Welcome to Day 4. Principles of Microeconomics

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1 Principles of Microeconomics Welcome to Day 4 What we did last class: 1) Law of demand and law of supply. 2) What equilibrium is. 3) Importance of incentives. 4) List of things that moves demand. 5) How moving a demand curve changes the equilibrium. Start of class today: 1) Go over homework #1. 2) Go over quiz #1 Goals for Today 1) What shifts the supply curve. 2) New Equilibrium when the supply curve shifts. 3) Price controls. 4) The invisible hand. What causes the supply curve to shift? P $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $ S Do we have a list of things that move the supply curve like we have a list of things that move the demand curve? 1. Prices of Inputs. 2. Technology. 3. Taxes and Regulations. 4. Seller Expectations. 5. Natural Conditions. 1. Price of an input changes. When the price of an input rises, the cost of making the good goes up. 1

2 Old Cost New Cost 1 st pizza $4.50 $ nd pizza $5.50 $ rd pizza $6.50 $ th pizza $7.50 $ th pizza $8.50 $11.50 Now how many pizzas will you make for $8.00? Decrease in supply because of rise in price of an input. Supply curve shifts left. P $13.00 $12.00 S 2 $11.00 $10.00 $9.00 $8.00 S 1 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $ The difference between a change in quantity demanded and a change in demand is the same on the supply side. Moving up and down the supply curve because the price changes is a change in quantity supplied. Shifting the curve so more or less is made at the same price is a change in supply. Technology $3, $3, $2, $2, $1, Technology usually lowers cost and so usually increases supply. 2. Technology $1, $ S 1 S Taxes Putting a $3 dollar tax on producing or selling an item increases its cost of production just like the $3 rise in the price of cheese did for pizza. The response is the same. Higher taxes cause a decrease in supply, lower taxes cause an increase in supply. Notice that the first 3 things on the list all do the same thing they change the cost of production. It is a general rule that things that raise the cost of production lower supply and things that raise the cost of production increase supply. 2

3 4. Seller Expectations. Iraq invades Kuwait in August Gas prices go from $1.88 in July to $2.35 by October. Why? People expect higher prices in the future. $3.50 P $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 S 2 S Natural Conditions. Japan Tidal Wave (CNN)--Toyota has announced drastic production cuts in North America and China due to difficulty in supplying parts following the massive earthquake and tsunami in Japan. Previously, Toyota Motor Engineering and Manufacturing North America, Inc. (TEMA), had said it would suspend production on Mondays and Fridays between April 15 and April 25. That will continue through June 3, the company said in a statement. "During the same period, production will run at 50% on Tuesday, Wednesday and Thursday," the statement said. The 5 factors that affect supply (again). 1. Prices of Inputs. 2. Technology. 3. Taxes and Regulations. 4. Seller Expectations. 5. Natural Conditions. What if there is a rise in the price of cloth used to make umbrellas? $16.00 P $14.00 S P 1 $12.00 $10.00 $8.00 $6.00 D Rise in price of resource decreases supply. $25.00 P P 2 P 1 $20.00 $15.00 $10.00 S 2 S 1 $4.00 $2.00 $5.00 D

4 What happens to gasoline if there is an expectation of a higher price? $7.00 P P 1 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 S D Assuming buyers can not store gas, only supply decreases. $8.00 P P 2 P 1 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 S 2 S 1 D Sometimes people do not like the equilibrium price. Buyers may not like it because they think it is too high and sellers may think it is too low. Price Controls A legal maximum or minimum selling price set by the government. In this case, the government may put in price controls. Dairy Price Supports For cheddar cheese in blocks, not less than $1.13 per pound; For cheddar cheese in barrels, not less than $1.10 per pound; For butter, not less than $1.05 per pound and; For nonfat dry milk, not less than $0.80 per pound. A Price Control Above Equilibrium Price Causes a Surplus Price P C P E $1.20 $1.00 Surplus $0.80 $0.60 $0.40 D $ D S S uantity Dry Milk 4

5 By 2003, the U.S. government had stockpiled 1.28 billion pounds of dry milk to keep the price high. Since then we have been lucky enough to have milk prices rise, and the government has gotten rid of much of the stockpile. New York renters want to pay a lower rent. New York City has rent control. A Price Control Below Equilibrium Price Causes a Shortage Rent $1, $1, $ S R E $ R C $ $ Shortage D S D N.Y. Apartments Do New York City landlords have the evil gene? The businesses now have more customers than they wish to serve. How do you think this affects how they treat the customers? How do you make the most money in a situation like this? 5

6 We want our economy to produce what we want and to be able to adjust to changes in the world. Will a market economy do that? How does a business make money? Producing a lot of what people want the most and selling it. The better a business correctly estimates what its customers value, and makes a lot of those things, the higher its profit. And of course, we want the economy to be able to adjust to changing circumstances. Will a market economy do that? Rainy Winter Increases Demand P P 2 $16.00 $14.00 $12.00 $10.00 P 1 $8.00 D 2 $6.00 $4.00 D 1 $2.00 S Can a command economy do this? The incentive problem and the information problem The Incentive Problem What does an umbrella businessman get if he gets umbrellas quickly out to a rainy area? What does the 2 nd undersecretary of umbrellas in Washington get if he gets umbrellas quickly out to a rainy area? The Information Problem How does the 2 nd Undersecretary of Umbrellas know we need more umbrellas in Bakersfield? How do private business owners of umbrella companies know? 6

7 Every time you go shopping, it is a transfer of information fest!!! You are letting sellers know what you want. Sellers are letting you know what they can make at what cost. The Invisible Hand Adam Smith 1776 The Wealth of Nations Because trades are voluntary, in helping yourself, you help others also. The way for the businessman to make money is to most effectively serve his customers. In doing what is best for him, he is being lead, as if by an invisible hand to help society. Incentive Problem The problem of getting people to do things that help other people in the society. Information Problem The problem of knowing what other people want me to do to help them. Invisible Hand Business owners being lead to do the things most beneficial to others in their own pursuit of profit. Sometimes it s not enough to know that purchases go down when price goes up. Sometimes you want to know how much they go down, a lot or a little. The most common measure to answer this question is Elasticity. 7

8 Elasticity measures the responsiveness of one variable to changes in another variable. Price elasticity is the ratio of the percent change in quantity demanded to the percent change in price. Price Elasticity of demand = percent change in quantity demanded divided by percent change in price. Ed = % d % P So a t-shirt shop notices that when they raise their price by 5%, they lose 10% of their customers. What is their elasticity of demand? -10% = -2 5% What does the -2 mean? For every 1 percent they raise their price, their sales drop by 2%. The elasticity of demand number always means that for every 1% they raise their price, their sales drop by X% Another store checks their data and sees when they raise their price by 10%, they lose 5% of their sales. What is their elasticity of demand? -5%= % For every 1% they raise their price, they lose 0.5% of their sales. What if the stores lowered their price? Then a store with an elasticity of -2 should gain 2% in sales for every 1% drop in price. A store with an elasticity of -0.5 should gain 0.5% more sales with every 1 percent drop in price. 8

9 Unfortunately, the data does not usually come in percentage terms. Usually you know the starting and ending prices, and the starting and ending quantities, and have to convert these to percentages. Here s how to do that. % d= ( 2-1 )/[( )/2] % P= (P 2 -P 1 )/[(P 2 +P 1 )/2] So the elasticity formula in all its glory is Ed = (2-1)/[(2+1)/2] (P 2 -P 1 )/[(P 1 +P 2 )/2] Notice that we are calculating percentage changes in an unusual way. Usually, you would just divide the change by the starting value, not the average of the starting and ending value. By doing it this way, we get the same elasticity answer if the price goes up from $10 to $12 or down from $12 to $10. The own price elasticity number will always be negative by the math, but it is common to drop the negative sign and write it as its absolute value. So -2 becomes 2. What is the range of possible own price elasticities? Ed < 1 then Inelastic Demand Ed > 1 then Elastic Demand 0 1 Ed = 1 then Unit Elastic Demand 8 9

10 Total Revenue for a store is TR = P x Imagine a store with a very inelastic demand, say 0.3 If they raise their price 10%, their sales drop by 3%. Does their revenue go up or down? TR? = P 10% x 3% TR goes up. Whenever the elasticity is below 1, the percent drop in purchases is always less than the percent rise in price and revenue always rises when price rises. What if the elasticity is greater than one? Then the percentage drop in sales is always greater than the percent rise in price and the revenue always fall. TR? = P 3% x 10% Inelastic Demand Raise price revenue goes up. Lower price revenue goes down. Elastic Demand Raise price revenue goes down. Lower price revenue goes up. TR goes down. And if the demand is unit elastic? Then the percentage change in price equals the percentage change in sales, and revenue remains unchanged. Unit Elastic Demand (Ed = 1) Raise price revenue stays the same. Lower price revenue stays the same. What happens if zero customers stop buying when the price rises? Ed = % d % P Ed = 0. This is called perfectly inelastic demand. 10

11 Note that an Ed = 0 does not mean the store has 0 customers. It means it loses 0 customers when it raises its price. And what if the store loses every customer when it raises its price the tiniest possible amount? Ed = % d % P As % P goes to 0, % dstays constant. This fraction is going to infinity. This is perfectly elastic demand. Perfectly Inelastic Demand Curve Perfectly Elastic Demand Curve What we did today: 1) What shifts the supply curve. 2) Equilibrium when the supply curve moves. 3) Price controls. 4) The invisible hand. 5) Elasticity of demand. Homework: 1) Read assigned sections in chapters 3 and 5. 2) Assignment #3 Principles of Microeconomics Welcome to Day 5 What we did last class: 1) What shifts the supply curve. 2) Equilibrium when the supply curve moves. 3) Price controls. 4) The invisible hand. 5) Elasticity of demand. 11

12 Goals Today 1) What factors determine elasticity of demand. 2) Elasticity of supply. 3) Applying elasticity to a real world problem. 4)Income and cross-price elasticity. What determines if the demand elasticity is high or low? 1) Number and closeness of substitutes. 2) Percentage of income spent on the good. 3) Time. 1) Number and closeness of substitutes. The more and better substitutes available for a good, the more consumers buy these substitutes in place of the good when the price of the good rises. Good substitutes high elasticity Poor substitutes low elasticity Tell me some high and low elasticity items. 2) Percentage of your income you spend on the good. The higher the percentage of your income you spend on the good, the higher its elasticity of demand. Do you care more if the price of cars doubles, or the price of gum? 3) Time The more time you have to respond, the higher the elasticity of demand. What can you do if the price of gas rises? 12

13 The textbook tells us the elasticity for gasoline is 0.35 Another study says it is 0.26 in the short-run (less than a year) and 0.58 in the longrun (more than a year) Price elasticity of supply is the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged. e s % change in quantity supplied = % change in price The terminology from the elasticity of demand transfers over to the elasticity of supply. Supply Curves and Their Price Elasticities Es> 1 is Elastic Supply Es< 1 is Inelastic Supply Es= 0 is Perfectly Inelastic Supply Es= Infinity is Perfectly Elastic Supply. Which supply curve has the larger elasticity? The more time suppliers have to S build more factories, the greater 1 the increase in the amount of the good will be in response to a given higher price. P 2 P 1 S2 Cars 13

14 Let s look at the effect of government subsidized student loans. Let s assume that the elasticity of supply for college education is low. Does this mean it is easy or hard to start a new college? Is the supply curve relatively flat or straight up and down? Students are given $300,000,000 to go to college (doubling current tuition spending) $9, Tuition $8, $7, S $6, $5, $4, $3, D 2 $2, D 1 $1, Number Students Number of students rises from 100,000 to 130,000. Tuition rises from $3,000 to $5,600. Everyone gets to pay the higher tuition, not just the additional students. And don t forget, these are loans, so you still have to pay the money back. So who is helped more by government guaranteed loans? The students or the colleges and banks? That result was because the elasticity of supply is low. What if elasticity of supply is high? Now there is a large increase in students and a small increase in tuition $8, $7, $6, $5, $4, $3, $2, $1, D 1 D S Income elasticity of demand is the percentage change in quantity demanded at a specific price divided by the percentage change in income that produced the demand change, all other things unchanged. Ei= % D D = Demand % I I = Income 14

15 What does the income elasticity number tell you? It is the percent change in purchases if there is a 1 percent rise in income. For example, an answer of 0.7 means for every 1% rise in income, people buy 0.7 percent more of the good. When the income elasticity is positive, that means people buy more of the good when their income goes up or less when their income goes down. In other words, a normal good. When the income elasticity is negative, people buy less when their income goes up, in other words, an inferior good. Cross price elasticity of demand is the percentagechange in the quantity demanded of one good or service at a specific price divided by the percentagechange in the price of a related good or service. E X,Y = % Dx % Py Remember how to find the percentage change in X. It is the change in X divided by the average of the starting and ending quantities of X. And don t forget to check for the sign. Cross-price elasticityis positive when the two goods are substitutes. It is negative when the two goods are complements. What we did this class: 1) Factors the determine elasticity. 2) Elasticity of supply. 3) Elasticity and college tuition. 4) Income elasticity. 5) Cross-price elasticity. 15

16 Principles of Microeconomics Welcome to Day 6 What we did last class: 1) Factors the determine elasticity. 2) Elasticity of supply. 3) Elasticity and college tuition. 4) Income elasticity. 5) Cross-price elasticity. Goal Today: Test Prep Welcome to Day 7 Principles of Microeconomics Test Day 16