Chapter 4 Using Demand and Supply

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Chapter 4Using Demand and Supply
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Sensitivity to Price Changes

• Firms need to know how much demand changes when
  prices change.
• Will an increase in price raise a firm's revenue
  even though the quantity sold falls?
• If a firm raises its price, it loses customers.
  How many?

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Price Elasticity and Revenues

• Firms earn revenue from sales total revenue TR
  pQ.
• If p rises but Q falls, what happens to TR? Which
  effect dominates?
• If ?p ? gt ?Q ?, then TR ?.
• If ?p ? lt ?Q ?, then TR ?.

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The Price Elasticity of Demand (a)

• e ? Qd/?p (?Qd/Qd)/( ?p/p).
• Elasticity of demand is always negative since
  when p increases Qd falls on any demand curve.
• e -4 ? Qd/?p means a 1 increase in price
  results in a 4 fall in sales
• Demand is very elastic.
• Consumers are very sensitive to small changes in
  price.
• If the price is 1, a 1 increase in price is 1
• In response the quantity demanded falls by 4, so
  1 out of every 25 consumers is sensitive to a 1
  change in the price.

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The Price Elasticity of Demand (b)

• Demand is more elastic when many very close
  substitutes are available.

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The Price Elasticity of Demand (c)

• Demand curves have different elasticities at
  different prices.
• If e gt 1, demand is elastic.
• If e 1, demand is unit elastic.
• If e lt 1, demand is inelastic.
• The cutoff point is an elasticity of 1.

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The Price Elasticity of Demand (d)
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Total Revenue

• The relationship between the price elasticity of
  demand and revenue changes when elasticity equals
  1.
• When the price rises, if e 1, then any increase
  in price will result in an equal decrease in
  quantity demanded, so TR remains constant.
• If e lt 1, inelastic demand, then any increase in
  price will result in a smaller decrease in
  quantity demanded, so TR rises.
• If e gt 1, elastic demand, then for any increase
  in price the result will be a large decrease in
  quantity demanded, so TR falls.

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Examples of Price Elasticity (a)

• Necessities, such as basic foods, have an
  inelastic demand since there are no close
  substitutes.
• The price elasticity for luxury goods is high.
• Price elasticity is a local measure.
• If e 4, then a 1 change in price causes a 4
  fall in the quantity demanded
• But we cannot say that a 20 increase in price
  causes an 80 decrease in the quantity demanded.

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Examples of Price Elasticity (b)
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Changing Elasticity Along a Demand Curve

• A given demand curve may have a section where
  demand is elastic, unit elastic and inelastic.

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Elasticity of Demand Over Time

• Demand curves tend to be more elastic in the long
  run as consumers have more time to adapt to price
  changes.

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The Price Elasticity of Supply

• Supply curves usually slope up, have positive
  slope.
• The elasticity of supply is usually positive.
• Supply elasticity ? Qs/?p (?Qs/Qs)/( ?p/p).

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Examples of the Elasticity of Supply

• The supply of oil is inelastic elasticity lt 1.
  So it is relatively difficult to increase the
  supply of oil.
• The supply of chicken is elastic elasticity gt 1.
  So it is relatively easy to increase the supply
  of chicken.

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Examples of the Elasticity of Supply
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Elasticity along the Supply Curve

• Different points on the supply curve have
  different elasticities.
• At low output, the elasticity of supply is quite
  high, while at high output it is quite low.

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The Short Run versus the Long Run (a)

• When a product can be stored, demand will be much
  more price sensitive in the short run than in the
  long run.
• Example cans of tuna are more price sensitive
  than emergency auto repairs.
• When a product or service is part of a system,
  demand will be much more price sensitive in the
  long run than in the short run.
• Example the price elasticity for gasoline was
  low following price jumps in 1970s because it
  took time to get rid of gas-guzzling automobiles.

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The Short Run versus the Long Run (b)

• The shorter the time frame, the less substitution
  is possible the longer the time frame, the more
  substitution is possible.
• In the short run, demand is less elastic than in
  the long run.
• In the short run, some inputs are fixed, so
  supply is difficult to change, while in the long
  run, all inputs are variable.
• As with demand, short-run elasticities of supply
  are lower than long-run elasticities of supply.
• Once a farm crop is planted, no more can be
  produced in that growing cycle, but in the long
  run, more or less acreage can be allocated to a
  crop.

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The Short Run versus the Long Run (c)
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Elasticity and Shifts in Demand and Supply (a)

• What are the effects of shifts of demand and
  supply on price and quantity?
• Depends on the elasticity of demand and supply.

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Elasticity and Shifts in Demand and Supply (b)

• In this Figure, the supply curve is nearly
  horizontal.
• If the demand shifts to the right, output
  increases but the price stays much the same. The
  shift in demand is reflected mostly in a change
  of quantity.

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Elasticity and Shifts in Demand and Supply (c)

• In this figure, the supply curve is close to
  vertical.
• Such a curve might arise from the market for
  original van Gogh paintings.
• If the demand shifts up and to the right, the
  quantity supplied remains the same but the price
  increases.
• The shifts in demand are reflected mostly in
  price changes.

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Elasticity and Shifts in Demand and Supply (d)

• In this figure, demand is fairly flat.
• Such a situation might arise with Coke, assuming
  that Pepsi is a perfect substitute.
• In this case, a shift in the supply curve is
  reflected primarily in a change of quantity.

is
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Elasticity and Shifts in Demand and Supply (e)

• In this figure, we have a vertical demand curve.
• This might occur for heart transplants.
• In this case, a shift in the supply curve is
  completely reflected in price.

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Long-Run versus Short-Run Adjustments

• In the long run, supply and demand are both more
  elastic than in the short run.
• So long-run supply and demand curves are both
  flatter than their short-run counterparts
• Therefore demand and supply shifts are reflected
  in prices to a greater extent in the short run
  than in the long run.

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Tax Policy and the Law of Supply and Demand a
10 cent tax
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Tax Policy and the Law of Supply and Demand (b)
(cont.)

• A tax on cheddar cheese would drive consumers to
  buy other cheeses, causing a sharp drop in
  quantity with only a small change in price.
• Consumers would pay a small part of the tax and
  cheddar cheese producers would pay most of the
  tax.

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Shortages and Surpluses (a)

• When Qd Qs, economists say that the market
  clears.
• Instances where the market does not clear are
  shortages or surpluses.
• A shortage means that people who are willing to
  pay the going price cannot find the good.
• A surplus means that goods go unsold at the going
  price.

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Shortages and Surpluses (b)

• In this figure, the horizontal gap between Qd and
  Qs is the size of the shortage. Consumers compete
  to get a bargain.

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Shortages and Surpluses (b) (cont.)

• In this figure, the horizontal gap between Qd and
  Qs is the size of the surplus.
• Now sellers compete to "move the merchandise."
• The rate of adjustment depends on the kind of
  market as well as the size of the surplus.

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Government Involvement

• Governments are often asked to interfere with the
  outcomes of the law of supply and demand because
  they are politically undesirable to some people.
• If rents on apartments are seen as too expensive,
  there will be pressure on city hall to regulate
  the market for apartments.
• If wages are seen as being too low, there will be
  pressure on the government to regulate the labor
  market.
• An obvious way to try to circumvent the law of
  supply and demand is to legislate the price of an
  object.
• Usually, such legislation involves either price
  ceilings or price floors.

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Price Ceilings

• Price ceilings are popular government controls on
  basic goods such as food, shelter, and oil.
• An example of a price ceiling is rent control.

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Price Ceilings (cont.)

• In the long run, the problem is worse.
• As this figure shows, long-run supply is more
  price elastic, so the effect of a price ceiling
  on quantity is more pronounced in the long run.

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Price Floors

• Agricultural subsidies Farmers participating in
  the federal commodity programs receive a target
  (floor) price for their crops.
• Price supports given to farmers are one of the
  most expensive price floors in the U.S. economy.

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Price Floors (cont.)

• If the market price for farmers' crops fall below
  this price floor, the U.S. Department of
  Agriculture pays them the difference.
• The Congressional Budget Office (CBO) has
  estimated the savings which would occur to the
  federal government if the price floor were
  reduced 3 a year starting in 1996.
• The estimated savings were 501 million in 1996,
  1.38 billion in 1997, 2.38 billion in 1998,
  3.34 billion in 1999, and over 4.1 billion in
  2000.
• The CBO also pointed out that many farmers might
  opt out of the price support framework.
• If they did, they would be free to plant as much
  or as little of a crop as they desired. This new
  found flexibility would lower their lost revenue.

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Alternative Solutions

• Attempts to get around the law of supply and
  demand generally do not work.
• If the government wants to solve social problems,
  it should try another way.
• If the government wants higher wages for
  unskilled labor, it can attempt to increase the
  demand for such labor.
• If it wants affordable housing, it can subsidize
  housing.
• Such methods often generate some problems of
  their own but are usually more effective than
  disregarding the law of supply and demand.