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# CH 4 - Interference with Market Prices Price Control a...

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Unformatted text preview: Interference with Market Prices Price Control: a government control or regulation that sets or limits the price to be charged for a particular good. Two Broad Types of Price Controls: Price Floor Price Ceiling Price Ceilings and Floors Price Ceiling: a government price control that sets the maximum allowable price for a good or a service. Example: Rent control: a government price control that sets a maximum allowable rent to a house or an apartment. Price Floors Price Floor: a government price control that sets the minimum allowable price for a good or a service. Example: Minimum wage: a wage per hour below which it is illegal to pay workers. Figure 1: Effects of a MaximumPrice Law Figure 1: Effects of a MaximumPrice Law Figure 2: Effects of a MinimumPrice Law (Top graph) Figure 2: Effects of a MinimumPrice Law (Bottom Graph) Elasticity of Demand Price Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in the price of that good. The Midpoint Formula Q2 - Q1 (Q + Q ) / 2 1 ed = 2 P2 - P 1 (P + P ) / 2 1 2 Figure 3: Comparing Different Sizes of the Price Elasticity of Demand Elasticity of Demand The price elasticity of demand for the top graph in Figure 3 is: Price Elasticity of Demand 20% =- = -2 = 2 10% Note: A price elasticity of demand of 2 implies that a one percentage point increase in the price results in a two percentage point decrease in the quantity demanded. Size of the Elasticity: High versus Low The elasticity of demand for the bottom graph is: Price Elasticity of Demand 5% 1 1 =- =- = 10% 2 2 Note: A price elasticity of demand of 1/2 implies that a one percentage point increase in the price results in a onehalf percentage point decrease in the quantity demanded. The Midpoint Formula Recall Figure 4. If we use the midpoint formula to calculate the elasticity on the top graph, the elasticity of demand is: 60 - 48 20 - 22 ed = = -2.33 ( 60 + 48) / 2 ( 20 + 22) / 2 Talking About Elasticities Elastic Demand demand where the elasticity is greater than one. Inelastic Demand demand where the elasticity is less than one. Unit Elastic Demand demand where the elasticity is exactly equal to one. Talking About Elasticities Perfectly Inelastic Demand demand (or part of the demand curve) where the price elasticity is zero, indicating no response to a change in price. A perfectly inelastic demand curve is a vertical line. Perfectly Elastic Demand demand (or part of the demand curve) where the price elasticity is infinite, indicating an infinite response to a change in price. A perfectly elastic demand curve is a horizontal line. Figure 6: Perfectly Elastic and Perfectly Inelastic Demand Revenue and the Price Elasticity of Demand Revenue of a firm = (P X Q) = (price of a good) X (quantity of the good sold) FIGURE 7: Effects of an Increase in the Price of Oil on Revenue Revenue and the Price Elasticity of Demand Example: If people purchase 60 million barrels of oil at \$20, then the firm's revenues equal: Revenue = 60 million X \$20 = \$1200 million = \$1.2 billion Revenue and the Price Elasticity of Demand Figure 7 shows that if the price increases in an elastic demand curve, the firm revenues will decrease. If the price increases in an inelastic demand curve, the firm revenues will increase. Revenue and the Price Elasticity of Demand If in the inelastic region of a straightline demand curve, an increase (a decrease) in the price will result in an increase (a decrease) in revenues. If in the elastic region of a straightline demand curve, an increase (a decrease) in the price will result in a decrease (an increase) in revenues. What Determines the Size of the Price Elasticity of Demand? Determinants of the Price Elasticity of Demand: Degree of substitutability Bigticket versus littleticket items Temporary versus permanent price change Differences in preferences Longrun versus shortrun elasticity Degree of Substitutability Goods with a lot of substitutes have a high price elasticity of demand. Goods with few substitutes have a low price elasticity of demand. BigTicket versus LittleTicket Items If a good represents a large share fraction of people's income, then the price elasticity will be high. If a good represents a small share fraction of people's income, then the price elasticity will be low. Temporary versus Permanent Price Change If the price change is perceived to be temporary, then the price elasticity of demand will be high. If the price change is perceived to be permanent, then the price elasticity of demand will be low. Differences in Preferences Some goods have varying price elasticity of demand across different consumer groups. Examples: 1) New smokers have a higher price elasticity of demand for cigarettes than established (addicted?) smokers. 2) Retired persons have a lower price elasticity of demand for motor homes than persons in the 1826 age group. Long Run vs. Short Run The length of time elapsed since a price change affects the price elasticity of demand. Example: If the price of gasoline rises, the price elasticity of demand for gasoline may be lower for SUV owners in the short run (just immediately after the price change) than in the long run (when they can buy a different car). Some elasticities Jewelry Eggs Foreign Travel Cigarettes(1824) Cigarettes(2539) Cigarettes(40+) Gasoline (short run) Gasoline (long run) 2.6 .1 1.2 .6 .4 .1 .2 .7 Income Elasticity of Demand Income Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in income. Income Elasticity of Demand Income Elasticity of Demand If the income elasticity of demand is positive (i.e., you buy more as income increases), then the good is a normal good. If the income elasticity of demand is negative (i.e., you buy less as income increases), then the good is an inferior good. Note: With income elasticity of demand, it is incorrect to take the absolute value of the computed elasticity. Some income elasticities of demand Food Clothing/Footwear Transport Medical care Recreation .58 .88 1.18 1.35 1.42 CrossPrice Elasticity of Demand Cross Price Elasticity of Demand: the percentage change in the quantity demanded of a good divided by the percentage change in the price of a related good (a substitute or a complement). CrossPrice Elasticity of Demand If the crossprice elasticity of demand is positive (i.e., you buy more as price of the other good increases), then the two related goods are substitutes. If the crossprice elasticity of demand is negative (i.e., you buy less as price of the other good increases), then the two related goods are complements. Elasticity of Supply Elasticity of Supply: the percentage change in the quantity supplied of a good divided by the percentage change in the price of a same good. Price Elasticity of Supply Elastic versus Inelastic Supply Elastic Supply: supply where the price elasticity is greater than one. Inelastic Supply: supply where the price elasticity is less than one. Unit Elastic Supply: supply where the price elasticity is exactly equal to one. Perfectly Elastic versus Perfectly Inelastic Supply Perfectly Elastic Supply: supply where the price elasticity is infinite, indicating an infinite response to a change in price. A perfectly elastic supply curve is a horizontal line. Perfectly Elastic versus Perfectly Inelastic Supply Perfectly Inelastic Supply: supply where the price elasticity is zero, indicating no response to a change in price. A perfectly inelastic supply curve is a vertical line. Examples: The Mona Lisa Super Bowl Tickets Figure 10: Comparing Different Sizes of the Price Elasticities of Supply Figure 10: Comparing Different Sizes of the Price Elasticities of Supply Elastic vs. Inelastic Supply In the next slide, Figure 11 shows that the same shift in the demand for oil to the left results in a lower equilibrium price in the bottom graph, where the supply curve has a lower price elasticity than in the top graph, which has a higher price elasticity. Figure 11: Importance of Knowing the Size of the Price Elasticity of Supply Key Terms price control price ceiling price floor rent control minimum wage price elasticity of demand unitfree measure elastic demand inelastic demand perfectly inelastic demand perfectly elastic demand income elasticity of demand crossprice elasticity of demand price elasticity of supply perfectly elastic supply perfectly inelastic supply ...
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