ECON200 Microeconomics Final Exam Study Notes Professor Peter Coughlin University of Maryland The Determinants of Elasticity of Demand The short run is a time period in which one or more important economic conditions cannot be changed The long run is a time period in which individual and firms are fully able to respond to economics incentives and take advantage of economic opportunities gasoline in the short run vs gasoline in the long run o when the price of gas rises there s not much people can do in the short run other than ride a bus or carpool in the long run people can buy smaller cars or live closer to where they work A demand curve is price elastic when the elasticity is greater than 1 Price elasticity of demand change in Q change in P 1 Perfectly elastic demand change in Q change in P A demand curve is inelastic when the elasticity is less than 1 Price elasticity of demand change in Q change in P 1 A demand curve is said to be unit elastic when the elastcitiy is equal to 1 Price elasticity of demand change in Q change in P 1 Price Elasticity and Revenues A firm gets revenue from selling its output Let R denote a firm s revenue o Let p denote the price of the firm s output o Let Q denote the quantity of output sold by the firm o o Using this notation R pQ Revenue Price x Quantity If p rises and Q falls what happens to R o Which effect dominates The answer depends on the price elasticity of demand o More specifically the relation between a firm s revenue and the price elasticity of demand hinges on a comparison of the absolute value of the elasticity with 1 o When D is elastic a price increase causes revenue to fall o When D is inelastic a price increase causes revenue to rise and a loss of revenue is due to lower Q When the price rises the quantity demanded will fall What happens to revenue o o o If e 1 elastic demand then the increase in price will result in a relatively large decrease in quantity demanded So revenue falls If e 1 inelastic demand then the increase in price will result in a relatively small decrease in quantity demanded So revenue rises If e 1 unit elastic demand then the two effects offset one another So revenue is constant Elasticity and Slope The slope of a demand curve o Slope p Q The slop of the linear demand curve is a constant The elasticity of a linear demand curve is not constant We can use price elasticity of supply to predict the effect of price changes on supply Price Elasticity of Supply change in Q change in p Supply curves usually have positive slopes o o But their sensitivity to price changes may vary If initially the price is low quantity is low the then elasticity of supply is high If inititally price is high quanitity is hight then the elasticity of supply is low Price Elasticity of Supply Elasticity zero perfectly Inelastic vertical supply curve o o Between 0 and 1 1 Inelastic Unitary Elastic o Greater than 1 undefined Elastic Perfectly Elastic horizontal supply curve Short Run vs Long Run Once the crop is planted no more can be produced in that growing cycle but in the long run more or less acreage can be allocated 10 10 Elasticity and its Application A market for wheat where the relevant part of the demand curve is inelastic Good news for farming o A new hybrid of wheat has been developed It increases production per acre by 20 o Affects supply but not demand An advance in farm technology increases the supply of wheat The equilibrium price of wheat decreases and the equilibrium quantity increases B c the demand for wheat is inelastic the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price from 3 to 2 A paradox of public policy Interest groups that represent farmers have gotten the U S govt to adopt policies that get some farmers to not plant crops o An economic paradox is a phenomenon that seems to be contradictory by received opinion or common sense When demand is inelastic an increase in supply has a bigger impact on price than on quantity When demand is inelastic a decrease in supply has a bigger impact on price than on quantity Elasticities of demand and supply can let us know the relative effects of a shift in a demand or supply curve on price and quantity When supply is elastic an increase in demand has a bigger impact on quantity than on price Ch 6 Supply Demand and Government Policies with the results of the law of supply and demand is a motivation for govt Dissatisfaction action This dissatisfaction arises from the outcome being politically unacceptable o Ex if rents on apartments are seen as too expensive then there may be pressure on the government to regulate the market for apartments An obvious way to try to circumvent the law of supply and demand is to legislate a restriction on the price of a good or service One type of price control o Price ceiling a legal maximum on the price of a good or service o Rent Control local govt imposes a maximum legal price With a shortage the goods must be rationed among the buyers Some rationing mechanisms 1 Long waiting lists 2 Preference given to tenants without children 3 Discrimination according to sellers biases e g on the basis of race 4 People who are willing to pay bribes to building superintendents Rent Control in the long run In the long run supply and demand are more price elastic So the shortage is larger Shortages Landlords lose their incentive to respond to tenants concerns Tenants get lower quality housing Another type of price control o Price floor a legal minimum on the price of a good or service If wages are believed to be too low then there may be pressure on the government to regulate the labor market Minimum wage laws do not affect highly skilled workers A minimum wage below the equilibrium wage is not binding and therefore has no effect on the market outcome The floor is binding on the wage and causes a surplus i e unemployment They do affect teen workers o Studies show a 10 increase in the minimum wage raises teen unemployment by 1 3 10 15 Evaluating Price Controls Prices are the signals that guide the allocation of society s resources o o This is allocation is altered when policymakers restrict prices Price controls often intend to help poor but end up hurting If govt is going to try to solve social problems there are good reasons to try another way Alternative Solutions o Attempts to get around the law of supply and demand generally do not work If govt wants higher wages for unskilled labor it can attempt to
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