Standard 8: The Price System

Prices send signals and provide incentives to buyers and sellers. When supply or demand
changes, market prices adjust, affecting incentives.

 Higher prices for a good or service provide incentives for buyers to purchase less of that
good or service and for producers to make or sell more of it. Lower prices for goods or
services provide incentives for buyers to purchase more of that good or service and for
producers to make or sell less of it.
 An increase in the price of a good or service encourages people to look for substitutes,
causing the quantity demanded to decrease, and vice versa. This relationship between
price and quantity demanded, known as the law of demand, exists as long as other factors
influencing demand do not change.
 An increase in the price of a good or service enables producers to cover higher per-unit
costs and earn profits, causing the quantity supplied to increase, and vice versa. This
relationship between price and quantity supplied is normally true as long as other factors
influencing costs of production and supply do not change.
 Demand for a product changes when there is a change in consumers’ incomes or
preferences, or in the prices of related goods or services, or in the number of consumers
in a market.
 Supply of a product changes when there are changes in the prices of the productive
resources used to make the good or service, the technology used to make the good or
service, the profit opportunities available to producers by selling other goods or services,
or the number of sellers in the market.
 Changes in supply or demand cause relative prices to change; in turn, buyers and sellers
adjust their purchase and sales decisions.

Standard 9: Role of Competition

Competition among sellers lowers costs and prices, and encourages producers to produce more
of what consumers are willing and able to buy. Competition among buyers increases prices and
allocates goods and services to those people who are willing and able to pay the most for them.

 Competition among sellers results in lower costs and prices, higher product quality, and
better customer service.
 The level of competition in a market is influenced by the number of buyers and sellers.
 The level of competition in an industry is affected by the ease with which new producers
can enter the industry and by consumers’ information about the availability, price, and
quantity of substitute goods and services.
 Collusion among buyers or sellers reduces the level of competition in a market. Collusion
is more difficult in markets with large numbers of buyers and sellers.

Standard 16: Role of Government:

There is an economic role for government to play in a market economy whenever the benefits of
a government policy outweigh its costs. . . .
  In the United States, the federal government enforces antitrust laws and regulations to try
to maintain effective levels of competition in as many markets as possible; frequently,
however, laws and regulations also have unintended effects – for example, reducing
competition.

Standard 17: Public Choice

Costs of government policies sometimes exceed benefits. This may occur because of incentives
facing voters, government officials, and government employees, because of actions by special
interest groups that can impose costs on the general public, or because social goals other than
economic efficiency are being pursued.

 Price controls are often advocated by special interest groups. Price controls reduce the
quantity of goods and services consumer, thus depriving consumers of some goods and
services whose value would exceed their cost.

Key Ideas
1. Review:

 In open markets, prices moving freely in response to changes in supply and demand
allocate resources to their most highly valued uses.
 Market equilibrium, the condition where quantity supplied equals quantity demanded,
emerges from the predictable responses of buyers and sellers to price incentives.

2. Institutions establish the rules of the game under which markets operate. Government(s) may
create or affect institutional arrangements.

 Government actions that support the effective operation of open markets include such
important activities as enforcing the rule of law and defining and protecting property
rights.
 Government actions that reduce the openness of markets inhibit the ability of price
incentives to allocate resources to their most highly-valued uses.
o Examples of changes in the rules of the game that inhibit markets include
restrictions on price levels or on the conditions of production, sale, and
consumption.
o Controls that prevent prices from rising to an equilibrium result in shortages
o Controls that prevent prices from falling to an equilibrium result in surpluses.
o Regulations, such as licensing, production regulations, and quality specifications
reduce supply and increase prices.
 Government actions that are well-intentioned often produce unintended consequences
such as “black markets” to allocate goods, or impacts on other markets that were not the
target of the actions.

3. Understanding how prices act as incentives that influence people’s choices allows us to predict
and explain the results of government actions that restrict the operation of markets.
  Price controls lead to shortages (price ceilings) and surpluses (price floors).
 Restrictions on competition, regulations, and subsidies reduce quantities sellers offer in
the market and raise prices to buyers.

4. Economists conceptually organize the apparent chaos of markets by using the supply and
demand model.

 Review: Law of demand and law of supply introduced in Lesson 2.

 Demand – people’s willingness and ability to buy – is affected by such factors as tastes,
incomes, and the price and availability of substitutes and complements.
 Supply – producers’ and sellers’ willingness and ability to offer products for sale – is
affected by such factors as availability of resources and production cost; the number of
sellers; and the prices of other products.
 Prices coordinate market activity by providing incentives to buyers and sellers to act so
that both gain from trade.

5. Equilibrium (market clearing) prices emerge from the interactions of demanders and suppliers
in markets and provide incentives that shape buyers’ and sellers’ future choices.

 If sellers offer more than buyers are willing to purchase at the current price, inventories
accumulate and the market receives a signal that price is too high.
 If buyers cannot purchase all that they demand or cannot find certain goods at the current
price, the market receives a signal that price is too low.
 The inventory and purchase signals move price in the direction of an equilibrium price, or
market clearing price, where quantity demanded equals quantity supplied.

6. Markets function most effectively when prices move freely in response to changes in supply
and demand. Institutional support for markets, in the form of clearly defined property rights and
the rule of law, facilitate the free movement of prices.

7. Market power results from successful efforts to reduce competition

Arc elasticity[edit]

A second solution to the asymmetry problem of having a PED dependent on which of the two
given points on a demand curve is chosen as the "original" point and which as the "new" one is
to compute the percentage change in P and Q relative to the average of the two prices and the
average of the two quantities, rather than just the change relative to one point or the other.
Loosely speaking, this gives an "average" elasticity for the section of the actual demand curve—
i.e., the arc of the curve—between the two points. As a result, this measure is known as the arc
elasticity, in this case with respect to the price of the good. The arc elasticity is defined
mathematically as:[13][17][18]

This method for computing the price elasticity is also known as the "midpoints formula",
because the average price and average quantity are the coordinates of the midpoint of the straight
line between the two given points.[12][18] This formula is an application of the midpoint method.
However, because this formula implicitly assumes the section of the demand curve between
those points is linear, the greater the curvature of the actual demand curve is over that range, the
worse this approximation of its elasticity will be.[17][19]

History[edit]

The illustration that accompanied Marshall's original definition of PED, the ratio of PT to Pt

Together with the concept of an economic "elasticity" coefficient, Alfred Marshall is credited
with defining PED ("elasticity of demand") in his book Principles of Economics, published in
1890.[20] He described it thus: "And we may say generally:— the elasticity (or responsiveness) of
demand in a market is great or small according as the amount demanded increases much or little
for a given fall in price, and diminishes much or little for a given rise in price".[21] He reasons this
since "the only universal law as to a person's desire for a commodity is that it diminishes... but
this diminution may be slow or rapid. If it is slow... a small fall in price will cause a
comparatively large increase in his purchases. But if it is rapid, a small fall in price will cause
only a very small increase in his purchases. In the former case... the elasticity of his wants, we
may say, is great. In the latter case... the elasticity of his demand is small."[22] Mathematically, the
Marshallian PED was based on a point-price definition, using differential calculus to calculate
elasticities.[23]

Determinants[edit]
The overriding factor in determining PED is the willingness and ability of consumers after a
price change to postpone immediate consumption decisions concerning the good and to search
for substitutes ("wait and look").[24] A number of factors can thus affect the elasticity of demand
for a good:[25]

Availability of substitute goods

The more and closer the substitutes available, the higher the elasticity is likely to be, as
people can easily switch from one good to another if an even minor price change is
made;[25][26][27] There is a strong substitution effect.[28] If no close substitutes are available,
the substitution effect will be small and the demand inelastic.[28]
Breadth of definition of a good
The broader the definition of a good (or service), the lower the elasticity. For example,
Company X's fish and chips would tend to have a relatively high elasticity of demand if a
significant number of substitutes are available, whereas food in general would have an
extremely low elasticity of demand because no substitutes exist.[29]
Percentage of income
The higher the percentage of the consumer's income that the product's price represents,
the higher the elasticity tends to be, as people will pay more attention when purchasing
the good because of its cost;[25][26] The income effect is substantial.[30] When the goods
represent only a negligible portion of the budget the income effect will be insignificant
and demand inelastic,[30]
Necessity
The more necessary a good is, the lower the elasticity, as people will attempt to buy it no
matter the price, such as the case of insulin for those who need it.[10][26]
Duration
For most goods, the longer a price change holds, the higher the elasticity is likely to be,
as more and more consumers find they have the time and inclination to search for
substitutes.[25][27] When fuel prices increase suddenly, for instance, consumers may still fill
up their empty tanks in the short run, but when prices remain high over several years,
more consumers will reduce their demand for fuel by switching to carpooling or public
transportation, investing in vehicles with greater fuel economy or taking other
measures.[26] This does not hold for consumer durables such as the cars themselves,
however; eventually, it may become necessary for consumers to replace their present
cars, so one would expect demand to be less elastic.[26]
Brand loyalty
An attachment to a certain brand—either out of tradition or because of proprietary
barriers—can override sensitivity to price changes, resulting in more inelastic
demand.[29][31]
Who pays
Where the purchaser does not directly pay for the good they consume, such as with
corporate expense accounts, demand is likely to be more inelastic.[31]
Interpreting values of price elasticity coefficients[edit]

Perfectly inelastic demand[10]

Perfectly elastic demand[10]

Elasticities of demand are interpreted as follows:[10]

Value Descriptive Terms

Perfectly inelastic demand
Inelastic or relatively inelastic demand
Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand
Elastic or relatively elastic demand
Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity demanded by
consumers because of the law of demand, and conversely, quantity demanded decreases when
price rises. As summarized in the table above, the PED for a good or service is referred to by
different descriptive terms depending on whether the elasticity coefficient is greater than, equal
to, or less than −1. That is, the demand for a good is called:
  relatively inelastic when the percentage change in quantity demanded is less than the
percentage change in price (so that Ed > - 1);
 unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the
percentage change in quantity demanded is equal to the percentage change in price (so
that Ed = - 1); and
 relatively elastic when the percentage change in quantity demanded is greater than the
percentage change in price (so that Ed < - 1).[10]

As the two accompanying diagrams show, perfectly elastic demand is represented graphically as
a horizontal line, and perfectly inelastic demand as a vertical line. These are the only cases in
which the PED and the slope of the demand curve (∆P/∆Q) are both constant, as well as the only
cases in which the PED is determined solely by the slope of the demand curve (or more
precisely, by the inverse of that slope).[10]

Relation to marginal revenue[edit]

The following equation holds:

where
R' is the marginal revenue
P is the price
Proof:
TR = Total Revenue

Effect on total revenue[edit]

See also: Total revenue test
A set of graphs shows the relationship between demand and total revenue (TR) for a linear
demand curve. As price decreases in the elastic range, TR increases, but in the inelastic range,
TR decreases. TR is maximised at the quantity where PED = 1.

A firm considering a price change must know what effect the change in price will have on total
revenue. Revenue is simply the product of unit price times quantity:

Generally any change in price will have two effects:[32]

The price effect

For inelastic goods, an increase in unit price will tend to increase revenue, while a
decrease in price will tend to decrease revenue. (The effect is reversed for elastic goods.)
The quantity effect
An increase in unit price will tend to lead to fewer units sold, while a decrease in unit
price will tend to lead to more units sold.

For inelastic goods, because of the inverse nature of the relationship between price and quantity
demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions.
But in determining whether to increase or decrease prices, a firm needs to know what the net
effect will be. Elasticity provides the answer: The percentage change in total revenue is
approximately equal to the percentage change in quantity demanded plus the percentage change
in price. (One change will be positive, the other negative.)[33] The percentage change in quantity
is related to the percentage change in price by elasticity: hence the percentage change in revenue
can be calculated by knowing the elasticity and the percentage change in price alone.

As a result, the relationship between PED and total revenue can be described for any good:[34][35]
  When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in
the price do not affect the quantity demanded for the good; raising prices will always
cause total revenue to increase. Goods necessary to survival can be classified here; a
rational person will be willing to pay anything for a good if the alternative is death. For
example, a person in the desert weak and dying of thirst would easily give all the money
in his wallet, no matter how much, for a bottle of water if he would otherwise die. His
demand is not contingent on the price.
 When the price elasticity of demand for a good is relatively inelastic (-1 < Ed < 0), the
percentage change in quantity demanded is smaller than that in price. Hence, when the
price is raised, the total revenue increases, and vice versa.
 When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1), the
percentage change in quantity is equal to that in price, so a change in price will not affect
total revenue.
 When the price elasticity of demand for a good is relatively elastic ( -∞ < Ed < -1), the
percentage change in quantity demanded is greater than that in price. Hence, when the
price is raised, the total revenue falls, and vice versa.
 When the price elasticity of demand for a good is perfectly elastic (Ed is − ∞), any
increase in the price, no matter how small, will cause demand for the good to drop to
zero. Hence, when the price is raised, the total revenue falls to zero. This situation is
typical for goods that have their value defined by law (such as fiat currency); if a 5 dollar
bill were sold for anything more than 5 dollars, nobody would buy it, so demand is zero.

Hence, as the accompanying diagram shows, total revenue is maximized at the combination of
price and quantity demanded where the elasticity of demand is unitary.[35]

It is important to realize that price-elasticity of demand is not necessarily constant over all price
ranges. The linear demand curve in the accompanying diagram illustrates that changes in price
also change the elasticity: the price elasticity is different at every point on the curve.