Understanding Economics
3rd edition
by Mark Lovewell, Khoa Nguyen and Brennan Thompson
Chapter 3
Competitive Dynamics and
Government
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
1
Learning Objectives
In this chapter, you will:
1.
2.
3.
4.
learn about the price elasticity of demand, its
relation to other demand elasticities, and its
impact on sellers’ revenues
learn about the price elasticity of supply and
the links between production periods and
supply
consider how governments use price controls
to override the “invisible hand” of competition
examine spillover costs and benefits and the
ways that government addresses the issues
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
2
Elastic and Inelastic Demand (a)

Price elasticity of demand shows how
responsive consumers are to price changes
•
•
•
elastic demand:demand for which a percentage
change in a product’s price causes a larger
percentage change in quantity demanded

% change in quantity demand is more than
% change in price
inelastic demand: demand for which a percentage
change in a product’s price causes a smaller
percentage change in quantity demanded

% change in quantity demand is less than %
change in price
unit-elastic demand means % change in
quantity demand equals % change in price
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
3
Elastic and Inelastic Demand (b)
Figure 3.1 Page 51
Inelastic Demand Curve
for Ice cream Cones
2.40
2.40
20%
2.00
D1
1.60
50%
1.20
0.80
0.40
0
500
1000
Quantity Demanded
(cones per winter month)
Price ($ per cone)
Price ($ per cone)
Elastic Demand Curve
for Ice Cream Cones
20%
2.00
D2
1.60
10%
1.20
0.80
0.40
0
500
1000
1800 2000
Quantity Demanded
(cones per summer month)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
4
Perfectly Elastic and Perfectly
Inelastic Demand (a)



Perfectly elastic demand:demand for which a
product’s price remains constant regardless of
quantity demand
•
means constant price and a horizontal demand
curve
Perfectly inelastic demand:demand for which
a product’s quantity demanded remains constant
regardless of price
•
means constant quantity demanded and a
vertical demand curve
See Figure 3.2, page 52
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
5
Perfectly Elastic and Perfectly Inelastic
Demand (b)
Figure 3.2 Page 52
Perfectly Inelastic
Demand Curve
for Insulin
D3
1.60
0
0
Quantity Demanded
(tonnes)
D4
Price ($ per tonnes)
Price ($ per tonnes)
Perfectly Elastic
Demand Curve
for Soybeans
1000
Quantity Demanded
(litres)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
6
Total Revenue and the Price
Elasticity of Demand (a)


Total revenue: the total income earned from a
product, calculated by multiplying the product’s price
by its quantity demanded, (TR=P x Qd).
A price change causes total revenue to change in the
opposite direction when demand is elastic
•

A price change causes total revenue to change in the
same direction when demand is inelastic
•

Eg, Increase of price causes decrease of total revenue
or decrease of price causes increase of total revenue
Eg, Increase of price causes increase of total revenue
A price change does not affect total revenue when
demand is unit-elastic
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
7
Revenue Changes with Elastic
Demand
Figure 3.3 Page 53
Price ($ to rent a video)
Demand Curve for Videos
5
4
A
3
2
D
B
C
1
0
500
1000
1500
Quantity Demanded (videos rented each day)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
8
Revenue Changes with Inelastic
Demand
Figure 3.4 Page 54
Price ($ per ride)
Demand Curve for Amusement Park Rides
5
4
3
E
2
F
1
0
2000
4000
D
G
6000
8000
10 000
Quantity Demanded (riders each day)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
9
Total Revenue and the Price Elasticity
of Demand (b)
Figure 3.5 Page 55
Demand Elasticity and Changes in Total Revenue
Price
Change
Change in
Total Revenue
Elastic Demand
up
down
down
up
Inelastic Demand
up
down
up
down
Unit-Elastic Demand
up
down
unchanged
unchanged
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
10
Determinants of the Price Elasticity
of Demand

There are four determinants:
•
•
•
•
portion of consumer incomes (products
with smaller portions more inelastic)
access to substitutes (products with more
substitutes more elastic)
necessities versus luxuries (more inelastic
for necessities and more elastic for
luxuries)
time (more elastic with the passage of
time)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
11
Calculating Price Elasticity of
Demand


A numerical value for price elasticity
of demand (ed) is found by taking the
ratio of the changes in quantity
demanded and in price, each divided
by its average value.
In mathematical terms:
ed = ΔQd ÷ average Qd
Δprice ÷ average price
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
12
Elasticity and a Linear Demand
Curve (a)



A linear demand curve has a different
price elasticity (ed) at every point.
At high prices, the change in quantity
demanded (price) is relatively large
(small), giving a large ed.
At low prices, the change in quantity
demand (price) is relatively small
(large), giving a small ed.
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
13
Elasticity and a Linear Demand
Curve (b)
Figure 3.6 Page 57
Market Demand Curve for Sodas
Market Demand Schedules
for Sodas
5
4
3
2
1
0
Quantity
Demanded
0
1
2
3
4
5
9.00
2.33
1.00
0.43
0.11
Price ($ per soda)
Price
Elasticity
of Demand
($ per
(ed)
soda) (millions of sodas)
Price
5
ed > 1
4
3
ed = 1
2
ed < 1
1
0
1
2
3
4
5
Quantity Demanded
(millions of sodas)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
14
Income Elasticity


Income elasticity (ei) is the
responsiveness of a product’s
quantity demanded to changes in
consumer income.
In mathematical terms:
ei = ΔQd ÷ average Qd
ΔI ÷ average I
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
15
Cross-Price Elasticity


Cross-price elasticity (exy) is the
responsiveness of the quantity
demanded of one product (x) to a
change in price of another (y)
In mathematical terms:
exy = ΔQd ÷ average Qd
ΔPy ÷ average Py
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
16
Elastic and Inelastic Supply

Price elasticity of supply measures the
responsiveness of quantity supplied to price
changes
•
•
elastic supply:supply for which a percentage
change in a product’s price causes a larger
percentage change in quantity supplied
 means % change in quantity supplied is more
than % change in price
inelastic supply:supply for which the
percentage change in a product’s price causes a
smaller percentage change in quantity supplied
 means % change in quantity supplied is less
than % change in price
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
17
Elastic and Inelastic Supply
Figure 3.7, Page 60
Inelastic Supply Curve
For Tomatoes
4
S1
3
50%
2
100%
1
0
100 000
Quantity Supplied
(kilograms per year)
120000
Price ($ per kilogram)
Price ($ per kilogram)
Elastic Supply Curve
for Tomatoes
4
S1
3
50%
2
1
0
20%
100 000 120 000
Quantity Supplied
(kilograms per year)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
18
Perfectly Elastic and Perfectly
Inelastic Supply

Perfectly elastic supply:supply for which a
product’s price remains constant, regardless of
quantity supplied
•
means constant price and a horizontal supply
curve

Perfectly inelastic supply:supply for which a
product’s quantity supplied remains constant
regardless of price
•
means constant quantity supplied and a
vertical supply curve
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
19
Time and the Price Elasticity of
Supply (a)

Price elasticity of supply changes over three
production periods
•
•
supply is perfectly inelastic in the
immediate run
 Immediate run:the production period during
which none of the resources required to
make a product can be varied
supply is either elastic or inelastic in the
short run
 Short run: the production period during
which at least one of resources required to
make a product cannot be varied.
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
20
•
supply is perfectly elastic for a constantcost industry and very elastic for an
increasing-cost industry in the long run
 Long run: the production period during
which all resources required to make a
product can be varied, and business may
either enter or leave the industry
 Constant-cost industry: an industry that is
not a major user of any single resource
 Increasing-cost industry: an industry that
is a major user of at least one resource
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
21
Time and the Price Elasticity of Supply (b)
Figure 3.8, Page 61 (continued in part (e))
Price ($ per kilogram)
S1
0
750 000
Quantity Supplied
(kilograms per month)
Short-Run
Supply Elasticity
For Strawberries
Price ($ per kilograms)
Immediate-Run
Supply Elasticity
for Strawberries
S2
2.50
2.00
0
9
11
Quantity Supplied
(millions of kilograms per year)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
22
Time and the Price Elasticity of
Supply (c)

If strawberries are produced in a
constant-cost industry:
•
•
•
A higher price of strawberries raises
production but not resource prices.
As new businesses enter the industry in
the long run due to a higher price of
strawberries, this price is gradually
pushed back down to its original level.
Therefore the long-run supply curve for a
constant-cost industry is perfectly elastic.
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
23
Time and the Price Elasticity of
Supply (d)

If strawberries are produced in a
increasing-cost industry:
•
•
•
A higher price of strawberries raises
production and also resource prices.
As new businesses enter the industry in
the long run due to a higher price of
strawberries, this price is gradually
pushed back down to its lowest possible
level, but this level is higher than it was
originally.
Therefore the long-run supply curve for
an increasing-cost industry is very elastic.
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
24
Time and the Price Elasticity of Supply (e)
Figure 3.8, Page 61 (continued from part (b))
Price ($ per kilograms)
Long-Run Supply Elasticity
S4
S3
2.00
Constantcost Industry
Increasingcost Industry
0
Quantity Supplied
(millions of kilograms per decade)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
25
Calculating Price Elasticity of
Supply


A numerical value for price elasticity
of supply (es) is found by taking the
ratio of the changes in quantity
supplied and in price, each divided by
its average value.
In mathematical terms:
es = ΔQs ÷ average Qs
Δprice ÷ average price
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
26
Price Controls

A price floor is a minimum price set
above the equilibrium price
•

it results in a surplus in the market
A price ceiling is a maximum price set
below the equilibrium price
•
it results in a shortage in the market
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
27
Agricultural Price Supports

Price supports for agricultural goods
are an example of a price floor
•
•
•
they help overcome unstable agricultural
prices
farmers win from these supports
consumers and taxpayers lose from these
supports
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
28
Reasons for Price Supports
Figure 3.9, page 64
Market Demand and Supply
Curves for Wheat
Market Demand and Supply
Schedules for Wheat
140
Price
120
S1
S0
Quantity
Quantity
Demanded
Supplied
($ per
(D)
(S0)
(S1)
tonne)
(millions of tonnes)
$140
120
100
80
60
10
11
12
13
14
14
13
12
11
10
12
11
10
9
8
Price ($ per tonne)
b
100
a
80
60
D
40
20
0
1
2 3 4
5
6
7
8
9 10 11 12 13 14
Quantity (millions of tonnes per year)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
29
Effects of Price Supports
Figure 3.11, page 66
Market Demand and Supply Curves
for Milk
Market Demand and Supply
Schedules for Milk
$1.30
Quantity Quantity
Demanded Supplied
(D)
(S)
(millions of litres)
59
62
1.10
60
60
0.90
61
58
S
Price ($ per litre)
Price
($ per
litre)
surplus
1.30
1.10
.90
A price floor
creates
a surplus.
.70
0
58
59
60
D
61
62
Quantity
(millions of litres per year)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
30
Rent Controls

Rent controls are an example of a
price ceiling
•
•
•
they keep down prices of controlled rental
accommodation
some (especially middle-class) tenants
win from these controls
other (especially poorer) tenants lose
from these controls
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
31
Effects of Rent Controls
Figure 3.12, page 66
Market Demand and Supply
Curves for Units
Market Demand and Supply
Schedules for Units
Price
($ rent
per
month)
Quantity
Quantity
Demanded
Supplied
(D)
(S)
(units rented per month)
$700
1700
2500
500
2000
2000
300
2300
1500
Price ($ per unit)
S
700
A price ceiling
creates
a shortage.
500
300
shortage
0
1500
D
2000 2300 2500
Quantity
(units rented per month)
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
32
Spillover Costs (a)

Spillover costs are the negative
external effects of producing or
consuming a product
•
•
•
adding these costs to private costs raises
the supply curve
the preferred outcome is at a lower
quantity than in a perfectly competitive
market
government intervention (e.g. an excise
tax) can produce the preferred outcome
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
33
Spillover Costs (b)
Figure 3.13, page 68
Market Demand Curve for Strawberries
Demand and Supply
Schedules for Gasoline
$2.50
2.00
1.50
1.00
0.05
Quantity
Quantity
Demanded
Supplied
(D)
(S0)
(S1)
(millions of litres)
4
5
6
7
8
8
7
6
5
4
S0
S1
2.50
6
5
4
3
2
Spillover
Costs,
Excise
Tax
a
Price ($ per litre)
Price
($ per
litre)
D
2.00
1.50
b
1.00
0.50
0
1
2
3
4
5
6
7
8
Millions of Litres
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
34
Spillover Benefits (a)

Spillover benefits are the positive
external effects of producing or
consuming a product
•
•
•
adding these benefits to private benefits
raises the demand curve
the preferred outcome is at a higher
quantity than occurs in a perfectly
competitive market
government intervention (e.g. a
consumer subsidy) can produce the
preferred outcome
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
35
Spillover Benefits (b)
Figure 3.14, page 69
Demand and Supply Curves for an
Engineering Education
Demand and Supply Schedules
for an Engineering Education
Enrollment
Quantity
Demanded
Supplied
(S0)
(S1)
(S)
(thousands of students)
$6000
5000
4000
3000
2000
8
9
10
11
12
10
11
12
13
14
12
11
10
9
8
b
5000
Tuition ($ per year)
Tuition
($ per
year)
6000
Spillover
Benefits,
Student
Subsidy
a
4000
3000
2000
S
D0
D1
1000
0
8
9 10 11 12 13 14
Thousands of Students
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
36