Lecture # 5 Applications of Supply and Demand

Transcription

1 Lecture # 5 Applicatins f Supply and Demand I. Price Cntrls We began class discussing cases where the gvernment sets a price ceiling a maximum price fr a gd. An example is rent cntrl The figure belw shws the changes in welfare resulting frm a price ceiling. Befre the price ceiling: Cnsumer surplus is areas A, B, & C Prducer surplus is areas D, E, & F After the price ceiling: Cnsumer surplus is areas A, B, & D Prducer surplus is area F Deadweight lss is areas C & E Because the gvernment sets the price belw the market equilibrium, there is excess demand fr the gd. Nt everyne wh wuld like t purchase the gd is able t d s. This may result in ther secndary effects, such as: peple may have t wait in lng lines t get the gds, a black market may develp, demand fr ther gds may increase (e.g. peple mve t suburbs if they can't get an apartment in the city). This is knwn as a general equilibrium effect.

2 While ttal cnsumer surplus may g up, nt everyne benefits, since sme peple wh culd purchase the gd befre cannt get it nw. Even thugh they can affrd it, suppliers are nt making the gd available. Prducer surplus will be lwer. Sme f the surplus that went t either cnsumers r prducers befre simply disappears. This is the deadweight lss. II. Trade Plicy Next, we cnsidered hw trade plicy affects welfare. Our example applies t a small cuntry. Because it is small, the cuntry is a price taker. That is, its actins d nt influence the wrld price f the prduct being cnsidered. Thus, we can apply ur cmpetitive mdel. If the cuntry were large enugh t affect prices thrughut the wrld, the perfectly cmpetitive mdel wuld nt apply. There are tw supply curves t cnsider. SDOM is dmestic supply. This is what can be prduced within the cuntry. SW is the wrld supply. Because the cuntry is small, it can purchase as much as it wants at the price prevailing in wrld markets. Thus, this supply curve is hrizntal.

3 Withut trade, nly the dmestic supply matters. The equilibrium is at P0 and Q0. With trade, the blue lines represent supply. The price that prevails in the market is the wrld price, PW. Ttal quantity demanded at this price is QT. Dmestic prducers make as much as they can fr that price. This is the blue prtin f SDOM. QD is the quantity prduced at hme. Freign prducers then prvide the remaining gds. Thus, imprts = QT - QD. Finally, cnsider the change in welfare: N trade: Cnsumer surplus is areas A & B. Prducer surplus is areas C, D, & G. With trade: Cnsumer surplus is areas A, B, C, D, E, & F. Cnsumers are better ff. They buy mre, and at a lwer price. Prducer surplus is area G. This is fr dmestic prducers nly. They are wrse ff because they face mre cmpetitin, and thus sell fewer gds at a lwer price. The gains frm trade are areas E & F. These areas are nly captured with free trade. Next, we cnsidered the effect f a tariff. A per unit tariff raises the wrld price in the cuntry impsing the tariff. The new supply is SW + tariff. The new price with trade is thus PW + t. The ttal quantity demanded at this higher price is Q'T. Lcal prducers can supply mre at the higher price. Thus, Q'D is nw prduced lcally. Imprts fall t Q'T - Q'D. Finally, cnsider the change in welfare. With free trade: Cnsumer surplus is areas A, B, C, D, E, & F. Prducer surplus is area G. With the tariff: Cnsumer surplus is areas A & B. Prducer surplus is areas C & G. Revenue is area E. Fr each unit imprted, the gvernment cllects the tariff. The tariff times the number f imprts is revenue t the gvernment. The rectangle E represents this area.

4 Areas D and F disappear. These are the deadweight lss. F represents lst pprtunities because fewer units are purchased. D is lst because sme gds are prduced at a higher cst by lcal prducers, rather than by freign prducers. Cnsider, fr example, the part time farmers in the Ecnmist article n rice tariffs in Japan wh wuld be frced ut f the market if Japan remved tariffs n rice. Cnsumers must nw pay the higher cst f lcal prductin.

5 III. Elasticity Elasticity tells us the percentage change that will ccur in ne variable due t a ne percent change in anther variable. It is a unit-free measure f cmparisn. Price elasticity f demand measures the sensitivity f quantity demanded t price changes. It tells us the percentage change in quantity demanded fr a 1% change in price. εp = % change quantity demanded/% change price Elastic vs. inelastic abslute value > 1 = elastic abslute value < 1 = inelastic Demand curves are steeper when demand is inelastic Inelastic demand is a steep demand curve Quantity demanded des nt change much, even fr large changes in price. An extreme case is perfectly inelastic demand: quantity demanded is the same at any price:

6 Elastic demand is a flat demand curve. Even small changes in price result in large changes in quantity demanded. An extreme case is perfectly elastic demand: the price is the same fr any quantity demanded.

7 Elastic vs. inelastic abslute value > 1 = elastic abslute value < 1 = inelastic Elasticity and revenue: When price is inelastic, price and revenue mve tgether. An increase in price raises revenue. Intuitin: if demand is inelastic, cnsumers will nt respnd much t a change in price. Mst peple still purchase the gd, and they pay mre t d s. When price is elastic, price and revenue mve in the ppsite directin. Revenues fall when the price is raised. Intuitin: if demand is elastic, cnsumers respnd strngly t a change in price. The drp in quantity dminates the increased price. The articles n husing illustrate why elasticity is imprtant. In the shrt-run, supply is very inelastic. This is particularly true in areas where there isn t much rm fr new husing, such as the Bay Area. Thus, as demand increases, prices rise sharply. One implicatin f this is that plicies that nly affect supply d nt help. Fr example, a husing subsidy wuld just increase demand mre, driving prices up even further. That culd change in the lng run, as investrs build new husing in respnse t increased demand. But that nly wrks if there is rm t build. Restrictins n develpment, such as described in the Ecnmist articles in the Bay Area, make additinal develpment difficult.