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

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1 CHAPTER 4 Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity CHAPTER OVERVIEW Price elasticity is one of the most useful concepts in economics. It measures the responsiveness of one variable to changes in another. This chapter introduces and defines the concept of price elasticity with respect to the supply and demand model developed in Chapter 3. The concepts of elasticity, inelasticity, unit elasticity, perfect elasticity, and relative elasticity are discussed. The link between revenue and price change is outlined. Factors that affect the degree of elasticity of demand and supply are presented in detail. Examples are given throughout the chapter. TEACHING OBJECTIVES 1. Begin with a discussion of market interference. Present price ceilings and price floors 2. Present the general definition of elasticity and discuss its importance. 3. Present the general and midpoint formulas for price elasticity of demand. 4. Review the terminology associated with elasticity. 5. Discuss the connection between price changes and revenue changes that is revealed using elasticity. 6. Discuss the factors that affect the degree of price elasticity of demand. 7. Discuss income and cross elasticities. 8. Introduce the formula for price elasticity of supply and discuss the appropriate terminology. 9. Outline the factors affecting the degree of price elasticity of supply. KEY TERMS price control price ceiling price floor rent control minimum wage price elasticity of demand unit-free measure elastic demand inelastic demand perfectly inelastic demand

2 26 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity perfectly elastic demand income elasticity of demand cross-price elasticity of demand price elasticity of supply perfectly elastic supply perfectly inelastic supply TEACHING TAYLOR AND WEERAPANA S ECONOMICS This chapter presents the fundamentals of price determination in a competitive market. Market interference in the forms of price ceilings and floors can be seen throughout history. Price ceilings and floors are associated with permanent shortages and surpluses. As with supply and demand analysis, price elasticity of demand and supply is an essential concept to an understanding of economics. It measures the sensitivity of one variable to another. The response of tax revenues to tax rates, of investment to interest rates, and of interest rates to the money supply are traced back to elasticity. Thus, the concept is important to both micro- and macroeconomics. In teaching about elasticity, one has a choice between emphasizing the intuitive idea that elasticity gives the percentage change in quantity for a given percentage change in price or requiring also that students learn how to use the midpoint formula to find the elasticity when given price and quantity data. LECTURE OUTLINE AND TEACHING TIPS I. Interference with Market Prices A. One form of government interference with the market process is the use of price controls. Price ceilings keep prices from rising, whereas price floors keep prices from falling. B. Price ceilings are always associated with shortages because the ceiling keeps the price from rising to equilibrium. Thus, the quantity demanded always exceeds the quantity supplied. Rent controls are a classic example. Black markets usually develop. Use Figure 1. C. Price floors are associated with surpluses. Use Figure 2. Governments must purchase the II. surplus to support the price. Elasticity of Demand A. Elasticity measures the sensitivity of the quantity demanded and the quantity of the good supplied to changes in the price of a good. B. Price elasticity of demand measures how much quantity demanded changes when price changes. : Be sure to stress that elasticity of demand tells us about movements along the demand curve. Movement of the demand curve does not occur because of the assumption of ceteris paribus. 1. The formula for price elasticity of demand is 2. Price elasticity of demand = (percentage change in quantity demanded)/(percentage change in the price) It may be helpful to show students that the elasticity formula is not the same as a slope formula. C. Price elasticity of supply measures how much quantity demanded changes when price changes.

3 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 27 Be sure to stress that elasticity of demand tells us about movements along the supply curve. Movement of the supply curve does not occur because of the assumption of ceteris paribus. 1. The formula for price elasticity of supply is 2. Price elasticity of supply = (percentage change in quantity supplied)/(percentage change in the price) It may be helpful to show students that the elasticity formula is not the same as a slope formula. D. Recall that elasticity measures the sensitivity of one variable to another. The price elasticity of demand measures the sensitivity of quantity demanded to the price of the good. Figure 3 illustrates the importance of high and low elasticities. Figure 4 is a case study of the oil market with different elasticities. See if students think that a firm should raise price to increase revenue. You will find that most believe it should. III. Working with Demand Elasticities A. The price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price. 1. Convention treats price elasticity of demand as positive even though the demand curve has a negative slope. 2. Elasticity is a unit-free measure. This makes comparison between two goods easier. For example, it allows a comparison between the demand elasticity for telephones and the demand elasticity for air travel 3. Elasticity of the demand curve is not the same as the slope of the demand curve. Use Figure 5 to illustrate this point. B. If the ratio between the percentage change in quantity demanded and the percentage change in price is greater than 1, demand is said to be elastic; inelastic if less than 1; and unit elastic when equal to 1. C. A horizontal demand curve is perfectly elastic; a vertical demand curve is perfectly inelastic. If the elasticity of one demand curve is larger than the elasticity of another, the first demand curve is said to be relatively elastic compared with the second. D. The midpoint formula averages the old and new quantities demanded and the old and new prices. E. Price and revenue are positively related when demand is inelastic and negatively related when demand is elastic. Price changes do not affect revenue when unit elasticity is present. Figure 7 and 8 show the relationship between price elasticity of demand and revenue This is very important. In fact, this relationship may be the main reason for using the concept of elasticity. Again, Figures 7 and 8 are very important. F. Price elasticity differs across products for many reasons. 1. The degree of substitutability: the presence of substitutes allows consumers to move to other goods when the price of one changes. 2. Big-ticket versus little-ticket items: the larger a part of a consumer's budget an item commands, the greater will be the effect of a price change. 3. Temporary versus permanent price changes: it is easier to wait to purchase if you think the price increase will be temporary.

4 28 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 4. Differences in preferences: different groups of consumers have different elasticities. G. Long run versus short run: the longer the time period, the easier it is to adjust to a price change. H. Income elasticity of demand is used to determine whether a good is normal or inferior. Cross elasticity is used to determine whether two goods are either substitutes or complements. IV. Elasticity of Supply A. Price elasticity of supply measures the sensitivity of quantity supplied to price. As with demand, elasticity of supply can be elastic, inelastic, or unit. Also, perfectly elastic and perfectly inelastic concepts are applicable. See Figure 9. B. It is important to know the price elasticity of supply when the demand curve shifts. See Figure 10. This is a way to measure the impact of a tax. This can be seen in taxing collegeage drinkers. See the reading in the chapter. Why are the supply curves for most farms in midseason nearly perfectly inelastic? What is the elasticity of supply of seats in a football stadium? DISCUSSION TOPICS 1. Tax revenues (or collections) are the product of a tax base and a tax rate. However, tax bases are usually inversely related to tax rates. Discuss whether tax rates should be increased or decreased to increase tax collections. Talk about the various ways to reduce the federal government's budget deficit. 2. Use demand elasticity to discuss whether tuition should be increased or decreased to raise college revenue so that professors may receive large pay increases. 3. Can firms affect the degree of relative elasticity in order to mitigate the adverse effects of possible price increases? Can advertising create enough product differentiation to reduce the number of substitutes consumers think exist for the product? 4. Review the formulas for price elasticity of supply and demand. Show that price elasticity is more than just the slope of the demand and supply curves. This allows you to maintain continuity by linking the Appendix to Chapter 2, Reading, Understanding, and Creating Graphs, to this chapter. 5. Have students list products that they view as having perfectly inelastic and perfectly elastic demand curves. Explain the lists are different due to differences in consumer preferences. This makes a good transition into the next chapter, The Demand Curve and the Behavior of Consumers.

5 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 29 SOLUTIONS TO END-OF-CHAPTER PROBLEMS 1. a. Figure 4.1 shows the market ATM transactions. Figure 4.1 b. Equilibrium is determined by competition between buyers and sellers. The presence of shortages or surpluses results in price adjustments until the market clears. c. A ban on fees forces prices to P 0. As a result, a shortage is created equal to Q 1 -Q 0. d. Banks incur costs when they provide ATM services. When a ban on fees is used, banks earn no revenue from transactions but incur costs. Therefore, banks are discouraged from providing ATM services.

6 30 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 2. a. Figure 4.2 shows a price floor. P 1 ($13.09) is a fixed price above the equilibrium price ($11.47). This legislation creates a surplus of milk equal to Q 2 Q 1. Figure 4.2 b. Sellers are better off because the floor price is above the free market price. However, consumers must pay more. As a result, consumers would oppose the legislation. 3. It might be the case that during an emergency, consumers have little concern over the quality of a good that is available. 4. Yes, at a zero price the quantity demanded will be larger than the quantity supplied. There will be a rise in nonprice forms of allocation. 5. As shown in the table below, the elasticity between $7 and $8 is 1.15, and between $3 and $4 it is Elasticity falls as you move up the supply curve. Price Quantity Supplied Elasticity a. Elasticity between $7 and $8: b. Elasticity between $3 and $4: 1.4. c. Elasticity falls.

7 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 31 d. The elasticity changes along a linear supply curve because the base (what the changes in price and quantity are relative to) changes. Elasticity is not the same as slope; it is the relative change in quantity demanded divided by the relative change in price. 7. a. Normal good b. Inferior good c. Normal good d. Normal good 8. a..4. Cross elasticity is positive. Movie tickets and video rentals are substitutes. b Cross elasticity is negative. Computers and software are complements. c. 1. Cross elasticity is positive. Apples and pears are substitutes. d Cross elasticity is positive. Ice cream and frozen yogurt are substitutes. 9. Low price elasticity indicates that demand is inelastic. As such, a fall in the price of a product will reduce total revenue even thought the quantity demanded will be greater. 10. The group who wish to cut fares are assuming that the elasticity of demand for airline seats is elastic, so that many more seats are filled as the price is reduced. Because there is a relatively large increase in passengers as the fare is cut, revenues increase substantially. Since the costs of servicing more passengers is relatively stable in an aircraft that is already scheduled to fly, profits will rise. If the demand is inelastic, revenues will decline as fares are cut. However, revenues will increase as the airfare is increased. Once again, because of the relative stability of costs for an aircraft that is already scheduled to fly, profits will rise. 11. The surplus AB is much smaller than the surplus CD. The surplus CD is larger because the demand and supply curves are relatively more elastic (flatter in slope). Figure 4.3

8 32 Chapter 4: Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 12. Figure 4.4 shows the market for luxury boats. Based on the 1992 events, the demand for yachts was more elastic relative to the demand for luxury cars. This is shown by the steepness of the two demand curves. A tax shifts supply from S 1 to S 2. In both cases, quantity (orders) fall. Orders for yachts fell by a relatively greater amount because demand is relatively more elastic. Figure 4.4

9 CHAPTER 5 Macroeconomics: The Big Picture CHAPTER OVERVIEW This chapter summarizes the overall workings of the economy, highlighting key facts to remember. It also provides a brief preview of macroeconomic theory designed to explain these facts. It emphasizes macroeconomics as the study of the big picture, with economic growth, recessions, unemployment, and inflation as its subject matter. The chapter begins by considering the major macroeconomic changes of the past quarter century ( ). These changes include the rapid economic growth of China and India, which is made more significant when compared to the dismal growth of many sub-saharan African countries. The stable performance of the United States economy and the reduction of deep poverty defined as a daily income equivalent to less than $1 worldwide are also mentioned. TEACHING OBJECTIVES 1. Define the study of macroeconomics. 2. Explain the behavior of real GDP over time by comparing and contrasting economic growth and economic fluctuations. 3. Provide an account of the important facts about economic growth and economic fluctuations. 4. Show that increased economic growth raises an economy s standard of living. 5. Introduce broad theoretical perspectives on both economic growth and economic fluctuations. 6. Define other key macroeconomic variables (unemployment, inflation, and interest rates) that provide information about the economy s performance. 7. Introduce the role that economic policy can play in promoting economic growth and reducing economic fluctuations. KEY TERMS real gross domestic product (real GDP) economic growth economic fluctuations recession peak trough expansion recovery unemployment rate inflation rate interest rate

This is what we call a demand schedule. It is a table that shows how much consumers are willing and able to purchase at various prices.

This is what we call a demand schedule. It is a table that shows how much consumers are willing and able to purchase at various prices. Demand Market: an institution or mechanism, which brings together buyers ("demanders") and sellers ("suppliers") of particular goods and services. The remainder of this unit assumes a perfectly competitive