Chapter 5 Applications of Supply and Demand

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1 1. Elasticity of Demand (E d ) Chapter 5 Applications of Supply and Demand Measures the responsiveness of Q d to a change in price. How much does Q d change (%) when P changes (%)? We can use a formula to calculate E d : Q d divided by P E d = Q d avg Pavg If E d > 1 then we say the price elasticity of demand is ELASTIC If E d < 1 then we say the price elasticity of demand is INELASTIC If E d = 1 then we say the price elasticity of demand is UNITARY

2 2. The Total Revenue Method Total Revenue (TR) = Price (P) x Quantity (Q) By calculating TR before and after a P change, we can determine the price elasticity of demand for a good, in that price range. The Total Revenue Rule: If P and TR move in the same direction, then E d is INELASTIC If P and TR move in the opposite direction, then E d is ELASTIC If P changes and TR remains the same, then E d is UNITARY 3. Factors Affecting Demand Elasticity AVAILABILITY OF SUBSTITUTES o Goods that have substitutes tend to be more elastic than goods that do not. NATURE OF THE ITEM o Goods that are necessities tend to be more inelastic than goods considered to be luxuries. FRACTION OF INCOME SPENT o The greater the proportion of income spent on a good, the more elastic it is. AMOUNT OF TIME AVAILABLE o Over time goods become more elastic because substitutes will be developed for them. 4. Elasticity of Supply (E s ) Measures the responsiveness of quantity supplied (Q s ) to a rise or fall in price. The same formula used for demand can be used here: Q s divided by P E s = Q s avg Pavg If E s > 1 then we say the price elasticity of supply is ELASTIC If E s < 1 then we say the price elasticity of supply is INELASTIC If E s = 1 then we say the price elasticity of supply is UNITARY

3 NOTE: The Total Revenue Method CANNOT be used with supply. Can you explain why? There is, however, a short cut to help determine E s 5. Factors Affecting Supply Elasticity TIME o The longer the time period the seller has increase production, the more elastic supply is. o Typically, in the short term, supply is INELASTIC and in the long term, supply is ELASTIC. EASE OF STORAGE o When the price of a good drops, the seller can try to sell it at the new price OR place it in storage (inventory) and wait for the price to go back up. o The easier it is to store something for prolonged periods of time, the more ELASTIC is the supply. COST FACTORS o Increasing output (supply) may be very costly, depending on the industry. o Supply is more elastic for industries that have lower input expenses. i.e. it is easier to increase the production of CD s compared to that of automobiles. 6. Government Intervention in The Markets For the most part, the governments of modern industrialized countries allow markets to operate relatively freely. There are times, however, when the government feels it is necessary to intervene (and they are usually wrong).

4 We will look at three examples: 1. If the government believes the price of a good is too high for consumers to afford, a price ceiling will be imposed. 2. If the government believes the price of a good is too low for sellers to make a profit, a price floor will be imposed. 3. If the government must intervene in the market for social or environmental reasons, a subsidy or quota will be introduced.

5 A. PRICE CEILINGS (To help consumers) If the ceiling price is set below equilibrium, a shortage will be the result. i.e. rent controls Another problem that may arise is the creation of an illegal or black market for the good in question. A final problem is that product quality may be affected as sellers try to reduce costs to regain profits lost by the imposed lower price. B. FLOOR PRICES (To help Sellers) A floor price set above equilibrium will create a surplus i.e. Minimum wage This creates the problem of what to do with the surplus. The government is usually forced to buy the surplus and dispose of it by either selling it on the world market, donating it to countries in need or turning it into some form of non-perishable good that can be stored. Consumers will be forced to pay higher prices for the product and receive less for their money. This will create problems if the consumers can find a cheaper substitute or do without the product. C. SUBSIDIES and QUOTAS A subsidy is a grant of money made to a particular industry by the government. o This will cause the supply to increase in the amount of the subsidy. o It will benefit buyers with lower prices and sellers with extra revenue. o Tax dollars are used to pay for this. o Some see this as a barrier to trade. i.e. unfair advantage A quota is a restriction placed on the amount of a product individual producers are allowed to make. o They are controlled by marketing boards e.g. milk o Raises farmer incomes and increases price of goods. o Works because food has inelastic demand.

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7 Price Ceilings: Natural Shortage Total Shortage Derived Shortage D S $1 000 E Price Ceiling = Shortage $ Can t go above the ceiling! # Natural Equilibrium is units at $ With the artificial price ceiling of $750: Natural shortage of Derived shortage of = Total shortage of 4 000

8 Price Floors: Natural Surplus Total Surplus Derived Surplus D S Can t go below the floor! $10 $5.00 E Price Floor = Surplus = Quota # Natural Equilibrium is 50 units at $5.00 With the artificial price floor of $10.00: Natural surplus of 20 + Derived surplus of 10 = Total surplus of 70

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