The Price System, Demand and Supply, and Elasticity

CHAPTER 4
The Price System, Demand

and Supply, and Elasticity
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Price System
• The market system, also called the price

system, performs two important and
closely related functions :
• Price Rationing
• Resource Allocation
Price Rationing
• Price rationing is the

process by which the
market system allocates
goods and services to
consumers when quantity
demanded exceeds
quantity supplied.
Price Rationing
• A decrease in supply
creates a shortage at
P0. Quantity demanded
is greater than quantity
supplied. Price will
begin to rise.
• The lower total supply
is rationed to those
who are willing and
able to pay the higher
price.
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.
Alternative Rationing Mechanisms
• A price ceiling is a maximum price

that sellers may charge for a good,
usually set by government.
• 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 is that

excess demand is created but not eliminated.
• 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, the
result was excess
demand.
• A black market is a
market in which illegal
trading takes place at
market-determined
prices.
• 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.
• With favored customers and black markets, the

final distribution may be even more unfair than
that which would result from simple price
rationing.
Prices and the Allocation of Resources
• Price changes resulting from shifts of demand 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.
Supply and Demand Analysis:
An Oil Import Fee
• At a world price of $18, • The tax on imports causes an

increase in domestic production, and
imports are 5.9 million barrels quantity imported falls.
per day.
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
• Price elasticity of demand measures how
responsive consumers are to changes in the
price of a product.
Price Elasticity of Demand
• Measures the responsiveness of demand to

changes in price.
• It is the ratio of the percentage change in
quantity demanded to the percentage change
in price.
% 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
• 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.
Characteristics of Demand Elasticity
Value of Type of Magnitudes of Response to

Elasticity Demand Change Price Changes
 > |1| Elastic %Qd > %P Responsive
 < |1| Inelastic %Qd < %P Unresponsive
 = |1| Unitary elastic %Qd = %P Proportional
Type of Substitutes
Elasticity Available
Elastic Many
Inelastic Few
Shape of Demand According to Elasticity
Type of Demand Inclination

Elastic Relatively Flat
Inelastic Relatively Steep
Extreme Elasticities
Elasticity Value Type of Elasticity Substitutes Available

=0 Perfectly Inelastic None
= Perfectly Elastic Infinite
Hypothetical Demand Elasticities
for Four Products
Hypothetical Demand Elasticities for Four Products
% CHANGE IN
% CHANGE QUANTITY
IN PRICE DEMANDED ELASTICITY
PRODUCT (% P) (% Qd) (% Qd/% P)
Insulin 10% 0% 0 Perfectly inelastic
Basic telephone service 10% -1% -0.1 Inelastic
Beef 10% -10% -1 Unitary elastic
Bananas 10% -30% -3 Elastic
Calculating Percentage Changes
• Elasticity is a ratio of percentages, and it involves

computing percentage changes.
P2  P1
% c h a n g e in p ric e  x 100%
P1
Q2  Q1
% c h a n g e in q u a n tity d e m a n d e d  x 100%
Q1
• Using the values on the graph to
compute elasticity, then:
 100%
p ric e e la s tic ity o f d e m a n d    3 .0
 3 3 .3 %
Computing the Value of Elasticity
• The midpoint formula to

compute elasticity is:
Q2  Q1
x 100%
% Qd (Q 1  Q 2 ) / 2

% P P2  P1
x 100%
( P1  P2 ) / 2
10  5 5
x 100% x 100%
% Qd (5  1 0 ) / 2 6 6 .7 %
  7 .5 =   1 .6 7
% P 2  3 -1 - 4 0 .0 %
x 100% x 100%
(3  2 ) / 2 2 .5
Interpreting the Value of Elasticity
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.
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.
Elasticity Changes along a Straight-
Line Demand Curve
• Along the elastic range,
 6.4
elasticity values are
greater than one.
• Along the inelastic range,
 .29 elasticity values are less
than one.
Elasticity Along a Straight-Line
Demand Curve
25.00 Elasticity = 4
Price (dollars per pizza)
20.00 Elastic
Elasticity = 1
15.00
12.50 Inelastic
10.00
Elasticity = 1/4
5.00
0 10 20 25 30 40 50
Quantity (pizza per hour)
Elasticity and Total Revenue
Effect of an
Change in quantity increase in Effect of a
Type of versus change in price on total decrease in price
demand Value of Ed price revenue on total revenue
Elastic Greater than Larger percentage change Total revenue Total revenue
1.0 in quantity decreases increases
Inelastic Less than 1.0 Smaller percentage Total revenue Total revenue
change in quantity increases decreases
Unitary Equal to 1.0 Same percentage change Total revenue Total revenue does
elastic in quantity and price does not change not change
• 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.
25.00 Elastic
demand
Total Revenue (billions of dollars) Price (dollars per pizza)

20.00
15.00 Unit
12.50 elastic
10.00 Inelastic
5.00 demand
0
25 50
350.00
312.50 Maximum
300.00 total revenue
250.00
When demand 200.00 When demand
is elastic, is inelastic,
price cut 150.00 price cut decreases
increases 100.00 total revenue
total revenue
50.00
Quantity (pizza per hour)
0 25 50
Elasticity and Total Revenue:
Inelastic Demand
Price Price …leads to an increase
An increase in price in total revenue
from $1 to $3... from$100 to $240
$3
Revenue = $240
$1
Revenue = $100
Demand Demand
0 100 Quantity 0 80 Quantity
Elasticity and Total Revenue: Elastic
Demand
Price Price …leads to a decrease
An increase in price in total revenue
from $4 to $5... from$200 to $100
$5
$4
Demand Demand
Revenue = $200 Revenue = $100
0 50 Quantity 0 20 Quantity
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 consumer’s budget.
• Time frame -- demand becomes
more elastic over time.
Other Important Elasticities
• Income elasticity of demand – measures the

responsiveness of demand to changes in
income.
% c h a n g e in q u a n tity d e m a n d e d
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
• 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
Elasticity of Supply
• Supply elasticity depends on:
• Resource substitution possibilities
• Time frame for the supply decision
Inelastic and Elastic Demand
Perfectly inelastic supply
Price S1
Elasticity of
supply = 0
0 Quantity
Unit elastic supply
Price
S1
Elasticity of
supply = 1
0 Quantity
Perfectly elastic supply
Price
Elasticity of
supply = 
S3
0 Quantity
• Resource Substitution Possibilities

• The more unique the resource, the more inelastic
the supply.
• Van Gogh painting - Van Gogh
• Wheat/corn — farmland
• Time Frame for Supply Decisions

• Momentary supply
• Long-run supply
• Short-run supply
• The longer producers have to adjust to a price

change, the more elastic is supply.
• 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 
% c h a n g e in p ric e
• 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
A Compact Glossary of Elasticities
PRICE ELASTICITIES OF DEMAND
A relationship is When its Which means that
described as magnitude is
Perfectly elastic Infinity The smallest possible increase in price causes
or infinitely elastic an infinitely large decrease in quantity demanded
Elastic Less than infinity The percent decrease in the quantity demanded
but greater than 1 exceeds the percent increase in price
Unit elastic 1 The percent decrease in the quantity demanded

equals the percent increase in price
In elastic Greater than zero The percentage decrease in the quantity demanded
but less than 1 is less than the percent increase in price.
Perfectly inelastic Zero The quantity demanded is the same at all prices
or completely inelastic
CROSS ELASTICITIES OF DEMAND
Perfect substitutes Infinity The smallest possible increase in price of one

good causes an infinitely large in the demand
of the other good.
Substitutes Positive, less If the price of one good increases, the quantity
than infinity demanded of the other good also increases.
Independent Zero The demand for one good remains constant,

regardless of the price of the other good.
Complements Less than zero The demand for one good decreases when the
price of the other good increases.
INCOME ELASTICITIES OF DEMAND
Income elastic Greater than 1 The percent increase in the quantity demanded
(normal good) is greater than the percentage increase in income.
Income inelastic Less than 1 but The percent increase in the quantity demanded
(normal good) greater than zero is less than the percentage increase in income.
Negative income elastic Less than zero When income increases, quantity demanded
(inferior good) decreases.
ELASTICITIES OF SUPPLY
Perfectly elastic Infinity The smallest possible increase in price causes an

infinitely large increase in the quantity supplied.
Elastic Less than infinity The percent increase in the quantity supplied
but greater than 1 exceeds the percentage increase in the price.
Inelastic Greater than zero The percentage increase in the quantity supplied
but less than 1 is less than the percentage increase in price.
Perfectly inelastic Zero The quantity supplied is the same at all prices.

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CHAPTER 4

The Price System, Demand

Prepared by: Fernando Quijano

• The market system, also called the price

• Price rationing is the

• There is some price that

• The price of a rare

• A price ceiling is a maximum price

• Queuing is a nonprice rationing

• Favored customers are those who receive

• Ration coupons are tickets or coupons that

• The problem with these alternatives is that

• No matter how good the intentions of private

• With favored customers and black markets, the

• Price changes resulting from shifts of demand in output

• Profits attract capital; losses lead to disinvestment.

• Higher wages attract labor and encourage workers to

• At the core of the system, supply, demand, and prices in

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

• Elasticity is a general concept that can be used

• Measures the responsiveness of demand to

Value of Type of Magnitudes of Response to

Type of Demand Inclination

Elasticity Value Type of Elasticity Substitutes Available

Hypothetical Demand Elasticities for Four Products

• Elasticity is a ratio of percentages, and it involves

• The midpoint formula to

Here is how to interpret two different

• Price elasticity of demand

• Demand is elastic on the

• When demand is inelastic, price and total revenues are directly

Total Revenue (billions of dollars) Price (dollars per pizza)

• Income elasticity of demand – measures the

• Cross-price elasticity of demand: A

• Supply elasticity depends on:

• Resource substitution possibilities

• Time frame for the supply decision

• Resource Substitution Possibilities

• Time Frame for Supply Decisions

• The longer producers have to adjust to a price

• Elasticity of supply: A measure of the

• Elasticity of labor supply: A measure of the

Unit elastic 1 The percent decrease in the quantity demanded

Perfect substitutes Infinity The smallest possible increase in price of one

Independent Zero The demand for one good remains constant,

Perfectly elastic Infinity The smallest possible increase in price causes an

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