Pricing System

CHAPTE
4
The Price System, Demand
and Supply, and Elasticity
Prepared by: Fernando Quijano

and Yvonn Quijano
2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 4: The Price System, Demand and Supply, and Elasticity
The Price System:

Rationing and Allocating Resources
The market system, performs
two important and closely
related functions:
1. Resource allocation: the
market system determines the

allocation of resources among
produces and the final mix of
outputs.
Karl Case, Ray Fair
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The Price System:

Rationing and Allocating Resources
The market system, performs
two important and closely
related functions:
2. Price rationing: the market
system distributes goods and

services on the basis of
willingness and ability to pay.
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Price Rationing
A decrease in supply
creates a shortage at
the original price.
The lower supply is
rationed to those who
are willing and able to
pay the higher price.
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Price Rationing
There is some price
that will clear any
market.
The price of a rare
painting will eliminate
excess demand until
there is only one bidder
willing to buy the single
available painting.
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Constraints on the Market
A price ceiling is a
maximum price that sellers
may charge for a good,
usually set by government.
In 1974, the government set
a price ceiling to distribute
the available supply of
gasoline.
At an imposed price of 57
cents per gallon, the result
was excess demand.
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Alternative Rationing Mechanisms
Queuing is a nonprice
rationing system that uses
waiting in line as a means of
distributing goods and
services.
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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.
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Attempts to restrict
prices often result in
the evolution of a
black market.
A black market is a
market in which illegal
trading takes place at
market-determined
prices.
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The problem with rationing systems
is that excess demand is created but
not eliminated.
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.
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Prices and the Allocation of Resources

Price changes resulting from shifts of demand
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.
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Price Floors
A price floor is a minimum price
below which exchange is not
permitted.
The most common example of a price
floor is the minimum wage, which is a

floor set under the price of labor.
The result of setting a price floor will

be excess supply, or higher quantity
supplied than quantity demanded.
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Supply and Demand Analysis:

An Oil Import Fee
At a world price of $18, imports The tax on imports causes an

increase in domestic production,
are 5.9 million barrels per day.
and quantity imported falls.
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Supply and Demand

and Market Efficiency
Supply and demand curves
can be used to illustrate the
idea of market efficiency, an
important aspect of normative
economics.
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Consumer Surplus
Consumer surplus is
the difference between
the maximum amount a
person is willing to pay
for a good and its current
market price.
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Consumer Surplus
Some consumers are

willing to pay as much
as $5 each for
hamburgers.
Since the price is only
$2.50, they receive a
consumer surplus of
$2.50.
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Consumer Surplus
Others are willing to

pay something less
than $5.00 but more
than $2.50.
Consumer surplus is
the area below the
demand curve and
above the price level.
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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.
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Producer Surplus
Some producers are

willing to accept as
little as 75 cents each
for hamburgers.
Since the price is
$2.50, they receive a
producer surplus of
$1.75 per hamburger.
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Producer Surplus
Others producers are

willing to receive
something less than
$5.00 but higher than
75 cents.
Producer surplus is
the area above the
supply curve and
below the price level.
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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.
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Markets Maximize the Sum of

Producer and Consumer Surplus
If the market produces

too little, say 4 million
instead of 7 million
hamburgers per month,
total producer and
consumer surplus is
reduced. This reduction
(triangle ABC) is called
a deadweight loss.
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Potential Causes of Deadweight Loss

From Under- and Overproduction
Deadweight losses can

occur from under- and
overproduction.
If the market produces 10
million instead of 7 million
hamburgers per month,
the cost of production rises
above the willingness of
consumers to pay,
resulting in a deadweight
loss.
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Elasticity
Elasticity is a general
concept that can be used
to quantify the response in
one variable when another
variable changes.
% A
e la s tic ity o f A w ith re s p e c t to B
% B
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Price Elasticity of Demand

A popular measure of elasticity is
price elasticity of demand
measures how responsive
consumers are to changes in the
price of a product.
% c h a n g e in q u a n tity d e m a n d e d
p ric e e la s tic ity o f d e m a n d
% c h a n g e in p ric e
The value of demand elasticity is

always negative, but it is stated in
absolute terms.
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Slope and Elasticity
The value of the slope of the

demand curve and the value of
elasticity are not the same.
Unlike the value of the slope,
the value of elasticity is a
useful measure of
responsiveness.
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Slope and Elasticity

slope
23
1
10 5
5
slope
23
1
160 80
80
Changing the units of measure yields a very

different value of the slope, yet the behavior of
buyers in both diagrams is identical.
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Types of Elasticity
Hypothetical Demand Elasticities for Four Products
PRODUCT
% CHANGE IN
% CHANGE
IN PRICE QUANTITY DEMANDED
(%QD)
(%P)
ELASTICITY
(%QD d %P)
Insulin
+10%
0%
0.0
Basic telephone service
+10%
-1%
-0.1
Inelastic
Beef
+10%
-10%
-1.0
Unitarily elastic
Bananas
+10%
-30%
-3.0
Elastic
Karl Case, Ray Fair
Perfectly inelastic
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Perfectly Elastic and

Perfectly Inelastic Demand Curves
Demand is perfectly elastic

When demand does not
when quantity demanded
respond at all to a change
drops to zero at the slightest
in price, demand is
increase in price.
perfectly inelastic.
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Calculating Elasticities
Calculating percentage changes:
P2 P1
x 100%
P1
Q2 Q
Q1
x 100%
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Elasticity is a ratio of
percentages.
Using the values on the
graph to compute
elasticity, using
percentage changes
yields the following
result:
100%
p ric e e la s tic ity o f d e m a n d
3 .0
3 3 .3 %
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A more accurate way of
computing elasticity than
percentage changes is the
midpoint formula:
Q2 Q1
x 100%
% Qd
(Q 1 Q 2 ) / 2
P2 P1
% P
x 100%
( P1 P2 ) / 2
10 5
5
x 100%
x 100%
% Qd
(5 1 0 ) / 2
7 .5
2 3
-1
% P
x 100%
x 100%
(3 2 ) / 2
2 .5
6 6 .7 %
=
1 .6 7
- 4 0 .0 %
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Here is how to interpret two different
values of elasticity:
When = 0.2, a 10% increase in
price leads to a 2% decrease in
quantity demanded.
When = 2.0, a 10% increase in
price leads to a 20% decrease in
quantity demanded.
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Elasticity Changes along a

Straight-Line Demand Curve
Price elasticity of
demand decreases as
we move downward
along a straight line
demand curve.
Demand is elastic in
the upper range and
inelastic in the lower
range of the line.
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Elasticity Changes along a

Straight-Line Demand Curve
6.4
.29
Along the elastic

range, elasticity
values are greater
than one.
Along the inelastic
range, elasticity
values are less than
one.
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Elasticity and Total Revenue
TR P Q
Value of Ed
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
Total revenue
decreases
Total revenue
increases
Inelastic
Less than 1.0
Smaller percentage
change in quantity
Total revenue
increases
Total revenue
decreases
Unitary
elastic
Equal to 1.0
Same percentage change

in quantity and price
Total revenue
does not change
Total revenue does

not change
Type of
demand
When demand is inelastic, price and total revenues are
directly related. Price increases generate higher revenues.

When demand is elastic, price and total revenues are
indirectly related. Price increases generate lower revenues.
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The 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 dimension -- demand becomes
more elastic over time.
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The Determinants of
Demand Elasticity
Nature of need that commodity satisfies For
luxury goods it is price elastic. For necessities it is
price elastic
Number of uses to which a commodity is put
when goods have multiple uses elasticity is more.
Consumer habits habitual consumers demand
for a commodity is inelastic irrespective of price
changes
Tied demand demand for goods tied to
others(complements) is normally inelastic
Price range goods which have high or low range
of price the demand is inelastic and goods with
middle range have elastic demand
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Other Important Elasticities

Income elasticity of demand
measures the responsiveness of
demand to changes in income.
in c o m e e la s tic ity o f d e m a n d
% c h a n g e in in c o m e
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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.
% c h a n g e in q u a n tity o f Y d e m a n d e d
c ro s s - p ric e e la s tic ity o f d e m a n d
% c h a n g e in p ric e o f X
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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.
% c h a n g e in q u a n tity s u p p lie d
e la s tic ity o f s u p p ly
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Elasticity of labor supply: A
measure of the response of labor
supplied to a change in the price of
labor.
% c h a n g e in q u a n tity o f la b o r s u p p lie d
e la s tic ity o f la b o r s u p p ly
% c h a n g e in th e w a g e ra te
Karl Case, Ray Fair
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Review Terms and Concepts

black market
income elasticity of
demand
price floor
cross-price elasticity of
demand
inelastic demand
producer surplus
midpoint formula
queuing
deadweight loss
minimum wage
ration coupons
elastic demand
perfectly elastic demand
unitary elasticity
elasticity
elasticity of labor supply
perfectly inelastic
demand
elasticity of supply
price ceiling
favored customers
price elasticity of
demand
consumer surplus
price rationing
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CHAPTE

Prepared by: Fernando Quijano

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

The Price System:

market system determines the

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

The Price System:

system distributes goods and

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Constraints on the Market

2004 Prentice Hall Business Publishing

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Alternative Rationing Mechanisms

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Alternative Rationing Mechanisms

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Alternative Rationing Mechanisms

2004 Prentice Hall Business Publishing

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Alternative Rationing Mechanisms

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Prices and the Allocation of Resources

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

floor is the minimum wage, which is a

The result of setting a price floor will

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity

Supply and Demand Analysis:

At a world price of $18, imports The tax on imports causes an

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 4: The Price System, Demand and Supply, and Elasticity