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ECONOMICS
TENTH EDITION

LIPSEY &
CHRYSTAL

Chapter 5
PRICE THEORY IN
ACTION

Slides by
Alex Stojanovic

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Learning Outcomes
Changes in price really do lead to changes in
quantity demanded
Market prices do adjust in response to shifts in
demand and supply conditions
Elasticity of demand can be measured directly so
long as other influences can be held constant
Intervention in markets by governments to fix
prices has important consequences, not all of
which can be considered desirable
Intervention in agricultural markets has been
costly for consumers and for foreign producers

Changes in demand for newspaper

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Price
Pre-Sep.93

Average daily sales

Post-Sep.93

Pre-Sep.93

Percent change

Post-Sep.93

Price

Sales

-33.3

+19.4

The Times

45p

35p

376,836

2,196,464

Guardian

45p

45p

420,154

401,705

0.0

-4.39

Daily Telegraph 45p

45p

1,137,375

1,017,326

0.0

-1.93

Independent

50p

362,099

362,099

0.0

-14.10

2,196,464

2,179,039

50p

Disequilibrium Quantity

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Price

p2

E
p0
p1

q2

q0
Quantity

q1

q3

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Disequilibrium Quantity
Market equilibrium is at point E with price p0 and quantity q0.
For prices below P0 the quantity exchanged will be determined by the supply
curve.
For example, q2 will be exchanged at price p1, in spite of the excess demand
of q1-q2.
For prices above p0 the quantity exchanged will be determined by the
demand curve.
For example, q2 will be exchanged at price p2 in spite of the excess supply of
q3-q2.
Thus the dark blue and dark yellow portions of the S and D curves show the
actual quantities exchanged at each price.
In other words, in disequilibrium, quantity exchanged is determined by the
lesser of quantity demanded and quantity supplied.

Black-market pricing

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D
S

p2
E
p0

Maximum price permitted

p1

Excess
Demand
0

q2

q0
Quantity

q1

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Black-market pricing
Equilibrium price is at p0.
Now let a price ceiling be set at p1.
The quantity demanded will rise to q1 and the quantity
supplied will fall to q2.
Quantity actually exchanged will be q2.
Excess demand is q1-q2.
Black marketers could buy q2 at the controlled price of
p1 paying the amount shown by the light blue area p1q2.
They could sell at the price p2 earning profits shown by
the dark blue area between p1 and p2.

Unplanned Fluctuations in Output

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Elastic demand

Inelastic demand

Price

Inelastic
Demand

De
E

p0

Elastic Demand

Di

q1

q0
Unplanned changes
in output

q2

Quantity

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Unplanned Fluctuations in Output

Unplanned fluctuations in output lead to much sharper fluctuations in price

if the demand curve is inelastic than if it is elastic.
Producers expect the market price to be p0 and they plan to produce q0.
The two curves Di and De, are alternative demand curves.
If actual production always equalled planned production, the equilibrium
price and quantity would be p0 and q0 with either demand curve.
Unplanned fluctuations in output, however, cause quantity to vary year by
year between q1 (a bad harvest) and q2, (a good harvest).
When demand is inelastic (shown by the yellow curve), prices will show
large fluctuations.
When demand is elastic (shown by the blue curve), prices will show much
smaller fluctuations.
(In both cases elasticity is measured around point E)

Income Stabilization

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Price

p2
p4
De

p1

p5
=1

p3

q2 q4 q1

q5
Quantity

q3

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Income Stabilization
Income stabilization is achieved when the government purchases or sells
just enough to allow price to fluctuate in inverse proportion to output.
D is the demand curve. S is the curve showing planned supply.
Equilibrium is at E.
However, actual production fluctuates between q2 and q3.
These unplanned fluctuations in output cause the free-market price to
fluctuate between p2 and p3.
A curve of unit elasticity over its whole range is drawn through E and
labelled =1.
To stabilize income, any given output must be sold at a price determined
by this curve.
The government buys or sells an amount equal to the horizontal distance
between the =1 curve and the demand curve.

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Income Stabilization
For example, when production is q3 market price must be held at
p5 if income is to be unchanged.
But at market price p5 the public wishes to purchase only q5.
So the government must buy up the remaining production, q3 - q5.
It adds this amount to its stocks.
Farmers total sales are q3 at price ps.
Since the broken yellow curve is a rectangular hyperbola,
income, p5 x q3, is equal to income p1 x q1.
When production is equal to q2 price must be allowed to rise only
to p4.
(By construction the area p4q2 is equal to the area p1q1.)
But at price p4 the public will wish to buy q4 so that the
government must sell q4 - q2 out of its stocks.

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CHAPTER 5: PRICE THEORY IN ACTION

Finish your coffee, were off to the museum
World commodity prices, such as coffee, change in response
to the balance of supply and demand factors.
The increase in museum visits following the abolition of
admission charge shows that demand curve really do have
negative slope.
Keeping up with The Times and the Tunnel
Demand and supply theory is a potent tool for analysing
many real-world situations as the effects of the Channel
Tunnel and price-cutting among British newspapers.
Government Intervention in Markets
Effective price ceilings lead to excess demand, black
markets,and non-price methods of allocating the scarce
supplies among would-be purchasers.
Rent controls are a form of price ceiling. Their major
consequence is a shortage of rental accommodation that
gets worse because of a slow but inexorable decline in the
quantity of rental accommodation.

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CHAPTER 5: PRICE THEORY IN ACTION

The Problems of Agriculture

On the free market many agricultural prices are
subject to wide fluctuations as a result of weatherinduced, year-to-year fluctuations in supply operating
on inelastic demand curves, and cyclical fluctuations
in demand operating on inelastic supply curves.
Governments can stabilise agricultural incomes by
reducing price fluctuations.
They achieve this by holding stocks, which they add
to through purchases in times of surplus and sell from
in times of shortage.

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CHAPTER 5: PRICE THEORY IN ACTION

The long-term problems of agriculture arise from

productivity growth on the supply side combined with low
income elasticity on he demand side.
This means that, unless many resources are being
transferred out of agricultural fairly rapidly, quantity
supplied tends to increase faster than quantity demanded
year after year.
Stabilisation schemes that hold prices above their freemarket levels on average, over short-term and cyclical
swings, frustrate the long-term adjustment process and
lead to over-growing surpluses - as the EUs Common
Agricultural Policy [the CAP].

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CHAPTER 5: PRICE THEORY IN ACTION

Some General Lessons about the price System:

Costs may be shifted, but they can not be avoided;
free-market prices and profits encourage economical use
of resources;
government intervention affects resource allocation; and
intervention requires alternative allocative mechanisms.