All goods and services are subject to scarcity at some level. Scarcity means that society must develop some allocation mechanism – rules to determine who gets what. Over recorded history, these allocation rules were usually command based – the king or the emperor would decide. In contemporary times, most countries have turned to market based allocation systems. In markets, prices act as rationing devices, encouraging or discouraging production and encouraging or discouraging consumption in such a way as to find an equilibrium allocation of resources. We will construct demand curves to capture consumer behavior and supply curves to capture producer behavior. The resulting equilibrium price “rations” the scarce commodity. Markets are frequent targets of government intervention. This intervention can be direct control of prices or it could be indirect price pressure through the imposition of taxes or subsidies. Both forms of intervention are impacted by elasticity of demand.
After this course, you will be able to:
• Describe consumer behavior as captured by the demand curve.
• Describe producer behavior as captured by the supply curve.
• Explain equilibrium in a market.
• Explain the impact of taxes and price controls on market equilibrium.
• Explain elasticity of demand.
• Describe cost theory and how firms optimize given the constraints of their own costs and an exogenously given price.
This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

From the lesson

Module 2: Government Intervention in Markets

Markets are frequent targets of governments. This module will introduce government policy intervention into the market. This intervention can be direct control of prices or it could be indirect price pressure through the imposition of taxes or subsidies. Both forms of intervention are impacted by elasticity.

Dean Emeritus and Professor of Finance and Professor of Economics University of Illinois, Urbana-Champaign College of Business Department of Business Administration

[NOISE] When we were considering the problem of excise taxes and

who bears what burden, we understood that it had a lot to do

with responsiveness of quantity demand at the prices.

Imagine the following, suppose you were running a store,

we'll put price on the vertical axis, and quantity on the horizontal axis,

and suppose that you had a deal where you found out at $7 per unit,

you would sell 100 of these units, in a day.

It's a retail output, alright?

You've got $7 for some product, and it's selling 100 units a day.

And somebody says hey, you know what, we should have a sale.

Let's put a sign on the door that says 50% off all day Thursday.

And so you say okay.

I understand what that is.

That's gonna be $3.50.

Now, suppose as a result of reducing it from $7.00 to $3.50, you move from

the original point which we'll call x, to this point, which we'll call y.

That's like 101 units.

So, as a result of dropping our price 50%, you get a 1% increase in volume.

Is that possible?

Sure.

You could imagine a demand curve that's just pretty steep, like this.

Now, that's probably not a very smart move.

Having a 50% off sale,

when all it does is increase the traffic through your door by 1%.

Ha!

That's gonna be pretty painful on your cash register at the end of the day.

Now alternatively, you could have that same sale, and

suppose that you sold some point z, which we'll say is 1,000 units.

Is that possible?

Sure, that demand curve could be one that looks just like this, D1.

That curve, which is much flatter than the steeper D0, that curve's quite possible.

It's realistic.

And you could see, in that case, your 50% reduction in price,

led to a ten-fold increase in the amount of volume through your door.

So, if you're running a retail outlet and you're thinking about whether you're gonna

run ads in the newspaper for having x off in Sunday's newspaper,

you've gotta have kind of an idea about what this looks like.

Understanding this responsiveness is very important to understanding whether

you should be having these types of sales or

perhaps even just thinking about inching your price up a bit.

Because very few people move away from your market.

Economists have a term for this, elasticity of demand.

Economists call this elasticity of demand and elasticity of demand is

the responsiveness of quantity demanded to changes in price.

And we have a definition for this, It's E, which, for us, is elasticity, is

equal to the percentage change in quantity out the percentage change in price.

This is elasticity to us, okay, and what it basically says, it's just

thinking about the ratio of the impact on quantity for any impact on price.

Keep thinking about that work ratio it's very important.

I'm gonna give you a classification of these and we'll call this classification.

And remember e, which is elasticity is equal to the ratio of

the percentage change in quantity over the percentage change in price.

And our classification says that it's inelastic if

the absolute value of e is less than one.

These vertical bars on either side of the variable named E, mean absolute value.

Just drop the sign, we're just looking at the raw number.

So what's absolute value mean?

Absolute value just means whatever the sign, that you compute that ratio and

just drop the sign.

The sign is always positive.

Now why do we do this?

Well economists can be sometimes a little bit lazy about doing simple arithmetic.

Look at this ratio.

What's the sign of that ratio?

Well, since we've already established that demand curve is downward sloping,

any time price is going up, quantity is going down.

Any time price is going down, quantity is going up.

We have that inverse relationship between price and quantity.

So the sign of that ratio is always going to have a positive change in

the numerator and a negative change in the denominator or the other way around, so

the sign of the total ratio is gonna be negative every time.

So instead of working with negative numbers, we just do absolute value.

We say that it's inelastic if the absolute value is less than one.

Let's write out the full classification and

then we'll spend some time thinking about it.

We say it is elastic if the absolute value,

if it's greater than one, it's elastic.

And we say it is unit elastic if the absolute value is exactly equal to one.

So what's the big deal about this one?

Everything seems to hinge about whether it's equal to one, greater than one,

less than one.

The big deal here is that we're talking about a ratio.

So the number one is always important in a ratio because it tells

you whether the numerator or the denominator is stronger.

If the absolute value was greater than one,

it means that the impact in the numerator, which would be change in quantity,

is much bigger than the impact in the denominator, which is change in price.

If it's less than one, it means that the numerator effect, that is,

the change in quantity, is smaller than the denominator effect.

Think about some arbitrary curve I might draw here.

And again, we have price in the vertical axis, quantity on the horizontal axis, and

think about that demand curve that we drew for gasoline.

That demand for gasoline looked pretty steep, and

that meant was that we can have very big swings in price, that's the denominator,

very big swings in price will lead to hardly any change in quantity.

Think about this example.

Suppose this is the original price and this is the original quantity.

And suppose price went up dramatically.

It doubled from $2 a gallon to $4 a gallon.

Well, that would be a huge increase in the denominator.

And the numerator would have what effect?

Hardly any.

People don't cut back very much on gasoline in this.

So there's very little change in quantity for a wild change in price.

That means the denominator can get really large compared to a small numerator.

That would be a situation that looks like this.

The ratio of the change in quantity over the change in price is less than one.

So, let's get a little bit more concrete about this and

let's just draw two curves then I'll ask you a question.

Okay?

So let's go over here and put a couple of axis systems up.

And we have one which we'll call market one, has a demand that looks like this.

And we have another one which we'll call market two,

which has a demand that looks like this.

And if I were to ask you to think which one of these would you call elastic or

which would you call inelastic, well hopefully you'll see that in fact

this product is the one that's going to be inelastic.

Because you can have wild swings in price, and hardly any change in quantity.

And if we remember our formula for elasticity, it's equal to the percentage

change in quantity divided by the percentage change in price.

That ratio is going to be less than one when the curve is very steep.

On the other hand, over here, you could have very little change in price,

could cause huge changes in quantity.

You'd have just a little bitty drop in price from here to here.

It would change quantity from here all the way down to here.

So in that market, the denominator can be small, but

the numerators going to be very big.

And that's of course, fits our story of about elasticity.

With the absolute value of that ratio is greater than one.