Ch04

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Ch04

  1. 1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair CHAPTERCHAPTER 44 Prepared by: FernandoPrepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano The Price System, DemandThe Price System, Demand and Supply, and Elasticityand Supply, and Elasticity
  2. 2. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair The Price SystemThe Price System • The market system, also called theThe market system, also called the priceprice system,system, performs two important andperforms two important and closely related functions :closely related functions : • Price RationingPrice Rationing • Resource AllocationResource Allocation
  3. 3. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Price RationingPrice Rationing • Price rationingPrice rationing is theis the process by which theprocess by which the market system allocatesmarket system allocates goods and services togoods and services to consumers when quantityconsumers when quantity demanded exceedsdemanded exceeds quantity supplied.quantity supplied.
  4. 4. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Price RationingPrice Rationing • A decrease in supplyA decrease in supply creates a shortage atcreates a shortage at PP00. Quantity demanded. Quantity demanded is greater than quantityis greater than quantity supplied. Price willsupplied. Price will begin to rise.begin to rise. • The lower total supplyThe lower total supply isis rationed to thoserationed to those who are willing andwho are willing and able to payable to pay the higherthe higher price.price.
  5. 5. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Price RationingPrice Rationing • There is some priceThere is some price that will clear anythat will clear any market.market. • The price of a rareThe price of a rare painting will eliminatepainting will eliminate excess demand untilexcess demand until there is only one bidderthere is only one bidder willing to buy the singlewilling to buy the single available painting.available painting.
  6. 6. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Alternative Rationing MechanismsAlternative Rationing Mechanisms • A price ceilingprice ceiling is a maximum price that sellers may charge for a good, usually set by government. • QueuingQueuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services.
  7. 7. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Alternative Rationing MechanismsAlternative Rationing Mechanisms • Favored customersFavored 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 thatThe problem with these alternatives is that excess demand is created but not eliminated.excess demand is created but not eliminated.
  8. 8. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Alternative Rationing MechanismsAlternative Rationing Mechanisms • In 1974, theIn 1974, the government used angovernment used an alternative rationingalternative rationing system to distribute thesystem to distribute the available supply ofavailable supply of gasoline.gasoline. • At an imposed price ofAt an imposed price of 57 cents per gallon, the57 cents per gallon, the result was excessresult was excess demand.demand.
  9. 9. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Alternative Rationing MechanismsAlternative Rationing Mechanisms • AA black marketblack market is ais a market in which illegalmarket in which illegal trading takes place attrading takes place at market-determinedmarket-determined prices.prices.
  10. 10. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Alternative Rationing MechanismsAlternative Rationing Mechanisms • No matter how good the intentions of privateNo matter how good the intentions of private organizations and governments, it is veryorganizations and governments, it is very difficult to prevent the price system fromdifficult to prevent the price system from operating and to stop the willingness to payoperating and to stop the willingness to pay from asserting itself.from asserting itself. • With favored customers and black markets, theWith favored customers and black markets, the final distribution may be even more unfair thanfinal distribution may be even more unfair than that which would result from simple pricethat which would result from simple price rationing.rationing.
  11. 11. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Prices and the Allocation of ResourcesPrices and the Allocation of Resources • Price changes resulting from shifts of demand in outputPrice changes resulting from shifts of demand in output markets cause profits to rise or fall.markets cause profits to rise or fall. • Profits attract capital; losses lead to disinvestment.Profits attract capital; losses lead to disinvestment. • Higher wages attract labor and encourage workers toHigher wages attract labor and encourage workers to acquire skills.acquire skills. • At the core of the system, supply, demand, and prices inAt the core of the system, supply, demand, and prices in input and output markets determine the allocation ofinput and output markets determine the allocation of resources and the ultimate combinations of thingsresources and the ultimate combinations of things produced.produced.
  12. 12. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Supply and Demand Analysis:Supply and Demand Analysis: An Oil Import FeeAn Oil Import Fee • At a world price of $18,At a world price of $18, imports are 5.9 million barrelsimports are 5.9 million barrels per day.per day. • The tax on imports causes anThe tax on imports causes an increase in domestic production,increase in domestic production, and quantity imported falls.and quantity imported falls.
  13. 13. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair ElasticityElasticity • Elasticity is a general concept that can be usedElasticity is a general concept that can be used to quantify the response in one variable whento quantify the response in one variable when another variable changes.another variable changes. e l a s t i c i t y o f A w i t h r e s p e c t t o B A B = % % ∆ ∆ • Price elasticity of demandPrice elasticity of demand measures howmeasures how responsive consumers are to changes in theresponsive consumers are to changes in the price of a product.price of a product.
  14. 14. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Price Elasticity of DemandPrice 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. • 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. p r i c e e l a s t i c i t y o f d e m a n d % c h a n g e i n q u a n t i t y d e m a n d e d c h a n g e i n p r i c e = %
  15. 15. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Response to Price Changes Responsive Unresponsive Proportional Value of Elasticity ε > |1| ε < |1| ε = |1| Characteristics of Demand ElasticityCharacteristics of Demand Elasticity Type of Demand Elastic Inelastic Unitary elastic Magnitudes of Change %∆Qd > %∆P %∆Qd < %∆P %∆Qd = %∆P Type of Elasticity Elastic Inelastic Substitutes Available Many Few
  16. 16. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Type of Demand Elastic Inelastic Inclination Relatively Flat Relatively Steep Shape of Demand According to ElasticityShape of Demand According to Elasticity
  17. 17. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Extreme ElasticitiesExtreme Elasticities Elasticity Value ε = 0 ε =  Type of Elasticity Perfectly Inelastic Perfectly Elastic Substitutes Available None Infinite
  18. 18. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Hypothetical Demand ElasticitiesHypothetical Demand Elasticities for Four Productsfor Four Products PRODUCT % CHANGE IN PRICE (%∆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 % CHANGE IN QUANTITY DEMANDED (%∆Qd) ELASTICITY (%∆Qd/%∆P) Hypothetical Demand Elasticities for Four Products
  19. 19. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Calculating Percentage ChangesCalculating Percentage Changes • Elasticity is aElasticity is a ratio of percentagesratio of percentages, and it involves, and it involves computing percentage changes.computing percentage changes. % c h a n g e i n q u a n t i t y d e m a n d e d x 1 0 0 %2 = −Q Q Q 1 1 p r i c e e l a s t i c i t y o f d e m a n d = + − = − 1 0 0 % 3 3 3 % 3 0 . . • Using the values on the graph to compute elasticity, then: % c h a n g e i n p r i c e x 1 0 0 %2 = −P P P 1 1
  20. 20. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Computing the Value of ElasticityComputing the Value of Elasticity % % ( ) / ( ) / ∆ ∆ Q P Q Q Q Q P P P P d = − + − + 2 1 1 2 2 1 1 2 2 1 0 0 % 2 x x 1 0 0 % % % ( ) / ( ) / . . ∆ ∆ Q P d = − + − + = = − 1 0 5 5 1 0 2 1 0 0 % 2 3 3 2 2 5 7 5 1 6 7 x x 1 0 0 % x 1 0 0 % - 1 2 .5 x 1 0 0 % = 6 6 .7 % - 4 0 .0 % • The midpoint formula to compute elasticity is:
  21. 21. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Interpreting the Value of ElasticityInterpreting the Value 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. Here is how to interpret two different values of elasticity:
  22. 22. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Elasticity Changes along a Straight-LineElasticity Changes along a Straight-Line Demand CurveDemand Curve • Price elasticity of demandPrice elasticity of demand decreases as we movedecreases as we move downward along a lineardownward along a linear demand curve.demand curve. • Demand is elastic on the upper part of the demand curve and inelastic on the lower part.
  23. 23. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Elasticity Changes along a Straight-Elasticity Changes along a Straight- Line Demand CurveLine Demand Curve • Along the elastic range,Along the elastic range, elasticity values areelasticity values are greater than one.greater than one. − 6.4 − .29 • Along the inelastic range,Along the inelastic range, elasticity values are lesselasticity values are less than one.than one.
  24. 24. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Elasticity and Total RevenueElasticity and Total Revenue • When demand isWhen demand is inelasticinelastic, price and total revenues are, price and total revenues are directlydirectly related. Price increases generate higher revenues.related. Price increases generate higher revenues. • When demand isWhen demand is elasticelastic, price and total revenues are, price and total revenues are indirectlyindirectly related. Price increases generate lower revenues.related. Price increases generate lower revenues. Type ofType of demanddemand Value of EValue of Edd Change in quantityChange in quantity versus change inversus change in priceprice Effect of anEffect of an increase inincrease in price on totalprice on total revenuerevenue Effect of aEffect of a decrease in pricedecrease in price on total revenueon total revenue ElasticElastic Greater thanGreater than 1.01.0 Larger percentage changeLarger percentage change in quantityin quantity Total revenueTotal revenue decreasesdecreases Total revenueTotal revenue increasesincreases InelasticInelastic Less than 1.0Less than 1.0 Smaller percentageSmaller percentage change in quantitychange in quantity Total revenueTotal revenue increasesincreases Total revenueTotal revenue decreasesdecreases UnitaryUnitary elasticelastic Equal to 1.0Equal to 1.0 Same percentage changeSame percentage change in quantity and pricein quantity and price Total revenueTotal revenue does not changedoes not change Total revenue doesTotal revenue does not changenot change
  25. 25. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Determinants of Demand ElasticityDeterminants of Demand Elasticity • Availability of substitutesAvailability of substitutes ---- demand is more elastic when theredemand is more elastic when there are more substitutes for the product.are more substitutes for the product. • Importance of the item in theImportance of the item in the budgetbudget -- demand is more elastic-- demand is more elastic when the item is a more significantwhen the item is a more significant portion of the consumer’s budget.portion of the consumer’s budget. • Time frameTime frame -- demand becomes-- demand becomes more elastic over time.more elastic over time.
  26. 26. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Other Important ElasticitiesOther Important Elasticities • Income elasticity of demandIncome elasticity of demand – measures the– measures the responsiveness of demand to changes inresponsiveness of demand to changes in income.income. i n c o m e e l a s t i c i t y o f d e m a n d % c h a n g e i n q u a n t i t y d e m a n d e d c h a n g e i n i n c o m e = %
  27. 27. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Other Important ElasticitiesOther Important Elasticities • Cross-price elasticity of demand:Cross-price elasticity of demand: AA measure of the response of the quantity of onemeasure of the response of the quantity of one good demanded to a change in the price ofgood demanded to a change in the price of another good.another good. c r o s s - p r i c e e l a s t i c i t y o f d e m a n d % c h a n g e i n q u a n t i t y o f d e m a n d e d c h a n g e i n p r i c e o f = Y X%
  28. 28. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Other Important ElasticitiesOther Important Elasticities • Elasticity of supply:Elasticity of supply: A measure of theA measure of the response of quantity of a good supplied to aresponse of quantity of a good supplied to a change in price of that good. Likely to bechange in price of that good. Likely to be positive in output markets.positive in output markets. e l a s t i c i t y o f s u p p l y % c h a n g e i n q u a n t i t y s u p p l i e d c h a n g e i n p r i c e = %
  29. 29. © 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair Other Important ElasticitiesOther Important Elasticities • Elasticity of labor supply:Elasticity of labor supply: A measure of theA measure of the response of labor supplied to a change in theresponse of labor supplied to a change in the price of labor.price of labor. e l a s t i c i t y o f l a b o r s u p p l y % c h a n g e i n q u a n t i t y o f l a b o r s u p p l i e d c h a n g e i n t h e w a g e r a t e = %

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