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Impact of Prices Chapter 6 Shortage • Let’s say that Loony’s uptown decides to sell their CDs for $3 each. • More than likely there will be a lot more people wanting to buy CDs than Loony’s has to sell. • Why? Because at such a low price, the quantity demanded is quite high. But Loony’s does not want to sell that many at such a low price. Shortage • This situation is called a shortage • Shortage - when Qd > Qs at current market price. – Amount of Shortage = Qd – Qs Shortage Result of Shortage: • If you are the manager of Loony’s and you find that you are selling out of CDs at $3, what do you want to do? – Raise the price • Buyers can’t get all they want. Therefore, competition among buyers drive prices up. • P will increase Shortage Shortage P 0 Q Shortage P D 0 Q Shortage P S D 0 Q Shortage P S Psh D 0 Qs Qd Amount of Shortage Q Results of Shortage P S Psh D 0 Qs Qd Q Results of Shortage P S E P* Psh D 0 Qs Q* Qd Q Surplus • Let’s say that as the manager, you raised the prices of CDs to $20. • At $20 you would love to sell a lot of CDs, but not a lot of people are willing to pay $20 for a CD. • So the CDs keep piling up as they come in from your supplier, but they don’t seem to be going out the door in sales. Surplus • This situation is called a surplus • Surplus - when Qs > Qd at current market price. • Amount of surplus = Qs - Qd • Note - not correct to say Supply exceeds Demand, but rather that quantity supplied exceeds quantity demanded. Results of Surplus Result of Surplus: • As manager you have to decide what do with all these CDs that are piling up and not selling. What do you do? – Have a sale! Results of Surplus • Firms have more than they can sell. Therefore, firms lower price to sell the product. • As price decreases, Qd increases and Qs decreases • P will decrease Surplus Surplus P 0 Q Surplus P S 0 Q Surplus P S D 0 Q Surplus Amount of Surplus P S Psur D 0 Qd Qs Q Results of Surplus Amount of Surplus P S Psur D 0 Qd Qs Q Results of Surplus Amount of Surplus P S Psur E P* D 0 Qd Q* Qs Q Equilibrium in the Market • Note that if the price is below P* then there will be a shortage causing price to rise • If the price is above P* then there will be a surplus causing price to fall • It’s as if P* is a magnet that keeps drawing price to it (and consequently quantity to Q*) • This magnet is sometimes called “The Invisible Hand” Equilibrium in the Market • Equilibrium - where quantity demanded equals quantity supplied. • Equilibrium Price (P*) - price where equilibrium occurs. Equilibrium P S E P* D 0 Q* Q Changes in Equilibrium • Remember that Supply and Demand are drawn under the ceteris paribus assumption. • Any factors which cause Supply and/or Demand to change will affect equilibrium price and quantity. Change in Demand • Demand will change for any of the factors discussed previously. • For instance, let’s say the demand for CDs increased due to an increase in income Increase in Demand Increase in Demand P 0 Q Increase in Demand P D 0 Q Increase in Demand P S D 0 Q Increase in Demand P S P* E D 0 Q* Q Increase in Demand P S P* E D’ D 0 Q* Q Increase in Demand P S P*’ P* E’ E D’ D 0 Q* Q*’ Q Change in Supply • Supply will change for any of the factors discussed previously. • For instance, let’s say that the government lowers taxes on CDs Increase in Supply Increase in Supply P 0 Q Increase in Supply P D 0 Q Increase in Supply P S D 0 Q Increase in Supply P S P* E D 0 Q* Q Increase in Supply P S S’ P* E D 0 Q* Q Increase in Supply P S S’ P* E P*’ E’ D 0 Q* Q*’ Q Increase in Supply and Demand Increase in Supply and Demand P 0 Q Increase in Supply and Demand P S 0 Q Increase in Supply and Demand P S D 0 Q Increase in Supply and Demand P S E P* D 0 Q* Q Increase in Supply and Demand P S E P* D’ D 0 Q* Q Increase in Supply and Demand P S S’ E P* D’ D 0 Q* Q Increase in Supply and Demand P S S’ P*’ P* E E’ D’ D 0 Q* Q*’ Q Increase in Supply and Demand Increase in Supply and Demand P 0 Q Increase in Supply and Demand P D 0 Q Increase in Supply and Demand P S D 0 Q Increase in Supply and Demand P S P* E D 0 Q* Q Increase in Supply and Demand P S S’ P* E D 0 Q* Q Increase in Supply and Demand P S S’ P* E D’ D 0 Q* Q Increase in Supply and Demand P S S’ P* P*’ 0 E E’ D’ D Q* Q*’ Q Increase in Supply and Demand Increase in Supply and Demand P 0 Q Increase in Supply and Demand P S 0 Q Increase in Supply and Demand P S D 0 Q Increase in Supply and Demand P S E P* D 0 Q* Q Increase in Supply and Demand P S S’ E P* D 0 Q* Q Increase in Supply and Demand P S S’ E P* D’ D 0 Q* Q Increase in Supply and Demand P S S’ E E’ P*’= P* D’ D 0 Q* Q*’ Q Price Controls Government can sometimes step in to control prices There are two types of price controls - Price Ceilings and Price Floors Price Ceilings • Price Ceiling - sets a maximum price that is allowed by law. • Result of Price Ceiling: – Stay at a permanent shortage situation • Note that a price ceiling can be any price the government chooses. It is, however only effective if it is below the equilibrium price Price Ceiling • Example of Price Ceiling • Rent controlled apartments • In New York City, San Francisco, Boston, and other cities the city or state determines the maximum amount that can be charged for rent on many apartments. • A maximum price is a price ceiling Rent Controlled Apartments Rent Controlled Apartments P 0 Q Rent Controlled Apartments P S 0 Q Rent Controlled Apartments P S D 0 Q Rent Controlled Apartments P S P* D 0 Q* Q Rent Controlled Apartments P S P* ($900) Pceiling ($600) D 0 Qs (20) Q* Qd Q (40) Amount of Shortage (In Thousands) Winners and Losers Who gains and loses with price ceilings: • 1. Benefit - those who get rent controlled apartments • 2. Loses - those who can’t find apartments due to the shortage. • 3. Loses - landlords who must accept lower rent. Price Floors • Price Floor - sets a minimum price that is allowed by law. • Result of Price Floor • Stay at a permanent surplus situation • Note that a price floor can be set at any price, but is only effective if it is above the equilibrium price Price Floors • Example of Price Floor • Minimum Wage Legislation • The minimum wage is a lowest price the government will allow firms to pay for labor. • A minimum price is a price floor Price Floors • When we look at the labor market it is similar to other supply and demand diagrams except for the labels. • L - quantity of workers • w - wages (the price we pay workers) • It is also different because the suppliers of labor are households, not firms and the demanders of labor are firms, not households Minimum Wage Legislation Minimum Wage Legislation Wage 0 # of Workers Minimum Wage Legislation Wage S 0 # of Workers Minimum Wage Legislation Wage S D 0 # of Workers Minimum Wage Legislation Wage S w* D 0 L* # of Workers Minimum Wage Legislation Amount of Unemployed Workers Wage S Wfloor ($5.15) w* ($4.50) D 0 Ld (2) L*(4) Ls (6) # of Workers (millions of workers) Winners and Losers Who gains and loses with price floors: • 1. Benefit - those who get higher wages • 2. Loses - those who can’t find jobs at the higher wage • 3. Loses - firms who must pay higher wages. Prices as Signals • The laws of supply & demand describe how people and firms respond to a change in price. • Prices are a signal that tell a consumer/producer how to adjust. (if goods are in short supply or available) Price as Signals - Producers Green Light- A high price is a green light that tells producers a specific good is in demand and they should produce more New suppliers produce more Red Light - a low price is a red light to producers that a good is being overproduced Price as Signals - Consumers Green Light – a low price is a green light to buy more of a good. It has a low opportunity cost for the consumer Red Light – A high price is a red light to stop and think carefully before buying. Elastic vs. Inelastic • When talking about the demand and the price of goods (services) certain goods are considered to be elastic or inelastic. – Elastic means that certain goods (luxury) are sensitive to changes in price. • Ex: Chocolate syrup • At the same note, certain goods are inelastic. – Inelastic means that the good (necessity) is not sensitive to price changes. • Ex: Bread, milk, etc. Equilibrium P S E P* D 0 Q* Q