Chapter 4 (macro)

Price Controls and Market Intervention

Introduction to Price Controls

• Governments may intervene in markets believing that the equilibrium price is inappropriate, resulting in either:

  • Price ceiling: Imposing a maximum allowable price for a good.

  • Price floor: Imposing a minimum allowable price for a good.

• Effects of price controls:

  • Price ceilings cause shortages, leading to rationing or black markets.

  • Price floors lead to surpluses, diverting resources from productive activities.

Price Ceilings

Definitions and Examples

• Definition: a maximum price at which a good can be bought and sold

• Reasons for government implementation:

  • make goods more affordable

    • Example: rent controls prevent landlords from charging high rents, making housing more affordable

  • prevent exploitation

  • control inflation

Downside of Price Ceilings

• If set below equilibrium price, it results in shortages:

  • Example: Rent control may discourage landlords from renting properties or reduces housing availability

  • A shortage can lead to rationing, black markets, or lower product quality

Price Floor

Definitions and Examples

• Price Floor: Sets a minimum price (e.g., minimum wage).

• Intent: To assist producers facing low market prices.

  • Reasons for government implementation:

    • protect producers’ income: ensures that producers get fair wages or prices for their goods

      • Example: minimum wage laws prevent workers from being underpaid

    • encourage production

Consequences of Price Floors

• If above equilibrium price, causes surpluses:

  • Surplus management strategies:

    • Governments may buy excess agricultural products.

    • Payments to farmers not to produce.

    • Minimum wages can lead to unemployment, which is not addressed by reducing wages.

Elasticity of Demand

Understanding Price Elasticity

• Price Elasticity of Demand: Percentage change in quantity demanded divided by percentage change in price.

Changes in Elasticity in terms of graphs

• Graph analysis shows quantifiable responses in different demand curves.

  • High elasticity (significant changes in demand)

  • Low elasticity (minimal change in demand as price changes).

Suppose your university raises student season ticket prices from $50 to $60, which results in the quantity of season tickets sold falling from 2,000 to 1,800. The price elasticity of demand for season ticket prices would be

• to find the numerator, calculate to the change in quantity demanded, which is 1,800 - 2,000 = -200. Then, for the denominator, calculate the change in price, which is $60 - $50 = $10.

Calculating Elasticity with a midpoint Formula

For example, if we use the midpoint formula to calculate the price elasticity of demand for oil when the price changes from $20 to $22 and the quantity demanded changes from 60 million to 48 million barrels a day, we get

Types of Elasticity:

• Elastic demand: Price elasticity greater than 1

  • a small change in price causes large change in demand

  • happens when consumers have many substitutes or when the product is not a necesity

    • Example: luxury bags and plane tickets

• Inelastic demand: Price elasticity less than 1

  • product is a necesity or has fewer substitutes

  • Example: gasoline or medicine, even if the price goes up people still need it

• Perfectly Elastic: horizontal line (price reacts strongly).

  • consumers will buy an unlimited quantity at specific price

• Perfectly Inelastic: vertical line (no response to price change).

  • people will buy the same amount no matter how high or low the price

Revenue and Elasticity

Relationship Between Price Elasticity and Revenue

• Revenue formula: Revenue = Price (P) × Quantity (Q)

• Elastic Demand: Increase in price reduces revenue (negatively related)

  • people stop buying as much because there are many other options or the product is not essential

• Inelastic Demand: Increase in price increases revenue (positively related)

  • people keep buying no matter what because it is a necesity

Determinants of Price Elasticity

Factors Affecting Elasticity

• Substitutability: More substitutes lead to higher elasticity. (easy to switch to a different good)

• Good Type: Big-ticket items have higher elasticity compared to little-ticket items.

• Price Change Perception:

  • Temporary changes imply higher elasticity.

  • Permanent changes imply lower elasticity.

• Consumer Preferences: Different elasticity among demographic groups.

• Time:** Long-run elasticity is often greater than short-run elasticity due to adjustments.

  • Long- run elasticity is greater since consumers and producers have more flexibilty to adjust

  • Short-run elasticity is lower becasue of immediate contraints

Cross-Price and Income Elasticity of Demand

Definitions of Elasticities

• Income Elasticity: Change in quantity demanded due to change in income.

• Cross-Price Elasticity: Change in quantity demanded for one good when the price of another related good changes.

Elasticity Classifications

• Normal goods exhibit positive income elasticity.

• Inferior goods show negative income elasticity.

Summary of Elasticity Effects on Revenue

• Higher elasticity decreases revenue when prices rise; lower elasticity increases revenue.

Elasticity of Supply

Understanding the Elasticity of Supply

• Price Elasticity of Supply: Percentage change in quantity supplied divided by percentage change in price.

• Types:

  • Elastic Supply: Price elasticity greater than 1

    • Small change in price leads to large change in quantity supplied

    • producers can quickly adjust to production

    • Example: If the price of t-shirts increases, manufacturers can quickly produce more because materials and labor are available.

  • Inelastic Supply: Price elasticity less than 1

    • change in price only leads to a small change in quantity supplied

    • producers can’t quickly adjust production

    • Example: If the price of gold increases, miners cannot immediately extract more because mining takes time.

  • Perfectly Elastic: horizontal line (price reacts strongly).

    • unlimited supply at a specific price

  • Perfectly Inelastic: vertical line (no response to price change).

    • quantity supplied does not change at all