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Chapter 6:
“The Economic
Way of Thinking
11th Edition
Supply and
Demand:
Issues and
Applications
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
Chapter 6 Outline
• Introduction
• The Urge to Fix Prices
• Competition When Prices Are Fixed
• Appropriate and Inappropriate Signals
• Looking for an Apartment in the City? Read the
Obituary
• Strong Booze, Stronger Drugs: Criminal
Incentives
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Heyne/Boettke/Prychitko
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Chapter 6 Outline
• Skim Milk, Whole Milk, and Gangster Milkmen
• Supports and Surpluses
• Supply, Demand and the Minimum Wage
• Who Pays the Tax?
• High-Priced Sports, Low-Priced Poetry: Who’s to
Blame?
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Chapter 6 Outline
• Do Costs Determine Prices?
• The Dropouts Release Their First CD
• “There’s Gold in Them Thar Hills!” So What?
• Even Butchers Don’t Have the Guts
• Why Does it Cost so Much to Change Bedpans?
© 2006 Prentice Hall Business Publishing
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Heyne/Boettke/Prychitko
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Chapter 6 Outline
• More Please, Since It’s Free
• Costs and Ownership
• Appendix: Framing Economic Questions
Correctly
– Beware of Wrong Questions or Misleading
Specifications of the Problem
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
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Chapter 6 Outline
• Appendix: Framing Economic Questions
Correctly (continued)
– Beware of Data that Appear to Speak for Themselves
– Beware of Academic Scribblers and Would-Be
Economists
– The Graphic Case of Growing and Permanent
Shortages
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The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
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Introduction
• The economic way of thinking is at work
regardless of economists’ actions.
– Economists have simply uncovered the principles with
respect to people’s choices, and the consequences of
their choices.
– Economists help us understand how individuals are
able to coordinate their production, consumption, and
exchange decisions through cooperative and
competitive activities in the marketplace.
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Heyne/Boettke/Prychitko
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Introduction
The forces of Supply and Demand
clarify markets, not economists.
Economists debunk popular myths,
and misconceptions, about market
processes.
In this chapter we consider other
examples of misconceptions about
the market system.
© 2006 Prentice Hall Business Publishing
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Heyne/Boettke/Prychitko
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The Urge to Fix Prices!
• In 2004 the price of gasoline in the USA was, at
certain times, $2.00 per gallon.
• What if a price control had been legislated at
$1.00 per gallon?
• Quantity demanded would have risen; and
inventories would have been depleted.
• Also, suppliers would have decreased output.
• A shortage (quantity demanded minus quantity
supplied) would have occurred.
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Competition When Prices Are Fixed
• In a free market, price would tend to rise during
a shortage.
• When there is a ceiling price (fixed price) and a
persistent shortage, the non-monetary costs of
purchasing will increase.
• In the example of gasoline, these costs might
include: longer lines; waiting times; special fees;
special arrangements; bribes; etc.
• Competition among buyers would bid up the
cost of purchasing.
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Appropriate and Inappropriate Signals
• If the law prevents suppliers from raising prices,
they will try to identify alternatives to create an
advantage or remedy.
• Gasoline outlets would reduce costs by reducing
hours of operation.
• Shorter hours would increase the non-monetary
costs to buyers.
• Changing money prices are signals and will help
secure cooperation in the economy.
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Appropriate and Inappropriate Signals
• If the price cannot change…
inappropriate signals occur.
• Thus, suppliers and demanders have no
incentives to attempt to identify ways to
accommodate.
• Changing money prices do provide such
incentives.
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Looking for an Apartment in the City?
Read the Obituary
• There has been a persistent shortage of
apartments in NYC for decades due to rent
controls.
• Results include:
– Tenants will want to keep their units
– Landlords will not wish to make repairs
– Property owners will want to convert buildings to
parking or condos
– Costly NYC administration
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Looking for an Apartment in the City?
Read the Obituary
Monthly
Rent
Supply
$600
De
$500
D Rent Controls
$400
$300
Shortage
D
$200
$100
100
200
300 400 500 600 700 800 900 1000 1100
Quantity of Apartment Units
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Looking for an Apartment in the City?
Read the Obituary
Monthly
Rent
Supply
$600
De
$500
D Rent Controls
$400
$300
The Below
Equilibrium
price causes the
shortage !
$200
$100
100
200
Shortage
D
300 400 500 600 700 800 900 1000 1100
Quantity of Apartment Units
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Strong Booze, Stronger Drugs:
Criminal Incentives
• Question
– Why didn’t the prohibition of the 1920’s abolish the
supply and demand process for alcohol?
• Answer
– People coordinated their activities through
underground market processes.
– Prohibition affected the elasticity of supply for
alcoholic drinks.
– Supply became much more inelastic while demand
remained stable, causing prices to surge.
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Strong Booze, Stronger Drugs:
Criminal Incentives
• People pursue comparative advantage.
• Underground production and distribution provides
criminals with a comparative advantage.
• The prohibition can be compared to the war on drugs.
• Current laws do not demolish the demand and supply of
illicit drugs.
• Like other forms of prohibition these laws have an
unintended consequence.
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Skim Milk, Whole Milk and Gangster
Milkmen
• Question
– What if the production, distribution and consumption
of milk were prohibited?
• Answer
–
–
–
–
These activities would be driven underground.
Supply would become inelastic.
Prices would rise.
Criminals would become milkmen.
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Supports and Surpluses
• We now know that an effective price ceiling
tends to generate an unintended shortage.
• A legally mandated minimum price – or a price
floor – is established to improve prospects for
suppliers.
• Will a price floor generate a surplus?
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Supply, Demand and the Minimum Wage
• Minimum Wage is another example of a price
floor.
• To be effective, it must be set above the market
clearing wage rate.
• A surplus of labor will occur:
– Quantity demanded will decrease
– Quantity supplied would increase
– Unemployment will increase for unskilled workers
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Supply, Demand and the Minimum Wage
• Consider the following:
– The effect of a 25% increase in the minimum wage on
fast food operators
– The argument that minimum wage will not adequately
support a family
– The effect of a large increase in the minimum wage
on skilled and unskilled workers
– Political debates over minimum wage
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Who Pays the Tax?
• Question
– What effect would a larger tax have on cigarettes?
• Cigarettes
– Currently demand is inelastic.
– Higher prices bring about greater responses.
– Further tax increases may reduce tax revenue.
• Goals of deterring smoking and raising tax
revenue are not completely compatible
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Who Pays the Tax?
Sposttax
.32
Price per Pound
.28
Spretax
.24
The imposition of a
nickel tax raises the price
from 20 to 24 cents-buyer pays 4 cents/seller
pays 1 cent.
.20
.16
.12
.08
D
.04
0
1
2
3
4
5
6
7
Quantity of Soybean Oil per Time Period
(billions of pounds)
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Who Pays the Tax?
• Any tax reduces buyers’ and sellers’ ability to
engage in that activity, and to enjoy the mutual
benefits of further opportunities for exchange.
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Higher Priced Sports, Low Prices Poetry:
Who’s to Blame?
Because the fans
are willing
to pay to see
us !
© 2006 Prentice Hall Business Publishing
Why are our
salaries so
high?
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Higher Priced Sports, Low Prices Poetry:
Who’s to Blame?
Unfortunatel
y the demand
for poetry
reading is
low.
© 2006 Prentice Hall Business Publishing
Why aren’t poets
paid as
much as professional
athletes?
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Do Costs Determine Prices?
• Sellers like for the public to believe that price increases
arise from rising costs.
• No sellers in history have announced that increases in
demand caused the price hike.
• Costs depend not only on supply, but on demand, too.
• The price of a commodity depends on its supply and
demand curves.
• The position of the supply curve depends on its cost of
production.
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The Dropouts Release Their First CD
• The Band tried to sell the CD at $22 each in a
market of $15 CD’s.
• $22 came from recording and packaging costs
for the 1,000 CD’s first produced.
• One musician wanted to include the costs of
instruments (sunk costs).
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The Dropouts Release Their First CD
Remember! Sunk costs
are history. They
are irrelevant to
current economic
decisions.
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The Dropouts Release Their First CD
• 12 CD’s were sold.
• The Band tried to use production cost to
determine price.
• They ignored demand and the fact that
demanders were part of a CD market with a
clearing price of $15.
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There’s Gold in Them Thar Hills:
So What?
Current market
price makes
it too costly to open
the mine. Let’s wait
for demand to increase.
Go for the
Gold!!!!
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Even Butchers Don’t Have The Guts
• When the demand for beef increases the
butcher’s sales increase.
• The demand for final beef products is elastic.
• The supply of new cattle, however, is inelastic.
• Customer’s increased demand for the final
product causes the price to increase.
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Why Does it Cost so Much to Change
Bedpans?
• Question
– Why are hospital costs forever on the increase?
• Insurance
– Lowers cost of physicians’ services
– Increases amount purchased
– Increases the cost of medical services
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Why Does it Cost so Much to Change
Bedpans?
• Question
– What will patients do if their payments are the same
regardless of whether they receive in- or outpatient
care?
• Care is usually better inside the hospital than
outside it.
• Physicians can more easily monitor a patient’s
progress inside the hospital than outside.
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Why Does it Cost so Much to Change
Bedpans?
• Employers
– Have been pressuring insurers to control costs
• Insurers
– Have been pressuring doctors
– Pay hospitals fixed amounts
• Hospitals economize
• Demand affects costs. Rationing medical care
services is unavoidable since at a zero out of
pocket cost, quantity demanded will far exceed
quantity supplied.
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Why Does it Cost so Much to Change
Bedpans?
P
D w/out
insurance
S
D with
insurance
Q
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More Please, Since It’s Free
• Congested highways are another kind of
shortage.
• Shortages occur when prices are low.
• Public transit systems do not seem to be
effective at reducing congestion.
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More Please Since It’s Free
• Private auto drivers don’t pay the full cost of
driving.
– Motorists generate a lot of spillover cost by driving.
• As long as we give away scarce urban street
space for nothing we will have congested
highways.
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More Please Since It’s Free
• Solution to traffic congestion
– Charge users of public transit a price high enough to
pay for improvements.
• Question
– What would happen?
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Costs and Ownership
• Property Rights matter.
• Question
– Why will personnel tend to be used in wasteful ways
in the military more than in civilian life?
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Costs and Ownership
• Answer
– Civilians are paid their opportunity cost.
– Efficient use occurs more often when resources (both
human and inhuman) are owned by someone.
– Resources tend to be employed less efficiently when
the users do not themselves have to pay the full
opportunity cost.
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Costs and Ownership
• How does the allocation of resources occur
when they are owned by the government?
– With public resource ownership, planners impose
their own evaluations on the alternatives.
• With private resource ownership, competing bids
and offers generate prices that approximate
opportunity costs.
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Appendix: Framing Economic Questions
Correctly
• Beware of Wrong Questions or Misleading
Specifications of the Problem
• Beware of Data that Appear to Speak for
Themselves
• Beware of Academic Scribblers and Would-Be
Economists
• The Graphic Case of Growing and Permanent
Shortages
© 2006 Prentice Hall Business Publishing
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
43 of 46
Once Over Lightly
• Price controls create unintended consequences.
• Prohibition on alcohol and drugs drives the
market process underground, and provides
criminals with comparative advantage.
• A taxed activity tends to reduce further
opportunities for people to participate in that
activity.
• Price is determined both by supply and demand,
not cost.
© 2006 Prentice Hall Business Publishing
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Once Over Lightly
• Supply, demand and the market process sets
prices that reflect the relative scarcities of goods,
and indicate how they can be used most
economically.
• When resources are not privately owned the
rules of the game governing their use are
unclear.
• Economic terms and concepts are often used in
misleading ways.
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End of Chapter 6
© 2006 Prentice Hall Business Publishing
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