Working with Demand and Supply
Price Ceilings
• Government-imposed maximum price that prevents the
price of a good from rising above a certain level in a
market
• Short side of the Market prevails
• Price ceiling creates a shortage
– While the price decreases, the opportunity cost may rise
• Black Market
– A market created by unintended consequences of government
intervention
• Goods are sold illegally at a price above the legal ceiling
Hall & Leiberman;
Economics: Principles
1
Figure 1: A Price Ceiling in the
Market for Maple Syrup
5. With a black market, the
lower quantity sells for a
higher price than initially.
Price per
Bottle
3. and decreases
quantity supplied.
4. The result is a shortage
– the distance between
S
R and V.
T
$4.00
3.00
R
2.00
E
V
2. increases quantity
demanded
D
40,000 50,000 60,000
1. A price ceiling lower than
the equilibrium price . . .
Hall & Leiberman;
Economics: Principles
Number of Bottles of
Maple Syrup per Period
2
Price Floors
• Government imposed minimum amount below which
price is not permitted to fall
– Price floors for agricultural goods are commonly called price
support programs
• When sellers produce more of the good than buyers
want at the price floor
– Remaining goods become a surplus that no one wants at the
imposed price
• Government responds by maintaining price floors
– Uses taxpayer dollars to buy up entire excess supply of the good
in question
– Prevents excess supply from doing what it would ordinarily do
• Drive price down to its equilibrium value
Hall & Leiberman;
Economics: Principles
3
Figure 2: A Price Floor in the
Market for Nonfat Dry Milk
Price
per
Pound
2. decreases quantity
demanded . . .
1. A price floor higher
than the equilibrium
price . . .
3. and increases
quantity supplied.
S
J
K
$0.81
A
0.65
4. The result is a surplus
the – distance between
K and J – which
government must buy.
D
180
Hall & Leiberman;
Economics: Principles
200
220
Millions of Pounds
4
Limiting Surplus
• A price floor creates a surplus of goods
– In order to maintain price floor, government
must prevent surplus from driving down
market price
• Government often accomplishes this goal by
purchasing surplus with taxpayers dollars
• Price floors often get government deeply
involved in production decisions
– Rather than leaving them to the market
Hall & Leiberman;
Economics: Principles
5
Supplier’s perspective
• A producer considers increasing his price
• Is it a good idea?
• Higher price means more revenue per unit
output BUT…
• Lower units of quantity sold (downward
sloping demand).
Hall & Leiberman;
Economics: Principles
6
The Demand Schedule
Demand for Maple Syrup
Price (per bottle)
$1.00
Quantity Demanded (bottles
per month)
75,000
$2.00
60,000
$3.00
50,000
$4.00
35,000
$5.00
20,000
Hall & Leiberman;
Economics: Principles
7
The Demand Schedule
Demand for Maple Syrup
Price (per
bottle)
Revenue (price
times quantity)
$1.00
Quantity
Demanded
(bottles per
month)
75,000
$2.00
60,000
$12,000
$3.00
50,000
$150,000
$4.00
35,000
$140,000
$5.00
20,000
$100,000
Hall & Leiberman;
Economics: Principles
$75,000
8
The Problem with Rate Change
• Rate of change of quantity demanded
compared to the change in price is not a
good measure of price sensitivity
– Doesn’t tell whether a change in price or a
change in quantity demanded is a relatively
large or relatively small change
• Relative means compared to value of price or
quantity before change
Hall & Leiberman;
Economics: Principles
9
The Elasticity Approach
• Elasticity approach improves on the problems with rate of change
– By comparing percentage change in quantity demanded with
percentage change in price
• Price elasticity of demand (ED) for a good is percentage change in
quantity demanded divided by percentage change in price
%Q

ED
D
%P
•
– Will virtually always be a negative number
– Tells us percentage change in quantity demanded for each 1%
increase in price
Price elasticity of demand tells us percentage change in quantity
demanded caused by a 1% rise in price as we move along a demand
curve from one point to another
Hall & Leiberman;
Economics: Principles
10
Calculating Price Elasticity of
Demand
• When calculating elasticity base value for percentage
changes in price or quantity is always midway between
initial value and new value
– When price changes from any value P0 to any other value P1, we
define the percentage change in price as
% Change in Price 
( P1  P 0 )
( P1  P 0 )
2
– When quantity demanded changes from Q0 to Q1, percentage
change is calculated as
% Change in Quantity Demanded 
Hall & Leiberman;
Economics: Principles
(Q1 _ Q0 )
Q  Q 
0
 1

2


11
Figure 3: Calculating Price
Elasticity of Demand
Price per
Laptop
D
$3,500
C
3,000
2,500
2,000
B
1,500
A
1,000
D
100,000 200,000 300,000 400,000 500,000 600,000
Hall & Leiberman;
Economics: Principles
Quantity of
Laptops
12
An Example: Calculating Price
Elasticity of Demand
• Now let’s calculate an elasticity of demand for
laptop computers using data in Figure 3 from
point A to point B (500,000  600,000)  100,000
% Change in Quantity Demanded 
% Change in Price 
 (500,000  600,000) 


2

550,000
 0.182, or  18.2 percent
($1,500  $1,000)
$500

 0.400, or 40.0 percent
 ($1,500  $1,000)  $1,250


2
• Use percentage changes for price and quantity
to calculate price elasticity of demand (ED)
ED 
 0.182
 0.46
0.400
Hall & Leiberman;
Economics: Principles
13
Elasticity and Straight-Line
Demand Curves
• As we move upward and leftward along a straight-line
demand curve
– Same absolute increment in price will correspond to smaller and
smaller percentage increments in price
• Why?
• As we move upward and leftward along a straight-line
demand curve
– Same absolute decrease in quantity corresponds to larger and
larger percentage decreases in quantity
• As we move upward and leftward by equal distances,
percentage change in quantity rises
– Percentage change in price falls
• Elasticity of demand varies along a straight-line demand
curve
– Demand becomes more elastic as we move upward and leftward
Hall & Leiberman;
Economics: Principles
14
Figure 4: Elasticity and StraightLine Demand Curves
Since equal dollar increases (vertical
arrows) are smaller and smaller
percentage increases . . .
Price
3
2
and since equal quantity decreases
(horizontal arrows) are larger and
larger percentage decreases . . .
1
demand becomes more and more
elastic as we move leftward and
upward along a straight-line
demand curve.
D
Quantity
Hall & Leiberman;
Economics: Principles
15
Categorizing Goods by Elasticity
• Inelastic Demand
– Price elasticity of demand between 0 and -1
Inelastic Demand 
% Change in Quantity Demanded
 1.0
% Change in Price
|% Change in Quantity Demanded| < |% Change in Price|
• Perfectly Inelastic Demand
– Price elasticity of demand equal to 0
Hall & Leiberman;
Economics: Principles
16
Categorizing Goods by Elasticity
• Elastic Demand
– Price elasticity of demand with absolute value > 1
Elastic Demand 
% Change in Quantity Demanded
1
% Change in Price
|% Change in Quantity Demanded| > |% Change in Price|
• Perfectly (infinitely) Elastic Demand
– Price elasticity of demand approaching minus infinity
• Unitary Elastic Demand
– Price elasticity of demand equal to -1
Hall & Leiberman;
Economics: Principles
17
Figure 5: Extreme Cases of
Demand
(a)
Price
per
Unit
(b)
Price
per
Unit
D
$4
$4
3
Perfectly Inelastic
Demand
2
1
3
Perfectly Elastic
Demand
2
D
1
20 40 60 80 100
Quantity
Hall & Leiberman;
Economics: Principles
20 40 60 80 100
Quantity
18
Elasticity and Total Revenue
• Total revenue (TR) of all firms in the market is
defined as
• TR = P x Q
• When two numbers are both changing, percentage
change in their product is (approximately) the sum
of their individual percentage changes
– Applying this to total revenue
• % Change in TR = % Change in Price + % Change in Quantity
Demanded
• Assume demand is unitary elastic and Q rises by
10%
– % Change in TR = 10% + (-10%) = 0
Hall & Leiberman;
Economics: Principles
19
Elasticity and Total Revenue
• If demand is inelastic, a 10% rise in price
will cause quantity demanded to fall by
less than 10%
– % change in TR = 10% + (something less
negative than –10%) > 0
• If demand is elastic, so that Q falls by
more than 10%
– TR will fall
• % Change in TR = 10% + (something more
negative than -10%) < 0
Hall & Leiberman;
Economics: Principles
20
Elasticity and Total Revenue
• Where demand is inelastic, total revenue moves
in same direction as price
• Where demand is elastic, total revenue moves in
opposite direction from price
• Where demand is unitary elastic, total revenue
remains the same as price changes
• At any point on a demand curve sellers’ total
revenue (buyers’ total expenditure) is the area of
a rectangle
– Width equal to quantity demanded
– Height equal to price
Hall & Leiberman;
Economics: Principles
21
Figure 6: Elasticity and Total
Expenditure
Price
per
Laptop
2. At point B, revenue
is $750 million.
$3,500
3,000
2,500
2,000
1. At point A , where
price is $1,000 and
600,000 laptops are
demanded, revenue
is $600 million.
3. Moving from A to B,
expenditure increases,
so demand must be
inelastic over that range.
B
1,500
A
1,000
D
500
100,000 200,000 300,000 400,000 500,000 600,000
Hall & Leiberman;
Economics: Principles
Quantity of
Laptops
22
Availability of Substitutes
• Demand is more elastic
– If close substitutes are easy to find and
buyers can cut back on purchases of the good
in question
• Demand is less elastic
– If close substitutes are difficult to find and
buyers can not cut back on purchases of the
good in question
Hall & Leiberman;
Economics: Principles
23
Narrowness of Market
• More narrowly we define a good, easier it
is to find substitutes
– More elastic is demand for the good
• More broadly we define a good
– Harder it is to find substitutes and the less
elastic is demand for the good
• Different things are assumed constant
when we use a narrow definition
compared with a broader definition
Hall & Leiberman;
Economics: Principles
24
Necessities vs. Luxuries
• The more “necessary” we regard an item,
the harder it is to find a substitute
– Expect it to be less price elastic
• The less “necessary” (luxurious) we regard
an item, the easier it is to find a substitute
– Expect it to be more price elastic
Hall & Leiberman;
Economics: Principles
25
Time Horizon
• Short-run elasticity
– Measured a short time after a price change
• Long-run elasticity
– Measured a year or more after a price change
• Usually easier to find substitutes for an item in
the long run than in the short run
– Therefore, demand tends to be more elastic in the
long run than in the short run
Hall & Leiberman;
Economics: Principles
26
Importance in the Buyer’s Budget
• The more of their total budgets that
households spend on an item
– The more elastic is demand for that item
• The less of their total budgets that
households spend on an item
– The less elastic is demand for that item
Hall & Leiberman;
Economics: Principles
27
Using Price Elasticity of Demand:
The War on Drugs
• Every year U.S. Government spends about $20
billion on efforts to restrict the supply of drugs
• Figure 9(a)
– Market for heroin without government intervention
• Figure 9(b)
– Result of government efforts to restrict supply (current
policy)
• Figure 9(c)
– Results of an effective policy of reducing demand
Hall & Leiberman;
Economics: Principles
28
Figure 7a: The War on Drugs
(a)
Price per
Unit
S1
A
P1
D1
Q1
Hall & Leiberman;
Economics: Principles
Quantity
29
Figure 7b: The War on Drugs
(b)
Price per
Unit
S2
B
S1
P2
A
P1
D1
Q2 Q1
Hall & Leiberman;
Economics: Principles
Quantity
30
Figure 7c: The War on Drugs
(c)
Price per
Unit
S1
A
P1
P3
C
D1
D2
Q3
Hall & Leiberman;
Economics: Principles
Q1
Quantity
31
Using Price Elasticity of Demand:
Mass Transit
• Elasticity studies show that long-run demand for
mass transit is inelastic
– Therefore, a rise in fare would increase revenues
• However, most cities do not raise transit fares
due to
– Desire to provide low-income households with
affordable transportation
– Desire to manage traffic congestion
– Desire to limit air pollution in the city
• An increase in fares would increase revenue
– Would also decrease ridership and require the city to
sacrifice these other goals
Hall & Leiberman;
32
Economics: Principles
Using Price Elasticity of Demand:
An Oil Crisis
•
•
For the past five decades, Middle East has been a geopolitical hot spot
Both military and economic government agencies ask “What if” questions
– If an event in the Middle East were to disrupt oil supplies, what would happen
to the price of oil on world markets?
•
Flipping the elasticity equation like so
1
E
D

% Change in Price
% Change in Quantity Demanded
•
Tells us percentage rise in price that would bring about a 1 percent
decrease in quantity demanded
– Enables us to make reasonable forecasts about the impact of various
events on oil prices
• Once we have established our forecasted oil prices we can then use that
data to examine effect that higher oil prices would have on many broader
issues
– Effect on U.S. inflation rate
– Effect on number of flights offered by U.S. airlines
Hall & Leiberman;
Economics: Principles
33
Income Elasticity of Demand
• Percentage change in quantity demanded
divided by the percentage change in income
– With all other influences on demand—including the
price of the good—remaining constant
EY 
% change in Quantity Demanded
% Change in Income
• Interpret this number as percentage increase in
quantity demanded for each 1% rise in income
Hall & Leiberman;
Economics: Principles
34
Income Elasticity of Demand
• Income elasticities vs. price elasticities of
demand
– Price elasticity of demand
• Measures effect of change in price of good
– Assumes that other influences on demand, including income,
remain unchanged
– Income elasticity
• Measures effect on demand we would observe if income
changed and all other influences on demand—including price
of the good—remained the same
• Instead of letting price vary and holding income
constant, now we are letting income vary and
holding price constant
Hall & Leiberman;
Economics: Principles
35
Income Elasticity of Demand
• Another difference between price and
income elasticity of demand
– Price elasticity measures sensitivity of
demand to price as we move along a demand
curve from one point to another
– Income elasticity tells us relative shift in
demand curve—increase in quantity
demanded at a given price
• While a price elasticity is virtually always
negative
– Income elasticity can be positive or negative
Hall & Leiberman;
Economics: Principles
36
Income Elasticity of Demand
• Economic necessity
– Good with an income elasticity of demand between 0 and 1
• Economic luxury
– Good with an income elasticity of demand greater than 1
• An implication follows from these definitions
– As income rises, proportion of income spent on economic
necessities will fall
• While proportion of income spent on economic luxuries will rise
• But, it is important to remember that economic
necessities and luxuries are categorized by actual
consumer behavior
– Not by our judgment of a good’s importance to human survival
Hall & Leiberman;
Economics: Principles
37
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand
– Percentage change in quantity demanded of one good caused
by a 1% change in price of another good
• While all other influences on demand remain unchanged
EXZ 
% Change in Quantity of X Demanded
% Change in Price of Z
• While the sign of the cross-price elasticity helps us
distinguish substitutes and complements among related
goods
• Its size tells us how closely the two goods are related
– A large absolute value for EXZ suggests that the two goods are close
substitutes or complements
– While a small value suggests a weaker relationship
Hall & Leiberman;
Economics: Principles
38
Price Elasticity of Supply
• Percentage change in quantity of a good
supplied that is caused by a 1% change in the
price of the good
– With all other influences on supply held constant
ES 
% Change in Quantity Supplied
% Change in Price
Hall & Leiberman;
Economics: Principles
39
Price Elasticity of Supply
• When do we expect supply to be price elastic,
and when do we expect it to be price inelastic?
– Ease with which suppliers can find profitable activities
that are alternatives to producing the good in question
• Supply will tend to be more elastic when suppliers can switch
to producing alternate goods more easily
– When can we expect suppliers to have easy alternatives?
Depends on
» Nature of the good itself
» Narrowness of the market definition—especially
geographic narrowness
» Time horizon—longer we wait after a price change, greater
the supply response to a price change
Hall & Leiberman;
Economics: Principles
40
Price Elasticity of Supply
• Extreme cases of supply elasticity
– Perfectly inelastic supply curve is a vertical
line
• Many markets display almost completely inelastic
supply curves over very short periods of time
– Perfectly elastic supply curve is a horizontal
line
Hall & Leiberman;
Economics: Principles
41
Figure 8: Extreme Cases of Supply
(a)
(b)
Price
per
Unit
Price
per
Unit
S
Perfectly Inelastic
Supply
P2
Perfectly Elastic
Supply
S
P1
Quantity per Period
Hall & Leiberman;
Economics: Principles
Quantity per Period
42
The Tax on Airline Travel: Taxes
and Market Equilibrium
• A tax on a particular good or service is called an
excise tax
– Shifts market supply curve upward by amount of tax
• For each quantity supplied, the new, higher curve tells us
firms’ gross price, and the original, lower curve tells us the
net price
• Who really pays excise taxes?
– Buyers and sellers share in the payment of an excise
tax
• Called tax shifting
– Process that causes some of tax collected from one side of
market (sellers) to be paid by other side of market (buyers)
Hall & Leiberman;
Economics: Principles
43
Figure 9a: The Tax on Airline
Travel
Price per
Ticket
(a)
4. and then find the minimum price needed
for the market to supply that quantity.
SBefore Tax
$300
$260
1. One way to use the supply
curve is to start with the
price . . .
Hall & Leiberman;
Economics: Principles
3. But another way
is to start with a
quantity . . .
A
7
10
Millions of
Tickets per Year
2. and then find the quantity
supplied at that price.
44
Figure 9b: The Tax on Airline
Travel
Price per
Ticket
(b)
SAfter Tax
$360
A'
SBefore Tax
$300
A
3. But another way is to start
with a quantity . . .
10
Millions of
Tickets per Year
4. and then find the minimum price needed for the
market to supply that quantity.
Hall & Leiberman;
Economics: Principles
45
Figure 10: Effect of Excise Tax on
Airlines
2. The $60 tax shifts the
supply curve up by $60.
Price per Ticket
SAfter Tax
B
$340
3. In the new
equilibrium,
buyers pay
$340.
SBefore Tax
$300
A
1. Before the tax,
the supply curve
is SBefore Tax and
the price is $300.
$280
4. And, net of the
tax, sellers
receive $280.
Hall & Leiberman;
Economics: Principles
D
Millions of Tickets per Year
46
Tax Incidence and Demand
Elasticity
• In most cases excise tax will be shared by
both buyer and seller
– For a given supply curve, the more elastic is
demand, the more of an excise tax is paid by
sellers
– The more inelastic is demand, the more of the
tax is paid by buyers
Hall & Leiberman;
Economics: Principles
47
Figure 11: Tax Incidence and
Demand Elasticity
(a)
Price per
Ticket
D
(b)
Price per
SAfter Tax Ticket
SAfter Tax
SBefore Tax
SBefore Tax
B
$360
$300
A
10
Hall & Leiberman;
Economics: Principles
$300
Millions of
Tickets per Year
B
A
2
10
D
Millions of
Tickets per Year
48
Tax Incidence and Supply Elasticity
• Although there are extreme cases of
supply elasticity, in general the following is
true
– For a given demand curve, the more elastic is
supply, the more of an excise tax is paid by
buyers
– The more inelastic is supply, the more of the
tax is paid by sellers
Hall & Leiberman;
Economics: Principles
49
Figure 12: Tax Incidence and
Supply Elasticity
(a)
Price per
Ticket
(b)
SBefore and After Tax
Price per
Ticket
$360
$300
A
$240
SAfter Tax
A
$300
D
10
Hall & Leiberman;
Economics: Principles
B
Millions of
Tickets per Year
SBefore Tax
D
8
10
Millions of
Tickets per Year
50
The Market For Food
• Shrinking and unstable incomes are problems
for farmers
• The market for farm goods would reach an
equilibrium if it were allowed to do so
• But farming seems to be special
– Notion of small family farm has tremendous political
appeal
– Farmers have banded together to form powerful and
effective government lobbies
• Result has been continual government
interference with supply and demand in
agricultural markets around the world
Hall & Leiberman;
Economics: Principles
51
Figure 13: The Market For
Food
(a)
(b)
per
SOld Technology Price
Unit of
Price per
Unit of
Food
Food
A
SNew Technology
P1
P2
SBad Weather
A
SGood Weather
P1
B
B
P2
D
Q1 Q2
Hall & Leiberman;
Economics: Principles
D
Quantity of
Food
Q1 Q2
Quantity of
Food
52
Health Insurance and the Market
for Health Care
• Health insurance has definite benefits to
our society
• Our current health care system keeps
patients from facing the full opportunity
cost of their health care decisions
– Can cause people to over consume health
care
• Health insurance reduces buyers’
incentives to monitor their health care
expenditures closely or to shop around for
Hall high-quality
& Leiberman;
53
low-cost
care
Economics: Principles
Figure 14: The Market For Health
Care With Coinsurance
Price per D
After Insurance
Examination
$100
S
DBefore Insurance
B
70
50
A
100,000 150,000
Hall & Leiberman;
Economics: Principles
Examinations per Year
54