure 8: Revenue and Elasticity of aStraight-Line Demand Curve

46. What Determines the Sizeof the Price Elasticity of Demand? Determinants of the Price Elasticity of Demand: • Degree of substitutability • Big-ticket versus little-ticket items • Temporary versus permanent price change • Differences in preferences • Long-run versus short-run elasticity

48. Degree of Substitutability Goods with a lot of substitutes have a high price elasticity of demand. Goods with few substitutes have a low price elasticity of demand.

49. Big-Ticket versus Little-Ticket Items If a good represents a large share fraction of people’s income, then the price elasticity willbe high. If a good represents a small share fraction of people’s income, then the price elasticity willbe low.

50. Temporary versusPermanent Price Change If the price change is perceived to be temporary, then the price elasticity of demand will be high. If the price change is perceived to be permanent, then the price elasticity of demand will be low.