Understanding Changes in Demand and Supply: An Analysis of the Price System and Markets

1. Chapter 4 Extensions of Demand and Supply Analysis

2. 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?

3. 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 • Prices signal what is relatively scarce and relatively abundant. • Prices provide information to individuals and businesses.

4. The Price System and Markets (cont'd) • Markets • Emphasize voluntary exchange • Determine the terms of exchange • Facilitate exchange

5. 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

6. The Price System and Markets (cont'd) • Transaction Costs • The costs associated with exchange • Examples • Price shopping • Determining quality • Determining reliability • Service availability • Cost of contracting

7. 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 • Real estate brokers • Stock brokers • Consignment shops • Car dealerships

8. 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.

9. Changes in Demand and Supply • Changes in supply and demand create a disequilibrium. • The market price and quantity adjust to a new equilibrium.

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

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

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

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

14. Changes in Demand and Supply (cont'd) • Summary • Increases in demand increase equilibrium price and quantity. • Decreases in demand decrease equilibrium price and quantity.

15. Changes in Demand and Supply (cont'd) • Summary • Increases in supply decrease equilibrium price and increase equilibrium quantity. • Decreases in supply increase equilibrium price and decrease equilibrium quantity.

16. Changes in Demand and Supply (cont'd) • When both demand and supply shift • Simultaneous changes in demand and supply put conflicting pressure on price or quantity. • The resulting effect depends upon how much each curve shifts. • Either equilibrium price or quantity will be indeterminate.

17. Changes in Demand and Supply (cont'd) • When both demand and supply increase • Change in price is indeterminate • Quantity will increase • When both demand and supply decrease • Change in price is indeterminate • Quantity will decrease

18. Changes in Demand and 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

19. 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.

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

21. 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

22. 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.

23. The Rationing Function of Prices • Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices.

24. 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

25. 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. • Price rationing leads to most efficient use of available resources; all gains from mutually beneficial trade are captured.

26. 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.

27. 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

28. 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.

29. 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

30. Figure 4-3 Black Markets

31. 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?

32. The Policy of Controlling Rents • The functions of rental prices • Promote the efficient maintenance and construction of housing • Allocate existing housing • Ration the use of housing

33. 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.

34. The Policy of Controlling Rents (cont'd) • 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”

35. The Policy of Controlling Rents (cont'd) • Attempts to evade rent controls • Forcing tenants to leave • Tenants subletting apartments • Housing courts

36. The Policy of Controlling Rents (cont'd) • Who gains and who loses from rent controls? • Losers • Property owners • Low-income individuals • Gainers • Upper-income professionals

37. Price Floors in Agriculture • Support Price • The governmentally established price floor • Associated with agricultural products

38. Figure 4-4 Agricultural Price Supports

39. Price Floors in Agriculture (cont'd) • Questions • How could the government keep the price from falling? • Who benefits from agricultural price supports?

40. 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?

41. 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

42. Figure 4-5 The Effect of Minimum Wages

43. 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

44. 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

45. 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?

46. Figure 4-6 How to Generate a Water Shortage

47. 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.

48. 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.

49. Summary Discussion of Learning Objectives (cont'd) • How changes in demand and supply affect market price and equilibrium quantity • When both demand and supply shift at the same time, the result is indeterminate.

50. 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.