[Editor’s Note: Dear readers, you delighted us with all your responses to Professor Cutsinger’s inaugural EconLog Price Theory Problem. Thanks! We reprint that question below, followed by his suggested solution. Next week, we’ll post problem #2. Long live price theory!]
Query:
In his guide, Fundamental Economics, Thomas Sowell (2015) writes, “the worth which one producer is keen to pay for any given ingredient turns into the worth that different producers are compelled to pay for that very same ingredient” (p. 20). With that quote in thoughts, contemplate the next situation:
The demand to drink milk rises whereas the demand for milk within the type of cheese, ice cream, and yogurt stays the identical. Assume that the availability of milk is completely inelastic. Clarify why the elasticities of demand for milk in these different makes use of decide how a lot milk will probably be reallocated from these makes use of for direct consumption.
Reply:
One of many causes I like this quote from Sowell’s guide is that it will get us to think about the position that market costs play in allocating a useful resource throughout its numerous makes use of. On this case, the milk worth allocates a hard and fast quantity between those that wish to drink it and people who demand milk to supply cheese, ice cream, and yogurt.
Determine 1 illustrates this concept. The market demand for milk consists of the varied calls for for milk. The interplay of the market demand for milk and the fastened provide determines the market worth, which, in flip, determines how a lot milk demanders will buy for every use. Thus, the client with the very best willingness to pay for milk determines the worth all patrons should pay.
Because the query signifies, the demand for ingesting milk rises. Determine 1 illustrates the rise in demand because the rightward shift of the demand for ingesting milk. Because the market demand consists, partly, of the demand for ingesting milk, it additionally shifts rightward, and so the worth of milk rises to clear the market.
Determine 1: Particular person and Market Demand for Milk
The query assumes that the market provide of milk is completely inelastic (mirrored by the vertical market provide of milk in Determine 1). Therefore, suppliers don’t produce any extra milk regardless of the upper worth. So, the quantity of milk allotted to the manufacturing of cheese, ice cream, and yogurt should fall to fulfill the elevated demand for ingesting milk.
What position do the worth elasticities of demand for milk in these different makes use of play in figuring out the quantity of milk reallocated from these makes use of to ingesting?
The value elasticity of demand tells us how responsive amount demanded is to cost modifications. It’s the ratio of the p.c change in amount caused by a p.c change in worth. The upper absolutely the worth of this ratio, the extra responsive the amount demanded to cost modifications.
Let’s suppose that on the preliminary market worth of milk, the worth elasticity of demand for cheese is lower than ice cream, which is lower than yogurt. The slopes of the demand curves for milk in these numerous makes use of in Determine 1 replicate these totally different elasticities.
Be aware that on the larger market worth of milk, the change in amount demanded for milk differs throughout the totally different makes use of of milk. As an example, the amount of milk demanded for yogurt falls probably the most whereas the amount of milk demanded for cheese falls the least. This consequence isn’t a surprise given our assumption that the worth elasticity of demand for yogurt was larger than that of cheese or ice cream.
Another excuse this consequence isn’t a surprise is that, intuitively, demanders most delicate to cost modifications could have the most important response to cost modifications. For instance, suppose there have been many substitutes for milk within the manufacturing of yogurt however few substitutes for milk within the manufacturing of cheese. On this case, the p.c change within the milk demanded for yogurt could be bigger than that demanded for cheese since yogurt producers have extra choices than cheese producers.
We might take this evaluation additional to uncover the results on cheese, ice cream, and yogurt costs. We might additionally hint how a rise in demand for milk to drink impacts the costs of milk substitutes. Our solutions to those questions would additionally rely on these worth elasticities.
This query highlights the interconnected nature of markets. Incorporating the idea of elasticity permits us to go deeper in understanding the character of those connections.
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For these keen on a proper dialogue of the relationships between modifications in provide, demand, costs, portions, and elasticity, see this lecture on the availability and demand perspective by Kevin Murphy.
Bryan Cutsinger is an assistant professor of economics within the School of Enterprise at Florida Atlantic College and a Phil Smith Fellow on the Phil Smith Middle for Free Enterprise. He’s additionally a fellow with the Sound Cash Mission on the American Institute for Financial Analysis, and a member of the editorial board for the journal Public Alternative.
