Topic 4 - Price Controls & Elasticity

PSCI 1500: Introduction to Economics

Price Control & Elasticity

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

• In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.

• While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.

• One of the roles of economists is to use their theories to assist in the development of policies.

PRICE CONTROLS: LIMITING PRICE MOVEMENTS

• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.

• Result in government-created price ceilings and floors.

PRICE CEILINGS & PRICE FLOORS

PRICE CEILING • A legally established maximum price at

which a good can be sold.

PRICE FLOOR• A legally established minimum price at

which a good can be sold.

•A government-set maximum price that can be charged for a good or service

•Upper Price Limit

PRICE CEILINGS (PC)

PRICE CEILINGS– NO EFFECT

$4

3

Quantity0

Price

Demand

Supply

Priceceiling

Equilibriumprice

100Equilibriumquantity

PRICE CEILING – WITH EFFECT

$3

Quantity0

Price

2

Demand

Supply

Equilibriumprice

Priceceiling

Shortage

125Quantitydemanded

75Quantitysupplied

• Since a Price Ceiling (Pc) should be placed below the equilibrium price, Pe, then Pe becomes illegal.

• Normally in a free market, adjustment will be through an increase in price, but here it is illegal.

PRICE CEILINGS (PC)

EFFECTS OF PRICE CEILINGS

An effective price ceiling creates ...

• Shortages because QD > QS.• Example: Gasoline shortage of the 1970s

• non-price rationing• Examples: Long lines, Discrimination by sellers

(Purchase will be limited to those able/willing to buy)

APPLICATION: LINES AT THE GAS PUMP

In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline.

What was responsible for the long gas lines?Economists blame government regulations that limited the price oil companies could charge for gasoline.

•A government-set minimum price that can be charged for a good or service

•Lower Price Limit

PRICE FLOORS

$3

Quantity0

Price

100Equilibriumquantity

Equilibriumprice

Demand

Supply

Pricefloor2

PRICE FLOORS – NO EFFECT

$3

Quantity0

Price

Equilibriumprice

Demand

Supply

Price floor$4

120Quantitysupplied

80Quantitydemanded

Surplus

PRICE FLOORS – WITH EFFECT

• A Price Floor (Pf) is placed above the equilibrium price, Pe, the government will penalize those who transact below the Price Floor (Pf) • To prevent the adjustment process to cause price to fall, government may buy the surplus, or sellers will have to absorb it.

PRICE FLOORS

EFFECTS OF PRICE FLOOR

• A price floor prevents supply and demand from moving toward the equilibrium price and quantity.

• When the market price hits the floor, it can fall no further, and the market price equals the floor price.

EFFECTS OF PRICE FLOOR

• An effective price floor causes . . .

• A surplus because QS >QD.

• Nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.

• Examples: The minimum wage, Agricultural price supports

APPLICATION: THE MINIMUM WAGE

• An important example of a price floor is the minimum wage.

• Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

THE MINIMUM WAGE

Quantity ofLabor

0

Wage

Equilibrium

wage

Labor demand

Labor supply

A Free Labor Market

Equilibriumemployment

Minimumwage

THE MINIMUM WAGE

Quantity ofLabor

0

Wage

Labor demand

Labor supply

Quantitysupplied

Quantitydemanded

Labor surplus(unemployment)

A Labor Market with a Minimum Wage

PRICE ELASTICITY OF DEMAND

Price Elasticity of Demand (Elasticity of Demand)

• Price Elasticity measures how much the quantity changes with a given change in price of the item.• Measure the strength of buyers responses to price

changes, in other words, the sensitivity of buyers towards the price changes.FORMULA:

d = % Quantity Demanded % Price

d = Q2 – Q1 x P1

Q1 P2 – P1


Try this! Calculate the Price Elasticity of Demand for the following products:

• PRODUCT A – As the price change from $10 to 8, the quantity demanded change from 10 to 14.

• PRODUCT B – As the price change from $10 to 8, the quantity demanded change from 10 to 11.

• PRODUCT C – As the price change from $10 to 8, the quantity demanded change from 10 to 12.

INTERPRETATIONS

Product A, d = 2For Ed > 1, the demand is Elastic

Product B, d = 0.5For Ed < 1, the demand is Inelastic

Product C, d = 1For Ed = 1, the demand is Unit Elastic


Price Elastic• Strong response to a price change.• Occurs when the % change in quantity is

greater than the % change in price (chg Q > chg P).• A small change in the price of the product

causes a large change in its quantity demanded.• Whenever the absolute value of price elasticity

of demand is greater than 1 (Ed > 1), demand is elastic. • Quantity demanded is “relatively

responsive”.


Price Inelastic• Weak response to a price change.• Occurs when the % change in quantity is less

than the % change in price (chg Q < chg P)• A large change in the price of the product will

only cause a small change in its quantity demanded.• Whenever the absolute value of price

elasticity of demand is less than 1 (Ed < 1), demand is inelastic. • Quantity demanded “relatively

unresponsive”.


Other level of elasticity.Unit Elastic Demand - A condition in which percentage changes in price equals to percentage changes in quantity demanded.2 Extreme Cases • Perfectly inelastic – A condition in which the

quantity demanded does not change as the price changes.

• Perfectly elastic demand - A condition in which a small percentage of change in price leads to an infinite percentage of change in the quantity demanded.

Price

Quantity Demanded

Unit Elastic Demand

DEGREES OF ELASTICITY

Inelastic DemandElastic Demand

Perfectly Inelastic Demand

Perfectly Elastic Demand

d > 1

d < 1

d = 1

d =0

d =


Factors Affecting Price Elasticity of Demand1) Necessities vs. luxury goods• Strong response to price changes in luxury

goods.• Weak response to price changes in necessities.2) Substitutes• Strong response to price changes in products

with many substitutes or similar alternatives.• Weak response to price changes in products that

have few substitutes or similar alternatives.3) Proportion of income• Strong response to price changes in products

that require a greater proportion of income.• Weak response to price changes in products that

require a lesser proportion of income.

TEST YOUR UNDERSTANDING

• Insulin vs. Star Cruises• The prices of both of these goods rise by

20%. For which good does Qd drop the most? Why?

• To millions of diabetics, insulin is a necessity.

A rise in its price would cause little or no decrease in demand. • A cruise is a luxury. If the price rises,

some people will forego it. • Lesson: Price elasticity is higher for luxuries

than for necessities.

DEMAND ELASTICITY & TOTAL REVENUE

Total Revenue TestPrice elasticity of demand can be estimated

by observing the change in total revenue that results from a price change (ceteris paribus).

The information on price elasticity of demand will be useful for the seller to adjust their selling price since it will affect the total revenue.

Three different scenarios to be considered– elastic, inelastic and unit elastic, which will result in a bigger gain in total revenue?

Total Revenue (TR) = Price (P) x Quantity (Q)

Price

D

RM30

10

RELATIONSHIP TO TOTAL REVENUE

DEMAND IS ELASTIC

Total Revenue RM20 x 10 = RM200If seller increases price to RM30New Total Revenue = RM30 x 5 = RM150 TR = RM50

RM20

5 Quantity Demanded


Price

D

RM2

15

RELATIONSHIP TO TOTAL REVENUE (cont.)

DEMAND IS INELASTIC

Total Revenue RM1 x 15 = RM15If seller increases price to RM2New Total Revenue = RM2 x 10 = RM20 TR = RM5

RM1

10 Quantity Demanded


Price

D

RM2

20

RELATIONSHIP TO TOTAL REVENUE (cont.)

DEMAND IS UNITARY ELASTIC

Total Revenue RM1 x 20 = RM20If seller increases price to RM2New Total Revenue = RM2 x 10 = RM20 TR = 0

RM1

10 Quantity Demanded


Total Revenue Test - SummaryPrice cut and total revenue increases —

demand is elastic.Price cut and total revenue decreases —

demand is inelasticPrice cut and total revenue does not change

— demand is unit elastic

DEMAND ELASTICITY & TOTAL REVENUE


List the factors that leads to inelastic demand.

1. Necessities 2. Few Substitutes3. Lesser proportion of income.

Interpret the coefficient of the price elasticity of demand, Ed = 1.5, and Ed = 0.7.

• A coefficient of 1.5 indicates that demand is elastic since the Ed > 1. This means, a relatively small change in price will result in large change in quantity demanded.

• A coefficient of 0.7 indicates that demand is inelastic since Ed < 1. This means that a relatively large change in price result in only small change in quantity demanded.


For each of the following pairs of goods, which good has the more elastic demand and why.

a) Gasoline vs. Shell Gasoline

b) Cigarettes today vs. Cigarettes over the next year

c) Required textbooks vs. mystery novels


How can the knowledge on elasticity of demand affects business firm’s pricing policy?

• Help firm decide whether to change prices in order to maximize their profit.

• If demand were relatively elastic, firm would know that lowering the price would expand the volume of sales, thus increasing total revenue.

• If demand were relatively inelastic, the firm would increase the price to increase total revenue (since buyer will not reduce their consumption or drop in sales is not much).


How can the knowledge on elasticity of demand affects government’s tax policy?

Tax charges raise the price of the goods affected, governments tend to charge taxes on goods that have a relatively inelastic demand, i.e. petrol and tobacco.

If the government were to impose it on good or services which its demand is relatively elastic, a small increase in price caused by the tax would lead to a large drop in sales, thus may not raise revenue to government.


PRICE ELASTICITY OF SUPPLY

DEFINITION:

Measures the sensitivity/responsiveness of the quantity supplied due to a change

in the price of a product or service.

FORMULA:

s = % Quantity Supplied % Price

S = Q2 – Q1 x P1

Q1 P2 – P1


Price (RM)

Quantity Demanded

Unitary Elastic SupplyPercentage change in price equals the percentage change in the quantity supplied.

DEGREE OF ELASTICITY

Inelastic SupplyA large percentage of change in the price of a good will only affect a small percentage of change of the quantity supplied.

Elastic SupplyA small percentage of change in the price of a good will lead to larger percentage of change in the quantity supplied.

Perfectly Inelastic Supply A percentage of change in price has no effect on the percentage of change in the quantity supplied.

Perfectly Elastic SupplyAn almost zero percentage of change in price brings a very large percentage of change in the quantity supplied.

ss > 1

ss < 1ss = 1ss =0

ss =

ELASTICITY OF SUPPLY

• Elastic• Inelastic• Unit/Unitary Elastic• Two extremes• Perfect elastic supply• Perfect inelastic supply

Mostly relevant and highlighted


• Whenever the absolute value of price elasticity of supply is greater than 1 (Es > 1), supply is elastic.

• The quantity supplied is “relatively responsive”.

• A small change in the price of the product will cause a large change in the quantity supplied for the product.


• Whenever the absolute value of price elasticity of supply is less than 1 (Es <1), demand is inelastic.

• The quantity supplied “relatively unresponsive”.

• A large change in the price of the product will cause a small change in the quantity supplied for the product.


Elastic Inelastic

DETERMINANTS FOR PRICE ELASTICITY OF SUPPLY

Factors Affecting Price Elasticity of Supply

1. Resource substitution possibilities

2. Time frame for the supply decision

Resource substitution possibilities

1. The ability of producers to alter input- the easier it is for producers to alter their input, the more elastic will the supply of the output/ product.

2. Storage Possibilities- the better the storability of resources, the more elastic is the price elasticity of supply


Time frame for the supply decision

3. Time Horizon/Time to React

- the price elasticity of supply for most products is more elastic in the long-run than in the short-run.

- this is because longer time horizon gives producers more opportunity to alter their input and output of a good.



Differentiate between Law of Supply and Price Elasticity of Supply.

Law of Supply – Relationship between 2 variablesPrice and quantity - direct relationship.

Price Elasticity of Supply – The sensitivity of one variable (quantity) to change or respond as a result of the change in another variable.

• Explain the factors that determine elasticity of supply

• Time factor – Long Run, Short Run; The ability of producers to alter input and output.

• Resources and storage – The ability of producers to alter input; Storage Possibilities


Topic 4 - Price Controls & Elasticity

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Transcript of Topic 4 - Price Controls & Elasticity