Class 7 - Supply, Demand and Government Policies

Test will be Nov 16th, not on Nov 9th as previously announced. Covering chapters 4, 5, 6, 10 and 11.

Wants to cover externalities and public goods
Today Ch 6
Ch 9 will not be covered
Focus on Ch 10-11 next week
Revised schedule will be posted to Blackboard and an email will be sent.

After the test, focus will be on Macroeconomics.

See end of chapter 5 - pg 110-11 - problems and applications dealing with price elasticity of demand, midpoint formula (pg 92).

Alfred Marshall (mentor of Keynes at Cambridge) invented the demand elasticity curve. He wasn't a mathematician so he interchanged the independent and dependent axis on the curve.

1. a. mystery novels. required textbooks are a necessity so they are less elastic. (publishers understand this and therefore raise prices to the levels that we see)
b. beethoven. it's more narrowly defined and therefore there are more substitutes for it.
c. over 5 years. time horizon is broader. (cta is assuming price inelasticity for fares. however, over the long run, it may be elastic and lead to lower revenues.)
d. root beer is more elastic. there are many substitutes.

2. (more calculations than we would see in a test)
this is a question of yield mgmt (see Hemispheres magazine, main article on October issue)
a. use the midpoint formula for elasticity of demand:
for business travelers
[-100/(3900/2)] / [50/225] = -0.051 / 0.222 = 0.23
this is an inelastic demand curve. it's less than 1.
for vacationers
[-200/700] / [50/225] = -0.286/.222 = 1.287
this is an elastic demand curve. it's greater than 1.
b. there are substitutes

6. - never did this problem

12. To answer this question you must first know (or at least have a feeling for or a judgement of) the price elasticity of demand. If it's less than 1, increase the price. If it's more than 1, decrease the price.

13. slope of pharma demand curve is steeper than the computer demand curve. as supply increases and the supply curve shifts to the right, equilibrium price goes down. pharma experiences a greater decrease in price decrease. computers have larger change in quantity demanded. the elastic demand in computers means that the quantity increase is larger than the price decrease and therefore total revenues will increase. conversely, the quantity increase for pharma is smaller than the price decrease because the price elasticity of demand for pharma is less than 1.

Handout: The textbook economics of cap-and-trade by Paul Krugman, Sept 27, 2009
This article is background for understanding the UN-sponsored Copenhagen summit on climate change.

see fig 4b, pg 214
see figure in Krugman's blog
We will go thru this more next week.

Break. After the break, we will zip through Chapter 6.

See chapter 6 - figure 1

Price Ceilings

Non- binding ceiling must be above equilibrium. Such a ceiling is extraneous. It has no effect on the market.

Binding ceiling must be set below equilibrium. In such a case, it will create a shortage. This happens in "real" socialism. Very low prices and lots of shortages. Promise of socialism was that there would be an abundance at low prices. So they set price ceilings, but this caused shortages. Same thing happens with rent control.

Shortages are handled in many ways. Under socialism/communism, it led to long lines and corruption.

See figure 2 - attempts to control prices of gasoline in the 1970s.
initially, the price ceiling was above equilibrium. but then the supply curve shifted and the price ceiling was then below the equilibrium, leading to a shortage.

Rent Controls

see figure 3, pg 117.
An aside: "Friends" was based on rent control. Monica and Rachel's apartment were under rent control. Her grandmother's name was on the lease and the rent control laws said that the rent could not be raised if the leaseholder was still living there.

In the short run, figure A, rent control creates a shortage. In the long run, figure B, elasticity increases on both the supply and dmand side, and the shortage increases.

If there are people who are homeless, some solution needs to be found as an alternative to rent control: public housing (which has many problems) or housing vouchers. Instead of providing housing, provide income subsidies. Same answer for education: vouchers are a better solution than restricting people to a specific school.

Minimum Wage Law

See figure 5. Affect of minimum wage laws. This is controversial and there is a debate as to how much harm these laws do. These laws don't impact educated workers, only young, uneducated laborers. That is the market that the figures refer to. Not the entire US labor market.

Minimum wage laws lead to a labor surplus, i.e. unemployment, in this market segment.

Economists would prefer government subsidies to hire young workers, rather than establishing minimum wage levels.

Taxes on Sellers

see figure 6, pg 125
Supply curve shifts leftward/upward, raising the price to a new equilibrium, but not by the full amount of the tax - because the demand goes down and the sellers end up "eating" the difference.

In the example, the 50 cent tax cost the consumers 30 cents and suppliers 20 cents.

Tax on Buyers

see figure 7 pg 126

A simliar thing happens and the effect of the tax is shared between producers and consumers. It doesnt matter who the initial tax is put upon. It has the same effect.

How much is shared by each side depends on the elasticity of the demand/supply curve.