ECON 102.004 – Principles of Microeconomics

1. ECON 102.004 – Principles of Microeconomics S&W, Chapter 4 Using Demand and Supply Instructor: Mehmet S. Tosun, Ph.D. Department of Economics University of Nevada, Reno

2. Lecture Outline • Elasticity • Price elasticity of demand and supply • Elasticity and demand and supply shifts • Government intervention in markets • Shortages and surpluses

3. Sensitivity to Price Changes • Firms need to know how much demand changes when prices change. • Will an increase in price raise a firm's revenue even though the quantity sold falls? • If a firm raises its price, it loses customers. How many?

4. Price Elasticity and Revenues • Firms earn revenue from sales; total revenue TR = pQ. • If p rises but Q falls, what happens to TR? Which effect dominates? • If %p > %Q, then TR. • If %p < %Q, then TR.

5. The Price Elasticity of Demand (a) • e = %Qd/%p = (Qd/Qd)/(p/p). • Elasticity of demand isalways negative since when p increases Qd falls on any demand curve. • e = -4 = %Qd/%p means a 1% increase in price results in a 4% fall in sales • Demand is very elastic. • Consumers are very sensitive to small changes in price. • If the price is $1, a 1% increase in price is 1¢ • In response the quantity demanded falls by 4%, so 1 out of every 25 consumers is sensitive to a 1¢ change in the price.

6. The Price Elasticity of Demand (b) • Demand is more elastic when many very close substitutes are available.

7. The Price Elasticity of Demand (c) • Demand curves have different elasticities at different prices. • If e > 1, demand is elastic. • If e = 1, demand is unit elastic. • If e < 1, demand is inelastic. • The cutoff point is an elasticity of 1.

8. The Price Elasticity of Demand (d)

10. Total Revenue • The relationship between the price elasticity of demand and revenue changes when elasticity equals 1. • When the price rises, if e = 1, then any increase in price will result in an equal decrease in quantity demanded, so TR remains constant. • If e < 1, inelastic demand, then any increase in price will result in a smaller decrease in quantity demanded, so TR rises. • If e > 1, elastic demand, then for any increase in price the result will be a large decrease in quantity demanded, so TR falls.

11. Examples of Price Elasticity (a) • Necessities, such as basic foods, have an inelastic demand since there are no close substitutes. • The price elasticity for luxury goods is high. • Price elasticity is a local measure. • If e = 4, then a 1% change in price causes a 4% fall in the quantity demaned • But we cannot say that a 20% increase in price causes an 80% decrease in the quantity demanded.

12. Examples of Price Elasticity (b)

13. Use of Price Elasticities in Practice: An Example From Cigarette Tax Impact Calculations

14. Cigarette Tax Impacts • The impact of different cigarette tax increase scenarios for West Virginia • Price elasticity of demand for cigarettes is the key parameter • Cross-border sales and internet sales make demand more elastic than expected

15. Changing Elasticity Along a Demand Curve • A given demand curve may have a section where demand is elastic, unit elastic and inelastic.

16. Elasticity of Demand Over Time • Demand curves tend to be more elastic in the long run as consumers have more time to adapt to price changes.

17. The Price Elasticity of Supply • Supply curves usually slope up, have positive slope. • The elasticity of supply is usually positive. • Supply elasticity = %Qs/%p = (Qs/Qs)/(p/p).

18. Examples of the Elasticity of Supply • The supply of oil is inelastic; elasticity < 1. So it is relatively difficult to increase the supply of oil. • The supply of chicken is elastic; elasticity > 1. So it is relatively easy to increase the supply of chicken.

19. Examples of the Elasticity of Supply

20. Elasticity along the Supply Curve • Different points on the supply curve have different elasticities. • At low output, the elasticity of supply is quite high, while at high output it is quite low.

21. The Short Run versus the Long Run (a) • When a product can be stored, demand will be much more price sensitive in the short run than in the long run. • Example: cans of tuna are more price sensitive than emergency auto repairs. • When a product or service is part of a system, demand will be much more price sensitive in the long run than in the short run. • Example: the price elasticity for gasoline was low following price jumps in 1970s because it took time to get rid of gas‑guzzling automobiles.

22. The Short Run versus the Long Run (b) • The shorter the time frame, the less substitution is possible; the longer the time frame, the more substitution is possible. • In the short run, demand is less elastic than in the long run. • In the short run, some inputs are fixed, so supply is difficult to change, while in the long run, all inputs are variable. • As with demand, short‑run elasticities of supply are lower than long‑run elasticities of supply. • Once a farm crop is planted, no more can be produced in that growing cycle, but in the long run, more or less acreage can be allocated to a crop.

23. The Short Run versus the Long Run (c)

24. Elasticity and Shifts in Demand and Supply (a) • What are the effects of shifts of demand and supply on price and quantity? • Depends on the elasticity of demand and supply.

25. Elasticity and Shifts in Demand and Supply (b) • In this Figure, the supply curve is nearly horizontal. • If the demand shifts to the right, output increases but the price stays much the same. The shift in demand is reflected mostly in a change of quantity.

26. Elasticity and Shifts in Demand and Supply (c) • In this figure, the supply curve is close to vertical. • Such a curve might arise from the market for original van Gogh paintings. • If the demand shifts up and to the right, the quantity supplied remains the same but the price increases. • The shifts in demand are reflected mostly in price changes.

27. Elasticity and Shifts in Demand and Supply (d) • In this figure, demand is fairly flat. • Such a situation might arise with Coke, assuming that Pepsi is a perfect substitute. • In this case, a shift in the supply curve is reflected primarily in a change of quantity. is

28. Elasticity and Shifts in Demand and Supply (e) • In this figure, we have a vertical demand curve. • This might occur for heart transplants. • In this case, a shift in the supply curve is completely reflected in price.

29. Long‑Run versus Short‑Run Adjustments • In the long run, supply and demand are both more elastic than in the short run. • So long‑run supply and demand curves are both flatter than their short‑run counterparts • Therefore demand and supply shifts are reflected in prices to a greater extent in the short run than in the long run.

30. Tax Policy and the Law of Supply and Demand – a 10 cent tax

31. Tax Policy and the Law of Supply and Demand (b) (cont.) • A tax on cheddar cheese would drive consumers to buy other cheeses, causing a sharp drop in quantity with only a small change in price. • Consumers would pay a small part of the tax and cheddar cheese producers would pay most of the tax.

32. Shortages and Surpluses (a) • When Qd = Qs, economists say that the market clears. • Instances where the market does not clear are shortages or surpluses. • A shortage means that people who are willing to pay the going price cannot find the good. • A surplus means that goods go unsold at the going price.

33. Shortages and Surpluses (b) • In this figure, the horizontal gap between Qd and Qs is the size of the shortage. Consumers compete to get a bargain.

34. Shortages and Surpluses (b) (cont.) • In this figure, the horizontal gap between Qd and Qs is the size of the surplus. • Now sellers compete to "move the merchandise." • The rate of adjustment depends on the kind of market as well as the size of the surplus.

35. Government Involvement • Governments are often asked to interfere with the outcomes of the law of supply and demand because they are politically undesirable to some people. • If rents on apartments are seen as too expensive, there will be pressure on city hall to regulate the market for apartments. • If wages are seen as being too low, there will be pressure on the government to regulate the labor market. • An obvious way to try to circumvent the law of supply and demand is to legislate the price of an object. • Usually, such legislation involves either price ceilings or price floors.

36. Price Ceilings • Price ceilings are popular government controls on basic goods such as food, shelter, and oil. • An example of a price ceiling is rent control.

37. Price Ceilings (cont.) • In the long run, the problem is worse. • As this figure shows, long‑run supply is more price elastic, so the effect of a price ceiling on quantity is more pronounced in the long run.

38. Price Floors • Agricultural subsidies: Farmers participating in the federal commodity programs receive a target (floor) price for their crops. • Price supports given to farmers are one of the most expensive price floors in the U.S. economy.

39. Price Floors (cont.) • If the market price for farmers' crops fall below this price floor, the U.S. Department of Agriculture pays them the difference. • The Congressional Budget Office (CBO) has estimated the savings which would occur to the federal government if the price floor were reduced 3% a year starting in 1996. • The estimated savings were $501 million in 1996, $1.38 billion in 1997, $2.38 billion in 1998, $3.34 billion in 1999, and over $4.1 billion in 2000. • The CBO also pointed out that many farmers might opt out of the price support framework. • If they did, they would be free to plant as much or as little of a crop as they desired. This new found flexibility would lower their lost revenue.

40. Alternative Solutions • Attempts to get around the law of supply and demand generally do not work. • If the government wants to solve social problems, it should try another way. • If the government wants higher wages for unskilled labor, it can attempt to increase the demand for such labor. • If it wants affordable housing, it can subsidize housing. • Such methods often generate some problems of their own but are usually more effective than disregarding the law of supply and demand.