PSCI 150 : INTRODUCTION TO ECONOMICS Bachelor of Political Science, KIRKHS, IIUM

1. PSCI 1500:
Introduction to Economics
Price Control &
Elasticity

2. 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.

3. 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.

4. 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.

5. • A government-set maximum price that can
be charged for a good or service
• Upper Price Limit
PRICE CEILINGS (PC)

6. PRICE CEILINGS– NO EFFECT
$4
3
Quantity0
Price
Demand
Supply
Price
ceiling
Equilibrium
price
100
Equilibrium
quantity

7. PRICE CEILING – WITH EFFECT
$3
Quantity0
Price
2
Demand
Supply
Equilibrium
price
Price
ceiling
Shortage
125
Quantity
demanded
75
Quantity
supplied

8. • 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)

9. 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)

10. 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.

11. • A government-set minimum price that
can be charged for a good or service
• Lower Price Limit
PRICE FLOORS

12. $3
Quantity
0
Price
100
Equilibrium
quantity
Equilibrium
price
Demand
Supply
Price
floor
2
PRICE FLOORS – NO EFFECT

13. $3
Quantity0
Price
Equilibrium
price
Demand
Supply
Price floor$4
120
Quantity
supplied
80
Quantity
demanded
Surplus
PRICE FLOORS – WITH EFFECT

14. • 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

15. 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.

16. 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

17. 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.

18. THE MINIMUM WAGE
Quantity of
Labor
0
Wage
Equilibrium
wage
Labor
demand
Labor
supply
A Free Labor Market
Equilibrium
employment

19. Minimum
wage
THE MINIMUM WAGE
Quantity of
Labor
0
Wage
Labor
demand
Labor
supply
Quantity
supplied
Quantity
demanded
Labor surplus
(unemployment)
A Labor Market with a
Minimum Wage

20. 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

21. PRICE ELASTICITY OF DEMAND
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.

22. INTERPRETATIONS
Product A, d = 2
For Ed > 1, the demand is Elastic
Product B, d = 0.5
For Ed < 1, the demand is Inelastic
Product C, d = 1
For Ed = 1, the demand is Unit Elastic

23. PRICE ELASTICITY OF DEMAND
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”.

24. PRICE ELASTICITY OF DEMAND
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”.

25. PRICE ELASTICITY OF DEMAND

26. PRICE ELASTICITY OF DEMAND
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.

27. Price
Quantity Demanded
Unit Elastic Demand
DEGREES OF ELASTICITY
Inelastic Demand
Elastic Demand
Perfectly Inelastic Demand
Perfectly Elastic Demand
d > 1
d < 1
d = 1
d =0
d = 

28. PRICE ELASTICITY OF DEMAND
Factors Affecting Price Elasticity of Demand
1) 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.

29. 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.

30. DEMAND ELASTICITY & TOTAL REVENUE
Total Revenue Test
 Price 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)

31. Price
D
RM30
10
RELATIONSHIP TO TOTAL REVENUE
DEMAND IS ELASTIC
Total Revenue
RM20 x 10 = RM200
If seller increases price to RM30
New Total Revenue
= RM30 x 5 = RM150
 TR =  RM50
RM20
5
Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)

32. Price
D
RM2
15
RELATIONSHIP TO TOTAL REVENUE (cont.)
DEMAND IS INELASTIC
Total Revenue
RM1 x 15 = RM15
If seller increases price to RM2
New Total Revenue
= RM2 x 10 = RM20
 TR =  RM5
RM1
10
Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)

33. Price
D
RM2
20
RELATIONSHIP TO TOTAL REVENUE (cont.)
DEMAND IS UNITARY ELASTIC
Total Revenue
RM1 x 20 = RM20
If seller increases price to RM2
New Total Revenue
= RM2 x 10 = RM20
 TR =  0
RM1
10
Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)

34. Total Revenue Test - Summary
 Price cut and total revenue increases — demand
is elastic.
 Price cut and total revenue decreases — demand
is inelastic
 Price cut and total revenue does not change —
demand is unit elastic
DEMAND ELASTICITY & TOTAL REVENUE

35. TEST YOUR UNDERSTANDING
List the factors that leads to inelastic demand.
1. Necessities
2. Few Substitutes
3. Lesser proportion of income.

36. 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.
TEST YOUR UNDERSTANDING

37. 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
TEST YOUR UNDERSTANDING

38. 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).
TEST YOUR UNDERSTANDING

39. 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.
TEST YOUR UNDERSTANDING

40. 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.

41. FORMULA:
s = %  Quantity Supplied
%  Price
S = Q2 – Q1 x P1
Q1 P2 – P1
PRICE ELASTICITY OF SUPPLY

42. Price (RM)
Quantity Demanded
Unitary Elastic Supply
Percentage change in price equals the percentage
change in the quantity supplied.
DEGREE OF ELASTICITY
Inelastic Supply
A large percentage of change in the price of a good
will only affect a small percentage of change of the
quantity supplied.
Elastic Supply
A 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 Supply
An almost zero percentage of change in price
brings a very large percentage of change in the
quantity supplied.
ss > 1
ss < 1
ss = 1
ss =0
ss = 

43. ELASTICITY OF SUPPLY
• Elastic
• Inelastic
• Unit/Unitary Elastic
• Two extremes
• Perfect elastic supply
• Perfect inelastic supply
Mostly relevant and highlighted

44. PRICE ELASTICITY OF SUPPLY
• 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.

45. PRICE ELASTICITY OF SUPPLY
• 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.

46. PRICE ELASTICITY OF SUPPLY
Elastic Inelastic

47. DETERMINANTS FOR PRICE
ELASTICITY OF SUPPLY
Factors Affecting Price Elasticity of Supply
1. Resource substitution possibilities
2. Time frame for the supply decision

48. 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.
1. Storage Possibilities
- the better the storability of resources, the
more elastic is the price elasticity of supply
DETERMINANTS FOR PRICE
ELASTICITY OF SUPPLY

49. 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.
DETERMINANTS FOR PRICE
ELASTICITY OF SUPPLY

50. TEST YOUR UNDERSTANDING
Differentiate between Law of Supply and Price
Elasticity of Supply.
Law of Supply – Relationship between 2 variables
Price 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.

51. • 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
TEST YOUR UNDERSTANDING