Price Ceilings The maximum legal price that can be charged Examples: Gasoline prices in the 1970s, Housing in New York City

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1 ECON4 (Fall 00) (Tutorial ) Chapter Market Forces: Demand and Supply Price Ceilings The maximum legal price that can be charged Examples: Gasoline prices in the 970s, Housing in New York City Graphical analysis Competitive equilibrium price: P * Shortage under the price ceiling Full economic price: the dollar amount paid to a firm under a price ceiling plus the non-pecuniary price P F = P c + (P F P C ) where P F = full economic price P C = price ceiling P F P C = non-pecuniary price The reduction in social welfare (Deadweight loss) How goods are allocated under the price ceiling? Why does the government impose price ceilings? Who will benefit and who will be worse off under the price ceiling? Price Floors The minimum legal price that can be charged Graphical analysis Competitive equilibrium price: P * Surplus/ unsold inventory under the price floor Why does the government impose price floors? Examples: Minimum wage, Agricultural price supports

2 Example: Demonstration problem -4 (P.54 of textbook) China recently accelerated its plan to privatize tens of thousands of state-owned firms. The estimates of the market demand and supply for the goods are given by Q d 0 P and Q s P respectively. Determine the competitive equilibrium price and quantity. Competitive equilibrium is determined when Q s = Q d 0 P P P * =, Q * = 6 Example: Demonstration problem -5 (P.56 of textbook) Based on the answers in problem -4, the government raises a concern that the free market price might be too high for the consumers and is planning to set a price ceiling of $.5. Determine (a) the quantity demanded, (b) the quantity supplied, (c) the amount of shortage and (d) the full economic price paid by the consumers if a price ceiling of $.5 is imposed in the market (a) Quantity demanded: d Q 0 (.5) 7 (b) Quantity supplies: s Q (.5) 5 (c) Shortage = units F (d) Full price: 5 0 P, P F =.5 ($.5 is in money and $ is the non-pecuniary price) Example: Demonstration problem -6 (P.59 of textbook) Based on the analysis in problem -4 and -5, the government worries that the free market price might be too high for the producers to earn a fair rate of return and is planning to set a price floor of $4. Determine (a) the quantity demanded, (b) the quantity supplied, and (c) the amount of surplus if a price floor of $4 is imposed in the market. (d) What is the cost to the Chinese government of buying the surplus under the price floor? (a) Quantity demanded: d Q 0 (4) s (b) Quantity supplied: Q (4) 0 (c) Surplus: 8 units (d) Cost of buying the surplus: 8 $4 = $3

3 Math supplement on Elasticity Own price elasticity of demand It measures the responsiveness of quantity demanded to a change in price E p %Q E Qx, Px % P Q Q Q P E Qx, Px P P P Q dq Q dq P E Qx, Px dp P dp Q Using the definition, we can discuss the relationship between the own-price elasticity and the slope of the demand curve. P dp Rearranging the definition, E Qx, Px Q dq dp/ dq is the slope of the demand curve Remarks: For a linear demand function, Q a bp where a is the x-intercept and b is the inverse slope (Q/P) P a / b Q / b where a/b is the y-intercept and /b is the slope Change in price We can forecast changes in quantity demanded as a function of the own-price elasticity, percentage change in price and the quantity demanded. dq Q dq P E Qx, Px, dp P dp Q dq dp Rearranging the definition, EQx, Px Q P Multiplying both side by 00, we have %Q = E %P Example: Given the linear demand function: Q = 6 p and the equilibrium price and quantity are $4 and 8 respectively. Find the elasticity of demand at the equilibrium. Q = 6 p P = 8 Q/ P dp 4 E Qx, Px Q dq 8 3

4 Chapter The Fundamentals of Managerial Economics Managerial economics: the study of how to direct scare resources in the way that most efficiently achieves a managerial goal The economics of effective management () Identify goals and constraints Sound decision making involves having well-defined goals. In striking to achieve a goal, we often face constraints. () Recognize the nature and importance of profits Economic profits VS Accounting profits Opportunity costs VS. Accounting costs Economic profits: Total revenue minus total opportunity cost. Profits as a signal to resource holders where resources are most highly valued by society. Resources will flow into industries that are most highly valued by society. Five forces model (3) Understand incentives Incentives play an important role within the firm. Incentives determine how resources are utilized and how hard individuals work. Managers must understand the role incentives play in the organization. Constructing proper incentives will enhance productivity and profitability. (4) Understand markets Consumer-Producer Rivalry: Consumers attempt to locate low prices, while producers attempt to charge high prices. Consumer-Consumer Rivalry: Scarcity of goods reduces consumers negotiating power as they compete for the right to those goods. Producer-Producer Rivalry: Scarcity of consumers causes producers to compete with one another for the right to service customers. The Role of Government: Disciplines the market process. (5) Recognize the time value of money FV Present Value VS Future Value: PV i n PV reflects the difference between the FV and the opportunity cost of waiting (OCW) PV = FV OCW FV FV FVn Present Value of a Series: PV... n i i i Net Present Value: NPV FV FV FVn... i i i C n 0 4

5 Present Value of a Perpetuity: Firm Valuation: PV Firm 0 PV Perpetuity CF CF CF... i i i Assuming that the firm s goal is to maximize profits, this means the present value of current and future profits, so the firm is maximizing its value. CF i t... t i i t i 3 (6) Use marginal analysis To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC. MB > MC means the last unit of the control variable increased benefits more than it increased costs. MB < MC means the last unit of the control variable increased costs more than it increased benefits. 5