The Price System         • The market system, also called the price           system, performs two important and          ...
Price Rationing                              • Price rationing is the                                process by which the ...
Price Rationing                                                          • A decrease in supply                           ...
Price Rationing                                                          • There is some price                            ...
Alternative Rationing Mechanisms                  • A price ceiling is a maximum price                    that sellers may...
Alternative Rationing Mechanisms                 • Favored customers are those who receive                   special treat...
Alternative Rationing Mechanisms                                                        • In 1974, the                    ...
Alternative Rationing Mechanisms                                                        • A black market is a             ...
Alternative Rationing Mechanisms       • No matter how good the intentions of private         organizations and government...
Prices and the Allocation of Resources         • Price changes resulting from shifts of demand in output           markets...
Supply and Demand Analysis:                                An Oil Import Fee        • At a world price of $18,            ...
Elasticity         • Elasticity is a general concept that can be used           to quantify the response in one variable w...
Price Elasticity of Demand         • Measures the responsiveness of demand to           changes in price.         • It is ...
Characteristics of Demand Elasticity       Value of                    Type of                 Magnitudes of            Re...
Shape of Demand According to Elasticity                             Type of Demand                         Inclination    ...
Extreme Elasticities          Elasticity Value                 Type of Elasticity                Substitutes Available    ...
Hypothetical Demand Elasticities                             for Four Products                          Hypothetical Deman...
Calculating Percentage Changes       • Elasticity is a ratio of percentages, and it involves         computing percentage ...
Computing the Value of Elasticity                                                        • The midpoint formula to        ...
Interpreting the Value of Elasticity                 Here is how to interpret two different                 values of elas...
Elasticity Changes along a Straight-Line                           Demand Curve                                           ...
Elasticity Changes along a Straight-                       Line Demand Curve                                              ...
Elasticity and Total Revenue                                                                     Effect of an             ...
Determinants of Demand Elasticity                   • Availability of substitutes --                        demand is more...
Other Important Elasticities        • Income elasticity of demand – measures the             responsiveness of demand to c...
Other Important Elasticities       • Cross-price elasticity of demand: A            measure of the response of the quantit...
Other Important Elasticities       • Elasticity of supply: A measure of the            response of quantity of a good supp...
Other Important Elasticities       • Elasticity of labor supply: A measure of the            response of labor supplied to...
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Ch04

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Ch04

  1. 1. The Price System • The market system, also called the price system, performs two important and closely related functions : • Price Rationing • Resource Allocation© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  2. 2. Price Rationing • Price rationing is the process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  3. 3. Price Rationing • A decrease in supply creates a shortage at P0. Quantity demanded is greater than quantity supplied. Price will begin to rise. • The lower total supply is rationed to those who are willing and able to pay the higher price.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  4. 4. Price Rationing • There is some price that will clear any market. • The price of a rare painting will eliminate excess demand until there is only one bidder willing to buy the single available painting.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  5. 5. Alternative Rationing Mechanisms • A price ceiling is a maximum price that sellers may charge for a good, usually set by government. • Queuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  6. 6. Alternative Rationing Mechanisms • Favored customers are those who receive special treatment from dealers during situations when there is excess demand. • Ration coupons are tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. • The problem with these alternatives is that excess demand is created but not eliminated.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  7. 7. Alternative Rationing Mechanisms • In 1974, the government used an alternative rationing system to distribute the available supply of gasoline. • At an imposed price of 57 cents per gallon, the result was excess demand.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  8. 8. Alternative Rationing Mechanisms • A black market is a market in which illegal trading takes place at market-determined prices.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  9. 9. Alternative Rationing Mechanisms • No matter how good the intentions of private organizations and governments, it is very difficult to prevent the price system from operating and to stop the willingness to pay from asserting itself. • With favored customers and black markets, the final distribution may be even more unfair than that which would result from simple price rationing.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  10. 10. Prices and the Allocation of Resources • Price changes resulting from shifts of demand in output markets cause profits to rise or fall. • Profits attract capital; losses lead to disinvestment. • Higher wages attract labor and encourage workers to acquire skills. • At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  11. 11. Supply and Demand Analysis: An Oil Import Fee • At a world price of $18, • The tax on imports causes an imports are 5.9 million barrels increase in domestic production, per day. and quantity imported falls.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  12. 12. Elasticity • Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes. % ∆A e la s tic ity o f A w ith re s p e c t to B = % ∆B • Price elasticity of demand measures how responsive consumers are to changes in the price of a product.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  13. 13. Price Elasticity of Demand • Measures the responsiveness of demand to changes in price. • It is the ratio of the percentage change in quantity demanded to the percentage change in price. % c h a n g e in q u a n tity d e m a n d e d p ric e e la s tic ity o f d e m a n d = % c h a n g e in p ric e • Its value is always negative, but stated in absolute terms. • The value of the line of the slope and the value of elasticity are not the same.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  14. 14. Characteristics of Demand Elasticity Value of Type of Magnitudes of Response to Elasticity Demand Change Price Changes ε > |1| Elastic %∆Qd > %∆P Responsive ε < |1| Inelastic %∆Qd < %∆P Unresponsive ε = |1| Unitary elastic %∆Qd = %∆P Proportional Type of Substitutes Elasticity Available Elastic Many Inelastic Few© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  15. 15. Shape of Demand According to Elasticity Type of Demand Inclination Elastic Relatively Flat Inelastic Relatively Steep© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  16. 16. Extreme Elasticities Elasticity Value Type of Elasticity Substitutes Available ε=0 Perfectly Inelastic None ε= Perfectly Elastic Infinite© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  17. 17. Hypothetical Demand Elasticities for Four Products Hypothetical Demand Elasticities for Four Products % CHANGE IN % CHANGE QUANTITY IN PRICE DEMANDED ELASTICITY PRODUCT (% ∆P) (% ∆Qd) (% ∆Qd/% ∆P) Insulin 10% 0% 0 Perfectly inelastic Basic telephone service 10% -1% -0.1 Inelastic Beef 10% -10% -1 Unitary elastic Bananas 10% -30% -3 Elastic© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  18. 18. Calculating Percentage Changes • Elasticity is a ratio of percentages, and it involves computing percentage changes. P2 − P1 % c h a n g e in p ric e = x 100% P1 Q2 − Q1 % c h a n g e in q u a n tity d e m a n d e d = x 100% Q1 • Using the values on the graph to compute elasticity, then: + 100% p ric e e la s tic ity o f d e m a n d = = − 3 .0 − 3 3 .3 %© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  19. 19. Computing the Value of Elasticity • The midpoint formula to compute elasticity is: Q2 − Q1 x 100% % ∆Qd (Q 1 + Q 2 ) / 2 = % ∆P P2 − P1 x 100% ( P1 + P2 ) / 2 10 − 5 5 x 100% x 100% % ∆Qd (5 + 1 0 ) / 2 6 6 .7 % = = 7 .5 = = − 1 .6 7 % ∆P 2 − 3 -1 - 4 0 .0 % x 100% x 100% (3 + 2 ) / 2 2 .5© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  20. 20. Interpreting the Value of Elasticity Here is how to interpret two different values of elasticity: • When ε = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded. • When ε = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  21. 21. Elasticity Changes along a Straight-Line Demand Curve • Price elasticity of demand decreases as we move downward along a linear demand curve. • Demand is elastic on the upper part of the demand curve and inelastic on the lower part.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  22. 22. Elasticity Changes along a Straight- Line Demand Curve • Along the elastic range, − 6.4 elasticity values are greater than one. • Along the inelastic range, − .29 elasticity values are less than one.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  23. 23. Elasticity and Total Revenue Effect of an Change in quantity increase in Effect of a Type of versus change in price on total decrease in price demand Value of Ed price revenue on total revenue Elastic Greater than Larger percentage change Total revenue Total revenue 1.0 in quantity decreases increases Inelastic Less than 1.0 Smaller percentage Total revenue Total revenue change in quantity increases decreases Unitary Equal to 1.0 Same percentage change Total revenue Total revenue does elastic in quantity and price does not change not change • When demand is inelastic, price and total revenues are directly related. Price increases generate higher revenues. • When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  24. 24. Determinants of Demand Elasticity • Availability of substitutes -- demand is more elastic when there are more substitutes for the product. • Importance of the item in the budget -- demand is more elastic when the item is a more significant portion of the consumer’s budget. • Time frame -- demand becomes more elastic over time.© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  25. 25. Other Important Elasticities • Income elasticity of demand – measures the responsiveness of demand to changes in income. % c h a n g e in q u a n tity d e m a n d e d in c o m e e la s tic ity o f d e m a n d = % c h a n g e in in c o m e© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  26. 26. Other Important Elasticities • Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good. % c h a n g e in q u a n tity o f Y d e m a n d e d c ro s s - p ric e e la s tic ity o f d e m a n d = % c h a n g e in p ric e o f X© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  27. 27. Other Important Elasticities • Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets. % c h a n g e in q u a n tity s u p p lie d e la s tic ity o f s u p p ly = % c h a n g e in p ric e© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
  28. 28. Other Important Elasticities • Elasticity of labor supply: A measure of the response of labor supplied to a change in the price of labor. % c h a n g e in q u a n tity o f la b o r s u p p lie d e la s tic ity o f la b o r s u p p ly = % c h a n g e in th e w a g e ra te© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

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