The Price System

1
The Price System

• The market system, also called the price system,
  performs two important and closely related
  functions
• Price Rationing
• Resource Allocation
• Price rationing is the process by which the
  market system allocates goods and services to
  consumers when quantity demanded exceeds quantity
  supplied.

2
Price Rationing
A.

• The market is initially in equilibrium at Price
  Po.
• a decrease in supply (what might cause this?)
  creates a shortage at P0. Quantity demanded is
  greater than quantity supplied. Price will rise.
• OR
• an increase in demand (what might cause this?)
  creates a shortage at Po. Quantity demanded is
  greater than quantity supplied. Price will rise.
• In both cases, the quantity is rationed to those
  who are willing and able to pay the higher price.

B.
3
Price Ceilings

• When a maximum price for a product or service is
  set (generally this is done by the government)
• Why? Because the equilibrium price appears to
  be unfair
• Consequences for the market?
• An alternative to price rationing is needed to
  allocate the available quantity

4
Alternative Rationing Mechanisms

• Queuing is a nonprice rationing system that uses
  waiting in line as a means of distributing goods
  and services.

• Favored customers are those who receive special
  treatment from dealers during situations when
  there is excess demand.

• Ration coupons are tickets or coupons that
  entitle individuals to purchase a certain amount
  of a given product per month.

The problem with these alternatives are the
hidden costs that increase the effective price
above the maximum price allowed.
5
Example of Price Ceiling

• In 1974, the government used an alternative
  rationing system to distribute the available
  supply of gasoline.
• At an imposed price of 57 cents per gallon (price
  ceiling), the result was excess demand.

6
Alternative Rationing Mechanisms

• No matter how good the intentions of private
  organizations and governments, it is very
  difficult to prevent the price system from
  operating and to stop the willingness to pay from
  asserting itself.
• A black market is a market in which illegal
  trading takes place at market-determined prices.
• With favored customers and black markets, the
  final distribution may be even more unfair than
  that which would result from simple price
  rationing.

7
Price Floors

• Some times it is believed that the equilibrium
  price of a good or service is too low.
• The government steps in and imposes a minimum
  price in the market
• Examples and Consequences

8
Prices and the Allocation of Resources

• When markets are allowed to work
• Changes in price resulting from shifts of demand
  and supply in output markets cause profits to
  rise or fall.
• Profits attract capital losses lead to
  disinvestment.
• Higher wages attract labor and encourage workers
  to acquire skills.
• At the core of the system, supply, demand, and
  prices in input and output markets determine the
  allocation of resources and the ultimate
  combinations of things produced.

9
Consumer and Producer Surplus

• Consumer surplus is the difference between the
  maximum amount a person is willing to pay for a
  good and its current market price.
• Consumer surplus measurement is a key element in
  cost-benefit analysis.

10
Consumer and Producer Surplus

• Producer surplus is the difference between the
  maximum amount a producer is willing to accept to
  supply a good and its current market price.

11
Markets Maximize the Sum of Producer and
Consumer Surplus

• Total producer and consumer surplus is highest
  where supply and demand curves intersect at
  equilibrium.
• Consumers receive benefits in excess of what they
  pay and producers receive compensation in excess
  of costs.

12
Deadweight Loss from Market InterventionPrice
Ceiling
13
Application of Demand and SupplyOil Import Fee

• At a world price of 18, imports are 5.9 million
  barrels per day.

• The tax on imports causes an increase in domestic
  production, and quantity imported falls.

14
Elasticity

• Some questions
• If a firm wants to increase its total revenues
  (sales), should it raise price or lower price?
• Why is a bumper crop often bad news for farmers?
• How would a tax on cigarettes affect the number
  of teenage smokers compared to adult smokers?
• Why do policies that limit the supply of illegal
  drugs often increase property crime?

15
Elasticity
Elasticity is a general concept that can be used
to quantify the response in one variable when
another variable changes.
Elasticity of A with respect to B
We can measure the responsiveness of quantity
demanded to changes in price, income, or prices
of related goods.
Price Elasticity of Demand
16
Elasticity
Price Elasticity of Demand

• Measures the responsiveness of quantity demanded
  to changes in price.
• It is the ratio of the percentage change in
  quantity demanded to the percentage change in
  price.
• Its value is always negative, but stated in
  absolute terms.
• The value of the line of the slope and the value
  of elasticity are not the same.

17
Why this formula?

• Law of Demand tells us that if Price increases ?
  quantity demanded will decrease, but not by how
  much
• Price elasticity of demand quantifies (in ) how
  quantity demanded changes will price changes.
• How much? Depends on the demand curve.
• If it is steep ? small change in Qd
• If it is flat ? large change in Qd
• But, cant use slope as a measure of elasticity
  it is sensitive to the units of measurement.

18
Elasticity
P
Elasticity is a ratio of percent changes. We
are interested in knowing whether quantity
demanded changes by relatively more or
relatively less than the price change.
4
3
10
20
Qd
19
How to Calculate Percent Changes
3 possibilities
1.
2.
3.
Midpoint formula
We will use formula 3
20
Elasticity using Mid-Point Formula
P
4
3
10
20
Qd
21
Interpreting Elasticity
Price elasticity of demand must always be
negative, due to the Law of Demand (demand
curves always have negative slope) ? we often
work with the absolute value
1. ?D lt 1 ? demand is said to be inelastic
2. ?D gt 1 ? demand is said to be elastic
3. ?D 1 ? demand is said to be unitary
elastic
22
Interpreting Elasticity (cont)
4. ?D 0 ? demand is said to be perfectly
inelastic
5. ?D ? ? demand is said to be perfectly
elastic
23
Hypothetical Demand Elasticitiesfor Four Products
24
Elasticity Changes along a Straight-Line Demand
Curve

• Price elasticity of demand decreases as we move
  downward along a linear demand curve.
• Demand is elastic on the upper part of the demand
  curve and inelastic on the lower part.

25
Elasticity Changes along a Straight-Line Demand
Curve

• Along the elastic range, elasticity values are
  greater than one.
• Along the inelastic range, elasticity values are
  less than one.

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26
Elasticity and Total Revenue
Type of demand Value of ?d Change in quantity versus change in price Effect of an increase in price on total revenue Effect of a decrease in price on total revenue
Elastic Greater than 1.0 Larger percentage change in quantity demanded ?Q gt ?P Total revenue decreases Total revenue increases
Inelastic Less than 1.0 Smaller percentage change in quantity demanded ?Q lt ?P Total revenue increases Total revenue decreases
Unitary elastic Equal to 1.0 Same percentage change in quantity and price ?Q ?P Total revenue does not change Total revenue does not change
27
Elasticity and Total Revenue
When demand is inelastic, price and total
revenues are positively related. Price
increases generate higher revenues. When demand
is elastic, price and total revenues are
negatively related. Price increases generate
lower revenues.

• Some questions and Answers
• If a firm wants to increase its total revenues
  (sales), should it raise price or lower price?
• Why is a bumper crop often bad news for farmers?
• How would a tax on cigarettes affect the number
  of teenage smokers compared to adult smokers?
• Why do policies that limit the supply of illegal
  drugs often increase property crime?

28
Determinants of Demand Elasticity

• Availability of substitutes -- demand is more
  elastic when there are more substitutes for the
  product.
• Importance of the item in the budget -- demand is
  more elastic when the item is a more significant
  portion of the consumers budget.
• Time frame -- demand becomes more elastic over
  time.

29
Other Important Elasticities

• Income elasticity of demand measures the
  responsiveness of demand to changes in income.

What values can this ratio take on?

• Cross-price elasticity of demand A measure of
  the response of the quantity of one good demanded
  to a change in the price of another good.

If A and B are substitutes
If A and B are complements
30
Other Important Elasticities

• Elasticity of supply A measure of the response
  of quantity of a good supplied to a change in
  price of that good. Likely to be positive in
  output markets.

Price Elasticity of Supply