Why is the Equilibrium Price Important? Market Forces, the Equilibrium Price, and the Actual Price

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1 Amherst College epartment of Economics Economics 111 Section 5 Fall 2015 Micro Handout 5: Elasticity Market emand and Market Supply Curves Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), IF the price of beer were, given that everything else relevant to the demand for beer remains the same? P Market S Market supply curve: How many cans of beer would firms produce (the quantity supplied), IF the price of beer were, given that everything else relevant to the supply of beer remains the same? P* In equilibrium Quantity emanded = Quantity Supplied emand and supply are equal partners in determining the equilibrium price and quantity. Q* Q Why is the Equilibrium Price Important? Market Forces, the Equilibrium Price, and the Actual Price If Actual Price < Equilibrium Price If Actual Price > Equilibrium Price Quantity emanded > Quantity Supplied Quantity emanded < Quantity Supplied Shortage exists Surplus exists Actual Price rises Actual Price falls until the equilibrium is reached until the equilibrium is reached P surplus S Market forces push the actual price toward its equilibrium level. P* Assuming that the actual price is free to move, the actual price will equal the equilibrium price in short order. shortage Q* Q Shifts versus Movements Along the emand and Supply Curves Shifts Movements Along Change in something OTHER Change in the price of beer ITSELF THAN the price of beer ITSELF The slopes of the demand and supply The demand curve for beer The supply curve of beer curves for beer capture the effect can SHIFT ONLY if can SHIFT ONLY if of a change in the BEER PRICE itself; something that affects something that affects a change in the price of beer leads demand OTHER THAN supply OTHER THAN to a MOVEMENT ALONG the the BEER PRICE changes. the BEER PRICE changes. demand and supply curves for beer.

2 2 Advice for AMTRAK The Vermonter is an AMTRAK train that travels from Washington,.C. to St. Albans, VT, with continuing bus service to Montreal, Quebec. The following two individuals are considering ways to increase the revenues generated from Vermonter ticket sales. Mr. A: The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices. Ms. B: That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse. Question: In general, what happens to the total revenue collected when the price falls? Total Revenues = Price Quantity emanded emand for the Vermonter Price ($/ticket) Quantity (tickets) Question: What additional information do we need to address the question? Claim: We need to know the price elasticity of demand. Price Elasticity of emand not very sensitive emand Is emand Is emand Is 1 percent change in 1 percent change in 1 percent change in price causes the quantity price causes the quantity price causes the quantity demanded to change by demanded to change by demanded to change by 1 percent 1 percent 1 percent Price elasticity of Price elasticity of Price elasticity of demand 1. demand 1. demand 1. Price Elasticity of emand = Percent change in the quantity demanded resulting from a 1 percent change in the price Two Warnings: Elasticity always refers to percent changes; elasticity differs from the slope more later. Inelastic demand means that the quantity demanded is not ; it does not mean that the quantity demanded is not at all sensitive to the price. not at all sensitive to the price we say that demand is perfectly inelastic.

3 3 Advice for AMTRAK revisited Mr. A: The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices. If emand is Elastic P Q TR = PQ Total Revenues = Price Quantity emanded = P Q Ms. B: That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse. not If emand is Inelastic P Q TR = PQ Question: If you are a consultant for Amtrak, what information do you need?

4 4 The Farming Paradox Mr. A: Good weather and bountiful harvests are bad for the farming community. Inclement weather and poor harvests are good because the total revenue collected by farmers will rise. Ms. B: You can't be serious. Have you gone crazy?" Year Wheat Price ($ per bushel) Wheat Quantity (millions of bushels) , ,000 P ($/bushel) U.S. Springs Wheat ata By TOM POLANKEK And MARK PETERS Wall Street Journal August 18, 2011 The U.S. epartment of Agriculture quietly released estimates it usually keeps under wraps Traders caught on to the new data set, posted on the USA's web site, earlier this week and latched on to figures indicating that the size of the nation's prized fall wheat crop could be smaller than expected. prices have soared this week. Supplies of this wheat have tightened since a historic drought hurt the spring harvest in states like Texas and Oklahoma ,000 2,050 2,100 2,150 2,200 (millions of bushels) 2010 Q Question: How did the drought in Texas and Oklahoma affect the U.S. wheat market? Based on the information cited in the Wall Street Journal excerpt, did the demand curve shift? supply curve shift? Question: How are the total revenues of wheat farmers affected by the drought? Total Revenues = Price Quantity emanded emand Is Elastic P Q TR = PQ not very sensitive emand Is Inelastic P Q TR = PQ Question: Is the demand for wheat elastic or inelastic? Total Revenue in 2010 = = $ Total Revenue in 2011 = = $

5 5 Question: What affects the (price) elasticity of demand? An Aside: The emand Curves for Insulin and Appendectomies Question: Suppose that the price of insulin fell by 50 percent.. What would happen to the quantity of insulin demanded? Question: Suppose our local hospital, Cooley-ickinson, announced a special reduced price for appendectomies. What would happen to the quantity of appendectomies demanded? Question: How are insulin and appendectomies similar? Price emand Curve Warning: Quantity Other Elasticities Income Elasticity of emand Income Elasticity of emand = very sensitive to income emand Is Income Elasticity of emand not very sensitive to income emand Is Income Elasticity of emand Price Elasticity of Supply Price Elasticity of Supply = If the quantity supplied is Supply Is Price Elasticity of Supply If the quantity supplied is not Supply Is Price Elasticity of Supply

6 6 Effect of the First Persian Gulf War on Crude Oil Prices Prior to Iraq s invasion of Kuwait on August 2, 1990, approximately 65 million barrels of crude oil were produced in the world per day. The price of crude oil was about $17 per barrel. Kuwait and Iraq produced 5 of the 65 million barrels. 1 The Security Council of the United Nations responded to the invasion by passing a resolution requiring nations to boycott Iraqi oil. The Security Council s action succeeded: no Iraqi or Kuwaiti oil reached world markets. Question: What does common sense suggest will happen to the quantity and price? Price ($/barrel) 17 S Question: Can we be more specific? As always, begin by focusing on the demand and supply curves: In terms of barrels, the supply curve shifted million barrels to the as a consequence of the first Persian Gulf War. 65 Quantity (millions of barrels per day) At a price of $17, how large was the shortage? million barrels. Question: Can we be more specific about the price? Claim: We can be more specific by applying the price elasticities: Price elasticity of demand =.05 Price elasticity of supply =.10 We will not see how. When the price rises In response to a shortage, the price of oil rises, we move Quantity emanded Quantity supplied along the demand and supply curves, increasing the Less than More than quantity supplied and decreasing the quantity 65 million barrels 60 million barrels demanded: Less than 5 million barrel shortage We begin by reviewing the definitions of the price elasticity of demand and supply: Price Elasticity of emand = Price Elasticity of Supply = Percent change in the quantity demanded resulting from a 1 percent change in the price Percent change in the quantity supplied resulting from a 1 percent change in the price Question: What is the shortage in percentage terms? = % 1 Crude oil production and price data from U.S. Energy Information Administration. Note that liberties were taken simplify the arithmetic.

7 7 If the price were to rise by one percentage point: When the price rises by 1 percentage point The quantity demanded would by percentage point(s). Quantity demanded decreases by Quantity supplied increases by percentage points percentage points The quantity supplied would by percentage point(s). Shortage decreases by percentage points After accounting for both the quantity demanded and the quantity supplied, the shortage gap would decrease by percentage point(s). If the price were to rise by ten percentage points: When the price rises by 10 percentage points The quantity demanded would by percentage point(s). Quantity demanded decreases by Quantity supplied increases by The quantity supplied would by percentage points percentage point percentage point(s). Shortage decreases by percentage points After accounting for both the quantity demanded and the quantity supplied, the shortage gap would decrease by percentage point(s). If the price were to rise by fifty percentage points: When the price rises by 50 percentage points The quantity demanded would Quantity demanded Quantity supplied by percentage point(s). decreases by increases by The quantity supplied would by percentage point(s). percentage points percentage points After accounting for both the quantity demanded and Shortage decreases by percentage points the quantity supplied, the shortage gap would decrease by percentage point(s). Summarizing: Price Quantity demanded Quantity supplied Portion of gap up by decreased by increased by eliminated 1% % % % 10% % % % % % % % Accordingly, we estimate that the price increases by about 50 percent: $17 50% = $ We estimate that the price rises from $17 to $ as a consequence of the Iraqi invasion and the Security Council s action. In fact, the price rose to about $27 in August.