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Understanding Economics

3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson

Chapter 3 Competitive Dynamics and Government
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Learning Objectives
In this chapter, you will:
1.

2.

3.

4.

learn about the price elasticity of demand, its relation to other demand elasticities, and its impact on sellers¶ revenues learn about the price elasticity of supply and the links between production periods and supply consider how governments use price controls to override the ³invisible hand´ of competition examine spillover costs and benefits and the ways that government addresses the issues

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Elastic and Inelastic Demand (a) 

Price elasticity of demand shows how responsive consumers are to price changes
‡

‡

‡

elastic demand:demand for which a percentage change in a product¶s price causes a larger percentage change in quantity demanded  % change in quantity demand is more than % change in price inelastic demand: demand for which a percentage change in a product¶s price causes a smaller percentage change in quantity demanded  % change in quantity demand is less than % change in price unit-elastic demand means % change in quantity demand equals % change in price
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Elastic and Inelastic Demand (b)
Figure 3.1 Page 51
Elastic Demand Curve for Ice Cream Cones
2.40 Price ($ per cone) 2.00 1.60 1.20 0.80 0.40 0 500 1000
20%

Inelastic Demand Curve for Ice cream Cones
2.40 2.00 1.60 1.20 0.80 0.40 0 500 1000 1800 2000
10% 20%

Price ($ per cone)

D1
50%

D2

Quantity Demanded (cones per winter month)

Quantity Demanded (cones per summer month)

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Perfectly Elastic and Perfectly Inelastic Demand (a) 

Perfectly elastic demand:demand for which a
product¶s price remains constant regardless of quantity demand ‡ means constant price and a horizontal demand curve 

Perfectly inelastic demand:demand for which
a product¶s quantity demanded remains constant regardless of price ‡ means constant quantity demanded and a vertical demand curve 

See Figure 3.2, page 52
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Perfectly Elastic and Perfectly Inelastic Demand (b)
Figure 3.2 Page 52
Perfectly Elastic Demand Curve for Soybeans
Price ($ per tonnes) Price ($ per tonnes)

Perfectly Inelastic Demand Curve for Insulin

D4

1.60

D3

0 Quantity Demanded (tonnes)

0

1000 Quantity Demanded (litres)

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Total Revenue and the Price Elasticity of Demand (a)  

Total revenue: the total income earned from a product, calculated by multiplying the product¶s price by its quantity demanded, (TR=P x Qd). A price change causes total revenue to change in the opposite direction when demand is elastic
‡

Eg, Increase of price causes decrease of total revenue or decrease of price causes increase of total revenue 

A price change causes total revenue to change in the same direction when demand is inelastic
‡

Eg, Increase of price causes increase of total revenue 

A price change does not affect total revenue when demand is unit-elastic
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Revenue Changes with Elastic Demand
Figure 3.3 Page 53
Demand Curve for Videos
Price ($ to rent a video)

5 4 3 2 1 0 500 1000 1500 B C A D

Quantity Demanded (videos rented each day)

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Revenue Changes with Inelastic Demand
Figure 3.4 Page 54
Demand Curve for Amusement Park Rides

Price ($ per ride)

5 4 3 2 1 0 2000 E F 4000 6000 8000 G D

10 000

Quantity Demanded (riders each day)

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Total Revenue and the Price Elasticity of Demand (b)
Figure 3.5 Page 55
Demand Elasticity and Changes in Total Revenue
Price Change Elastic Demand up down up down up down Change in Total Revenue down up up down unchanged unchanged

Inelastic Demand

Unit-Elastic Demand

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Determinants of the Price Elasticity of Demand 

There are four determinants:
‡

‡

‡

‡

portion of consumer incomes (products with smaller portions more inelastic) access to substitutes (products with more substitutes more elastic) necessities versus luxuries (more inelastic for necessities and more elastic for luxuries) time (more elastic with the passage of time)

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Calculating Price Elasticity of Demand  

A numerical value for price elasticity of demand (ed) is found by taking the ratio of the changes in quantity demanded and in price, each divided by its average value. In mathematical terms: ed = Qd ÷ average Qd price ÷ average price

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Elasticity and a Linear Demand Curve (a)   

A linear demand curve has a different price elasticity (ed) at every point. At high prices, the change in quantity demanded (price) is relatively large (small), giving a large ed. At low prices, the change in quantity demand (price) is relatively small (large), giving a small ed.

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Elasticity and a Linear Demand Curve (b)
Figure 3.6 Page 57
Market Demand Curve for Sodas Market Demand Schedules for Sodas
Price Elasticity ($ per of Demand soda) (millions of sodas) (ed) 5 4 3 2 1 0 0 1 2 3 4 5 9.00 2.33 1.00 0.43 0.11 Price Quantity Demanded

5

Price ($ per soda)

ed > 1 4 3 2 ed < 1 1 ed = 1

0

1

2

3

4

5

Quantity Demanded (millions of sodas)
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Income Elasticity  

Income elasticity (ei) is the responsiveness of a product¶s quantity demanded to changes in consumer income. In mathematical terms: ei = Qd ÷ average Qd I ÷ average I

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Cross-Price Elasticity  

Cross-price elasticity (exy) is the responsiveness of the quantity demanded of one product (x) to a change in price of another (y) In mathematical terms: exy = Qd ÷ average Qd Py ÷ average Py

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Elastic and Inelastic Supply 

Price elasticity of supply measures the responsiveness of quantity supplied to price changes
‡

‡

elastic supply:supply for which a percentage change in a product¶s price causes a larger percentage change in quantity supplied  means % change in quantity supplied is more than % change in price inelastic supply:supply for which the percentage change in a product¶s price causes a smaller percentage change in quantity supplied  means % change in quantity supplied is less than % change in price
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Elastic and Inelastic Supply
Figure 3.7, Page 60
Elastic Supply Curve for Tomatoes
Price ($ per kilogram) Price ($ per kilogram) 4 S1 3
50%

Inelastic Supply Curve For Tomatoes
4 3
50%

S1

2 1 0
100%

2 1 0
20%

100 000

120000

100 000 120 000 Quantity Supplied (kilograms per year)

Quantity Supplied (kilograms per year)

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Perfectly Elastic and Perfectly Inelastic Supply 

Perfectly elastic supply:supply for which a
product¶s price remains constant, regardless of quantity supplied ‡ means constant price and a horizontal supply curve 

Perfectly inelastic supply:supply for which a
product¶s quantity supplied remains constant regardless of price ‡ means constant quantity supplied and a vertical supply curve

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Time and the Price Elasticity of Supply (a) 

Price elasticity of supply changes over three production periods
‡

‡

supply is perfectly inelastic in the immediate run  Immediate run:the production period during which none of the resources required to make a product can be varied supply is either elastic or inelastic in the short run  Short run: the production period during which at least one of resources required to make a product cannot be varied.
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‡

supply is perfectly elastic for a constantcost industry and very elastic for an increasing-cost industry in the long run  Long run: the production period during which all resources required to make a product can be varied, and business may either enter or leave the industry  Constant-cost industry: an industry that is not a major user of any single resource  Increasing-cost industry: an industry that is a major user of at least one resource

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Time and the Price Elasticity of Supply (b)
Figure 3.8, Page 61 (continued in part (e))
Immediate-Run Supply Elasticity for Strawberries
Price ($ per kilogram) S1 Price ($ per kilograms) 2.50 2.00

Short-Run Supply Elasticity For Strawberries
S2

0

750 000 Quantity Supplied (kilograms per month)

0

9

11

Quantity Supplied (millions of kilograms per year)

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Time and the Price Elasticity of Supply (c) 

If strawberries are produced in a constant-cost industry:
‡

‡

‡

A higher price of strawberries raises production but not resource prices. As new businesses enter the industry in the long run due to a higher price of strawberries, this price is gradually pushed back down to its original level. Therefore the long-run supply curve for a constant-cost industry is perfectly elastic.

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Time and the Price Elasticity of Supply (d) 

If strawberries are produced in a increasing-cost industry:
‡ ‡

‡

A higher price of strawberries raises production and also resource prices. As new businesses enter the industry in the long run due to a higher price of strawberries, this price is gradually pushed back down to its lowest possible level, but this level is higher than it was originally. Therefore the long-run supply curve for an increasing-cost industry is very elastic.
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Time and the Price Elasticity of Supply (e)
Figure 3.8, Page 61 (continued from part (b))

Long-Run Supply Elasticity
Price ($ per kilograms) S4 2.00 Increasingcost Industry S3

Constantcost Industry

0 Quantity Supplied (millions of kilograms per decade)

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Calculating Price Elasticity of Supply  

A numerical value for price elasticity of supply (es) is found by taking the ratio of the changes in quantity supplied and in price, each divided by its average value. In mathematical terms: es = Qs ÷ average Qs price ÷ average price

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

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Price Controls 

A price floor is a minimum price set above the equilibrium price
‡

it results in a surplus in the market 

A price ceiling is a maximum price set below the equilibrium price
‡

it results in a shortage in the market

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Agricultural Price Supports 

Price supports for agricultural goods are an example of a price floor
‡

‡ ‡

they help overcome unstable agricultural prices farmers win from these supports consumers and taxpayers lose from these supports

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Reasons for Price Supports
Figure 3.9, page 64
Market Demand and Supply Curves for Wheat Market Demand and Supply Schedules for Wheat
Price ($ per tonne) Quantity Quantity Demanded Supplied ($ per (D) (S0) (S1) tonne) (millions of tonnes) $140 120 100 80 60 10 11 12 13 14 14 13 12 11 10 12 11 10 9 8 Price
140 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 D a S1 b S0

Quantity (millions of tonnes per year)

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Effects of Price Supports
Figure 3.11, page 66
Market Demand and Supply Curves for Milk Market Demand and Supply Schedules for Milk
Price ($ per litre) $1.30 1.10 0.90 Quantity Quantity Demanded Supplied (D) (S) (millions of litres) 59 60 61 62 60 58 0 58 59 60 61 62

surplus
S

Price ($ per litre)

1.30 1.10 .90 .70
A price floor creates a surplus.

D

Quantity (millions of litres per year)
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Rent Controls 

Rent controls are an example of a price ceiling
‡

‡

‡

they keep down prices of controlled rental accommodation some (especially middle-class) tenants win from these controls other (especially poorer) tenants lose from these controls

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Effects of Rent Controls
Figure 3.12, page 66
Market Demand and Supply Curves for Units Market Demand and Supply Schedules for Units
S Price ($ per unit) Price ($ rent per month) $700 500 300 Quantity Quantity Demanded Supplied (D) (S) (units rented per month) 1700 2000 2300 2500 2000 1500 0 1500 2000 2300 2500 700 500 300
A price ceiling creates a shortage.

shortage

D

Quantity (units rented per month)

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Spillover Costs (a) 

Spillover costs are the negative external effects of producing or consuming a product
‡

‡

‡

adding these costs to private costs raises the supply curve the preferred outcome is at a lower quantity than in a perfectly competitive market government intervention (e.g. an excise tax) can produce the preferred outcome
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Spillover Costs (b)
Figure 3.13, page 68
Market Demand Curve for Strawberries Demand and Supply Schedules for Gasoline
Price ($ per litre) Price ($ per litre) $2.50 2.00 1.50 1.00 0.05 Quantity Quantity Demanded Supplied (D) (S0) (S1) (millions of litres) 4 5 6 7 8 8 7 6 5 4 6 5 4 3 2 D 2.50
a

S0

S1
Spillover Costs, Excise Tax

2.00 1.50 1.00 0.50
b

0

1

2

3

4

5

6

7

8

Millions of Litres

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Spillover Benefits (a) 

Spillover benefits are the positive external effects of producing or consuming a product
‡ ‡

‡

adding these benefits to private benefits raises the demand curve the preferred outcome is at a higher quantity than occurs in a perfectly competitive market government intervention (e.g. a consumer subsidy) can produce the preferred outcome

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Spillover Benefits (b)
Figure 3.14, page 69
Demand and Supply Curves for an Engineering Education
6000
b

Demand and Supply Schedules for an Engineering Education
Tuition ($ per year) $6000 5000 4000 3000 2000 Enrollment Quantity Demanded Supplied (S0) (S1) (S) (thousands of students) 8 9 10 11 12 10 11 12 13 14 12 11 10 9 8

5000 Tuition ($ per year) 4000 3000 2000 S 1000 D0
a

Spillover Benefits, Student Subsidy

D1

0

8

9

10 11 12 13 14

Thousands of Students

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