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Chapter 5
USING
DEMAND
AND
SUPPLY
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2
Today’s lecture will:
• Explain real-world events using
supply and demand.
• Analyze the market for advertising
with the supply and demand model.
• Discuss how exchange rates are
determined using supply and
demand.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-3
Today’s lecture will:
• Demonstrate the effect of a price
ceiling and a price floor on a market.
• Explain the effects of excise taxes
and tariffs on equilibrium price and
quantity.
• Explain the effect of a third-partypayer system on equilibrium price
and quantity.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-4
The Market for Advertising
• In 2001, demand for
advertising fell as the
U.S. economy slowed
down.
P0
• The supply/demand
model would predict
that price and quantity
P1
would fall.
• Instead of lowering the
price, the media offered
higher quality
advertising at the same
price.
S
D0
D1
Q1 Q0
Quantity of advertisements
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-5
The Price of a Foreign Currency
• The market for foreign exchange is
called the foreign exchange (forex)
market.
• The exchange rate is the price of one
currency in terms of another one.
• People demand currencies to buy
those countries’ goods and assets.
• Exchange rates are determined by
supply and demand.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-6
The Supply and
Demand for Euros
•
S
•
$0.85
•
D
The quantity of euros is on
the horizontal axis.
The price of the currency is
on the vertical axis,
measured in terms of dollars
(how many dollars it takes to
buy or sell one euro.
The supply of euros
represents people who want
to sell euros and buy dollars,
while the demand for euros
represents people who want
to buy euros and sell dollars.
Quantity of Euros
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-7
The Price of a Foreign Currency
• The 12 members of the European Union began
•
•
using a common currency, the euro, in 1999.
The euro dropped from $1.17 to $0.85 in 2001.
By 2004 the euro had risen to $1.30 because:
 U.S. interest rates decreased and Europeans bought
fewer U.S. financial assets, so the supply of euros
decreased.
 Americans increased their demand for euros in order
to buy European financial assets.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-8
The Price of a Foreign Currency
Europeans buy fewer U.S.
financial assets and ↓supply
of euros.
S1
S0
$1.30
Americans buy more
European financial assets
and ↑demand for euros.
$0.85
D0
The price of euros
Increases to $1.30.
D1
Quantity of Euros
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-9
Florida Freeze
• The crop-damaging
•
•
freeze shifted the
supply curve to the
left.
P1
At P0 quantity
demanded > quantity
P0
supplied.
Price rose to P1 until
the quantity
demanded equaled
the quantity
supplied.
McGraw-Hill/Irwin
S1
S0
Excess
Demand
D
Q1 Q0
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-10
Burkhas in Afghanistan
• Once the Taliban was
S
P0
P1
D0
Excess
Supply
D1
Q1
McGraw-Hill/Irwin
Q0
•
•
ousted, demand for
burkhas fell as many
women quit wearing
them.
At P0 quantity
supplied > quantity
demanded.
Price fell to P1 until
quantity demanded =
quantity supplied.
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-11
Coffee Beans
• The supply of coffee
increased as new
growers entered the
market, technology
improved, and
weather was
P0
favorable. Price
decreased to P1.
P1
• Coffee growers
attempted to
increase demand
and raise price to P0
with a marketing
campaign.
McGraw-Hill/Irwin
S0
S1
D1
D0
Q0
Q1
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-12
Review of Changes in
Supply and Demand
No change in Supply shifts Supply shifts
supply
out
in
No change No change.
in demand
Demand
shifts out
Demand
shifts in
McGraw-Hill/Irwin
Price falls;
Price rises;
Quantity rises. Quantity falls.
Price rises; Quantity rises; Price rises;
Quantity could
Quantityrises. Price could be
high or lower. rise or fall.
Price falls;
Quantity falls;
Price falls;
Quantity falls Quantity could Price could
rise or fall.
rise or fall.
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-13
Government Intervention in the
Market
• Buyers look to the government for ways
to hold prices down.
• A price ceiling is a government-imposed
limit on how high a price can be charged.
• Sellers look to the government for ways
to hold prices up.
• A price floor is a government-imposed
limit on how low a price can be charged.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-14
Rent Controls
• Rent control is a price
•
McGraw-Hill/Irwin
S
Rental Price (per month)
•
ceiling on rents set
by the government.
Rent control in Paris
after World War I
created a housing
shortage.
The shortage would
have been eliminated
if rents had been
allowed to rise to $17
per month.
$17.00
Shortage
2.50
D
QS
QD
Quantity of apartments
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-15
Minimum Wage
S
• The minimum wage, a
Wage per hour
Wmin
We
D
Q2
Qe
Q1
price floor, is set by
government specifying the
lowest wage a firm can
legally pay.
• A minimum wage, Wmin,
above the equilibrium
wage, We, helps those who
are employed, Q2, but
hurts those who would
have been employed at We,
but can no longer find
employment, Qe- Q2.
Quantity of Workers
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-16
Excise Taxes
• An excise tax is a tax that is levied
on a specific good.
• A tariff is an excise tax on an
imported good.
• Taxes and tariffs raise prices and
reduce quantity.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-17
Excise Taxes
Price of luxury boats
D
$70,000
65,000
60,000
0
McGraw-Hill/Irwin
S1
S0
A $10,000 excise tax on
luxury boats shifts the
supply curve up by
$10,000.
At $70,000, there is
excess supply of
600- 420 = 180.
The price of the
boats rises by less
than the tax to
$65,000.
420 510 600
Quantity of luxury boats
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-18
Quantity Restrictions
In 1937 New York City limited the number
of taxi licenses to 12,000 to increase the
wages of taxi drivers.
McGraw-Hill/Irwin
Because taxi medallions were limited in
supply, as demand for taxi services rose,
so did the demand for medallions, increasing
their price to $2500 by 1947. Today,
medallions sell for $300,000!
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-19
Third-Party-Payer Markets
• In third-party-payer markets, the
person who receives the good differs
from the person paying for the good.
• Equilibrium quantity and total
spending is much higher in thirdparty-payer markets.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-20
Third-Party-Payer Markets
S
D
McGraw-Hill/Irwin
With a co-payment of $5,
consumers demand 18 units.
sellers require $45 for that
quantity.
Total expenditures, shown by
the entire shaded region, are
much greater than when
consumers pay the entire
cost, shown by the dark
shaded area.
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-21
Summary
• Almost all events can be explained in terms of
•
•
•
shifts of and movements along demand and
supply curves.
Supply and demand analysis is used to
determine exchange rates – prices of
currencies.
Price ceilings, government imposed limits on
how high a price can be charged, create
shortages.
Price floors, government-imposed limits on how
low a price can be charged, create surpluses.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-22
Summary
• Taxes and tariffs paid by suppliers shift the
•
•
supply curve up by the amount of the tax or
tariff and increase equilibrium price and
decrease quantity.
Quantity restrictions increase equilibrium price
and reduce equilibrium quantity.
In a third-party-payer market, the consumer
and the one who pays the cost differ. Quantity
demanded, price, and total spending are
greater when a third party pays.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-23
Review Question 5-1 Use a graph to explain the likely impact
on the price of gasoline of a decrease in OPEC oil production
due to instability in Iraq and an increase in sales of large
SUVs.
P
The decrease in production
will decrease supply from
S0
to S1. The increase in
demand for SUVs (a
complement) will increase
demand from D0 to D1.
Price increases from P0 to
P1.
S1
S0
P1
P0
D0
D1
Q
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5-24
Review Question 5-2
Given the following demand and supply of pizza:
Price
per Pizza
Quantity
Supplied
$8
7
6
5
4
200
150
100
50
0
Quantity
Demanded
60
80
100
120
140
What is the effect of a price floor of $8?
A price floor of $8 will create a surplus of 200 – 60 = 140
Pizzas.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.