Demand and Supply: Price Controls and Elasticity

• This topic covers applications of demand and supply

The Road Ahead

• The plan is to explore price controls, elasticity concepts, and tax incidence.

Price Controls: Price Ceiling (Pc)

• A price ceiling is also known as a maximum price policy.
• It represents an upper limit on the price of a good or service.
• For example, if Pc = 10 pesos, the good/service cannot be sold for more than 10 pesos.
• Some examples are jeepney fares, transport fares, and rent control.
• Price ceilings set below the equilibrium price cause a shortage in the market.
• A price ceiling has no impact if set above the equilibrium price (ineffective).
• In the Philippines, Republic Act 7581 (The Price Act of 1992), as amended by RA 10623, addresses price controls.
• The goal of RA 7581 is to stabilize prices of basic necessities during emergency situations.
• Considerations regarding RA 7581 include: what constitutes an emergency, who determines when one exists, and how long price controls should last.

Price Ceiling (Generic Diagram)

• A price ceiling causes a shortage, since the quantity demanded exceeds the quantity supplied.

Price Controls: Rent Control Example

• A price ceiling below the market equilibrium has direct and indirect effects.
• Shortage = quantity demanded exceeds the quantity supplied, potentially leading to waiting lines.
• Quality deterioration and unfavorable changes in non-price factors are likely to occur for buyers.
• The quantity exchanged will fall, and gains from trade will be less than if the good was allocated freely.
• Shortage = people who want to rent a house but cannot get one
• Dismayed renters = people who would have had housing if there was no price ceiling
• Additional potential renters = people who are priced out of the market

Other Indirect Effects of Rent Control

• Black markets may develop.
• Future supply of housing decreases.
• The quality of housing deteriorates.
• Non-price methods of rationing increase in importance.
• Inefficient use of housing results.
• Long-term renters benefit at the expense of newcomers.

Price Controls: Floor Price (Pf)

• A price floor is also known as a minimum price policy.
• This sets a lower limit on the price.
• A price floor of 10 pesos means the good/service cannot be sold for less than 10 pesos.
• An example includes minimum wages and price supports for agricultural commodities.
• Price floors set above the equilibrium price cause a surplus.
• A price floor has no impact if set below the equilibrium price (ineffective).
• Price support for dry palay was Php 23/kg in September 2023
• Minimum wage in NCR is already Php 645/day (non-agri) and Php 608 (agri) since July 2024.

Minimum Wage: An Example of a Price Floor

• Setting the minimum wage above the market equilibrium for low-skill labor has effects.
• The direct effect is reduced employment of low-skilled labor.
• Indirect effects include a reduction in non-wage compensation, less on-the-job training, and encouraging students to drop out of school.
• The unemployed workers = the surplus of workers

Floor Price: Application to Minimum Wages

• If wages are the price of labor, the surplus shows the amount of unemployed workers
• Displaced workers show how many employees would be hired at no minimum wage

Are Economists Inherently Opposed to Minimum Wage?

• Markets are not perfect, especially labor markets.

Recent Studies Deviate from Traditional Economic Theories

• Employment was not affected after New Jersey increased the hourly minimum wage in April 1992 from $4.25 to $5.05.

Elasticity Concepts

• Elasticity measures the responsiveness of one variable to a change in another.
• Types of elasticity include own price, cross price, and income elasticity of demand, as well as own price elasticity of supply.

Meaning of Elasticity

• If Y = f(X), elasticity measures how Y responds to changes in X.
• Elasticity indicates the percentage change in Y for a one percent change in X.
• Formula: ε = (%ΔY) / (%ΔX)
• Interpretation: ε = 0.75 means a 1% change in X leads to a 0.75% change in Y

Own Price Elasticity of Demand

• It measures the responsiveness of the quantity demanded of a good to changes in its own price.
• Formula: ε = (%ΔQd) / (%ΔP)
• Qd = quantity demanded and P = own price.

Two Ways of Estimating Elasticity

• Point elasticity is measured for a single point on the demand curve.
  • It is more precise, since elasticity can vary at every point on a demand curve.
  • This can be obtained with a demand function.
• Arc elasticity uses two points along a demand curve for the computation.
  • It is implemented when there are a limited number of observations.
• Formula: ε =

Perfectly Inelastic Demand Curve

• A vertical demand curve implies that any change in price will not lead to a change in quantity demanded.
• ε = 0 indicates perfectly inelastic demand.

Perfectly Elastic Demand Curve

• A horizontal demand curve implies a very small change in price will lead to an infinitely large change in quantity demanded.
• ε = ∞ indicates perfectly elastic demand.

The elasticity of a good impacts total revenue

• Total revenue (TR) is equal to the quantity sold multiplied by the price (TR = P x Q).
• Sellers want to know what happens to total revenue if there is a change in price (P).
• If demand is elastic, a higher price leads to lower total revenue.
• If demand is inelastic, a higher price leads to higher total revenue.
• If demand is unit elastic, a higher price has essentially no change in total revenue.

Determinants of the Own Price Elasticity of Demand

• Availability of substitutes: the more substitutes, the more elastic the demand.
• Price of the good relative to purchasing power: the larger the share of the budget, the more elastic.
• Time frame under consideration: the longer the period, the more elastic.
• Location along the demand curve.

Cross-Price Elasticity of Demand

• It measures the responsiveness of the demand for one good to changes in the price of another good.
• % change in the demand for good x for a one percent change in the price of good y
• Formula for goods X and Y: exy = (%Δ demand for good x) / (%Δ price of good y)

The sign of exy indicates whether x and y are substitutes or complements.

• If exy > 0, the goods are substitutes.
• If exy < 0, the goods are complements.

Income Elasticity of Demand

• It measures the responsiveness of the demand for a good to a change in income.
• Formula: η = (%Δ demand for good x) / (%Δ income)
• A positive estimate indicates a normal good.
• A negative estimate indicates an inferior good.
• For positive estimates, the magnitude also tells you if the good is a luxury or a necessity.
  • If the Estimate > 1, it's a luxury.
  • If 0 < Estimate < 1, it's a necessity.

Price Elasticity of Supply

• It measures the degree of responsiveness of quantity supplied to changes in the own price of the good.
• Formula: εs = (%ΔQs) / (%ΔP)
• Estimates are generally non-negative (zero or higher).
• Interpretation is similar to own price elasticity of demand, but is now applied to supply.

Tax Incidence

• This is concerned with the effects of government taxes on consumption and production.
• Two types of taxes include specific/excise tax and ad valorem tax.
• A specific/excise tax is a tax per unit of the product.
• Ad valorem is a tax as a percentage of the selling price.
• The supply and demand model anazlyes impacts of the tax.
• The tax will raise the equilibrium price.
• The increase in the equilibrium price is likely to be less than the amount of the tax.
• The burden of the tax is generally shared by producers and consumers.

Specific Tax (t)

• The initial impact: The specific tax shifts up the supply curve by the amount of the tax

Incorporating the demand side

• Producers will likely be unable to raise prices by the full amount of the tax.
• For each unit of the good, this shows the component of the tax that is paid for by the producer
• For each unit of the good, this shows the component of the tax that is paid for by the consumer

Numerical Example of Tax Incidence

• Given tax = Php 5 /unit; old equilibrium price (P*) = Php 10 per unit; new P* = Php 13 per unit means:
  • the Consumer pays Php 3 /unit of the tax
  • the Producer pays Php 2 /unit of the tax

Additional Points on Tax Incidence

• The distribution of the tax burden depends on the own price elasticity of demand.
• If demand is less price elastic, the burden of the tax is likely to be shouldered more by the consumers.
• If demand is more price elastic, the burden of the tax is likely to be shouldered more by the producers.
• Perfectly inelastic demand: tax is borne solely by the consumers