1 what are elasticities of supply and demand? how do short-run and long-run elasticities differ?...
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• What are elasticities of supply and demand?• How do short-run and long-run elasticities differ?• Applications of supply, demand and elasticity.• What are the effects of government intervention
– price controls?
Reading: chapter 2
Lecture 2. The Elasticity of Supply and Demand
2
Elasticities of Supply and Demand• Not only are we concerned with what direction
price and quantity will move when the market changes, but we are concerned about how much they change
• Elasticity gives a way to measure by how much a variable will change with the change in another variable
• Specifically, it gives the percentage change in one variable resulting from a one percent change in another
3
Warm-up exercise
• People buy greeting cards and roses throughout the year. As Valentine’s Day approaches, however, cards and roses become necessities. The demand for both products jump and we expect the prices of both products to jump. The price of roses, however, always increases more sharply than the price of greeting cards. Why?
4
Price Elasticity of Demand
• Measures the sensitivity of quantity demanded to price changes– It measures the percentage change in the
quantity demanded of a good that results from a one percent change in price
P
QE DDP
%
%
5
Price Elasticity of Demand• The price elasticity of demand can also be written as:
P
Q
Q
P
PP
QQE D
P
• Since quantity demanded and price are negatively related, we drop the negative sign.
• e.g. the price elasticity of demand of 0.5 means that every 1% increase in price leads to a 0.5% decrease in quantity demanded.
6
Price Elasticity of Demand• The primary determinant of price elasticity of demand is t
he availability of substitutes– Many substitutes, demand is price elastic
• Can easily move to another good with price increases
– Few substitutes, demand is price inelastic• Necessities vs. discretionary expenditure
. . . Basic food vs. restaurant meals• Budget share
. . . salt vs. car• Time horizon
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Price Elasticity of Demand
• Looking at a linear demand curve, the slope of the curve is constant, but as we move along the curve, P and Q will change;
so price elasticity along a linear demand curve is not constant– The top portion of a linear demand curve is elastic
• Price is high and quantity small
– The bottom portion of a linear demand curve is inelastic
• Price is low and quantity high
P
Q
Q
P
PP
QQE D
P
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Price Elasticity of a Linear Demand Curve
Q
Price
4
8
2
4
Ep = 1
Ep = 0
EP =
Elastic
Inelastic
The top portion of demand curve is elastic Price is high and quantity small
The bottom portion of demand curve is inelasticPrice is low and quantity high
P
Q
Q
P
PP
QQE D
P
0
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• Two extreme cases of demand curves
– Infinitely elastic demand: horizontal demand curve– Completely inelastic demand: vertical demand curve
12
Other Demand Elasticities
• Income Elasticity of Demand– Measures how much quantity demanded
changes with a change in income
I
Q
Q
I
I/I
Q/Q EI
13
Other Demand Elasticities
• Cross-Price Elasticity of Demand– Measures the percentage change in the
quantity demanded of one good that results from a one percent change in the price of another good
m
b
b
m
mm
bbPQ P
Q
Q
P
PP
QQE
mb
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• Complements: Cars and Tires– Price of cars increases, quantity demanded of tires decreases
• Cross-price elasticity of demand is negative
• Substitutes: Butter and Margarine– Price of butter increases, quantity of margarine demanded increases
• Cross-price elasticity of demand is positive
b m
b bQ P
m m
Q QE
P P
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Price Elasticity of Supply
• Measures the sensitivity of quantity supplied given a change in price– Measures the percentage change in quantity
supplied resulting from a 1 percent change in price
P
QE SSP
%
%
16
Point vs. Arc Elasticities• Point elasticity of demand
– Price elasticity of demand at a particular point on the demand curve
• Arc elasticity of demand– Price elasticity of demand calculated over a
range of prices
QP
PQE D
P
17
Short-Run Versus Long-Run Elasticity
• Price elasticity varies with the amount of time consumers have to respond to a price
• Short-run demand and supply curves often look very different from their long-run counterparts
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Short-Run Versus Long-Run Elasticity
• Demand– In general, demand is much more price elastic
in the long run• Consumers take time to adjust consumption habits• Demand might be linked to another good that
changes slowly• More substitutes are usually available in the long
run
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Gasoline: Short-Run and Long-Run Demand Curves
DSR
DLR
• People cannot easily adjust consumption in the short run.• In the long run, people tend to drive smaller and more fuel efficient cars.
Quantity of Gas
Price
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• Demand and Durability– For some durable goods, demand is more
elastic in the short run– If goods are durable, then when price
increases, consumers choose to hold on to the good instead of replacing it
– But in long run, older durable goods will have to be replaced
21
Short-Run Versus Long-Run Elasticity
• Income elasticity also varies with the amount of time consumers have to respond to an income change– For most goods and services, income
elasticity is larger in the long run– When income changes, it takes time to adjust
spending
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SSR
Quantity
Price
Short-Run Versus Long-Run Supply Elasticity
SLR
Due to limitedcapacity, firmsare limited by
output constraintsin the short run.
In the long run, theycan expand.
Most goods and services:Long-run price elasticity of supply is greater than short-run price elasticity of supply
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Short-Run vs. Long-Run Elasticity – An Application
• Demand and supply are more elastic in the long run
• In the very short run, supply is completely inelastic– E.g. Weather may destroy part of the fixed
supply, decreasing supply
• Demand is relatively inelastic as well
• Price increases significantly
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D
P0
S
Q0 Quantity
PriceA freeze or drought
decreases the supplyof coffee
S’
Q1
An Example - Coffee
Price increases significantly due to inelastic supply and
demand
P1
25
Elasticity: An Application
• During the 1980’s and 1990’s, the market for wheat went through changes that had great implications for American farmers and US agricultural policy
• Using the supply and demand curves for wheat, we can analyze what occurred in this market
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Elasticity: An Application• Supply: QS = 1800 + 240P• Demand: QD = 3550 – 266P• At equilibrium: QS = QD
1800 + 240P = 3550 – 266P506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million bushels
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Elasticity: An Application
• We can find the elasticities of demand and supply at these points
3.46( 266) .035
2,630D DP
QPE
Q P
3.46(240) .032
2,630S SP
QPE
Q P
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Elasticity: An Application
• If the price of wheat rose to $4.00/bushel due to decrease in supply
3,550 (266)(4.00) 2,486DQ
4.00( 266) 0.43
2,486DPE
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Effects of Price Controls
• Markets are rarely free of government intervention– Imposed taxes and granted subsidies– Price controls
• Price controls usually hold the price above or below the equilibrium price
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Policy 1: price ceiling• Price ceiling: a legal maximum on the price
(to be effective, it has to be lower than the equilibrium price)
• Examples: price ceiling on gasoline; rent control
• Objectives of the price control: promotion of equity (or to satisfy voters?)
• What are the likely outcomes of the policy?
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D
Effects of Price Ceiling
Quantity
Price
P0
Q0
S
Pmax
• Price is regulated to be no higher than Pmax• Quantity supplied falls and quantity demanded increases• A shortage results
QS
QD
Shortage
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Effects of Price Ceiling
• Excess demand sometimes takes the form of queues– Lines at gas stations during shortage
• Sometimes get curtailments and supply rationing– Natural gas shortage of the mid ’70’s
• Producers/suppliers typically lose, but some consumers gain. Some consumers lose.
33
Price Controls andNatural Gas Shortages
• In 1954, the federal government began regulating the wellhead price of natural gas
• In 1962, the ceiling prices that were imposed became binding and shortages resulted
34
Price Controls andNatural Gas Shortages
• Price controls created an excess demand of 7 trillion cubic feet
• Price regulation was a major component of US energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s
35
Questions for discussion• What are the problems with rent control?
• Who will lose and who will gain?
• What do you think are better alternatives to rent control?
36
A Rent Control
Quantity (thousands of units per month)
Ren
t (do
llars
per
uni
t per
mon
th)
0 44 72 100 150
12
16
20
24
D
S
Housingshortage
Rentceiling a
b
e
Search time increases
Black market may develop
37
Policy 2: price floor• Price floor: a legal minimum on the price
that can be charged (to be effective, it has to be higher than the equilibrium price)
• Example: minimum wage• Objectives of the price control: promotion
of equity (or to satisfy voters?)• what will be the impact on youth workers?
38
Policy 2: price floor
Price
Quantity
demand
supply
q
p
With the price floor at pmin, there is excess supply of qS - qD.
pminAs a result, unemployed young workers may rise.
and some may willing to accept lower (illegal) wage rate in order to work
qSqD
Without the price floor, the market equilibrium is (p, q).
pill
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