Chapter 5
Elasticity and Its
Applications
Second Edition
Chapter Outline
 The Elasticity of Demand
 The Elasticity of Supply
 Using Elasticities for Quick Predictions
(Optional)
 Takeaway
 Appendix 1: Using Excel to Calculate
Elasticities
 Appendix 2: Other Types of Elasticities
2
Elasticity of Demand
 We know there is an inverse relationship
between price and quantity demanded.
 But how much does quantity
demanded change when price
changes?
Elasticity of Demand
 Elasticity of demand - a measure of how
responsive the quantity demanded is to a
change in price
• more responsive equals more elastic.
 The slope of the demand curve is related
to the elasticity of demand.
Let’s see how this works.
4
Elasticity of Demand
price
$50
c
Price ↑ from $40 to $50:
• a → b less responsive
• a → c more responsive
b
a
40
Demand E
(more elastic)
Demand I (less elastic)
20
95 100
Quantity
5
Determinants of the Elasticity of Demand
 Ease in finding substitutes ***
• Easier → greater elasticity
 Time required to adjust to price changes
• Long term → more substitutes → greater elasticity
 The definition of the commodity
• Narrow definition → more substitutes → greater
elasticity
• Example: Coffee vs. specific brand
 Necessities versus Luxuries
 Share of budget devoted to the good.
• Larger share → greater elasticity
6
Determinants of the Elasticity of Demand
 Summary of Determinants of Elasticity of Demand
Less Elastic
More Elastic
Fewer Substitutes
More Substitutes
Short Run (less time)
Long Run (more time)
Necessities
Luxuries
Small Part of Budget
Large Part of Budget
Mathematics of Demand Elasticity
Elasticity of demand is always negative, so
we typically drop the negative sign and use
absolute value instead.
 If the |Ed| < 1, the demand curve is inelastic.
 If the |Ed| > 1, the demand curve is elastic.
 If the |Ed| = 1, the demand curve is unit elastic.
Calculating the Elasticity of Demand
 Elasticity measures the responsiveness of
quantity demanded to changes in price.
Elasticity
of demand
 Ed 

Percentage
change in quantity
Percentage
demanded
change in price
%  Q demanded
% P
 Usually interpreted using the absolute
value:
E  1  Elastic
d
E d  1  Inelastic
E d  1  Unit Elastic
9
Calculating the Elasticity: Midpoint Method
 We use the midpoint as the base:
Change in quantity
Ed 
%  Q demanded
%  Price

demanded
Average quantity
Change in price
Average
price
Q after  Q before

( Q after  Q before ) / 2
Pafter  P before
(P after  P before )/2
Let’s work an example.
10
Calculating the Elasticity: Midpoint Method
 Given:
Price
Quantity Demanded
Point a
$40
100
Point b
$50
20
2 0  1 00
 80
( 2 0  1 00 ) / 2
Ed 
 60
50  40
10
(50  4 0 )/2

 1 . 33
  6 .0
0 . 22
45
 What does this number mean?
11
Total Revenue and the Elasticity of Demand
 A firm’s revenues are equal to price per
unit times quantity sold.
• Revenue = Price x Quantity
 The elasticity of demand directly
influences revenues when the price of the
good changes.
Total Revenue and Elasticity of Demand
Inelastic Demand
Price
% P  %  Q d
Elastic Demand
Price
% P  %  Q d
Result: ↑TR
Result: ↓TR
$50
$50
40
40
Demand
Demand
95 100 Quantity
↓TR due to ↓Qd
20
↑TR due to ↑P
100
Quantity
13
Total Revenue and the Elasticity of Demand
 Knowing the value of the elasticity allows
us to understand what happens to total
revenue when the price changes.
 If…
E d  1  %  Q d  %  P  P and TR move in opposite
directions
E d  1  %  Q d  %  P  P and TR move in same direction
E d  1  %  Q d  %  P  TR is constant
We can use diagrams to see how this works.
14
Total Revenue and Elasticity of Demand:
Summary
 Summary: Total revenue and Ed
Elasticity and Revenue
Absolute Value
of Ed
Name
How Revenue
Changes with Price
|Ed | > 1
Elastic
TR and P move
together
|Ed | < 1
Inelastic
TR and P move in
opposite directions
|Ed | = 1
Unit Elastic TR remains the same
when price changes
15
Applications of Elasticity of Demand
How the American Farmer has Worked Himself Out of a Job:
• Increased agricultural productivity has the
supply of food BUT the supply of farmers….
• And
their revenues because the demand for
most agricultural products is inelastic.
Try it!
• Which is more elastic, the demand for
computers or the demand for Dell
computers? Why?
• The elasticity of demand for eggs has
been estimated to be 0.1. If the price
of eggs increases by 10%, what will
happen to total revenue of egg
producers?
To next
Try it!
Try it!
If a fashionable clothing store
raised its prices by 25 percent, what
does that tell you about the store’s
estimate of the elasticity of demand
for its products?
a) They think it’s elastic
b) They think it’s inelastic
To next
Try it!
The Elasticity of Supply
 Elasticity of supply – measures how
responsive the quantity supplied is to the a
change in price.
• more responsive equals more elastic.
 The slope of the supply curve is related to
the elasticity of supply.
Let’s see how this works.
19
The Elasticity of Supply
Elasticity of Supply Captures the Sensitivity of Quantity Supplied to
Changes in Price
Price
per Unit
The Same
Price
Increase
Inelastic Supply
Elastic Supply
$50
$40
…Causes a Small Increase in
Quantity Supplied if Supply is
Inelastic
80 85
170
Quantity
…Causes a Big Increase in Quantity
Supplied if Supply is Elastic
Determinants of the Elasticity
of Supply
 How much per-unit costs ↑ as production ↑
• Greater ↑ in per unit costs → ↓ elasticity of
supply.
• Examples:
 Elasticity of supply tends to be low for raw
materials like oil and coal.
 Elasticity of supply tends to greater for
manufactured goods
 Local supply is more elastic than the global
supply. Why?
21
Determinants of the Elasticity
of Supply
 Consider two polar cases
Picasso painting
Price Perfectly inelastic supply
Quantity
Toothpicks
Price
Perfectly elastic supply
Quantity
22
Mathematics of Supply Elasticity
 If the Es < 1, the supply curve is inelastic.
 If the Es > 1, the supply curve is elastic.
 If the Es = 1, the supply curve is unit elastic.
Determinants of the Elasticity of Supply:
Summary
Primary Factors Determining the Elasticity of Supply
Less Elastic
More Elastic
Difficult to increase
production at constant unit
cost (e.g., some raw
materials)
Large share of market for
inputs
Easy to increase production
at constant unit cost. (e.g.,
some manufactured goods)
Global supply
Local supply
Short-run
Long-run
Small share of market for
inputs
24
Calculating the Elasticity of Supply
 Measure of the responsiveness of quantity
supplied to a change in price
 Computed by
Elasticity
of supply  E s 

Percentage
change in quantity
Percentage
supplied
change in price
%  Q supplied
% P
25
Calculating the Elasticity: Midpoint Method
 Again, we use the midpoint as the base
Change in quantity
Es 
%  Q supplied
%  Price

supplied
Average quantity
Change in price
Average
price
Q af ter  Q bef ore

( Q af ter  Q bef ore ) / 2
Paf ter  Pbef ore
(P af ter  Pbef ore )/2
26
Applications of Supply Elasticity: Gun
Buyback Programs
 Gun buyback programs
• Several cities in the U.S. have spent millions of
dollars buying guns with “no questions asked”.
• Objective
 Reduce the number of guns on the streets in order to…
 Lower crime rates.
 Principles of economics predict these
programs are unlikely to reduce the number
of guns on the streets of these cities. Why?
27
Applications of Supply Elasticity: Gun
Buyback Programs




Demand for guns will increase.
Guns will be imported to sell to the police.
People will sell old, low quality guns
Result
• The supply of guns is perfectly elastic to the
city.
 Price of guns does not increase
• No fewer, but higher quality, guns are on the
streets.
Let’s use our model to see this.
28
Applications of Supply Elasticity: Gun
Buyback Programs
Price of low quality guns
Increase in supply = buyback
Supply of old, low
quality guns (perfectly
elastic)
$84
Demand w/buyback
Demand w/o buyback
1,000
6,000
Quantity of guns
traded
29
Takeaway
 Elasticities of demand and supply help us
quantify…
• The effects of shifts in the demand and supply
curves.
• How revenues respond to changes in price
along a demand curve
 You should know how to calculate these
elasticities using data on prices and
quantities.
30
End of Chapter 5
Second Edition
Chapter 6
Taxes and Subsidies
Second Edition
Chapter Outline
 Commodity Taxes
 Subsidies
33
Commodity Taxes
 We will emphasize the following:
1. Who ultimately pays the tax is not dependent
on who writes the check
2. Who ultimately pays the tax does depend on
the relative elasticities of supply and
demand.
3. Commodity taxation raises revenue and
creates lost gains from trade (deadweight
loss)
Let’s look at each of these in turn.
34
Who Ultimately Pays the Tax
 Assume a 1$ per basket tax on apples.
 Government can collect the tax in two
ways:
• From the seller
• From the buyer
 It doesn’t matter which way is chosen.
Let’s use our model to analyze each.
35
Commodity Tax Collected From the Seller
Price of Apples
(per basket)
Commodity tax = $1
1. Supply shifts up by $1
Supply w/tax 2. Seller wants to charge $3
3. At $3: Qd < Qs → surplus
4. Price ↓ → Qd ↑and Qs ↓ →
500
Supply w/o tax
Result:
$1
 Seller’s net price = $1.65
 Buyer’s net price = $2.65
 Burden of the tax
• Buyer - $0.65
• Seller - $0.35
$4
3
2.65
2
1.65
1
Demand
400 500
700
Quantity of
1,250 Apples (baskets)
36
Commodity Tax Collected From the Buyer
Price of Apples
(per basket)
$4
3
Commodity tax = $1
1.
2.
3.
4.
Demand w/o tax
Demand
w/tax
Supply
2.65
2
1.65
1
Buyer wants to pay $1.00
Demand shifts down by $1
At $1: Qd > Qs → shortage
Price ↑→ ↑Qs and Qd ↓ →
↑Qs → 500
Result:
 Buyer’s net price = $2.65
 Seller’s net price = $1.65
 Burden of the tax
• Buyer - $0.65
• Seller - $0.35
$1
200
500
700
Quantity of
1,250 Apples (baskets)
37
The Burden of the Tax Depends on the
Relative Elasticities of Demand and Supply
 The Wedge shortcut
• Tax wedge – a vertical line measuring the
difference between the price paid by buyers
and the price received by sellers.
• This tool simplifies our analysis
• The output where the wedge “fits” between the
demand and supply curves tells us…
 the after tax price consumers pay
 the after tax price that sellers receive.
Let’s go to our model now.
38
Using the Tax Wedge
Price of Apples
(per basket)
Tax Wedge = $1
Price buyers pay
$4
3
Supply
2.65
2
1.65
Price sellers
receive
1
200
500
700
Demand
Quantity of
1,250 Apples (baskets)
39
The Burden of the Tax Depends of the
Elasticities of Supply and Demand
 An elastic demand curve means that buyers
can substitute
 An elastic supply curve means that workers
and capital can easily find work in another
industry
 Result
• When demand is more elastic than supply, buyers
pay less of the tax
• When supply is more elastic than demand, sellers
pay less of the tax
• In other words elasticity = escape
Let’s use the model to show this
40
The Burden of the Tax Depends of the
Elasticities of Supply and Demand
Case I: Demand is more elastic than supply
Price
Supply
Price paid
by buyers
Result:
Most of the tax is paid
By sellers
Pno tax
Tax
Wedge
Demand
Price received
by sellers
Qw/tax Qno tax
Quantity
41
The Burden of the Tax Depends of the
Elasticities of Supply and Demand
Case II: Supply is more elastic than demand
Price paid
by buyers
Tax
Wedge
Result:
Most of the tax is paid
By buyers
Price
Supply
Pno tax
Price received
by sellers
Demand
Qw/tax
Qno tax
Quantity
42
SEE THE INVISIBLE HAND
This pleasure boat seems like a good thing to tax…
Or not: The Omnibus Budget Reconciliation Act of 1990
applied a 10% federal luxury tax to the retail sale of luxury
goods like pleasure boats with a sales price above $100,000.
Expected tax revenue? $9 billion. Reality?
The federal luxury tax was repealed in 1993.
•Sales of boats down 52.7%;
• Net loss of 30,000 jobs;
• The federal government paid out > $7 million
more in unemployment benefits to those workers
than it collected in luxury tax revenues.
BACK TO
Health Insurance Mandates and Tax
Analysis
 Suppose government mandates that firms
buy health insurance for its workers.
• Think of this as a tax on labor.
 Who actually pays for the health
insurance?
• Depends which is more elastic: supply or
demand
• That is, which is easier:
 For firms to escape the tax by not employing?
 For workers to escape the tax by not working?
44
Health Insurance Mandates and Tax
Analysis
 Firms can escape the tax in lots of ways
• Substitute capital for labor.
• Move operations overseas.
• Close up shop.
 It is more difficult for workers to escape the
tax
• Most workers will work at a lower wage
• The cost of leaving the labor force is high
 Conclusion: demand is more elastic than
supply
 Result: most of the tax is paid by workers.
45
Who Pays the Cigarette Tax?
 Because nicotine is addictive,
demand is inelastic.
 Taxes are imposed by states.
 A manufacture can easily
escape these taxes by selling…
• Overseas
• Other states
 Conclusion: Supply elasticity is very high
 Result: most of tax is paid by buyers.
46
Who Pays the Cigarette Tax
 An interesting test
• If buyers pay almost all of the tax, the after tax
price paid by sellers must be equal in all
states.
• This table shows that is the case.
After tax
price paid
by buyers
After tax
price
received
by sellers
South Carolina $0.07
$3.35
$3.28
New Jersey
$6.45
$3.88
Year
2000
Tax per
Pack
$2.57
47
A Commodity Tax Raises Revenues
and Creates Lost Gains From Trade
 Lost gains from trade = deadweight loss
 Tax increases reduce consumer and
producer surplus
Let’s use our model to show this.
48
A Commodity Tax Raises Revenues
and Creates Lost Gains From Trade
Price
Price
No Tax
With Tax
Consumer
Consumer
surplus
surplus
S
$2.65
$2.00
Tax wedge
S
Deadweight
loss
D
$2.00
D
$1.65
Producer
surplus
Producer
surplus
700
Q
Government
revenue
500
Q
700
49
Try it!
What is the tax revenue that the
government collects from the tax
on gadgets?
a) $350
b) $450
c) $100
d) $550
To next
Try it!
A Commodity Tax Raises Revenues and
Creates Lost Gains From Trade
 Elasticities of demand and supply
determine consumer and producer surplus
• The greater these elasticities, the greater will
be the deadweight loss
Let’s use our model to show this.
51
A Commodity Tax Raises Revenues and
Creates Lost Gains From Trade
Case I: Elastic Demand
Price
Pw/tax
Pno tax
Tax wedge
Tax
Revenue
Deadweight
loss
Supply
Demand
Qw/ tax
Qno tax
Quantity
52
A Commodity Tax Raises Revenues and
Creates Lost Gains From Trade
Case II: Inelastic Demand
Price
Pw/tax
Pno tax
Tax wedge
Tax
Revenue
Deadweight
loss
Supply
Demand
Qw/ tax Qno tax
Note:
 Tax rate and Tax revenue
are the same as before.
 Deadweight loss is much
smaller.
Quantity
53
A Commodity Tax Raises Revenues and
Creates Lost Gains From Trade
Case III: Elastic Supply
Price
Tax wedge
Deadweight
loss
Pw/tax
Pno tax
Supply
Tax
Revenue
Demand
Qw/ tax
Qno tax
Quantity
54
A Commodity Tax Raises Revenues and
Creates Lost Gains From Trade
Note:
 Tax rate and Tax revenue
are the same as before.
Tax wedge
Supply  Deadweight loss is smaller.
Case IV: Inelastic Supply
Price
Pw/tax
Pno tax
Tax
Revenue
Deadweight
loss
Demand
Qw/ tax Qno tax
Quantity
55
Try it!
• Suppose that the government taxes insulin
producers $50 per dose produced. Who is
likely to pay this tax?
• Although the government taxes almost
everything, would the government rather
tax items that have relatively inelastic or
relatively or relatively elastic demands and
supplies? Why?
To next
Try it!
Subsidies
 A subsidy is a reverse tax
 Important facts about commodity subsidies
1. Who gets the subsidy does not depend on who
gets the check from the government.
2. Who benefits from the subsidy does depend on
the relative elasticities of demand and supply.
3. Subsidies…
1.
2.
Are paid for by taxpayers
Result in inefficient increases in trade (deadweight
loss)
 We can use the same wedge shortcut as
before.
Let’s use our model to analyze subsidies.
57
Subsidies
Price of apples
Per basket
$4
Deadweight
loss
Supply
3
Price received
By sellers = $2.40
Subsidy
wedge
2
Price paid
By buyers = $1.40
1
Demand
700
900
Quantity of apples
(baskets)
58
Taxes and Subsidies Compared
 Whoever Bears the Burden of the Tax Receives
the Benefits of a Subsidy
Price
Price paid
by buyers
Price received
by sellers
Supply
Benefit
of subsidy
on sellers
Subsidy
wedge
Pno
tax
no subsidy
Tax
wedge
Price received
by sellers
Price paid
by buyers
Burden
of tax on
sellers
Q with
tax
Demand
Q no
tax
no subsidy
Q with
Quantity
subsidy
59
Try it!
Who benefits most from the large
agricultural water subsidy?
Farmers in California’s Central Valley typically pay $20-$30 an
acre-foot for water that costs $200-$500 an acre-foot
Hint: which is more elastic: demand or supply for cotton?
a) California cotton suppliers
b) California cotton buyers
To next
Try it!
King Cotton and the Deadweight Loss of
Water Subsidies
Price of Cotton
Price
Sellers
receive
World
Market
price
Supply of
California Cotton
Total subsidy payments
received by farmers
Subsidy wedge
Demand
For California
Cotton
Can you see why sellers of
Cotton lobby for subsidies,
not buyers?
Qno subsidy Qw/subsidy
Quantity
of Cotton
61
Wage Subsidies
 Edmund Phelps – Nobel Prize winner
• Wage subsidies can be used to increase
employment of low wage workers.
• Although costly, they may reduce
 Welfare payments.
 Crime
 Drug dependency
 “Rational defeatism”
• A better alternative to the minimum wage.
Let’s analyze a wage subsidy program.
62
Wage Subsidies
Wage
Wage received
by workers
Cost to
taxpayers
Supply
of Labor
$12
Market wage
= $10.50
Subsidy
Wedge = $4
$8
Demand
for labor
Wage paid
by firms
Qm
Qs
Quantity
of labor 63
Try it!
• The U.S. government subsidizes college
education in the form of Pell grants and
lower-cost government Stafford loans. How
do these subsidies affect the price of
college education? Which is relatively more
elastic: supply or demand? Who benefits
the most from these subsidies: suppliers
(colleges) or demanders of education
(students)?
To next
Try it!
Try it!
If demand of some good is more elastic than
supply and a tax is imposed on the
consumption of the good, who will bear more
of the burden of the tax?
a) Producers, because consumers have a
greater ability to change their behavior in
response to the tax.
b) Both parties will share the burden equally.
c) Consumers, because they pay the tax out of
pocket.
d) The government, because the tax will cause
less of the good to be produced and
consumed.
To next
Try it!
Takeaway
 Taxes decrease the quantity traded.
 Subsidies increase the quantity traded.
 The burden of the tax and the benefit of the
subsidy do not depend on who sends or
receives the government check.
 The side of the market that is more elastic will
escape more of the tax and receive less of the
benefit of the subsidy.
 The greater the elasticity of demand or supply
the greater will be the deadweight loss.
66
End of Chapter 6
Second Edition
Chapter 8
Price Ceilings and
Floors
Second Edition
Chapter Outline




Price Ceilings
Rent Control (optional section)
Arguments for Price Controls
Price Floors
69
Introduction
 August 1971 – President Nixon imposed
wage and price controls in the U.S.
• Made it illegal to trade at a higher price even if
both buyer and seller agreed to the higher price.
• Supposed to be in effect for 90 days
• Had lasting effects for over 10 years
 We will show how price controls…
• Affect a single market
• Delink some markets and link other markets in
ways that are counterproductive.
70
Price Ceilings
 Price ceiling – a maximum price allowed by
law
 Five important effects
1.
2.
3.
4.
5.
Shortages
Reductions in product quality
Wasteful lines and other search costs
A loss in gains from trade
A misallocation of resources
 Let’s look at each one in turn.
71
Shortages
 When the price ceiling is below the market
price…
• Quantity demanded is greater than quantity
supplied: Qd > Qs
 We call this a shortage
• A shortage is different from scarcity
 Scarcity is reflected in the market price
 Shortage is due only to a price ceiling
 The lower the ceiling price is below the
market price, the greater the shortage
72
Shortages
 Shortages appeared soon after prices were
frozen in 1971
• ↑ demand for housing → ↑ demand for
materials (inputs) needed to build houses
• Normally this would result in ↑ price of inputs
→ a signal to produce more inputs.
 With fixed prices, this signal was missing.
• Shortages of inputs: lumber, steel bars, toilets
and other materials were common.
Let’s use our model to examine a price ceiling.
73
Price Ceilings Create Shortages
Price of gasoline
per gallon
Supply
Market
Equilibrium
Controlled Price
(ceiling)
Shortage
Qs
Demand
Qd
Quantity
74
Shortages
 A shortage of vinyl in
1973 forced Capitol
Records to melt down
slow sellers so they
could keep pressing
Beatle’s albums.
75
Reductions in Quality
 One way to evade price controls is to lower
quality
• Printing books on lower quality paper
• Shrinking 2” x 4” lumber to 15/8” x 35/8”
• Fewer coats of paint on new automobiles
• Some newspapers switched to a smaller font size.
76
Reductions in Quality
 Another way to lower
quality is to reduce
service
 With a surplus of
buyers, sellers have
less of an incentive to
give good service.
• Full service gas stations disappeared in 1973.
• Owners would close whenever they wanted to
take a break.
77
Reductions in Quality
 The great matzo ball
debate
 In 1972 George
Meany, AFL-CIO boss
complained that his
favorite soup, Mrs.
Adlers, had shrunk from 4 to 3 matzo balls!
 The chairman of the wage and price
commission had his staff count the number of
balls in many can’s of Mrs. Adler’s soup.
78
Wasteful Lines and Other Search Costs
 There are other ways
of paying for gas
• Some buyers might
try bribing the station
owners
• Another way is to be
willing to wait in line.
• Time waiting in line is also a cost.
 How long will the line get?
Let’s answer this question using our model.
79
Wasteful Lines and Other Search Costs
Price of gasoline
per gallon
Willingness to
pay for Qs = $3
Controlled
Price = 1
(ceiling)
Supply
Market
Equilibrium
At the controlled price:
Total
Value of
Wasted
time
 Quantity supplied = Qs
 Buyers are willing to pay
$3/gallon
 Line will grow until the time
cost per gallon $3 - $1
= $2.00/gallon
Demand
Shortage
Qs
Qd
Quantity80
Wasted Time and Other Search Costs
 What’s the difference between paying
a bribe and waiting in line?
• Waiting in line is more wasteful!
 A bribe goes to the station owner.
 Time waiting in line is lost; it benefits no
one.
81
Lost Gains From Trade
 Deadweight loss – total of lost consumer
and producer surplus when not all mutually
profitable gains from trade are exploited.
 As long as P
 P
consumers
are willing
to pay
sellers are
willing to
accept
there are mutually profitable trades that
can be made.
 Price ceilings create a deadweight loss
Let’s go to our model again.
82
Price Ceilings: Reduce Gains From Trade
Price of gasoline
per gallon
Lost
consumer
surplus
Lost
producer
surplus
A + B = Lost gains
from trade
$3
Market price
Controlled
Price = 1
(ceiling)
Total
Value of
Wasted
time
A
Market
Equilibrium
B
Demand
Shortage
Qs
Supply
Qd
Quantity
83
Misallocation of Resources
 When prices are controlled, resources do
not flow to their highest valued uses.
• Example: When it gets cold in the Northeast,
the demand for heating oil goes up.
 If the price is allowed to rise…
• There is a greater incentive to produce more heating oil.
• The incentive to consume less heating oil increases.
• This provides a signal for more heating oil to be delivered
to Maine instead of California.
 If the price is fixed…
• Swimming pools in California are heated
• Homes in Maine are cold
Let’s use our model to show this.
84
Misallocation of Resources
Price
($)
Highest-valued
uses
Supply
Price control prevents
highest valued uses
from outbidding lower
Lower-valued
valued uses.
uses
Result: some oil flows
to lower valued uses
$3
Controlled
Price
(ceiling)
Least-valued
uses
Shortage
Qs
Demand
Qd
Quantity
85
The Loss From Random Allocation
 Let’s ignore wasteful time and search costs
 The maximum CS is the area between the
demand curve and the controlled price up to
the quantity supplied with the controlled price.
 Because the good is not necessarily allocated
to the highest values uses…
• Consumer surplus will be less
• How much less?
• Let’s do some reasonable calculations
86
The Loss From Random Allocation
 Best case scenario
• Buyers with the highest valued uses get in line
first.
 Worst case scenario
• All goods are allocated to the lowest value uses.
 Random allocation scenario
• Let’s assume that goods are allocated randomly
with equal probabilities for each user.
• Suppose: Highest price any buyer is willing to pay
= $30; controlled price = $6.
• Average price consumers would be willing to pay
= ½ ($30) + ½ ($6) = $18
87
The Loss From Random Allocation: Best
Case Scenario
Price of gasoline
per gallon
Highest-valued
uses
Supply
Willingness to
pay for Qs = $3
Best Case Scenario:
 Buyers with the highest
valued uses get the
goods
 CS = total green area
Controlled
Price = 1
(ceiling)
Demand
Shortage
Qs
Qd
Quantity88
The Loss From Random Allocation: Worst
Case Scenario
Price of gasoline
per gallon
Loss to random allocation
Supply
Willingness to
pay for Qs = $3
Worst Case
Scenario:
Lower-valued  Buyers with lower
valued uses get
uses
the goods.
 CS = total green
area
Controlled
Price = 1
(ceiling)
Demand
Shortage
Qs
Qd
Quantity89
The Loss From Random Allocation: Equal
Probability Scenario
Price of gasoline
per gallon
Loss due to random allocation
Supply
Willingness to
pay for Qs = $3
Average
Price = $18
Equal Probability
Scenario:
 Av price = $18
 CS = total green
area
Controlled
Price = 1
(ceiling)
Demand
Shortage
Qs
Qd
Quantity90
The End of Price Controls
 Controls on most prices were lifted by April
1974
 Controls on oil prices continued in some form
over the next 7 years.
• “Old oil”-“New oil” and wasteful gaming
 Controls on oil prices ended on the morning
of President Reagan’s inauguration day
January 20, 1981
 Oil price ↓ over the next several years
 No shortages of oil have occurred since.
91
Try it!
• Nixon’s price controls set price
ceilings below the market price. What
would have happened if the price
ceilings had been set above the market
prices?
• Under price controls, why were the
shortages of oil in some local markets
much more severe than in others?
To next
Try it!
Try it!
• Shortages in the former Soviet Union
were very common, but why were there
also surpluses of some goods at some
times and places?
To next
Try it!
Price Floors
 Price floor – a minimum price allowed by
law
 Price floors create:
1.
2.
3.
4.
Surpluses
Lost gains from trade (deadweight loss)
Wasteful increases in quality
A misallocation of resources
94
Surpluses
 A good example of a price floor is the
minimum wage
 Workers with very low productivity are
most affected by the minimum wage.
• Least experienced
• Least educated or trained
 Low-skilled teenagers are most affected.
Let’s use the labor market model to analyze the minimum wage.
95
Minimum Wage Creates a Surplus
Wage
($/hr)
Supply
of labor
Labor surplus
(unemployment)
Minimum
wage
Market
wage
Demand
for labor
Qd
Market
employment
Qs
Quantity
of labor
(unskilled)
96
Minimum Wage Creates Lost Gains From
Trade
Wage
($/hr)
Supply
of labor
Labor surplus
(unemployment)
Minimum
wage
Lost gains from trade
(deadweight loss) = lost
consumer surplus + lost
producer surplus
Market
wage
Demand
for labor
Qd
Market
employment
Qs
Quantity
of labor
(unskilled)
97
Minimum Wage
 Hotly debated in the U.S.
• 93.9% of workers < 25 years earn more than
the minimum wage
• At best, the minimum wage raises the wages
of some teenagers and young workers whose
wages would have increased anyway as they
became more skilled.
• At worst, increases in the price of hamburgers
can create some teenage unemployment.
98
Minimum Wage
 A large increase in the minimum wage will
cause serious unemployment
 Test Case: Puerto Rico, 1938
• Congress set the first minimum wage at $0.25/hr.
 Average wage in U.S. = $0.625/hr
• Congress forgot to exempt Puerto Rico
 Average wage in Puerto Rico = $0.03 to $0.04/hr
• Puerto Rican firms went bankrupt → devastating
unemployment
• Puerto Rican politicians begged for exemption
99
Minimum Wages in France
 Firms in France are reluctant to hire
• Minimum wage is higher than in the U.S.
• Labor laws make it very difficult to fire workers
 Younger workers are affected the most
• Less productive
• Risk of hiring is greater
 Result:
• Unemployment among workers < 25 yrs old
was 23% in 2005.
100
Try it!
• The European Union guaranteed its
farmers that the price of butter will stay
above a floor. The floor price is often
above the market equilibrium price. What
do you think has been the result of this?
• The U.S. has set a price floor above the
equilibrium price. Has this led to
shortages or surpluses? How do you
think the U.S. government has dealt with
this?
To next
Try it!
Takeaway
 You should be able to explain the effects of
price ceilings to your uncle.
 You should be able to draw a diagram
showing the price ceiling, label the shortage,
wasteful losses, and the lost gains from
trade.
 You should understand why a price ceiling
reduces product quality and misallocates
resources.
 You should be able to a similar analysis for
price floors.
102
End of Chapter 8
Second Edition