Extensions of Demand and Supply Analysis

1. Extensions of Demand and Supply Analysis 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.

2. 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

3. 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

4. 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?

5. 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.

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

7. The Price System and Markets (cont'd) • Voluntary Exchange • Acts of trading between individuals that make both parties to the trade better off • Terms of Exchange • The prices we pay for the desired items

8. 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

9. 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

10. 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.

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

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

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

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

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

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

17. 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.

18. 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.

19. 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

20. 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

21. 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.

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

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 Controlling Rents • 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”

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

31. Figure 4-4 Agricultural Price Supports

32. 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

33. Figure 4-5 The Effect of Minimum Wages

34. 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

35. 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

36. 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

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

38. 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.

39. 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.

40. 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.

41. 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.

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

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

44. Summary Discussion of Learning Objectives (cont'd) • Government-imposed restrictions on market quantities • Bans on sale or ownership • Licensing restrictions • Import quotas