HCA 586 Lecture 2

price serves 3 important functions

1. it provides useful info to both consumers and producers regarding the relative value of a good or service in the market

2. it serves as a rationing device which distributes the goods and services to consumers who value them most

3. it acts as an incentive mechanism

   1. it encourages more resources to markets with natural shortages, though it increases

   2. it encourages fewer resources to markets with natural surpluses through —- decreases

the law of supply

• a direct relationship exists between the price of a good and the quantity supplied of that good

  • as the price of the good increases, sellers are willing to supply more

  • all other things remaining constant, the higher the price of a good or service, the higher the supply

  • this occurs because producers want to produce more of that good or service at the higher price to increase profits. Conversely, the lower the price, the lower the supply

analysis of supply curve (upward sloping)

• identifies what the seller is willing to supply at different prices

• change in quantity supplied

  • direct relationship (price and quantity move in the same direction)

  • as the price of the good increases, sellers are willing to supply more of the good

supply curve shifts

• change in supply

• at a constant price (shift left): sellers supply less than did before

• shift right: sellers supply more than before

• associated with exogenous events. Ceteris Paribus does not hold

supply curve shift left

• at all possible prices you have a decrease in supply

• at the same price, you have a decrease in supply

• ex. the cost/availability of hospital services taking into account the effects of a nursing shortage

supply curve shift right

• at all possible prices you have an increase in supply

• at a constant price, suppliers are wiling to supply more

• ex. federal policy allows more international nurses to work in the US

factors associated with a shift in the supply curve

• changes in the prices of other goods: the change in the price of a good related in production

  • ex. lab services and physician services

• taxes on goods/services: increase in taxes leads to a shift to the left. A decrease in taxes leads to a shift to the left

• effects of labor: an increase in supply of labor leads to a shift to the right, a decrease in labor leads to a shift to the left

• weather/major occurrences: good weather/other beneficial supply factors leads to a. shift to the right, bad weather/cataclysmic events leads to a shift to the left

• changes in the prices of other goods: the change in the price of a good related in production

• changes in the price of inputs: inputs are resources such as people, raw materials, energy, info, or finance that are put into a system to obtain a desired output

• changes in technology: technology is the collection of techniques, skills, methods, and processes used in the production of goods or services

elasticity

• focuses on understanding how demand and supply change in response to changes in prices and incomes. There are several types of elasticity

price elasticity of demand

• demand is elastic: if the percent change in quantity demanded is greater than the percentage change in price

• demand is inelastic: if the percentage change in quantity demanded is less than the percentage change in price

factors impacting price elasticity of demand

• the price elasticity of demand is a measure of how much the quantity demanded changes with a change in price

• the PED for a given good is determined by one or a combination of the following:

  • degree of necessity

  • proportion of the purchaser’s budget consumed by the item

  • time frame

  • breadth of definition of a good

  • brand loyalty

degree of necessity

• the greater the necessity for a good, the lower the elasticity

  • ex. consumers will continue to buy necessary products regardless of the price

• luxury products have greater elasticity, however, some goods that initially have a low degree of necessity are habit forming and can become necessities to consumers, such as coffee

proportion of the purchaser’s budget consumed by the item

• products that consume a large portion of the purchaser’s budget tend to have greater elasticity

  • the relatively high cost of such goods will cause consumers to pay attention to the purchase and seek substitutes

• in contrast, demand will tend to be inelastic when a good represents only a negligible portion of the budget

  • essentially higher income individuals are more inelastic to price changes in goods/services

time frame

• for non-durable goods, elasticity tends to be greater over the long-run than the short-run

  • in the short term it may be difficult for consumers to find substitutes in response to a price change, but, over a longer time period, consumers can adjust their behavior

breadth of definition of a good/service

• the broader the definition of a good, the lower the elasticity

brand loyalty

• an attachment to a certain brand (either out of tradition or because of proprietary barriers) can override sensitivity to price changes, resulting in more inelastic demand

price elasticity of supply

how the quantity supplied responds to changes in price

supply is elastic

if the percent change in quantity supplied is greater than the percentage change in price

supply is inelastic

if the percentage change in quantity supplied is less than the percentage change in price

factors impacting supply elasticity

• the availability of raw materials: greater availability leads to an increased ability to supply

• the availability of labor: if labor is in short supply elasticity of supply will be lower

• the extend to which labor can be reduced: if labor is heavily unionized, in short supply or there is strict legislation regarding firing of labor, it might not be possible to reduce supply in response to a price drop

• whether finished products or raw materials are available: greater availability means a faster response to changes in market price

• whether the firm has spare capacity: with spare capacity, production can be quickly increased as a response to higher prices

• the timeframe being considered: supply will be much more elastic in the long run compared with the short run

cross elasticity of demand (XED)

• measures the effect of a change in the price of one good on consumer demand for another good

• the significance:

  • given that most firms sell goods and services which have both complements and substitutes it is important to analyze the presence of cross elasticities

  • complements are goods that are consumed together. substitutes are goods where you can consume one in place of the other

  • complementary goods: if the increase in price of a good/service A decreases the demand for good/service B

  • data on cross elasticities indicates the relative strength or closeness of substitutes as well as the significance of complements

equilibrium analysis

when the demand for good X equals the supply of good X, the market for good X is said to be in equilibrium

demand and supply curves

• the meeting point is known as market equilibrium (or market clearing price level)

market equilibrium

• the price at which the customer is willing to pay for the good and the price at which the seller is willing to sell the good

• markets are able to efficiently allocate scarce resources by establishing this meeting point or price level

consumer surplus

• area under the curve and above the equilibrium price

• aggregate difference between the price consumers are willing to pay and what they actually had to pay

• the value received but not paid for

producer surplus

• area under the curve and below the equilibrium price

• aggregate difference between the minimum price at which producers are willing to sell/produce the good/service and the price that they actually receive

total surplus

consumer surplus + producer surplus