Price System Functions

The Price System

• The market system, also called the price
system, performs two important and
closely related functions :

• Price Rationing
• Resource Allocation

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Price Rationing

• Price rationing is the
process by which the
market system allocates
goods and services to
consumers when quantity
demanded exceeds
quantity supplied.


Price Rationing

• A decrease in supply
creates a shortage at
P0. Quantity demanded
is greater than quantity
supplied. Price will
begin to rise.
• The lower total supply
is rationed to those
who are willing and
able to pay the higher
price.

Price Rationing

• There is some price
that will clear any
market.
• The price of a rare
painting will eliminate
excess demand until
there is only one bidder
willing to buy the single
available painting.


Alternative Rationing Mechanisms

• A price ceiling is a maximum price
that sellers may charge for a good,
usually set by government.

• Queuing is a nonprice rationing
system that uses waiting in line as a
means of distributing goods and
services.



• Favored customers are those who receive
special treatment from dealers during
situations when there is excess demand.

• Ration coupons are tickets or coupons that
entitle individuals to purchase a certain
amount of a given product per month.

• The problem with these alternatives is that
excess demand is created but not eliminated.



• In 1974, the
government used an
alternative rationing
system to distribute the
available supply of
gasoline.
• At an imposed price of
57 cents per gallon, the
result was excess
demand.



• A black market is a
market in which illegal
trading takes place at
market-determined
prices.



• No matter how good the intentions of private
organizations and governments, it is very
difficult to prevent the price system from
operating and to stop the willingness to pay
from asserting itself.

• With favored customers and black markets, the
final distribution may be even more unfair than
that which would result from simple price
rationing.


Prices and the Allocation of Resources

• Price changes resulting from shifts of demand in output
markets cause profits to rise or fall.

• Profits attract capital; losses lead to disinvestment.

• Higher wages attract labor and encourage workers to
acquire skills.

• At the core of the system, supply, demand, and prices in
input and output markets determine the allocation of
resources and the ultimate combinations of things
produced.


Supply and Demand Analysis:
An Oil Import Fee

• At a world price of $18, • The tax on imports causes an
imports are 5.9 million barrels increase in domestic production,
per day. and quantity imported falls.

Elasticity

• Elasticity is a general concept that can be used
to quantify the response in one variable when
another variable changes.

% ∆A
e la s tic ity o f A w ith re s p e c t to B =
% ∆B
• Price elasticity of demand measures how
responsive consumers are to changes in the
price of a product.


Price Elasticity of Demand

• Measures the responsiveness of demand to
changes in price.
• It is the ratio of the percentage change in
quantity demanded to the percentage change
in price.
% c h a n g e in q u a n tity d e m a n d e d
p ric e e la s tic ity o f d e m a n d =
% c h a n g e in p ric e
• Its value is always negative, but stated in
absolute terms.
• The value of the line of the slope and the
value of elasticity are not the same.

Characteristics of Demand Elasticity

Value of Type of Magnitudes of Response to
Elasticity Demand Change Price Changes
ε > |1| Elastic %∆Qd > %∆P Responsive
ε < |1| Inelastic %∆Qd < %∆P Unresponsive
ε = |1| Unitary elastic %∆Qd = %∆P Proportional

Type of Substitutes
Elasticity Available
Elastic Many
Inelastic Few

Shape of Demand According to Elasticity

Type of Demand Inclination
Elastic Relatively Flat
Inelastic Relatively Steep


Extreme Elasticities

Elasticity Value Type of Elasticity Substitutes Available
ε=0 Perfectly Inelastic None
ε= Perfectly Elastic Infinite


Hypothetical Demand Elasticities
for Four Products

Hypothetical Demand Elasticities for Four Products

% CHANGE IN
% CHANGE QUANTITY
IN PRICE DEMANDED ELASTICITY
PRODUCT (% ∆P) (% ∆Qd) (% ∆Qd/% ∆P)
Insulin 10% 0% 0 Perfectly inelastic
Basic telephone service 10% -1% -0.1 Inelastic
Beef 10% -10% -1 Unitary elastic
Bananas 10% -30% -3 Elastic


Calculating Percentage Changes

• Elasticity is a ratio of percentages, and it involves
computing percentage changes.
P2 − P1
% c h a n g e in p ric e = x 100%
P1
Q2 − Q1
% c h a n g e in q u a n tity d e m a n d e d = x 100%
Q1
• Using the values on the graph to
compute elasticity, then:
+ 100%
p ric e e la s tic ity o f d e m a n d = = − 3 .0
− 3 3 .3 %


Computing the Value of Elasticity

• The midpoint formula to
compute elasticity is:

Q2 − Q1
x 100%
% ∆Qd (Q 1 + Q 2 ) / 2
=
% ∆P P2 − P1
x 100%
( P1 + P2 ) / 2

10 − 5 5
x 100% x 100%
% ∆Qd (5 + 1 0 ) / 2 6 6 .7 %
= = 7 .5 = = − 1 .6 7
% ∆P 2 − 3 -1 - 4 0 .0 %
x 100% x 100%
(3 + 2 ) / 2 2 .5

Interpreting the Value of Elasticity

Here is how to interpret two different
values of elasticity:
• When ε = 0.2, a 10% increase in price
leads to a 2% decrease in quantity
demanded.
• When ε = 2.0, a 10% increase in price
leads to a 20% decrease in quantity
demanded.


Elasticity Changes along a Straight-Line
Demand Curve

• Price elasticity of demand
decreases as we move
downward along a linear
demand curve.

• Demand is elastic on the
upper part of the demand
curve and inelastic on the
lower part.


Elasticity Changes along a Straight-
Line Demand Curve
• Along the elastic range,
− 6.4
elasticity values are
greater than one.
• Along the inelastic range,
− .29 elasticity values are less
than one.


Elasticity and Total Revenue

Effect of an
Change in quantity increase in Effect of a
Type of versus change in price on total decrease in price
demand Value of Ed price revenue on total revenue
Elastic Greater than Larger percentage change Total revenue Total revenue
1.0 in quantity decreases increases
Inelastic Less than 1.0 Smaller percentage Total revenue Total revenue
change in quantity increases decreases
Unitary Equal to 1.0 Same percentage change Total revenue Total revenue does
elastic in quantity and price does not change not change

• When demand is inelastic, price and 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 Demand Elasticity

• 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.
• Time frame -- demand becomes
more elastic over time.


Other Important Elasticities

• Income elasticity of demand – measures the
responsiveness of demand to changes in
income.
% c h a n g e in q u a n tity d e m a n d e d
in c o m e e la s tic ity o f d e m a n d =
% c h a n g e in in c o m e



• Cross-price elasticity of demand: A
measure of the response of the quantity of one
good demanded to a change in the price of
another good.
% c h a n g e in q u a n tity o f Y d e m a n d e d
c ro s s - p ric e e la s tic ity o f d e m a n d =
% c h a n g e in p ric e o f X



• Elasticity of supply: A measure of the
response of quantity of a good supplied to a
change in price of that good. Likely to be
positive in output markets.
% c h a n g e in q u a n tity s u p p lie d
e la s tic ity o f s u p p ly =
% c h a n g e in p ric e



• Elasticity of labor supply: A measure of the
response of labor supplied to a change in the
price of labor.
% c h a n g e in q u a n tity o f la b o r s u p p lie d
e la s tic ity o f la b o r s u p p ly =
% c h a n g e in th e w a g e ra te


Price System Functions

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