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What are elasticities of supply and demand?

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Lecture 2. The Elasticity of Supply and Demand What are elasticities of supply and demand? How do short-run and long-run elasticities differ? Applications of supply ... – PowerPoint PPT presentation

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Title: What are elasticities of supply and demand?


1
Lecture 2. The Elasticity of Supply and
Demand
  • What are elasticities of supply and demand?
  • How do short-run and long-run elasticities
    differ?
  • Applications of supply, demand and elasticity.
  • What are the effects of government intervention
    price controls?
  • Reading chapter 2

2
Elasticities of Supply and Demand
  • Not only are we concerned with what direction
    price and quantity will move when the market
    changes, but we are concerned about how much they
    change
  • Elasticity gives a way to measure by how much a
    variable will change with the change in another
    variable
  • Specifically, it gives the percentage change in
    one variable resulting from a one percent change
    in another

3
Warm-up exercise
  • People buy greeting cards and roses throughout
    the year. As Valentines Day approaches,
    however, cards and roses become necessities. The
    demand for both products jump and we expect the
    prices of both products to jump. The price of
    roses, however, always increases more sharply
    than the price of greeting cards. Why?

4
Price Elasticity of Demand
  • Measures the sensitivity of quantity demanded to
    price changes
  • It measures the percentage change in the quantity
    demanded of a good that results from a one
    percent change in price

5
Price Elasticity of Demand
  • The price elasticity of demand can also be
    written as
  • Since quantity demanded and price are
    negatively related,
  • we drop the negative sign.
  • e.g. the price elasticity of demand of 0.5
    means that every 1 increase in price leads to a
    0.5 decrease in quantity demanded.

6
Price Elasticity of Demand
  • The primary determinant of price elasticity of
    demand is the availability of substitutes
  • Many substitutes, demand is price elastic
  • Can easily move to another good with price
    increases
  • Few substitutes, demand is price inelastic
  • Necessities vs. discretionary expenditure
  • . . . Basic food vs. restaurant meals
  • Budget share
  • . . . salt vs. car
  • Time horizon

7
Price Elasticity of Demand
  • Looking at a linear demand curve, the slope of
    the curve is constant, but as we move along the
    curve, P and Q will change
  • so price elasticity along a linear demand curve
    is not constant
  • The top portion of a linear demand curve is
    elastic
  • Price is high and quantity small
  • The bottom portion of a linear demand curve is
    inelastic
  • Price is low and quantity high

8
Price Elasticity of a Linear Demand Curve
The top portion of demand curve is elastic Price
is high and quantity small The bottom portion of
demand curve is inelastic Price is low and
quantity high
0
9
  • Two extreme cases of demand curves
  • Infinitely elastic demand horizontal demand
    curve
  • Completely inelastic demand vertical demand curve

10
Infinitely Elastic Demand
EP ?
11
Completely Inelastic Demand
D
EP 0
Q
12
Other Demand Elasticities
  • Income Elasticity of Demand
  • Measures how much quantity demanded changes with
    a change in income

13
Other Demand Elasticities
  • Cross-Price Elasticity of Demand
  • Measures the percentage change in the quantity
    demanded of one good that results from a one
    percent change in the price of another good

14
  • Complements Cars and Tires
  • Price of cars increases, quantity demanded of
    tires decreases
  • Cross-price elasticity of demand is negative
  • Substitutes Butter and Margarine
  • Price of butter increases, quantity of margarine
    demanded increases
  • Cross-price elasticity of demand is positive

15
Price Elasticity of Supply
  • Measures the sensitivity of quantity supplied
    given a change in price
  • Measures the percentage change in quantity
    supplied resulting from a 1 percent change in
    price

16
Point vs. Arc Elasticities
  • Point elasticity of demand
  • Price elasticity of demand at a particular point
    on the demand curve
  • Arc elasticity of demand
  • Price elasticity of demand calculated over a
    range of prices

17
Short-Run Versus Long-Run Elasticity
  • Price elasticity varies with the amount of time
    consumers have to respond to a price
  • Short-run demand and supply curves often look
    very different from their long-run counterparts

18
Short-Run Versus Long-Run Elasticity
  • Demand
  • In general, demand is much more price elastic in
    the long run
  • Consumers take time to adjust consumption habits
  • Demand might be linked to another good that
    changes slowly
  • More substitutes are usually available in the
    long run

19
Gasoline Short-Run and Long-Run Demand Curves
  • People cannot easily adjust consumption in the
    short run.
  • In the long run, people tend to drive smaller
    and
  • more fuel efficient cars.

20
  • Demand and Durability
  • For some durable goods, demand is more elastic in
    the short run
  • If goods are durable, then when price increases,
    consumers choose to hold on to the good instead
    of replacing it
  • But in long run, older durable goods will have to
    be replaced

21
Short-Run Versus Long-Run Elasticity
  • Income elasticity also varies with the amount of
    time consumers have to respond to an income
    change
  • For most goods and services, income elasticity is
    larger in the long run
  • When income changes, it takes time to adjust
    spending

22
Short-Run Versus Long-Run Supply Elasticity
Most goods and services Long-run price
elasticity of supply is greater than short-run
price elasticity of supply
Due to limited capacity, firms are limited
by output constraints in the short run. In the
long run, they can expand.
23
Short-Run vs. Long-Run Elasticity An Application
  • Demand and supply are more elastic in the long
    run
  • In the very short run, supply is completely
    inelastic
  • E.g. Weather may destroy part of the fixed
    supply, decreasing supply
  • Demand is relatively inelastic as well
  • Price increases significantly

24
An Example - Coffee
A freeze or drought decreases the supply of
coffee
Price increases significantly due to inelastic
supply and demand
25
Elasticity An Application
  • During the 1980s and 1990s, the market for
    wheat went through changes that had great
    implications for American farmers and US
    agricultural policy
  • Using the supply and demand curves for wheat, we
    can analyze what occurred in this market

26
Elasticity An Application
  • Supply QS 1800 240P
  • Demand QD 3550 266P
  • At equilibrium QS QD
  • 1800 240P 3550 266P
  • 506P 1750
  • P 3.46 per bushel
  • Q 1800 (240)(3.46) 2630 million bushels

27
Elasticity An Application
  • We can find the elasticities of demand and supply
    at these points

28
Elasticity An Application
  • If the price of wheat rose to 4.00/bushel due to
    decrease in supply

29
Effects of Price Controls
  • Markets are rarely free of government
    intervention
  • Imposed taxes and granted subsidies
  • Price controls
  • Price controls usually hold the price above or
    below the equilibrium price

30
Policy 1 price ceiling
  • Price ceiling a legal maximum on the price (to
    be effective, it has to be lower than the
    equilibrium price)
  • Examples price ceiling on gasoline
  • rent control
  • Objectives of the price control promotion of
    equity (or to satisfy voters?)
  • What are the likely outcomes of the policy?

31
Effects of Price Ceiling
  • Price is regulated to be no higher than Pmax
  • Quantity supplied falls and quantity demanded
    increases
  • A shortage results

32
Effects of Price Ceiling
  • Excess demand sometimes takes the form of queues
  • Lines at gas stations during shortage
  • Sometimes get curtailments and supply rationing
  • Natural gas shortage of the mid 70s
  • Producers/suppliers typically lose, but some
    consumers gain. Some consumers lose.

33
Price Controls andNatural Gas Shortages
  • In 1954, the federal government began regulating
    the wellhead price of natural gas
  • In 1962, the ceiling prices that were imposed
    became binding and shortages resulted

34
Price Controls andNatural Gas Shortages
  • Price controls created an excess demand of 7
    trillion cubic feet
  • Price regulation was a major component of US
    energy policy in the 1960s and 1970s, and it
    continued to influence the natural gas markets in
    the 1980s

35
Questions for discussion
  • What are the problems with rent control?
  • Who will lose and who will gain?
  • What do you think are better alternatives to rent
    control?

36
A Rent Control
Search time increases
Black market may develop
S
b
24
Rent (dollars per unit per month)
e
20
a
16
D
12
0 44 72 100 150
Quantity (thousands of units per month)
37
Policy 2 price floor
  • Price floor a legal minimum on the price that
    can be charged (to be effective, it has to be
    higher than the equilibrium price)
  • Example minimum wage
  • Objectives of the price control promotion of
    equity (or to satisfy voters?)
  • what will be the impact on youth workers?

38
Policy 2 price floor
Without the price floor, the market equilibrium
is (p, q).
Price
With the price floor at pmin, there is excess
supply of qS - qD.
supply
As a result, unemployed young workers may rise.
pmin
and some may willing to accept lower (illegal)
wage rate in order to work
p
pill
demand
qS
qD
q
Quantity
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