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4
The Price System, Demand
and Supply, and Elasticity
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Price Rationing
A decrease in supply
creates a shortage at
the original price.
The lower supply is
rationed to those who
are willing and able to
pay the higher price.
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Price Rationing
There is some price
that will clear any
market.
The price of a rare
painting will eliminate
excess demand until
there is only one bidder
willing to buy the single
available painting.
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A price ceiling is a
maximum price that sellers
may charge for a good,
usually set by government.
In 1974, the government set
a price ceiling to distribute
the available supply of
gasoline.
At an imposed price of 57
cents per gallon, the result
was excess demand.
Principles of Economics, 7/e
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Queuing is a nonprice
rationing system that uses
waiting in line as a means of
distributing goods and
services.
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Attempts to restrict
prices often result in
the evolution of a
black market.
A black market is a
market in which illegal
trading takes place at
market-determined
prices.
Principles of Economics, 7/e
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Price Floors
A price floor is a minimum price
below which exchange is not
permitted.
The most common example of a price
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Consumer Surplus
Consumer surplus is
the difference between
the maximum amount a
person is willing to pay
for a good and its current
market price.
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Consumer Surplus
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Consumer Surplus
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Producer Surplus
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Producer Surplus
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Producer Surplus
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Elasticity
Elasticity is a general
concept that can be used
to quantify the response in
one variable when another
variable changes.
% A
e la s tic ity o f A w ith re s p e c t to B
% B
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23
1
10 5
5
slope
23
1
160 80
80
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Types of Elasticity
Hypothetical Demand Elasticities for Four Products
PRODUCT
% CHANGE IN
% CHANGE
IN PRICE QUANTITY DEMANDED
(%QD)
(%P)
ELASTICITY
(%QD d %P)
Insulin
+10%
0%
0.0
+10%
-1%
-0.1
Inelastic
Beef
+10%
-10%
-1.0
Unitarily elastic
Bananas
+10%
-30%
-3.0
Elastic
Perfectly inelastic
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Calculating Elasticities
Calculating percentage changes:
P2 P1
% c h a n g e in p ric e
x 100%
P1
Q2 Q
% c h a n g e in q u a n tity d e m a n d e d
Q1
x 100%
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Calculating Elasticities
Elasticity is a ratio of
percentages.
Using the values on the
graph to compute
elasticity, using
percentage changes
yields the following
result:
100%
p ric e e la s tic ity o f d e m a n d
3 .0
3 3 .3 %
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Calculating Elasticities
A more accurate way of
computing elasticity than
percentage changes is the
midpoint formula:
Q2 Q1
x 100%
% Qd
(Q 1 Q 2 ) / 2
P2 P1
% P
x 100%
( P1 P2 ) / 2
10 5
5
x 100%
x 100%
% Qd
(5 1 0 ) / 2
7 .5
2 3
-1
% P
x 100%
x 100%
(3 2 ) / 2
2 .5
6 6 .7 %
=
1 .6 7
- 4 0 .0 %
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Calculating Elasticities
Here is how to interpret two different
values of elasticity:
When = 0.2, a 10% increase in
price leads to a 2% decrease in
quantity demanded.
When = 2.0, a 10% increase in
price leads to a 20% decrease in
quantity demanded.
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Price elasticity of
demand decreases as
we move downward
along a straight line
demand curve.
Demand is elastic in
the upper range and
inelastic in the lower
range of the line.
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TR P Q
Value of Ed
Change in quantity
versus change in
price
Effect of an
increase in
price on total
revenue
Effect of a
decrease in price
on total revenue
Elastic
Greater than
1.0
Total revenue
decreases
Total revenue
increases
Inelastic
Smaller percentage
change in quantity
Total revenue
increases
Total revenue
decreases
Unitary
elastic
Equal to 1.0
Total revenue
does not change
Type of
demand
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The Determinants of
Demand Elasticity
Availability of substitutes -- demand
is more elastic when there are more
substitutes for the product.
Importance of the item in the budget
-- demand is more elastic when the
item is a more significant portion of
the consumers budget.
Time dimension -- demand becomes
more elastic over time.
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The Determinants of
Demand Elasticity
Nature of need that commodity satisfies For
luxury goods it is price elastic. For necessities it is
price elastic
Number of uses to which a commodity is put
when goods have multiple uses elasticity is more.
Consumer habits habitual consumers demand
for a commodity is inelastic irrespective of price
changes
Tied demand demand for goods tied to
others(complements) is normally inelastic
Price range goods which have high or low range
of price the demand is inelastic and goods with
middle range have elastic demand
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income elasticity of
demand
price floor
cross-price elasticity of
demand
inelastic demand
producer surplus
midpoint formula
queuing
deadweight loss
minimum wage
ration coupons
elastic demand
unitary elasticity
elasticity
elasticity of labor supply
perfectly inelastic
demand
elasticity of supply
price ceiling
favored customers
price elasticity of
demand
consumer surplus
price rationing
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