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Chapter 4

Extensions of Demand and

Supply Analysis

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-2

Introduction

In recent years, shoppers have experienced a type of “sticker shock” when they find that prices of used cars are only slightly lower than prices of new models.

You can use the concept of simultaneous shifts in supply and demand to explain why we observe this outcome in the vehicle market.

Chapter 4 will show you how to represent the effects of a simultaneous change in supply and demand.


Learning Objectives

• Discuss the essential features of the price system

• Evaluate the effects of changes in demand and supply on the market price and equilibrium quantity

• Understand the rationing function of prices


Learning Objectives (cont'd)

• Explain the effects of price ceilings

• Explain the effects of price floors

• Describe various types of government-imposed quantity restrictions on markets


Chapter Outline

• The Price System and Markets• Changes in Demand and Supply• The Rationing Function of Prices• The Policy of Government-Imposed Price

Controls• The Policy of Controlling Rents• Price Floors in Agriculture• Price Floors in the Labor Market• Quantity Restrictions


Did You Know That ...

• A coffee shortage exists in Venezuela?

• This country, with its traditionally high levels of coffee production and consumption, now faces a situation in which the quantity of coffee demanded exceeds the quantity supplied.

• The shortage results from a price ceiling that prevents the price from rising to its equilibrium level.


The Price System and Markets

• Price System or Market System

– An economic system in which relative prices are constantly changing to reflect changes in supply and demand

• The prices are signals as to what is relatively scarce and relatively abundant

• Prices provide information to individuals and businesses


The Price System and Markets (cont'd)

• Voluntary Exchange– An act of trading between individuals in the price

system

– Makes both parties to the trade subjectively better off



• Transaction Costs

– All of the costs associated with exchange

– Including:• The informational costs of finding out the price and

quality, service record, and durability of a product• The cost of contracting and enforcing that contract



• The role of middlemen

– Middlemen (intermediaries) or brokers reduce transaction costs by providing information to buyers and sellers

– Examples• Real estate brokers• Stock brokers• Consignment shops• Car dealerships


Example: Linking Businesses to Customers on the Go via QR Apps

• Many small businesses arrange for customers to order products through QR apps.

• For example, you might be able to use your smartphone to order a cup of coffee before you even arrive at the local coffee shop.

• The middlemen companies who provide these QR apps facilitate the process of linking firms with their customers.


Changes in Demand and Supply

• Changes in supply and demand create a disequilibrium.

• The market price and quantity adjust to a new equilibrium.


Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (a)


Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (b)


Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (c)


Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (d)


Changes in Demand and Supply (cont'd)

• Summary

– Increases in demand increase equilibrium price and quantity

– Decreases in demand decrease equilibrium price and quantity



• Summary

– Increases in supply decrease equilibrium price and increase equilibrium quantity

– Decreases in supply increase equilibrium price and decrease equilibrium quantity



• When both demand and supply change– If both the supply and demand curves shift

simultaneously, the outcome is indeterminate for either equilibrium price or equilibrium quantity

– The resulting effect depends upon how much each curve shifts



• When both demand & supply increase– Change in equilibrium price is indeterminate

– Equilibrium quantity increases unambiguously

• When both demand & supply decrease– Change in equilibrium price is indeterminate

– Equilibrium quantity decreases unambiguously



• When supply decreases & demand increases– Equilibrium price increases– The change in the equilibrium quantity is

uncertain without more information

• When supply increases & demand decreases– Equilibrium price decreases– The change in the equilibrium quantity is

uncertain without more information


International Example: What Accounts for the Rising Price of Shipping Containers?

• We can identify several reasons for the recent rise in prices of shipping containers.– One reason is that many containers purchased

were originally purchased in 2001, and as they have now reached the end of their useful life, they must be replaced.

– This is illustrated by the graph on the next slide.


Figure 4-2 The Effects of a Simultaneous Decrease in Shipping Container Supply and Increase in Shipping Container Demand


International Example: What Accounts for the Rising Price of Shipping Containers? (cont’d)

• There have also been decreases in the supply of shipping containers.– Many shipping containers were lost in the

tsunami of 2011.– The price of steel, an important input for the

manufacture of shipping containers, has increased by 7 percent.

• Taken together, these supply and demand shifts have caused a higher equilibrium price for shipping containers.



Price Flexibility

• Prices quite flexible in some markets can be less flexible in other market scenarios.

– May take the form of subtle adjustments such as hidden payments, quality changes

– May not reach equilibrium right away



• Adjustment speed

– Market characteristics influence adjustment speed

– Markets may overshoot in the adjustment process

– Markets are subject to energy shocks, labor strikes, severe weather


The Rationing Function of Prices

• Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices


The Rationing Function of Prices (cont'd)

• Methods of non-price rationing

– Rationing by queues (waiting in line)

– Rationing by random assignment or coupons


Example: An Airline Boarding Lottery

• Airline passengers have an incentive to take more carry-on bags, now that fees are charged for checked luggage.

• Under the traditional boarding procedure, passengers at the rear of the plane board first, and many of them tend to place their carry-ons in compartments at the front of the aircraft cabin.

• What problem has resulted from this boarding arrangement?


Example: An Airline Boarding Lottery (cont’d)

• The difficulty is that passengers in the front of the plane often have to scramble to find a free luggage compartment.

• American Airlines has circumvented this problem by assigning boarding-group numbers randomly, rather than by boarding the rear of the plane first.

• This change has speeded up the boarding process by several minutes.


The Rationing Function of Prices (cont'd)

• The essential role of rationing – Implied by the presence of scarcity

– Price vs. non-price rationing mechanism:

• Price rationing leads to the most efficient use of available resources

• All gains from mutually beneficial trade are captured in a freely rationing price system


The Policy of Government-Imposed Price Controls

• Price Controls– Government-mandated minimum or maximum

prices

• Price Ceiling– A legal maximum price

• Price Floor– A legal minimum price


The Policy of Government-Imposed Price Controls (cont'd)

• Price ceiling and black markets

– A price ceiling may prevent the equilibrium price from being achieved if it is above the ceiling price

– A price ceiling that is set below the market clearing price creates a shortage


The Policy of Government-Imposed Price Controls (cont'd)

• Non-Price Rationing Devices– All methods used to ration scarce goods that are

price-controlled

• Black Market– A market in which price-controlled goods are

sold at an illegally high price


Figure 4-3 Black Markets for Portable Electric Generators


International Policy Example: Multiple Price Ceilings Lead to Electricity Rationing in China

• In China, two key sources of electricity are coal and diesel fuel used to power generators.

• However, both of these items are subject to price ceilings.

• There are also price ceilings imposed on electricity provided by power companies.

• As a consequence, much of China experiences “brownouts” when the flow of electricity is reduced.


The Policy of Controlling Rents

• The functions of rental prices

1. Promote the efficient maintenance and construction of housing

2. Allocate existing housing

3. Ration the use of housing


The Policy of Controlling Rents (cont'd)

• Rent controls and construction

– Controls discourage construction

• With a 16% vacancy rate and no controls, Dallas recently built 11,000 new rental units

• With a 1.6% vacancy rate and controls, San Francisco recently built 2,000 new rental units



• Effects on the existing supply of housing and current use of housing

– Property owners cannot recover costs• Maintenance, repairs, capital improvements

– Rations the current use of housing• Reduces mobility, e.g., New York’s “housing gridlock”



• Attempts to evade rent controls

– Forcing tenants to leave

– Tenants subletting apartments

– Housing courts



• Who wins and who loses from rent controls?

– Losers• Property owners

• Low-income individuals

– Winners• Upper-income professionals


Price Floors in Agriculture

• Support Price– The government chooses a price floor for a

product and then acts to ensure that the price of the product never falls below the support level

• Associated with many agricultural products

• A price floor that is set above the market clearing price results in a surplus.


Figure 4-4 Agricultural Price Supports


Price Floors in Agriculture (cont'd)

• Questions

– How could the government keep the price from falling?

– Who benefits from agricultural price supports?


What If . . . the government decides to “help dairy farmers” by imposing a price floor in the market for milk that is above the equilibrium price?

• A price floor imposed above the equilibrium price would lead to an increase in the quantity of milk supplied and a decrease in the quantity demanded.

• To maintain the price floor, the government would have to purchase the surplus of milk.

• Indeed, dairy farmers would benefit, but consumers would end up paying higher prices for milk.


Price Floors in the Labor Market

• Minimum Wage

– A wage floor, legislated by government, setting the lowest hourly wage rate that firms may legally pay their workers


Figure 4-5 The Effect of Minimum Wages


Policy Example: A Higher Minimum Wage Translates into Fewer Employed Teens

• The federal minimum wage was increased in three steps from $5.15 to $7.25 per hour between 2007 and 2009.

• This legislation had little effect in 18 states where market wages already exceeded $7.25 per hour.

• In the other 32 states, however, the wage increases caused a drop of 114,000 in the total number of teenagers employed.


Quantity Restrictions

• Governments can impose quantity restrictions, most obvious—banning ownership or trading of a good

– Human organs

– Drugs

– Hospital beds

– Gold from 1933 to 1973


Quantity Restrictions (cont'd)

• Government Prohibitions and Licensing Requirements– Some commodities cannot be purchased at all

legally; others require a license

• Import Quota– Supply restriction that prohibits the importation

of more than a specified quantity of a particular good


You Are There: Explaining the “Crisis” of Persistent Drug Shortages

• Today, the FDA has identified shortages of more than 200 drugs.

• Some have suggested that the persistent shortages are the result of government price restrictions.

• The FDA limits the amount by which the price of any drug can increase in a given year.

• This may result in some prices being below the market-clearing level.


Issues & Applications: Why Prices of Used Cars Are So High

• Since 2009, the average price of a used car has increased by nearly 10 percent.

• Simultaneous changes in supply and demand account for this price change.

• The supply of used cars has decreased due to the “cash for clunkers” program.

• You can see this illustrated in the graph on the next slide.


Figure 4-6: The Effects of a Decrease in the Supply of Used Cars in Conjunction With an Increase in the Demand for Used Cars


Issues & Applications: Why Prices of Used Cars Are So High (cont’d)

• Also, the supply of new cars decreased due to the earthquake and tsunami in Japan.

• This decreased supply led to a higher price of new cars, and therefore the demand for used cars (a substitute good) also increased.

• Taken together, the decreased supply and increased demand have caused a higher equilibrium price of used cars.


Summary Discussion of Learning Objectives

• Essential features of the price system

– A price system (market system) allows prices to respond to changes in supply and demand for different commodities

– Prices are communicated in markets that tend to minimize transactions costs


Summary Discussion of Learning Objectives (cont'd)

• How changes in demand and supply affect market price and equilibrium quantity

– Increases in demand increase equilibrium price and quantity; decreases in demand decrease equilibrium price and quantity

– Increases in supply decrease market price and increase equilibrium quantity; decreases in supply increase market price and decrease equilibrium quantity



• How changes in demand and supply affect equilibrium price and equilibrium quantity

– When both demand and supply shift at the same time, the outcome is indeterminate for either equilibrium price or equilibrium quantity



• The rationing function of prices

– In a market system, prices ration scarce goods and services

– Other ways of rationing include first come, first served; political power; physical force; random assignment; and coupons



• The effects of price ceilings

– A price ceiling set below the market clearing price results in a shortage

• The resulting shortage can lead to non-price rationing devices and black markets



• The effects of price floors

– If the price floor is set above the market clearing price, a surplus results

• A price floor can take the form of a government-imposed price support or minimum wage



• Government-imposed restrictions on market quantities

– Bans on sale or ownership

– Licensing restrictions

– Import quotas


Appendix B: Consumer Surplus

• Consumer Surplus

– The difference between the total amount that consumers would have been willing to pay for an item and the total amount that they actually pay


Figure B-1 Consumer Surplus


Appendix B: Producer Surplus

• Producer Surplus– The difference between the total amount that

producers actually receive for an item and the total amount that they would have been willing to accept for supplying that item


Figure B-2 Producer Surplus


Appendix B: Gains from Trade within a Price System

• Gains from trade– The sum of consumer surplus and producer

surplus


Figure B-3 Consumer Surplus, Producer Surplus, and Gains from Trade


Appendix B: Price Controls and Gains from Trade

• How do price controls affect gains from trade?

– Consumer surplus and producer surplus are both lower

– Either a price ceiling or a price floor reduces gains from trade

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