Microeconomics Study Guide: Price Controls and Elasticity of Demand

Price Controls in Microeconomics

Price Ceilings and Price Floors

Price controls are government-imposed limits on the prices that can be charged for goods and services in a market. The two main types are price ceilings and price floors.

• Price Ceiling: A legally determined maximum price that sellers may charge for a good or service. Example: Rent control.

• Price Floor: A legally determined minimum price that sellers may receive. Example: Minimum wage.

To affect the market outcome, a price ceiling must be set below the equilibrium price.

• Effects of Price Ceilings:

  • Increase in quantity demanded

  • Reduction in quantity supplied

  • Creation of shortages

  • Some consumer surplus may be converted to producer surplus

Rent control is an example of a price ceiling, not an illegal market or a price floor.

Minimum Wage as a Price Floor

The minimum wage is an example of a price floor, which sets the lowest legal price for labor.

Elasticity in Microeconomics

Price Elasticity of Demand

Price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price.

• Definition: The percentage change in quantity demanded divided by the percentage change in price.

$\text{Price Elasticity of Demand} = \frac{\%\,\text{Change in Quantity Demanded}}{\%\,\text{Change in Price}}$

• Interpretation:

  • If elasticity is negative, quantity demanded decreases as price increases.

  • If elasticity is greater than 1 (in absolute value), demand is elastic.

  • If elasticity is less than 1 (in absolute value), demand is inelastic.

  • If elasticity equals 1, demand is unit elastic.

  • If elasticity is zero, demand is perfectly inelastic (quantity demanded does not respond to price changes).

  • If elasticity is infinite, demand is perfectly elastic (quantity demanded drops to zero if price increases).

Calculating Elasticity

• If the price of a good increases by 10% and quantity demanded falls by 10%, elasticity is -1 (unit elastic).

• If the price of Stork ice cream increases by 2.5% and quantity demanded falls by 10%, elasticity is -4.

• If the absolute value of elasticity is 0.8, demand is inelastic.

Elasticity and Demand Curves

• A perfectly elastic demand curve is horizontal.

• A perfectly inelastic demand curve is vertical.

• A unit elastic demand curve is curvilinear.

Determinants of Price Elasticity of Demand

• Availability of Substitutes: More substitutes make demand more elastic.

• Share of the Good in Consumer's Budget: Goods that take up a larger share of the budget tend to have more elastic demand.

• Necessity vs. Luxury: Necessities tend to have inelastic demand; luxuries are more elastic.

• Time Horizon: Demand is more elastic in the long run.

Examples and Applications

• Perfectly Inelastic Demand: Demand for insulin for diabetics.

• Elastic Demand: Demand for luxury goods or goods with many substitutes.

• Unit Elastic Demand: If a 10% increase in price leads to a 10% decrease in quantity demanded.

• Salt: Salt is a necessity for low-income consumers, making its demand inelastic.

Summary Table: Types of Price Elasticity of Demand

Type	Elasticity Value	Description	Example
Perfectly Elastic	Infinity	Any price increase drops quantity demanded to zero	Tickets for a specific event with many alternatives
Elastic	> 1	Quantity demanded changes by a larger percentage than price	Luxury cars
Unit Elastic	= 1	Quantity demanded changes by the same percentage as price	Some food items
Inelastic	< 1	Quantity demanded changes by a smaller percentage than price	Salt, gasoline
Perfectly Inelastic	0	Quantity demanded does not respond to price changes	Insulin for diabetics

Additional info:

• Elasticity is a central concept in microeconomics, used to analyze consumer and producer behavior, market outcomes, and the effects of government policies such as price controls.

• Price controls can lead to unintended consequences such as shortages, surpluses, and changes in consumer and producer surplus.