Lecture 2 Notes

HE191 Principles of Economics Lecture 2 Chapters 4, 5 and 6 Principles of Economics, Fourth Edition N. Gregory Mankiw 1

In this lecture, look for the answers to these questions: „ What factors affect buyers’ demand and sellers’ supply for goods? „ How do changes in the factors that affect demand or supply affect the market price and quantity of a good? „ How do markets allocate resources? „ What is elasticity? How is price elasticity of demand related to the demand curve? How is it related to revenue & expenditure? What are the income and crossprice elasticities of demand? „ What is the price elasticity of supply? How is it related to the supply curve? „ What are price ceilings and price floors and how do they affect market outcomes? „ How do taxes affect market outcomes? What is the incidence of a tax? What determines the incidence?

Demand „ Demand comes from the behavior of buyers. „ The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. „ Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

Helen’s Demand Schedule & Curve $6.00

Price Quantity of of lattes lattes demanded

$5.00

$0.00

16

$4.00

1.00

14

2.00

12

3.00

10

4.00

8

$1.00

5.00

6

$0.00

6.00 Quantity 15 of Lattes

4

Price of Lattes

$3.00 $2.00

0

5

10

Market Demand versus Individual Demand „ The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. „ Suppose Helen and Ken are the only two buyers in the Latte market. (Qd = quantity demanded) Price $0.00 1.00 2.00 3.00 4.00 5.00 6.00

Helen’s Qd 16 14 12 10 8 6 4

+ + + + + + +

Ken’s Qd 8 7 6 5 4 3 2

= = = = = = =

Market Qd 24 21 18 15 12 9 6

The Market Demand Curve WhenThe the price is $2.00, When the price $2.00, The market demand at market demand curve is isthe horizontal sum of the Helen will demand 12 Ken will demand 6 latte. $2.00 will be 18 latte. individual demand curves! latte.

+

Helen’s Demand Price of Latte

=

Ken’s Demand

Price of Latte

Price of Latte

2.00

2.00

2.00

1.00

1.00

1.00

12

Quantity of latte

14

6

Market Demand

7

Quantity of latte

18

21

Quantity of latte

When the price is $1.00, When the price is $1.00, The market demand at Note also the change in quantity demanded from 18 to 21 when price Helen will demand 14 $1.00, will be 21 latte. Nicholas will demand 7 dropped from $2 to $1: This is movement along the demand curve latte. latte.

Demand Curve Shifters „ The demand curve shows how price affects quantity demanded, other things being equal. „ These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). „ Changes in them shift the D curve… „ An increase in the number of buyers causes an increase in quantity demanded at each price, which shifts the demand curve to the right.

Demand Curve Shifters: Number of buyers P Suppose the number of buyers increases. Then, at each price, quantity demanded will increase (by 5 in this example).

$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00

Q 0

5

10

15

20

25

30

Demand Curve Shifters „ Income

„ Demand for a normal good is positively related to income. An increase in income causes increase in quantity demanded at each price, shifting the D curve to the right. „ Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.

„ Prices of related goods „ Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. Examples … „ Two goods are complements if an increase in the price of one causes a fall in demand for the other. Examples …

„ Tastes „ Expectations

Supply „ Supply comes from the behavior of sellers. „ The quantity supplied of any good is the amount that sellers are willing and able to sell. „ Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

Starbucks’ Supply Schedule & Curve P $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00

Q 0

5

10

15

Price of lattes $0.00 1.00 2.00 3.00 4.00 5.00 6.00

Quantity of lattes supplied 0 3 6 9 12 15 18

Market Supply versus Individual Supply „ The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. „ Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied) Price $0.00 1.00 2.00 3.00 4.00 5.00 6.00

Starbucks 0 3 6 9 12 15 18

+ + + + + + +

Jitters 0 2 4 6 8 10 12

= = = = = = =

Market Qs 0 5 10 15 20 25 30

Supply Curve Shifters „ The supply curve shows how price affects quantity supplied, other things being equal. „ These “other things” are non-price determinants of supply. „ Changes in them shift the S curve… „ Input prices „ Examples: wages, prices of raw materials. „ A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right.

Supply Curve Shifters: input prices P

$1.00

Suppose the price of milk falls. At each price, the quantity of Lattes supplied will increase (by 5 in this example).

$0.00

Q

$6.00 $5.00 $4.00 $3.00 $2.00

0

5

10 15

20 25 30

35

Supply Curve Shifters „ Technology „ A cost-saving technological improvement has same effect as a fall in input prices, shifts the S curve to the right.

„ Number of sellers „ An increase in the number of sellers increases the quantity supplied at each price, shifts the S curve to the right.

„ Expectations „ Suppose a firm expects the price of the good it sells to rise in the future. „ The firm may reduce supply now, to save some of its inventory to sell later at the higher price. „ This would shift the S curve leftward.

Supply and Demand Together $6.00

P

D

S

Equilibrium: P is the level where quantity supplied equals quantity demanded

$5.00 $4.00 $3.00 $2.00 $1.00 $0.00

Q 0

5

10 15 20 25 30 35

Three steps to analyzing changes in Equilibrium price and quantity „ To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction the curve shifts. 3. Use supply-demand diagram to see how the shift changes equilibrium P and Q.

Market for hybrid cars with a change in supply EVENT: New technology reduces cost of P producing hybrid cars.

S1

S2

STEP 1:

S curve shifts because event affects STEP 2: P1 cost of production. S shifts right P2 D curve does not because event STEPbecause 3: shift, reduces cost, production technology The shift causes makes production is not to one price fallof the more profitable at factors that affect and quantity to rise. any given price. demand.

D1 Q1 Q2

Q

Market for hybrid cars with a change in both demand and supply EVENTS: price of gas rises AND new technology reduces production costs

P S1

S2

STEP 1:

Both curves shift. STEP 2:

P2 P1

Both shift to the right. STEP 3:

Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.

D1 Q1

Q2

D2 Q

Terms for Shift vs. Movement Along Curve „ Change in supply: a shift in the S curve „ occurs when a non-price determinant of supply changes (like technology or costs) „ Change in the quantity supplied: a movement along a fixed S curve „ occurs when P changes „ Change in demand: a shift in the D curve „ occurs when a non-price determinant of demand changes (like income or # of buyers) „ Change in the quantity demanded: a movement along a fixed D curve „ occurs when P changes

A scenario… „You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. „Your costs are rising (including the opportunity cost of your time), so you’re thinking of raising the price to $250. „The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?

Elasticity „ Basic idea: Elasticity measures how much one variable responds to changes in another variable. „One type of elasticity measures how much demand for your websites will fall if you raise your price. „ Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.

Price Elasticity of Demand Price elasticity of = demand (Ed)

%Δ Qd

{(Q1d – Q2d)/[(Q1d + Q2d)/2]}*100

= -------------

{(P1-P2)/ [(P1+P2)/2]}*100

%Δ P

• Price elasticity of demand measures how much Qd responds to a change in P. • Loosely speaking, it measures the pricesensitivity of buyers’ demand. P rises by 50%, Q falls by 100%

Price elasticity of demand equals 100% = 2.0 50%

=

P P2=20 P1=12

D

{(300 –100)/ [(300 + 100)/2]}*100 {(12-20)/ [(12+20)/2]}*100

Q2= 100

Q1= 300

23

Q

What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: „ Suppose the prices of both goods rise by 20%. „ The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? „ What lesson does the example teach us about the determinants of the price elasticity of demand?

EXAMPLE 1: Rice Krispies vs. Sunscreen „ The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? „ Rice Krispies has lots of close substitutes (e.g., Cap’n Crunch, Count Chocula), so buyers can easily switch if the price rises. „ Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises.

„ Lesson: Price elasticity is higher when close

substitutes are available.

EXAMPLE 2: Blue Jeans” vs. “Clothing” „ The prices of both goods rise by 20%. For which good does Qd drop the most? Why? „ For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). „ There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for clothing, other than living in a nudist colony?) „ Lesson: Price elasticity is higher for narrowly

defined goods than broadly defined ones.

EXAMPLE 3: Insulin vs. Caribbean Cruises „ The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? „ To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. „ A cruise is a luxury. If the price rises, some people will forego it. „ Lesson: Price elasticity is higher for luxuries

than for necessities.

EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run „ The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? „ There’s not much people can do in the short run, other than ride the bus or carpool. „ In the long run, people can buy smaller cars or live closer to where they work. „ Lesson: Price elasticity is higher in the

long run than the short run.

The Variety of Demand Curves „ Economists classify demand curves according to their elasticity. „ The price elasticity of demand is closely related to the slope of the demand curve. ED =

{(Q1d – Q2d)/ [(Q1d + Q2d)/2]}*100 {(P1-P2)/ [(P1+P2)/2]}*100

=

(P1+P2)/ [(Q1d + Q2d)] (P1-P2)/ (Q1d – Q2d)

„ Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. „ The different classifications of demand curves are presented on page 94 of Mankiw’s text, from least to most elastic.

Elasticity of a Linear Demand Curve P

200% E = = 5.0 40%

$30

67% E = = 1.0 67%

20

40% E = = 0.2 200%

10 $0

0

20

40

60

The slope of a linear demand curve is constant, but its elasticity is not.

Q

30

Elasticity of a Linear Demand Curve P

$30

E =

20

2.5 0.5 E =

10 $0

= 5.0 0.5 0.5 E =

0

20

40

60

= 1.0 0.1 0.5 Q ED =

Slope along the line is constant

= 0.2

The slope of a linear demand curve is constant, but its elasticity is not. Midpoints of two points along the line change

[(P1+P2)/2]/ [(Q1d + Q2d)/2] (P1-P2)/ (Q1d – Q2d) 31

Price Elasticity and Total Revenue „ Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q „ A price increase has two effects on revenue: „ Higher P means more revenue on each unit you sell. „ But you sell fewer units (lower Q), due to Law of Demand. „ Which of these two effects is bigger? It depends on the price elasticity of demand.

Price Elasticity and Total Revenue Price elasticity = of demand

Percentage change in Q Percentage change in P

Revenue = P x Q „ If demand is elastic, then

price elast. of demand > 1 % change in Q > % change in P „ The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. „ In our example, suppose that Q falls to 8 when you raise your price to $250, ED = 1.8, Revenue drops from $2,400 to $2000

Price Elasticity and Total Revenue Price elasticity = of demand

Percentage change in Q Percentage change in P

Revenue = P x Q „ If demand is inelastic, then

price elast. of demand < 1 % change in Q < % change in P „ The fall in revenue from lower Q is smaller than the increase in revenue from higher P,

so revenue rises. „ In our example, suppose that Q only falls to 10 when you raise your price to $250, ED = 0.8, Revenue rises from $2,400 to $2,500

Price Elasticity of Supply Price elasticity of supply

=

Percentage change in Qs Percentage change in P

„ Price elasticity of supply measures how much Qs responds to a change in P. „ Loosely speaking, it measures the pricesensitivity of sellers’ supply. „ Again, use the midpoint method to compute the percentage changes.

The Variety of Supply Curves „ Economists classify supply curves according to their elasticity. „ The slope of the supply curve is closely related to price elasticity of supply. „ Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. „ The different classifications of supply curves are presented on page 101 of Mankiw’s text, from least to most elastic.

The Determinants of Supply Elasticity „ The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. „ Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars (family sedans). „ For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.

Other Elasticities „ The income elasticity of demand measures the response of Qd to a change in consumer income. d Percent change in Q Income elasticity = Percent change in income of demand „ Recall: an increase in income causes an increase in demand for a normal good. „ Hence, for normal goods, income elasticity > 0. „ For inferior goods, income elasticity < 0.

Other Elasticities „ The cross-price elasticity of demand measures the response of demand for one good to changes in the price of another good. d for good 1 % change in Q Cross-price elast. = of demand % change in price of good 2 „ For substitutes, cross-price elasticity > 0 E.g., an increase in price of beef causes an increase in demand for chicken. „ For complements, cross-price elasticity < 0 E.g., an increase in price of computers causes decrease in demand for software.

Government Policies That Alter the Private Market Outcome „ Price controls „Price ceiling: a legal maximum on the price of a good or service. Example: rent control. „Price floor: a legal minimum on the price of a good or service. Example: minimum

wage.

„ Taxes „The government can make buyers or sellers pay a specific amount on each unit bought/sold.

How Price Ceilings Affect Market Outcomes The eq’m price P ($800) is above the ceiling and therefore illegal. $800 The ceiling is a binding $500 constraint on the price, and causes a shortage.

S

Price ceiling shortage D 250

400

Q

How Price Ceilings Affect Market Outcomes P

S

In the long run, supply and demand $800 are more price-elastic. $500 So, the shortage is larger.

Price ceiling shortage 150

450

D Q

Shortages and Rationing „ With a shortage, sellers must ration the goods among buyers. „ Some rationing mechanisms: (1) long lines (2) discrimination according to sellers’ biases „ These mechanisms are often unfair, and inefficient: the goods don’t necessarily go to the buyers who value them most highly. „ In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair).

How Price Floors Affect Market Outcomes The eq’m wage ($4) W is below the floor $5 and therefore illegal. The floor $4 is a binding constraint on the wage, and causes a surplus (i.e., unemployment)

labor surplus S

Price floor

D 400

550

L

Evaluating Price Controls „ Recall one of the Ten Principles:

Markets are usually a good way to organize economic activity. „ Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. „ Price controls are often intended to help the poor, but they often hurt more than help them: „ The minimum wage can cause job losses. „ Rent control can reduce the quantity and quality of affordable housing.

Taxes „ The government levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. „ The government can make buyers or sellers pay the tax. „ The tax can be a percentage of the good’s price, or a specific amount for each unit sold. „ For simplicity, we analyze per-unit taxes only.

A Tax on Buyers Effects of a $1.50 per unit tax on buyers „A tax on P buyers shifts the D curve down by the PB = $11.00 amount of $10.00 the tax. PS = $9.50 „The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

Tax

S1

D1 D2 430 500

Q

The Incidence of a Tax: How the burden of a tax is shared among market participants P PB = $11.00 Because of the tax, $10.00 buyers pay P = $9.50 S $1.00 more, sellers get $0.50 less.

Tax

S1

D1 D2 430 500

Q

A Tax on Sellers Effects of a $1.50 per unit tax on sellers „ A tax on P sellers shifts the S curve P = $11.00 B up by the amount of $10.00 the tax. PS = $9.50 „ The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

S2 Tax

S1

D1 430 500

Q

The Outcome Is the Same in Both Cases! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters is this: PB = $11.00 A tax drives $10.00 a wedge between the PS = $9.50 price buyers pay and the price sellers receive.

P Tax

S1

D1 430 500

Q

Elasticity and tax incidence (a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . . Price buyers pay Supply

Tax

2. . . . the incidence of the tax falls more heavily on consumers . . .

Price without tax Price sellers receive 3. . . . than on producers. 0

Demand Quantity

Elasticity and the tax burden (b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply . . . Price buyers pay

Supply

Price without tax

3. . . . than on consumers. Tax

Price sellers receive

0

2. . . . the incidence of the tax falls more heavily on producers . . .

Demand

Quantity

End of Lecture 2 „ Thank you