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Demand and Supply Applications Chapter 4 1 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES price rationing The process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied. 2 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES PRICE RATIONING The Market for Lobsters 3 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES When supply is fixed or something for sale is unique, its price is demand determined. Price is what the highest bidder is willing to pay. The adjustment of price is the rationing mechanism in free markets. Price rationing means that whenever there is a need to ration a good—that is, when a shortage exists—in a free market, the price of the good will rise until quantity supplied equals quantity demanded—that is, until the market clears. 4 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES Market for a Rare Painting 5 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES CONSTRAINTS ON THE MARKET AND ALTERNATIVE RATIONING MECHANISMS On occasion, both governments and private firms decide to use some mechanism other than the market system to ration an item for which there is excess demand at the current price. 6 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES Oil, Gasoline, and OPEC price ceiling A maximum price that sellers may charge for a good, usually set by government. Excess Demand (Shortage) Created by a Price Ceiling 7 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES PRICES AND THE ALLOCATION OF RESOURCES Thinking of the market system as a mechanism for allocating scarce goods and services among competing demanders is very revealing, but the market determines much more than just the distribution of final outputs. It also determines what gets produced and how resources are allocated among competing uses. Price changes resulting from shifts of demand in output markets cause profits to rise or fall. Profits attract capital; losses lead to disinvestment. Higher wages attract labor and encourage workers to acquire skills. At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced. 8 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES PRICE FLOORS price floor A minimum price below which exchange is not permitted. minimum wage A price floor set under the price of labor. 9 SUPPLY AND DEMAND ANALYSIS: AN OIL IMPORT FEE The basic logic of supply and demand is a powerful tool of analysis. The U.S. Market for Crude Oil, 1989 10 SUPPLY AND DEMAND AND MARKET EFFICIENCY CONSUMER SURPLUS consumer surplus The difference between the maximum amount a person is willing to pay for a good and its current market price. 11 SUPPLY AND DEMAND AND MARKET EFFICIENCY Market Demand and Consumer Surplus 12 SUPPLY AND DEMAND AND MARKET EFFICIENCY PRODUCER SURPLUS producer surplus The difference between the current market price and the full cost of production for the firm. 13 SUPPLY AND DEMAND AND MARKET EFFICIENCY Market Supply and Producer Surplus 14 SUPPLY AND DEMAND AND MARKET EFFICIENCY COMPETITIVE MARKETS MAXIMIZE THE SUM OF PRODUCER AND CONSUMER SURPLUS Total Producer and Consumer Surplus 15 SUPPLY AND DEMAND AND MARKET EFFICIENCY deadweight loss The net loss of producer and consumer surplus from underproduction or overproduction. Deadweight Loss 16 SUPPLY AND DEMAND AND MARKET EFFICIENCY POTENTIAL CAUSES OF DEADWEIGHT LOSS FROM UNDER- AND OVERPRODUCTION When supply and demand interact freely, competitive markets produce what people want at least cost, that is, they are efficient. 17