Chapter 4Government Intervention in MarketsGovernment Intervention in MarketsPrice CeilingsSlide 5Price FloorsSlide 7Problems with the Rate of ChangeThe Elasticity ApproachPrice Elasticity of DemandCalculating Price Elasticity of DemandSlide 12Types of Demand CurvesSlide 14Slide 15Elasticity and Straight-Line Demand CurvesSlide 17Elasticity and Total RevenueSlide 19Determinants of ElasticityTwo Practical ExamplesIncome Elasticity of DemandSlide 23Cross-Price Elasticity of DemandPrice Elasticity of SupplyTaxes and Market EquilibriumAn Excise Tax on Sellers - AirlinesSlide 28An Excise Tax on BuyersSlide 30The War on DrugsSlide 32Slide 33Slide 34How Scholarships Increase College TuitionSlide 36Chapter 4Working withSupply and DemandECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western2Government Intervention in Markets •Excess demand –Quantity demanded exceeds quantity supplied –Sellers - short side of the market •Excess supply–Quantity supplied exceeds quantity demanded–Buyers - short side of the market3Government Intervention in Markets•Shortage–Excess demand not eliminated by a rise in price •Surplus–Excess supply not eliminated by a fall in price•When quantity supplied and quantity demanded differ, the short side of the market will prevail4Price Ceilings•A government imposed maximum price–Prevents the price from rising above a certain level•Creates a shortage•Unintended consequences–Black market•illegal•price above the ceiling–Long lines, higher prices5Price Ceilings60,00050,00040,000TEVRDS$4.003.002.00Number of Bottles of Maple Syrup per PeriodPrice per Bottle•Figure 1 A Price Ceiling in the Market for Maple Syrup1. A price ceiling lower thanthe equilibrium price…2. increases thequantity demanded3. and decreases thequantity supplied4. The result is a shortage – the distance betweenR and V5. With a black market, the lower quantity sellsfor a higher price than initially.6Price Floors•A government imposed minimum price–prevents the price from falling below a certain level•Creates a surplus–that no one wants at the imposed price•the government buys the excess supply•Get the government involved in production decisions–Rather than leaving them to the market7Price Floors200180 220$0.810.65KJSDAMillions of PoundsPrice per Pound•Figure 2 A Price Floor in the Market for Nonfat Dry Milk1.A price floor higherthan the equilibriumprice . . .2. decreases quantitydemanded…3.and increasesquantity supplied4. the result is a surplus(distance between K and J)8Problems with the Rate of Change•Price elasticity of demand–Measures the sensitivity of quantity demanded to a change in price•Problems with the rate of change (slope)–Not a good measure of elasticity•Depends on the units of measurement•Significance of a change in price or quantity9The Elasticity Approach•Price elasticity of demand (ED) –percentage change in quantity demanded divided by percentage change in price PQEDD%%10Price Elasticity of Demand•Negative•Percentage change in quantity demanded for each 1% change in price•The greater the ED the more sensitive quantity demanded is to price•Percentage Change–Use the midpoint formula•Change in variable divided by the average11Calculating Price Elasticity of Demand•%Change in Price •%Change in Quantity demanded 1 01 0( )% P2P PP P-D =+� �� �� �1 0D1 0( )% Q2Q QQ Q-D =+� �� �� �12Calculating Price Elasticity of Demand•Figure 3 Using the Midpoint Formula for ElasticityQuantity of Avocados per weekPricePerAvocadoAB4,500 5,500$1.501.001. Using the midpoint formula, the percentage drop in price is $0.50/$1.25 = 0.40 or 40% …2. and the percentage rise in quantity is 1,000 / 5,000 = 0.2 or 20%.3. Elasticity of demand for the move from A to B is 20% / 40% = 0.513Types of Demand Curves•Perfectly inelastic demand: ED=0•Inelastic demand: ED between 0 and 1•1% rise in price will cause quantity demanded to fall by less than 1% •Perfectly elastic demand: –ED approaching infinity•Elastic demand: ED >1•a 1% rise in price will cause quantity demanded to fall by more than 1%•Unit elastic demand: ED=114Types of Demand Curves•Figure 4 Categories of Demand CurvesPQ1009$11DPricerisesQuantity doesn’t changea) Perfectly Inelastic DemandPQ1059$11DPricerisesby 20%Quantity falls by less than 20%b) Inelastic Demand9515Types of Demand Curves•Figure 4 Categories of Demand CurvesPQ1159$11DPricerisesby 20%Quantity falls by more than 20%c) Elastic Demand85PQ100$9Consumers will buy any quantity at $9, none at a higher priced) Perfectly Elastic DemandD16Elasticity and Straight-Line Demand Curves•Figure 5 How Elasticity Changes along a Straight-Line Demand $2,000Price1,5001,00015,000 25,00035,000DQuantity of LaptopsABCEach time P drops by $500, the %ΔP is largerEach time Q rises by another 10,000, the%ΔQ is smaller.Elasticity falls as we move rightward along a straight-line demand curve17Elasticity and Straight-Line Demand Curves•Demand becomes less elastic (ED gets smaller) as we move downward and rightward.•Demand becomes more elastic (ED increases) as we move upward and leftward18Elasticity and Total Revenue•Total Revenue TR=PxQ•Inelastic Demand (ED < 1)•total revenue moves in same direction as price •Elastic Demand (ED > 1)•total revenue moves in opposite direction from price •Unitary elastic demand•total revenue remains the same as price changes19Elasticity and Total Revenue•Figure 6 Elasticity and Total RevenuePQ1059$11Da) Inelastic Demand95PQ1159$11Db) Elastic Demand85ABAB20Determinants of Elasticity1. Availability of substitutes2. Necessities vs. Luxuries3. Importance in the Buyer’s Budget4. Time Horizon•The demand is more price elastic:–close substitutes are easy to find–The less of a “necessity” (luxurious)–The more of total budgets spent on good–The longer the time horizon21Two Practical Examples1. Elasticity and Mass Transit•long-run demand for mass transit is inelastic•An increase in fares–would increase revenue–would decrease ridership 2. Elasticity and an Oil Crisis•to bring about 1% percent decrease in world oil demand•oil prices would have to rise by 6.67%22Income Elasticity of Demand•Percentage change in quantity demanded divided by the percentage change in income–percentage increase in quantity demanded for each 1% rise in incomeIncomeQEDY%%23Income
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