Chapter 4 Application of Demand and Supply and the Concept of Elasticity The pricing system in a competitive economy can be distorted by the action of the government to protect the interest of the great majority of people through its pricing policy. The intervention can occur in the form of price control, price support and minimum wages which are discussed in the first part of this chapter. The second part of this chapter focuses on the determination of the degree of responsiveness of demand to changes in the price, consumer income and to prices of other goods. This pertains to topics on elasticity; the price elasticity of demand, price elasticity of supply, income elasticity of demand and the cross elasticity of demand. The interpretation of elasticity is important so it is can be best understood even by a non-economist. Government Intervention: Price Control, Price Support and Minimum Wages Prices in a purely competitive market are free to rise or fall until their equilibrium levels, no matter how high or how low those levels might be as long as the market clears. However, government may intervene if supply and demand generate prices that are unfairly high for buyers such that they are unable to buy or unfairly low for sellers that they are unable to make profit. The government may set legal limits on how high or how low prices may go but it must be ready to supply whenever there is shortage in the market or be prepared to buy when there is a surplus of produced goods. For the government to become successful in its program of protecting the consumers through price fixing, it must be able to assure a continuous supply of the goods by market monitoring. ~63=Figure 4.1 The Market Price and the Price Control for Rice 30 Price control 20 10 200 400 600 Quality Given the demand and supply curves for rice, the position of the price ceiling or the price control is set at P25 per kilo. Notice that the price ceiling is below the market price of P30. This is to safeguard consumers interest so they can buy at a lower price compared to prevailing prices. Price ceiling creates shortage of the product in the market. Figure 4.2 Market Price and the Price Support for Palay SURPLUS:Figure 4.2 shows the demand and supply curves for palay. The position of the price support is set at P18 per kilo in this example. Notice that the price support is above the market price of P16. Purpose isto safeguard the farmers interest so they can sell their product even at higher prices compared to prevailing prices to the traders. The most prevalent uses of price floors are those prices set for agricultural products usually rice and corn. The government normally attempts to stabilize, to raise farm incomes by maintaining the prices of farm commodities above the equilibrium values using its power to alter the price. As a result of the price floor there is usually a surplus for agricultural products. The problem of a surplus can only be solved if the government commits to buy from the farmers whatever is not bought by the traders. Minimum wage SAAS (SWS y Wage LRSM ONTOS, Equivalently, it is the lowest wage which workers may receive for the services rendered. In the case of the Philippines the minimum wage is determined by a Regional Wage Board considering among others, the cost of living ina particular area or region. For example, in Metro Manila the minimum wage is Php426 (effective May 26, 2011) while it is lower in regions ouside Metro Manila. There are differences of opinion about the benefits and drawbacks of a minimum wage. Supporters of the minimum wage say that it increases the standard of living of workers and reduces poverty. Opponents say that if it is high enough to be effective, it increases unemployment, particularly among workers with very low productivity due to inexperience or handicap, thereby harming lesser skilled workers to the benefit of better skilled ones.Figure 4.3 The Equilibrium Wage (W,) and the Minimum Wage (Wm) \ unemployment The minimum wage (wm) is usually above the equilibrium wage, therefore it may cause surplus of labor, hence there is unemployment. ELASTICITY As to how responsive is the dependent variable with respect to change in independent variable, it can be very responsive, quite responsive or not responsive at all, is answered by the concept of elasticity. Elasticity from the term elastic, a word associated toa lastico’ or rubber band which can be elastic or stretchable or inelastic or not stretchable. Four kinds of elasticity are as follows with corresponding elasticity coefficient: Le Price Elasticity of Demand (é,) 2. Income Elasticity of Demand (€,) 3: Cross Elasticity of Demand (€,) 4. Price Elasticity of Supply (€,) Price elasticity of demand(Ed) The Price elasticity of demand (€ ") Measures the degree of responsiveness of quantity demanded to changes in the price of the good itself, other things constant. -66-Fd 7! dashe Ea <|_ inelaste, £4 =| unitary AQ E = = Where:A Q=Q,-Q, AP=P,-P, PB and Q, are the original price and quantity, respectively. P, and Q, are the new price and quantity, respectively Sample problem for price elasticity of demand: The price of a poster is P10.00 and its average daily sales are 20. In the desire to increase sales the store owner decided to cut its price toP5.00 makingsales of SO posters for that day. How responsive is the demand for poster to changes in its price? Using the formula for elasticity Simplifying the given : P,=10, Q=20, P2=5, Q,=50 Q,-0, 50-20 30 20 20 15 Sis eg 5 % AQ % AP Examining the given problem, the price elasticity of demand (E,) is the appropriate elasticity for adoption. Based on the computation , €, for poster is -3 for an absolute value of 3 which means that demand for poster is elastic. The value of €, tells us that for every 1% change in the price of poster , the demand for poster will change by 3%. Type of the price elasticity of demand Quantity demanded can be very responsive, not so responsive or does not respond at all to changes in price of the good itself. This is determined by the value of the price elasticity of demand (E,). Economists, however, just get the absolute value of the price elasticity of demand (€,) for interpretation purposes to determine its type. -67-1. Elastic or Relatively Elastic: eeu. % AQA>% AP Figure 4.4 Relatively Elastic Demand Quantity Relatively elastic demand curve has a flatter a demand curve, as shown in the above graph. Products which are considered luxuries and have a lot of substitutes are example of products with elastic demand. These can be shoes, shirts, pants whose quantity bought increases more than a decrease in prices. To increase total revenue, price should be reduced because demand is very responsive to a change in price, other things constant. | If for example a 50% fall in price leads to a 100% increase in quantity demanded, E, = 2.0 2. Unitary or Unit Elastic Demand: = €,=1 , % AQ=% AP Figure 4.5 Unitary Demand A unitary demand curve shows that the percentage change in quantity demanded is just proportional to percentage change in price. 68%Products for which buyers allocate a specific amount have unitary elasticity. For some people this can be a demand for a load for their cell phone when their budget is pegged to P300 a month. Their demand for load changes by the amount proportionate to changes in price of cell phone load. For a unitary elastic demand, any change in price has no effect to total revenue because demand changes proportionately to a price change as shown in Figure 4.5. 3. Inelastic or Relatively Inelastic Demand: E<1, %¥AP>%AQ Figure 4.6 Relatively Inelastic Demand Q Relatively inelastic demand is a steep curve as in Figure 4.6. Products which are considered basic goods are example of products with relatively inelastic demand. These can be rice, sugar or salt whose quantity bought is not so much affected by changes in the price of the goods itself. If the €, is less than one, demand for the good is inelastic. Demand is not very responsive to changes in price. For example, a 20% increase in price leads to a 5% fall in quantity demanded, than the €, = 0.25. =-.25 i69-To increase total revenue, sellers may increase the price causing buyers to reduce demand by a little but this may not be a tremendous decline because these goods are considered necesseties. 4. Perfectly Elastic Demand: €, = Infinity Figure 4.7 Perfectly Elastic Demand ° @ Perfectly Elastic demand is a horizontal demand curve; its slope is infinite or undefined as in Figure 4.7. This shows that regardless of quantity demanded, the price is set at a specified given level. This is true in the case of a firm in the pure competition, because price is determined not by a single seller or buyer but by the interplay of the demand and supply in the industry. Take note that the industry’s demand curve is downward sloping but the firms demand curve is perfectly elastic or horizontal. 5. Perfectly Inelastic Demand: &,=0, Figure 4.8 Perfectly Inelastic Demand e + Quantty Perfectly Inelastic Demand has a vertical demand curve. If the the good is perfectly inelastic, a change in price will have no influence on quantity demanded as in Figure 4.8. =70<Avery good example of product with perfectly inelastic demand is the medicine for anti-rabbies. This good is considered extremely important at a given time, that when doctor needs a certain dosage, it has to be bought at the expected quantity demanded regardless of its price. Price Elasticity of Supply (€,) The Price elasticity of supply (€) measures the degree of responsiveness of quantity supplied due to changes in the price of the good itself other things constant. Formula: Where: AQ=Q,-Q, AP=P,-P, P, and Q, are the original price and quantity supplied, respectively. P, and Q, are the new price and quantity supplied, respectively. The demand curve is negatively sloped, so the price elasticity of demand is negative, unlike the price elasticity of supply, whose €, is always positive. The price elasticity of supply works similarly to price elasticity of demand. When the price elasticity of supply is greater than one, supply is said to be elastic; when less than one, supply is inelastic and when equal to one it is unitary. However, when supply is perfectly inelastic, elasticity coefficient is equal to zero with a vertical supply curve. Perfectly elastic supply is illustrated using a horizontal supply curve with an elasticity coefficient {€,) of infinity. Income elasticity of demand (£,) The Income elasticity of demand (€,) measures the degree of responsiveness of quantity demanded due to changes in the consumer’sincome other things constant. 71 -If consumer’s Income is considered instead of the price as a factor that affects demand, then the elasticity formula changes as follows: AQ % AQ Q, g = nvnnstnes Sp sie os % AY AY Y. Where:A Q=Q,-Q, AY=Y,-Y, Y, and Q, are the original income and quantity, respectively. Y, and Q, are the new income and quantity, respectively. Income elasticity of demand coefficients can be positive; it can be negative depending on the type of product. For normal good, income elasticity of demand is positive that is, an increase in income will normanlly increase quantity demanded for goods. Inferior good like rice, eggs and sardines the €, is negative. Cross Elasticity of Demand (€,) The Cross Elasticity of Demand (€,) measures the degree of responsiveness of quantity demanded due to changes in the price of related goods, other things constant. If the price of related products changes, then the elasticity formula changes as follows: %AQ é, a). alae = % AP, Where: AQ = Q,— A Pa el Pat P,, and Q, are the original price of related good and quantity of good, respectively.P., and Q, are the new price of related good and quantity of good, respectively. The Cross Elasticity of Demand can be positive when the goods and services under study are substitutes and for complementary goods the cross elasticity of demand is negative. Factors that Affect Elasticity of Demand al Number of close substitutes available - The demand is said to be elastic when there are more (and closer) substitutes available in the market in response to a change in price. In this case, the substitution effect will be quite strong. Luxuries and necessities - Demand for necessities tends to be more inelastic, whereas that for luxury goods and services it tends to be more elastic. For example, the demand for party dresses is more elastic than the demand for their school uniforms. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent for the goods, the more inelastic demand will be at for example, spending on cellphone as compared to budget for its accessories. Time period under consideration - Demand tends to be more elastic in the long-run rather than in the short run because consumers have enough time to adjust their consumption pattern.