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Chapter 4
Extensions of
Demand and
Supply Analysis
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
The global demand for water doubles every 20 years,
so there will likely be pressure of its equilibrium price
to rise.
In fact, inflation-adjusted prices of water have
barely increased because government controls keep
water prices lower than they otherwise would be.
In this chapter, you will learn why such regulations
have contributed to shortages of water in some
nations.
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
Learning Objectives (cont'd)
• Explain the effects of price ceilings
• Explain the effects of price floors
• Describe various types of governmentimposed quantity restrictions on markets
Chapter Outline
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The Price System and Markets
Changes in Demand and Supply
The Rationing Function of Prices
The Policy of Government-Imposed Price Controls
The Policy of Controlling Rents
Price Floors in Agriculture
Price Floors in the Labor Market
Quantity Restrictions
Did You Know That ...
• Nearly 90,000 U.S. residents seek kidney transplants each year,
but only about 20,000 kidney transplants occur?
• Despite the high demand for kidney transplants, selling a
kidney is illegal, so the maximum price of a kidney—called a
price ceiling—is $0.
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
• The prices are signals as to what is relatively scarce and
relatively abundant
• Prices provide information to individuals and
businesses
The Price System and Markets (cont'd)
• Voluntary Exchange
– An act of trading between individuals in the price
system
– Makes both parties to the trade subjectively
better off
The Price System and Markets (cont'd)
• Transaction Costs
– All of the costs associated with exchange
– Including:
• The informational costs of finding out the price and
quality, service record, and durability of a product
• The cost of contracting and enforcing that contract
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
International Example: Assisting Scattered Emigrants Who Want
to Help Kin at Home
• About 25 million people have left India to work in other nations
around the globe.
• To assist Indian emigrants who desire to help family members
back home, a company called Sahara Care House offers a suite
of 60 products and services, including delivering flowers and
dropping off good and clothing to emigrants’ families in India.
• By performing tasks for family members on behalf of Indian
expatriates, this company acts as a middleman.
Changes in Demand and Supply
• Changes in supply and demand create a
disequilibrium.
• The market price and quantity adjust to a new
equilibrium.
Figure 4-1 Shifts in Demand and in Supply: Determinate Results,
Panel (a)
Figure 4-1 Shifts in Demand and in Supply: Determinate Results,
Panel (b)
Figure 4-1 Shifts in Demand and in Supply: Determinate Results,
Panel (c)
Figure 4-1 Shifts in Demand and in Supply: Determinate Results,
Panel (d)
Changes in Demand and Supply
(cont'd)
• Summary
– Increases in demand increase equilibrium price
and quantity
– Decreases in demand decrease equilibrium price
and quantity
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
Changes in Demand and Supply
(cont'd)
• When both demand and supply change
– If both the supply and demand curves shift
simultaneously, the outcome is indeterminate for
either equilibrium price or equilibrium quantity
– The resulting effect depends upon how much each
curve shifts
Changes in Demand and Supply
(cont'd)
• When both demand & supply increase
– Change in equilibrium price is indeterminate
– Equilibrium quantity increases unambiguously
• When both demand & supply decrease
– Change in equilibrium price is indeterminate
– Equilibrium quantity decreases unambiguously
Changes in Demand and Supply
(cont'd)
• When supply decreases & demand increases
– Equilibrium price increases
– The change in the equilibrium quantity is
uncertain without more information
• When supply increases & demand decreases
– Equilibrium price decreases
– The change in the equilibrium quantity is
uncertain without more information
International Example: What Accounts for Rising Pork Prices in
China?
• Since the early 2000s, Chinese pork prices have surged. Why?
• Pork is a normal good, so that rising Chinese incomes had
raised the demand for pork.
• Meanwhile, rising prices of feed for hogs and higher prices of
land to raise hogs contributed to a reduction in the supply of
pork.
Figure 4-2 The Effects of a Simultaneous Decrease in Pork
Supply and Increase in Pork Demand
Changes in Demand and Supply
(cont'd)
Price Flexibility
• Prices quite flexible in some markets can be
less flexible in other market scenarios.
– May take the form of subtle adjustments such as
hidden payments, quality changes
– May not reach equilibrium right away
Changes in Demand and Supply
(cont'd)
• Adjustment speed
– Market characteristics influence adjustment speed
– Markets may overshoot in the adjustment process
– Markets are subject to energy shocks, labor
strikes, severe weather
The Rationing Function of Prices
• Synchronization of decisions of buyers and
sellers that leads to equilibrium is called the
rationing function of prices
The Rationing Function of Prices
(cont'd)
• Methods of non-price rationing
– Rationing by queues (waiting in line)
– Rationing by random assignment or coupons
The Rationing Function of Prices
(cont'd)
• The essential role of rationing
– Implied by the presence of scarcity
– Price vs. non-price rationing mechanism:
• Price rationing leads to the most efficient use of
available resources
• All gains from mutually beneficial trade are captured in
a freely rationing price system
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
The Policy of Government-Imposed
Price Controls (cont'd)
• Price ceiling and black markets
– A price ceiling may prevent the equilibrium price
from being achieved if it is above the ceiling price
– A price ceiling that is set below the market
clearing price creates a shortage
The Policy of Government-Imposed
Price Controls (cont'd)
• Non-Price Rationing Devices
– All methods used to ration scarce goods that are
price-controlled
• Black Market
– A market in which price-controlled goods are sold
at an illegally high price
Figure 4-3 Black Markets for Portable Electric
Generators
International Example: The Rice Must Be White!
• In Venezuela, there is a legal ceiling price of white rice of
about 1 cent per kilogram, which is about half of the price at
which most Venezuelan rice sellers are willing to offer white
rice.
• What would you suppose that rice sellers in Venezuela could
do to avoid the effect of the government’s price controls on
white rice?
The Policy of Controlling Rents
•
The functions of rental prices
1. Promote the efficient maintenance and
construction of housing
2. Allocate existing housing
3. Ration the use of housing
The Policy of Controlling Rents (cont'd)
• Rent controls and construction
– Controls discourage construction
• With a 16% vacancy rate and no controls, Dallas
recently built 11,000 new rental units
• With a 1.6% vacancy rate and controls, San Francisco
recently built 2,000 new rental units
The Policy of Controlling Rents (cont'd)
• 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”
The Policy of Controlling Rents (cont'd)
• Attempts to evade rent controls
– Forcing tenants to leave
– Tenants subletting apartments
– Housing courts
The Policy of Controlling Rents (cont'd)
• Who gains and who loses from rent controls?
– Losers
• Property owners
• Low-income individuals
– Gainers
• Upper-income professionals
Why Not … require owners of residential buildings to provide low-cost
housing so that all U.S. residents can “afford” roofs over their heads?
• The result of a legal price ceiling for residential housing set
lower than the market clearing price would be a shortage of
residential housing.
• More people would want to purchase or rent housing at the
ceiling price than owners of residential housing would desire
to supply.
Price Floors in Agriculture
• Support Price
– The government chooses a price floor for a
product and then acts to ensure that the price of
the product never falls below the support level
• Associated with many agricultural products
• A price floor that is set above the market clearing price
results in a surplus.
Figure 4-4 Agricultural Price Supports
Price Floors in Agriculture (cont'd)
• Questions
– How could the government keep the price from
falling?
– Who benefits from agricultural price supports?
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
Figure 4-5 The Effect of Minimum
Wages
Policy Example: Bad Timing for Increasing the Minimum Wage
• In 2007, Congress decided to increase the hourly minimum
wage in 3 steps from $5.15 to $7.25 in 2009.
• By 2008, the unemployment rate was 5.8 percent. When the
final $0.70-per hour increase was added in 2009, the U.S.
economy was experiencing an economic downturn with a 9.4
unemployment rate.
• If the imposition of a minimum wage currently generates
unemployment, what happens to the unemployment rate
when the demand for labor declines?
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
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
You Are There: “Cash for Clunkers” Subsidies and the Market for
“Liquid Glass”
• “Liquid glass” is a sodium-silicate chemical that auto
mechanics use for stopping leaks in engine gaskets.
• In 2009, that chemical rose from less than $2.50 per quart to
nearly $3.50 per quart.
• What effect did the federal government’s “Cash for Clunkers”
program, which offered subsidies for people to trade in
energy-inefficient vehicles, have on the demand and the
market clearing price of liquid glass?
Issues & Applications: Contemplating Two Ways to Tackle Water
Shortages
• What can be done to help the roughly 20 percent of the
world’s human population who are unable to obtain as much
usable freshwater as they desire?
• Ending government-mandated price ceilings on of usable
freshwater is one way to eliminate water shortages.
• Another way to cut shortages is to remove salt from seawater.
Figure 4-6 Two Methods of Eliminating a Water
Shortage, panel (a)
Figure 4-6 Two Methods of Eliminating a Water
Shortage, panel (b)
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
– Prices are communicated in markets that tend to
minimize transactions costs
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
Summary Discussion of Learning
Objectives (cont'd)
• How changes in demand and supply affect
equilibrium price and equilibrium quantity
– When both demand and supply shift at the same
time, the outcome is indeterminate for either
equilibrium price or equilibrium quantity
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
Summary Discussion of Learning
Objectives (cont'd)
• The effects of price ceilings
– A price ceiling set below the market clearing price
results in a shortage
• The resulting shortage can lead to non-price rationing
devices and black markets
Summary Discussion of Learning
Objectives (cont'd)
• The effects of price floors
– If the price floor is set above the market clearing
price, a surplus results
• A price floor can take the form of a governmentimposed price support or minimum wage
Summary Discussion of Learning
Objectives (cont'd)
• Government-imposed restrictions on market
quantities
– Bans on sale or ownership
– Licensing restrictions
– Import quotas
Appendix B: Consumer Surplus
• Consumer Surplus
– The difference between the total amount that
consumers would have been willing to pay for an
item and the total amount that they actually pay
Figure B-1 Consumer Surplus
Appendix B: Producer Surplus
• Producer Surplus
– The difference between the total amount that
producers actually receive for an item and the
total amount that they would have been willing to
accept for supplying that item
Figure B-2 Producer Surplus
Appendix B: Gains from Trade within a Price System
• Gains from trade
– The sum of consumer surplus and producer
surplus
Figure B-3 Consumer Surplus, Producer Surplus, and
Gains from Trade
Appendix B: Price Controls and Gains from Trade
• How do price controls affect gains from trade?
– Consumer surplus and producer surplus are both
lower
– Either a price ceiling or a price floor reduces gains
from trade