Theory: Changes in Market Equilibrium - Price Controls

Microeconomics: Effects of Government Intervention – Price Controls

In most industrial countries, markets are hardly ever free from types of government intervention. This intervention takes many forms, such as: taxes, subsidies and regulation. Moreover, governments often use price controls as one of their main forms of market intervention.

Price controls occur when the government increases or reduces the price of the product in the market. They can do this by implementing a ‘ceiling’ price where the price can go no higher than this ‘ceiling’ or a ‘floor’ price where the price can go no lower than this ‘floor’.

So what effect would this have on the market? Let’s use supply-demand analysis to graphically imagine these effects…

In the above diagram, the government has implemented a ceiling price as their price control. This ceiling price therefore has altered the market equilibrium price and quantity. Prior to the change the equilibrium between supply and demand was at (Q,P). Now, however, the market is in a state of disequilibrium.

As we have discussed before, a fall in the market price leads to a reduction in supply and an increase in demand levels because consumers will be able to buy more but producers will be faced with higher relative production costs. The implementation of a ceiling price which is lower than the equilibrium price has the effect of reducing the price. Therefore, in this case there would be a fall in supply and an increase in demand. This would then cause a state of excess of demand (D > S) which would cause a shortage. Shortages can sometimes lead to supply rationing and sometimes it can in fact spill over into other markets where it creates an artificial increase in demand. For instance, in the USA in the 1970’s gas prices were increased by the government, this lead to shortages as well as artificially increasing demand in oil markets as it is a substitute for gas.

In these circumstances, some people stand to win and some people stand to lose from price controls. Typically the producers of the product lose out whilst the consumers gain. The buyers get to purchase at a lower price and some suppliers leave the market. However, not all consumers gain. As we have mentioned before an increase in demand from a lower price is caused by more people being able to afford the product, however because some of the suppliers leave the market there are those who have been ‘rationed’ out of purchasing.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.

Theory: Short-Run versus Long-Run Elasticities

Microeconomics: Short-Run versus Long-Run Elasticities

If we ask ourselves the question: ‘how much does demand or supply change in response to a change in on its determinants?’ we must define the period of time in which we are referring to i.e. how much time is allowed to pass before we measure the changes in quantity demanded/supplied. This is an essential element to the study of economies. In economics we refer to the short run and the long run. The short run is typically defined as one year or less and the long run is defined as the time period in which consumers/producers are allowed to full adjust to changes in price or other determinants. In essence, the curves of supply and demand in the short run are different than their counterparts in the long run.

First of all let’s look at demand. The case is that the demand curve for most goods in the long run is more price elastic than in the short run. This is for several reasons. One of these is that it takes time for people to alter their spending habits. Moreover, the demand for a good may be related to the stock of a different good that changes more slowly.

On the contrary, the opposite holds true for other goods where demand is more elastic in the short run than in the long run. Typically these goods are capital stock/equipment i.e. cars, TVs or other durable goods. The total stock of each good owned by the consumer is large relative to yearly production. Due to this, a small change in the aggregate stock that consumers want can cause a large percentage change in the level of purchases. Consider the case of cars, although annual demand for new ones is well in to the millions, the stock that people own is usually 10 times the size of the demand. The quantity demanded will drop fast is prices rise because people will put off buying them for the time being. Eventually however, because older cars wear out and need to be replaced, the quantity demanded of new cars – in the long run – will rise again. As a result of this, long run change in the quantity demanded is more inelastic than in the short run. People will always need cars!

Furthermore, we have income elasticities. They too differ in the short run and in the long run. For most goods (normal goods) the YED is larger in the long run than it is in the short run. Similarly with demand elasticity, the opposite is true for durable goods where short run elasticity is greater than in the long run.

Now, if we look at this concept and apply it to the wider economy it leads us to such a thing called cyclical industries. These are defined as industries in which sales end to magnify changed in GDP and national income. BECAUSE the demand for durable goods (capital equipment etc.) fluctuate violently in response to short run alterations in national income, the industries that produce said goods are therefore obviously more vulnerable to changing macroeconomic conditions. This brings us on to the business cycle – the cyclical view that the economy goes through stages (recessions/booms etc.). The cyclical industries have sales patterns that tend to magnify the cyclical changes in GDP and national income levels. Typically, the sales of durable equipment (investment) follow the same pattern as GDP but these sales are much larger than the changes in GDP and are so described as being ‘magnified’. So, in a boom phase the purchases of capital equipment grow faster than GDP does and on the contrary, in a recession phase the equipment purchases fall faster than levels of GDP fall.

Looking further into this idea, levels of consumer expenditure follow and match the levels of GDP over time however, only the purchases of capital equipment (investment) magnify these changes. This means that there are companies out there (those that sell TVs, cars etc.) who are considered ‘cyclical’ i.e. General Motors and General Electric.

Now let’s look at the other side of the coin: elasticities of supply. These also differ between the long run and the short run. For most products, long run supply is typically more elastic than in the short run. This stems from a few causes. One of these is capacity constraint whereby firms need time to expand capacity buy searching and hiring more workers or building new factories. This doesn’t mean that the quantity supplied won’t rise in the short run, however. If price rises quickly in the short run then a firm can expand capacity by hiring workers overtime or hiring new workers immediately. This just means that firms will expand their supply capabilities when they have the time to do so and think carefully about their decisions.

It should be noted that some goods have a completely inelastic short run supply. Take the example of house renting. In the short run, there is only a fixed number of available housing. This means that a rise in its demand level would purely cause rent prices to increase. In the long run though, provided there is no rent control, higher levels of rent would be a motivation for new construction of rentable housing.

It should be duly noted that more often than not firms will find methods to expand their output in the short run when the profit/price incentive is strong enough. Although, due to the fact that various constraints make it expensive to promptly increase output, it may in fact require large increases in the price to evoke short term increases of the supply quantity.

Likewise with demand, supply has a similar scenario when it comes to durable goods. For certain goods, supply is more elastic in the short run. This is because these durable goods, they can be recycled as part of supply if and when price goes up. Scrap metal is a good example of this as it can be melted down and refabricated. So say the price of copper falls, the incentive to convert it into new supply is less than before. Initially, its supply drops quickly but then as the stock of it falls, the refabricating becomes more expensive for the producer and so it then rises again slowly. Therefore the short run elasticity is larger than the long run.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.

Theory: Elasticities of Supply and Demand

Microeconomics: Elasticities of Supply and Demand

Let’s now develop on the fact that we know the demand for a good not only depends on price but also the price of other goods, tastes and income. Similarly, supply of a good depends on both price and factors that affect the cost of production. Logically it makes sense to know by how much levels of supply and demand will rise/fall. This asks the question: ‘how sensitive is demand or supply to a change in one of its determining factors?’ – In other terms it’s elasticity.

This leads us to a definition of elasticity: the percentage change in one variable resulting for a 1% increase in another.

As an example, take the price elasticity of demand. It measures the sensitivity of the quantity demanded to changes in price. It tells us what the percentage change in quantity demanded will be following a 1% increase in the price of a particular good.

PED (Price Elasticity of Demand) usually takes the form of a negative number because as the price of a good increases, the quantity demanded usually falls – it has an inverse relationship.

In practice, economists sometimes refer to the magnitude of price elasticity i.e. its actual size. So, say that PED = (-)3, then the elasticity is 3 in magnitude.

When PED > 1 we say that it is PRICE ELASTIC because the percentage fall in quantity demanded is greater than the percentage increase in price.

When PED < 1 we say that it is PRICE INELASTIC because the percentage fall in quantity demanded is less than the percentage increase in price.

Generally speaking, PED for a good depends on the availability of its substitutes. When there are close substitutes for a good then a price increase for that good will cause the buyers to purchase less of it and to buy more of its substitute. In this case demand will be highly elastic (PED>1). On the other hand, when there are no close substitutes for a product then demand will be highly inelastic.

From previous theory lesson posts, we have seen that demand can be represented graphically with a linear downward-sloping curve. For the mathematicians out there, you will know that elasticity can be described with a differential equation. This is because PED is the change of quantity associated with the change in price i.e. (ΔQ / ΔP). To develop this into the linear demand curve we need to times it by the ratio of price to quantity (P / Q). However, due to the fact that as you move down the demand curve the (ΔQ / ΔP) may change and the (P / Q) will always change, the PED must be measured at a PARTICULAR POINT on the demand curve. To make this latter point clearer, because it depends on the ratio of (P / Q) the PED is higher at higher prices as ‘P’ will be larger.

Mathematically, because we draw demand and supply curves with price on the vertical axis and quantity on the horizontal one, for any price-quantity combination the steeper the slope of the demand curve is, the less elastic is demand.

This leads us on to two special cases. Perfectly inelastic and elastic demand. Perfectly elastic demand develops on the idea that consumers will buy as much of a god as they can get at a single price. However, for a higher price the level of demand falls to zero while any lower price causes the level of demand to increase without limit. Here, a tiny change in price will cause a massive change in demand and so the demand curve is perfectly elastic.

On the contrary, we have perfectly inelastic demand. It is defined as the idea that buyers will buy a fixed quantity of a good regardless of its price. In this scenario, (ΔQ / ΔP) = 0 due to the fact that the quantity demanded will always be the same irrespective of its price.

                  Perfectly Elastic                                                               

                

  Perfectly Inelastic

There are, obviously, other demand elasticities within the study of economics. Often we are interested in income elasticity of demand (YED) and cross elasticity of demand (XED). In terms of supply we are also concerned with the price elasticity of supply (PES).

Income elasticity of demand (YED) is the percentage change in the quantity demanded resulting from a 1% increase in income. We also have XED which incorporates the fact that demand for some goods is affected by the price of its related goods. XED refers to the percentage change in the quantity demanded for a good resulting in a 1% increase in the price of another.

YED > 1, income elastic i.e. an increase in income causes an increase in demand for the good

YED < 1, income inelastic i.e. an increase in income causes a decrease in demand for the good

YED = 1, perfectly income elastic i.e. a 1% increase in income causes a 1% unit increase in demand for the good

XED > 1, cross-price elastic i.e. the goods are substitutes for each other

XED < 1, cross-price inelastic i.e. the goods are complements for each other

XED = 0, goods have no relation to one another

Price elasticity of supply (PES) is the percentage change in the quantity supplied resulting from a 1% increase in price. This usually is positive as a higher price of a good gives the producer more of an incentive to produce said good. It should also be noted that elasticities of supply can be referred to with respect to wage rates or interest rates or the prices of raw materials/factors of production. For example, the elasticity of supply with respect to the cost of raw materials is negative because an increase in the cost of these materials with mean higher costs for the firm and so the quantity supplied will fall ceteris paribus.  

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Theory: Changes in Market Equilibrium

Microeconomics: Changes in Market Equilibrium

As has already been discussed, supply and demand respond to changes in many variables such as wage rates, capital costs and income. Moreover, the market mechanism develops an equilibrium. Now, we must go that step further and notice how changes in supply and demand curves cause a change in the equilibrium.

Firstly, let’s look at shifts in the demand curve.

A rightward shift in the demand curve could have potentially arisen due to an increase in income. The original equilibrium before the shift was at (Q,P) but now the new equilibrium after the shift is at (Q1,P1). This is called the new equilibrium position. In this case, this is at a higher price and also at a greater quantity so the market now clears at a higher price and quantity when the demand curve shits out right.

Now, let’s look at shifts in the supply curve.

A rightward shift in the supply curve could have potentially been caused by a fall in the price of raw materials. The original equilibrium before the shift was at (Q,P) but now the new equilibrium is at (Q1,P1). This new equilibrium position has coincided with a fall in the price (from P to P1) and an increase in the quantity (from Q to Q1).

In most markets, both curves will fluctuate over time. Levels of disposable income change as the economy changes (boom/recession). The demand for certain goods changes with seasons of the year as well as changes in the prices of related goods or simply with a change in tastes. Likewise, capital costs, wage rates and raw material costs vary over tie and these variations cause shifts in the supply curve.

Supply and demand curves are therefore used to trace the effects of these changes. The changes are of price and quantity but to predict the size and directions of these changes, we have to quantitatively identify the dependence of supply and demand on price and other variables. This if the concept behind elasticities of supply and demand.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.