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

[SOUND] [SOUND]

We have established that economists have a metric to measuring

responsiveness of quantity demanded of prices, it's called elasticity.

And the formal definition of elasticity is equal to the percentage

change in quantity over the percentage change in price.

And if that ratio, if the absolute value of that ratio is greater than one,

it means that quantity effects dominate price effects.

And we sort of thought about that intuitively.

We thought about a product where if that number's greater than one,

it's say, relatively flat demand.

This looks elastic to us.

Because the impact of a small change in price can have wide swings in quantity.

Meaning that ratio is greater than one.

See how quantity jumps dramatically just for a small step function down in price?

Alternatively, we could think about a product that had a very steep demand

curve.

And this particular product, with its steep demand curve,

you can have wild swings in price with hardly any change in quantity.

So in this case, the denominator dominates the size of the numerator.

So that ratio, in an absolute value sense, is less than one.

But it turns out, we have to be a little bit more careful about that.

So what I'm gonna do is I'm gonna go on a little exercise of analytics here.

Okay, so let's walk through here.

And let's recall that elasticity is equal to the percentage change in quality,

over the percentage change in price.

That could be rewritten as the change in quantity over quantity,

divided by the change in price over price.

Simple algebraic manipulation.

Which is the same thing as writing,

change in quantity over change in price times price or quantity.

Nothing fancy there.

Simple straightforward algebraic manipulation.

Well now, let's assume that demand curve is linear.

Well if the demand curve is linear, then we know several things about this ratio.

If the demand curve is linear about this formula.

This is the inverse of a slope of demand.

If you think about our demand curve.

This is price, this is quantity, this is our demand curve.

The slope of that curve would be change in price over change in quantity.

Rise over the run.

But in this case, we actually have the inverse of that,

we have change in quantity over change in price, which is one over the slope.

But that's not important.

What's important is that you know for a straight line demand curve,

what a linear function means, is that the slope is the constant.

So if the slope is a constant, the inverse of the slope is also a constant,

which means that this term is going to be constant.

This is the ratio of price over Q, P over Q.

And as you can see along this demand curve,

every point you pick along this demand curve, pick any point,

the ratio of P over Q is gonna be falling everywhere along there.

And so what we say, is along the linear demand curve,

this P over Q ratio changes along the entire demand.

Now, you might say, well, why are we doing this?

Very well, we have decomposed our formula for elasticity in to simple algebra.

Change in Q over base Q.

Change in P over base P.

Which is through algebraic manipulation, just this, two terms.

The first term, constant, along any linear demand curve.

The second term changes everywhere along the linear demand curve.

Now what that means is, that every point along a linear demand curve,

has a different elasticity.

I have to be a little bit more careful, as long as the demand curve has some slope to

it, you can't have it perfectly vertical or perfectly horizontal.

As long as there's some downward slope, everything changes along it.

And in fact, we're not gonna do it.

But you can look up tons of sources that will make the proof for you.

There's a simple proof that says, that if you have a straight line demand curve,

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

Along a straight line demand curve, suppose this is the midpoint,

if that's the midpoint,

we could prove that every point in the top of the demand curve is elastic.

Every point in the bottom half of the demand curve is inelastic.

And exactly at this midpoint, the demand curve is what we called unit elastic.

Now, let's think about this.

We're not gonna do this proof.

But what it says is, that if you give me a straight line demand curve,

that has some slope to it, some downward slope.

It's not horizontal, it's not vertical its got some downward slope.

I can prove to you that exactly half of the points, the upper half,

are elastic and the lower half are inelastic.

Now, the reason I'm showing you this is because that's the truth.

But if we were to go back to this picture, I asked you when you looked at

these two graphs, let's call this MKT I and let's call this MKT II.

I told you you would be correct to think about MKT II as being elastic, and

MKT I as being inelastic.

MKT 1 looks steep feels inelastic.

MKT II is flatter and feels elastic, and that's true.

But then you would say, Larry, you just showed us that, in fact,

if those are straight line demand curves, which they look like that's what you're

trying to represent, half of that curve is elastic and half is inelastic.

And that's true, but think about our picture.

If you were gonna complete this curve out, you'd have to complete it down here.

And you'd have to complete way up there.

So essentially,

what I've shown you is really the bottom half of a linear demand curve.

Like on this picture here, I've shown you the bottom half because the top half is

kind of off the edge of the page.

Over here, I said to think of this as elastic,

and you could say, well, yeah, but Larry, it's linear,

so half of it would always be elastic, and half inelastic.

But the way you've drawn it,

you're really only showing what turns out to be the upper half of a demand curve

that would have to go a long way over there to find the horizontal intercept.

And so, if this region would correspond to the upper half of the total demand

curve that I was trying to represent with this linear picture.

Or on this other picture, it would correspond to this upper half part,

which is indeed elastic.

So elasticity, point here is that you should know that if it's a linear demand

curve, exactly half is elastic and half is inelastic.

Yet, when I tell that for any given demand curve that it's inelastic,

you know that in the space you're drawing it.

If I say, draw me an inelastic curve,

you're really only showing me the bottom half.

It's true that the slope's the same across, and

it's true that half of it way up off the top of the screen would be elastic.

But this is definitely inelastic, so it's okay to think in your head that steep