Chapter 4 Extensions of Demand Supply Analysis Introduction

Introduction Water covers 71% of the Earth, but only 2. 5% is fresh water.

Learning Objectives • Discuss the essential features of the price system • Evaluate the

Learning Objectives (cont'd) • Explain the effects of price ceilings • Explain the effects

Chapter Outline • The Price System and Markets • Changes in Demand Supply •

Chapter Outline (cont'd) • The Policy of Controlling Rents • Price Floors in Agriculture

Did You Know That. . . • The inflation-adjusted value of the U. S.

The Price System and Markets • Price System or Market System § An economic

The Price System and Markets (cont'd) • Markets § Emphasize voluntary exchange § Determine

The Price System and Markets (cont'd) • Voluntary Exchange § Acts of trading between

The Price System and Markets (cont'd) • Transaction Costs § The costs associated with

The Price System and Markets (cont'd) • The role of middlemen § Middlemen (intermediaries)

Policy Example: Profiting by Lowering Transaction Costs of Junking Computers • Transaction costs can

Changes in Demand Supply • Changes in supply and demand create a disequilibrium. •

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

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

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

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

Changes in Demand Supply (cont'd) • Summary § Increases in demand increase equilibrium price

Changes in Demand Supply (cont'd) • Summary § Increases in supply decrease equilibrium price

Changes in Demand Supply (cont'd) • When both demand supply shift § Simultaneous changes

Changes in Demand Supply (cont'd) • When both demand supply increase § Change in

Changes in Demand Supply (cont'd) • When supply decreases and demand increases § Price

Example: Why Gasoline Prices Have Increased • One factor—an increase in demand, shown by

Figure 4 -2 The Effects of a Simultaneous Decrease in Gasoline Supply and Increase

Price Flexibility and Adjustment Speed • Prices quite flexible in unfettered markets can be

Price Flexibility and Adjustment Speed (cont'd) • Adjustment speed § Market characteristics influence adjustment

The Rationing Function of Prices • Synchronization of decisions of buyers and sellers that

The Rationing Function of Prices (cont'd) • Methods of non-price rationing § Rationing by

The Rationing Function of Prices (cont'd) • The essential role of rationing (with scarcity

The Rationing Function of Prices (cont'd) • Question § If price rationing is the

The Policy of Government-Imposed Price Controls • Price Controls § Government-mandated minimum or maximum

The Policy of Government-Imposed Price Controls (cont'd) • Price ceiling and black markets §

The Policy of Government-Imposed Price Controls (cont'd) • Non-Price Rationing Devices § All methods

Figure 4 -3 Black Markets Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Example: Preventing Price Gouging Promotes Black Markets in Florida • Florida’s antigouging law penalizes

The Policy of Controlling Rents • The functions of rental prices 1. Promote the

The Policy of Controlling Rents (cont'd) • Rent controls and construction § Controls discourage

The Policy of Controlling Rents (cont'd) • Effects on the existing supply of housing

The Policy of Controlling Rents (cont'd) • Attempts to evade rent controls § Forcing

The Policy of Controlling Rents (cont'd) • Who gains and who loses from rent

Price Floors in Agriculture • Support Price § The governmentally established price floor Ø

Figure 4 -4 Agricultural Price Supports Copyright © 2008 Pearson Addison Wesley. All rights

Price Floors in Agriculture (cont'd) • Questions § How could the government keep the

International Policy Example: The High Cost of European Sugar Subsidies • Sugar is most

Price Floors in the Labor Market • Minimum Wage § A wage floor, legislated

Figure 4 -5 The Effect of Minimum Wages Copyright © 2008 Pearson Addison Wesley.

Quantity Restrictions • Governments can impose quantity restrictions, most obvious—banning ownership or trading of

Quantity Restrictions (cont'd) • Government Prohibitions and Licensing Requirements § Some commodities cannot be

Issues and Applications: Coping with a Growing Global Demand for Fresh Water • Today,

Figure 4 -6 How to Generate a Water Shortage Copyright © 2008 Pearson Addison

Summary Discussion of Learning Objectives • Essential features of the price system § A

Summary Discussion of Learning Objectives (cont'd) • How changes in demand supply affect market

Summary Discussion of Learning Objectives (cont'd) • The rationing function of prices § In

Summary Discussion of Learning Objectives (cont'd) • The effects of price ceilings § A

Summary Discussion of Learning Objectives (cont'd) • The effects of price floors § If

Summary Discussion of Learning Objectives (cont'd) • Government-imposed restrictions on market quantities § Bans

End of Chapter 4 Extensions of Demand Supply Analysis

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Chapter 4 Extensions of Demand Supply Analysis

Introduction Water covers 71% of the Earth, but only 2. 5% is fresh water. People in many locales complain of “shortages” of safe drinking water. In this chapter you will learn more about shortages. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 2

Learning Objectives • Discuss the essential features of the price system • Evaluate the effects of changes in demand supply on the market price and equilibrium quantity • Understand the rationing function of prices Copyright © 2008 Pearson Addison Wesley. All rights reserved. 3

Learning Objectives (cont'd) • Explain the effects of price ceilings • Explain the effects of price floors • Describe various types of governmentimposed quantity restrictions on markets Copyright © 2008 Pearson Addison Wesley. All rights reserved. 4

Chapter Outline • The Price System and Markets • Changes in Demand Supply • The Rationing Function of Prices • The Policy of Government-Imposed Price Controls Copyright © 2008 Pearson Addison Wesley. All rights reserved. 5

Chapter Outline (cont'd) • The Policy of Controlling Rents • Price Floors in Agriculture • Price Floors in the Labor Market • Quantity Restrictions Copyright © 2008 Pearson Addison Wesley. All rights reserved. 6

Did You Know That. . . • The inflation-adjusted value of the U. S. minimum wage peaked at about $8 in 1964? • We can use supply and demand analysis to analyze effects of the minimum wage? • The model of supply and demand can explain instances of a gap between quantity supplied and quantity demanded? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7

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 Ø Prices signal what is relatively scarce and relatively abundant. Ø Prices provide information to individuals and businesses. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8

The Price System and Markets (cont'd) • Voluntary Exchange § Acts of trading between individuals that make both parties to the trade subjectively better off • Terms of Exchange § The prices we pay for the desired items Copyright © 2008 Pearson Addison Wesley. All rights reserved. 10

The Price System and Markets (cont'd) • Transaction Costs § The costs associated with exchange § Examples Ø Price shopping Ø Determining quality Ø Determining reliability Ø Service availability Ø Cost of contracting Copyright © 2008 Pearson Addison Wesley. All rights reserved. 11

The Price System and Markets (cont'd) • The role of middlemen § Middlemen (intermediaries) or brokers reduce transaction costs by providing information to buyers and sellers § Examples Ø Real estate brokers Ø Stock brokers Ø Consignment shops Ø Car dealerships Copyright © 2008 Pearson Addison Wesley. All rights reserved. 12

Policy Example: Profiting by Lowering Transaction Costs of Junking Computers • Transaction costs can be lowered by middlemen (intermediaries). § Consumers and businesses can dispose of old computer equipment. • Intermediaries can refurbish old computers. § Useable parts and computer upgrades can be resold. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13

Changes in Demand Supply • Changes in supply and demand create a disequilibrium. • The market price and quantity adjust to a new equilibrium. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14

Changes in Demand Supply (cont'd) • Summary § Increases in demand increase equilibrium price and quantity. § Decreases in demand decrease equilibrium price and quantity. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 19

Changes in Demand Supply (cont'd) • Summary § Increases in supply decrease equilibrium price and increase equilibrium quantity. § Decreases in supply increase equilibrium price and decrease equilibrium quantity. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20

Changes in Demand Supply (cont'd) • When both demand supply shift § Simultaneous changes in demand supply put conflicting pressure on price or quantity. Ø The resulting effect depends upon how much each curve shifts. q Either equilibrium price or quantity will be indeterminate. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21

Changes in Demand Supply (cont'd) • When both demand supply increase § Change in price is indeterminate § Quantity will increase • When both demand supply decrease § Change in price is indeterminate § Quantity will decrease Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22

Changes in Demand Supply (cont'd) • When supply decreases and demand increases § Price will increase § Change in quantity is indeterminate • When supply increases and demand decreases § Price will decrease § Change in quantity is indeterminate Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23

Example: Why Gasoline Prices Have Increased • One factor—an increase in demand, shown by a rightward shift in the demand curve • Another factor—a reduction in supply, shown by a leftward shift in the supply curve • As a result, the market clearing price of gasoline increased. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24

Price Flexibility and Adjustment Speed • Prices quite flexible in unfettered markets can be less flexible in other market scenarios. § May experience indirect adjustments such as hidden payments, quality changes § May not reach equilibrium right away Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26

Price Flexibility and Adjustment Speed (cont'd) • Adjustment speed § Market characteristics influence adjustment speed. § Markets may overshoot in the adjustment process. § Markets are subject to energy shocks, labor strikes, severe weather. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27

The Rationing Function of Prices • Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 28

The Rationing Function of Prices (cont'd) • Methods of non-price rationing § Rationing by queues (waiting in line) § Rationing by random assignment, and/or coupons Copyright © 2008 Pearson Addison Wesley. All rights reserved. 29

The Rationing Function of Prices (cont'd) • The essential role of rationing (with scarcity rationing must occur) § We must choose the rationing mechanism: price or non-price. Ø Price rationing leads to most efficient use of available resources; all gains from mutually beneficial trade are captured. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 30

The Rationing Function of Prices (cont'd) • Question § If price rationing is the most efficient is it the “best” way to ration? • Answer § Economists cannot say which system is “best. ” They can say rationing via the price system leads to the most efficient use of available resources. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 31

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 32

The Policy of Government-Imposed Price Controls (cont'd) • Price ceiling and black markets § Price ceilings may prevent the equilibrium price from being achieved if it is above the ceiling price. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 33

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 34

Example: Preventing Price Gouging Promotes Black Markets in Florida • Florida’s antigouging law penalizes a seller for selling an item for a high price during an emergency. • After a hurricane, temporary shortages exist, causing prices to rise, but antigouging laws prevent price increases from occurring. • When prices are fixed, producers have less incentive to deliver, and a parallel, or black, market develops. • So who wins and who loses? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 36

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 37

The Policy of Controlling Rents (cont'd) • Rent controls and construction § Controls discourage construction Ø With a 16% vacancy rate and no controls, Dallas recently built 11, 000 new rental units. Ø With a 1. 6% vacancy rate and controls, San Francisco recently built 2, 000 new rental units. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 38

The Policy of Controlling Rents (cont'd) • Effects on the existing supply of housing and current use of housing § Property owners cannot recover costs Ø Maintenance, repairs, capital improvements § Rations the current use of housing Ø Reduces mobility, e. g. , New York’s “housing gridlock” Copyright © 2008 Pearson Addison Wesley. All rights reserved. 39

The Policy of Controlling Rents (cont'd) • Attempts to evade rent controls § Forcing tenants to leave § Tenants subletting apartments § Housing courts Copyright © 2008 Pearson Addison Wesley. All rights reserved. 40

The Policy of Controlling Rents (cont'd) • Who gains and who loses from rent controls? § Losers Ø Property owners Ø Low-income individuals § Gainers Ø Upper-income professionals Copyright © 2008 Pearson Addison Wesley. All rights reserved. 41

Price Floors in Agriculture (cont'd) • Questions § How could the government keep the price from falling? § Who benefits from agricultural price supports? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 44

International Policy Example: The High Cost of European Sugar Subsidies • Sugar is most efficiently extracted from sugar cane grown in warm, moist climates. • Extracting sugar from beets is four times more costly. • European taxpayers pay $1. 5 billion per year to subsidize beet sugar production. • Why do you suppose governments in developing countries complain? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 45

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 46

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 48

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 49

Issues and Applications: Coping with a Growing Global Demand for Fresh Water • Today, about 2. 5 billion people have safe drinking water; nearly 4 billion do not, resulting in 2 million deaths annually. • Price controls make a scarce resource, such as water, harder to obtain. • What rationing method do you think can best ensure greater access to safe drinking water? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 50

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. § The terms of exchange—prices—are communicated in markets that tend to minimize transactions costs. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 52

Summary Discussion of Learning Objectives (cont'd) • How changes in demand 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 53

Summary Discussion of Learning Objectives (cont'd) • How changes in demand supply affect market price and equilibrium quantity § When both demand supply shift at the same time, the result is indeterminate. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 54

Summary Discussion of Learning Objectives (cont'd) • 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 55

Summary Discussion of Learning Objectives (cont'd) • The effects of price ceilings § A price ceiling set below the market (equilibrium) price results in a shortage. Ø The resulting shortage can lead to non-price rationing devices and black markets. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 56

Summary Discussion of Learning Objectives (cont'd) • The effects of price floors § If the price floor is set above the market price, a surplus results. ØA price floor can take the form of a government -imposed price support or minimum wage. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 57

Summary Discussion of Learning Objectives (cont'd) • Government-imposed restrictions on market quantities § Bans on sale or ownership § Licensing restrictions § Import quotas Copyright © 2008 Pearson Addison Wesley. All rights reserved. 58

End of Chapter 4 Extensions of Demand Supply Analysis