(Editor’s note: dear readers made us happy See your answers to Professor Cutsinger’s first EconLog price theory problem. thank you! I’ll reproduce that question below, followed by his proposed solution. I’ll post issue #2 next week. Long live price theory! )
question:
In his book basic economicsThomas Sowell (2015) writes that “the price one producer is willing to pay for a particular raw material is the price that other producers must pay for that same raw material” (p. 20). I am. With this quote in mind, consider the following scenario.
While the demand for milk in the form of cheese, ice cream, and yogurt remains the same, the demand for drinking milk is increasing. Assume that the supply of milk is perfectly inelastic. Explain why the elasticity of demand for milk in these other uses determines the amount of milk that is reallocated from these uses for direct consumption.
answer:
One of the reasons I like this quote from Sowell’s book is because it makes me think about the role that market prices play in allocating resources to their various uses. In this case, the price of milk allocates a fixed amount between those who want to drink milk and those who require milk to produce cheese, ice cream, and yogurt.
Figure 1 illustrates this idea. market request In the case of milk, it consists of different demands for milk. The interaction between the market demand for milk and the fixed supply determines the market price, which in turn determines how much milk consumers buy for each use. Therefore, the buyer who is most willing to pay for milk determines the price that all buyers must pay.
As you asked, the demand for drinking milk is increasing. Figure 1 shows the increase in demand as a rightward shift in the demand for drinking milk. Since part of the market demand is made up of demand for potable milk, demand will also shift to the right and the price of milk will rise to clear the market.
Figure 1: Private and market demand for milk
This question assumes that the market is as follows: supply The quantity of milk is completely inelastic (reflected in the vertical market milk supply in Figure 1). Therefore, despite the higher price, suppliers will not produce any more milk. Therefore, to meet the increasing demand for drinking milk, the amount of milk allocated to cheese, ice cream, and yogurt production must be reduced.
What role does the price elasticity of demand for milk in these other uses play in determining the amount of milk that is reallocated from these uses to drinking?
Price elasticity of demand indicates how responsive the quantity demanded is to changes in price. This is the ratio of the percentage change in quantity caused by the percentage change in price. The higher the absolute value of this ratio, the more responsive the quantity demanded to changes in price.
Let’s assume that at the initial market price of milk, the price elasticity of demand for cheese is less than for ice cream and less than for yogurt. The slopes of the demand curves for milk for different uses in Figure 1 reflect different elasticities.
Note that as the market price of milk increases, the change in the quantity of milk demanded depends on the use of the milk. For example, the amount of milk required for yogurt will decrease the most, while the amount required for cheese will decrease the least. This result is not surprising given the assumption that the price elasticity of demand for yogurt is higher than that for cheese or ice cream.
Another reason why this result is not surprising is that, intuitively, the demanders who are most sensitive to price changes will have the greatest reaction to price changes. For example, suppose there were many milk substitutes for making yogurt, but few for making cheese. In this case, yogurt producers have more options than cheese producers, so the percentage change in milk required for yogurt is greater than the percentage change in milk required for cheese.
This analysis can be taken further to reveal the impact on cheese, ice cream, and yogurt prices. You can also track how the increased demand for drinking milk affects the price of milk substitutes. Our answers to these questions also depend on price elasticity.
This question highlights the interconnected nature of markets. Incorporating the concept of elasticity allows us to better understand the nature of these connections.
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For those interested in a formal discussion of the relationships between supply, demand, price, quantity, and changes in elasticity, see below. This lecture on supply and demand perspectives by Kevin Murphy.
Brian Cutsinger is an assistant professor of economics at Florida Atlantic University’s School of Business and a Phil Smith Fellow at the Phil Smith Center for Free Enterprise. He is also a Fellow of the American Bureau of Economic Research’s Sound Money Project and a member of the editorial board of the journal Public Choice.
