ECO 240 – 3 The Price System:

Application of Price Theory 2Rationing and Allocating Resources

Reading In an economy where the the
market is not regulated the price
• SLO Chapter 3 system performs two important
• BD Chapters 3 & 4 and closely related functions:
• LCR Chapters 5 & 6
• Price Rationing
• Resource Allocation

Price Rationing in the Market for

PRICE RATIONING shell fish
Price
Price rationing is the process per S
by which the market system pound
allocates goods and services At $3.23, the quantity
demanded and quantity
to consumers when quantity $3.23 supplied are both 45
demanded exceeds quantity shell fish
supplied.
D
45 Millions of lbs. of
shell fish

This rationing process At a price of $3.23, there is now an excess

demand of 23 lobsters:
determines:
• the allocation of resources Price S96
among suppliers per
pound
S95
At a price of $3.23,
there is now an
$3.23 excess demand of 23
• the final mix of output to be lobsters.
allocated across consumers
D

22 45 Millions of lbs.

1
 Equilibrium is restored: Firms may use alternative
allocation methods:
Price S96
per
pound S95 Some of these methods include:
• Equilibrium is restored
$4.50 at a price of $4.50. • Price ceilings
$3.23 • Quantity supplied rises
and quantity demanded
• Queuing
falls as price rises • Favored customers
D • Ration coupons
35 45 Quantity

Alternative Allocation Methods: Price Ceiling Set Below EQM Price

• Shortage pushes price up, waiting creates

A price ceiling is a maximum
price that sellers may charge for
a good, usually established by
government.
Queuing is a non-price rationing
system that uses waiting in line as
a means of distributing goods and
services.
queues
• Government may have to ration supply
• Sellers might decide whom to sell to
• Black markets result
• Chance allocation may arise resulting from
irregular supply
• Buyers may look for substitutes

Excess demand created by a

Alternative Allocation Methods
ceiling price placed on gasoline in
(cont.):
1974:
P
S1974 Favored customers are those who
receive special treatment from
1.50
dealers during situations when
there is excess demand.
1.00
Ration coupons are tickets or
.57
coupons that entitle individuals to
D1974
Q
purchase a certain amount of a
Excess Demand given product per month.

2
 The average ticket price was set at
The problem with these alternatives is $450 for the final game of the World
that excess demand is created but not Cup
eliminated:
P S
Consider the market for This price was below the
tickets to popular sporting equilibrium price, and
scalpers made a tidy
events, like the finals of the ??? profit. Can you explain
World Cup Soccer why?
championship in 2006... $450
D
Q
121,088 ???

The World and U.K. Markets for The import tax raises the price of
Crude Oil, 2000 (without tax) all gasoline in the U.K.
P Su.K. Su.k.
Sworld P P What is the impact of this
policy on :
• domestic producers?
$28 $28 $29 • foreign producers?
$23 • U.K. consumers?
• U.K. government?
Du.K. Du.K.
Dworld Q
76 Q 8.7 23.6 Q 17.8 22.8
Imports = ? Imports = ?

Government Intervention Taxes & Subsudies

• In the real world world where the
market is imperfect, government
intervention is inevitable.
• Taxes and subsidies are used to
promote greater social efficiency by
altering the composition of production
and consumption; and for income
redistribution.
• Used to correct externalities / spillover / third
party costs or benefits
• Taxes are used to correct for monopoly I.e,.
To regulate the behaviour of monopolies and
oligopolies e.g. lump-sum tax is used to
tackle the problem of excessive profits
• The windfall tax is imposed on profits of
various privatized utilities.
• Note: The lump-sum tax is a fixed cist to the
firm and it does not affect its marginal cost.

3
 Advantages of Taxes & Subsidies Disadvantages of Taxes & Subsidies

• Both can still allow the market to operate
• Both force firms to take on board the full
social costs and benefits of their actions
• Both are adjustable according to the
magnitude of the problem
• Where taxes are imposed on the firms
because of pollution, they encourage firms to
find cleaner ways of producing. Tax is an an
incentive to reduce pollution; while subsidies
on good practices encourage firms to adopt
more good practices
• Not feasible to use different tax and subsidy
rates because of different of levels of
production; different types of externality and
firms operate under different degree of
imperfect competition
• It is administratively difficult and costly to
charge every firm its own particular tax rate /
grant every relevant firm its own particular
rate of subsidy.

Disadvantages of Taxes & subsidies Elasticity and the

Price Elasticity of Demand
• Lack of knowledge on measuring those costs
and apportioning blame * Elasticity is a concept that is
• Example: damage to lakes and forests from used to measure the response in
acid rain ---
one variable when another
How serious is the damage
variable changes.
What is the current monetary cost?
How long lasting is the damage? * The price elasticity of demand
what to blame and who are to blame? measures how responsive
Can the correct pollution tax rate be fixed?
consumers are to changes in
the price of a product.

PRICE ELASTICITY OF DEMAND: PRICE ELASTICITIES OF DEMAND

Demand is elastic (i.e.
P
Price elasticity of demand
is always negative.
> 1 demand is responsive
to price changes)
P1=$3

Elasticity is not the same Unitary elasticity (i.e.
P2=$2 as the slope of the demand the percentage change is
curve. If Ed = 1 quantity is the same as
the percentage change in

Ed = % change Qd price)
D
% change P
Q1 Q2 Demand is inelastic (i.e.
5 10 Q
< 1 demand is relatively
unresponsive to price
changes)

4
 Hypothetical Demand Elasticities
The following categories help to describe
consumer responsiveness: for Four Products
• If the elasticity coefficient is less than -1 Product % change in % change in Elasticity
demand is elastic. Consumers are price quantity QD)/(%
(% P)
(% P) demanded
relatively responsive to price changes. (%QD)

• If the elasticity coefficient is between -1 Insulin +10% 0% 0.0 Perfectly Inelastic

Basic Telephone +10% -1% -0.1 Inelastic

and 0 demand is inelastic. Consumers are Service
not very responsive to price changes. Beef +10% -10% -1.0 Unitarily Inelastic

• If the elasticity coefficient is equal to -1, Bananas +10% -30% -3.0 Elastic

demand is unitary elastic.

To calculate price elasticity of

The shape of a demand curve
demand, use the midpoint
gives you some idea of the good’s
general elasticity:
formula:
P P
D D (Q1 - Q2)
Q Q Ed = % change Qd = (Average Q)
Perfectly elastic Relatively elastic
% change P (P1 - P2)
D
P P (Average P)
D
Q
Q
Perfectly inelastic Relatively inelastic

Most demand curves have

To find the price elasticity of
elastic, unitary, and inelastic
demand between points a and b :
region:
P (5 - 10) - 5
a
P
P1=$3 Ed = (5+10)/2 = 7.5 =- 1.67 Elastic
P2=$2
b (3 - 2) 1
Unitary Elastic
(3+2)/2 2.5
D Inelastic
Q1 Q2 Q D
5 10
Q

5
 Elasticity and Total
Revenues Elasticity and Total Revenues

•When demand is inelastic, price and

There is an important relationship
between price elasticity of
demand and total revenues (price
times quantity) :
total revenues are directly related.
Price increases generate higher
revenues.
•When demand is elastic, price and
total revenues are indirectly related.
Price increases generate lower
revenues.

DETERMINANTS OF PRICE Income Elasticity

ELASTICITY OF DEMAND
• Availability of substitutes -- demand
is more elastic when there are more
substitutes for the product.
• Importance of the item in the budget
-- demand is more elastic when the
item is a more significant portion of
the consumer’s budget.
• Income elasticity of demand - measures
the responsiveness of demand to changes
in income.
•Normal goods have positive income elasticity
•When it is greater than one they are luxury goods
•When it less than on and greater than zero, such
goods are necessities
•Inferior goods have negative income elasticity

• Time frame -- demand becomes

more elastic over time.

Other Important Elasticities Cross-Price Elasticity

INCOME % change Qd • Cross-price elasticity of demand -

ELASTICITY = % change in consumer income measures the response of the quantity of
one good demanded to a change in the
% change Qd
CROSS-PRICE =
price of another good
ELASTICITY % change in the price of another
good • Substitute goods – cross-price elasticity is
positive
PRICE % change Qs • Complementary goods – cross price
ELASTICITY OF = elasticity is negative
SUPPLY % change in price

6
 Cross-Price Elasticity
• Major determinants are
Closeness of the substitute or complement- The
closer iit is , the bigger will be the effect on the
first good of a change in the price of the
substitute or complement, and hence the greater
the cross elasticity – either positive or negative.
Firms need to know the cross-price elasticity for
their product when considering the effect on the
demand for their product of a change in the price
of a rival’s product or of a complementary
product. The is necessary for production
planning.
Elasticity of Supply
• Elasticity of supply - measures the response of
a quantity of a good supplied to a change in the
price of that good.
• Determinants –
The amount that costs rise as output rises –
The less the additional costs of producing
additional output, the more firms will be
encouraged to produce for a given price rise :
the more elastic will the supply be
Elasticity of Supply
• Immediate Time Period – firms are unlikely to
be able toi increase supply immediately. The
supply is either fixed or can only vary
according to available stocks. Supply is
highly inelastic.
• Short run -- because fixed factors e.g. heavy
machinery, some inputs e.g. raw materials,
can be increased – supply can increase.
• Long run – all factor inputs are variable,
there will be sufficient time for supply to
increase and even new firms to enter the
industry. Supply is likely to be highly elastic.
Cross-Price Elasticity
• For international trade and the balance of
payments firms need to know how does a
change in the price of domestic goods affect the
demand for imports.
• If there is a high cross elasticity of demand for
imports (because they close substitutes for
home-produced goods), and if prices at home
rise due to inflation, the demand for imports will
rise substantially, thus worsening the balance of
payments.
Elasticity of Supply
• Supply is likely to be elastic if firms have
plenty of spare capacity; if they can readily
get extra supplies of raw materials; if they
can easily switch away from producing
alternative products and if they can avoid
having to introduce over time working (at
higher pay rate). Given all these conditions
costs will little affected by a rise in output
and the supply will be very elastic.
4242Time Dimension
• The full adjustment of price, demand and
supply to a situation of disequilibrium will
not be instantaneous. It is necessary to
analyze the time path which supply takes
to respond to demand changes, and which
demand takes in responding to changes in
supply.