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CHAPTER 4 Demand and Supply Applications Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair C H A P T E R 4:Demand and Supply Applications The Price System: Rationing and Allocating Resources • The market system, performs two important and closely related functions: 1. Resource allocation: the market system determines the allocation of resources among produces and the final mix of outputs. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 24 C H A P T E R 4:Demand and Supply Applications The Price System: Rationing and Allocating Resources • The market system, performs two important and closely related functions: 2. Price rationing: the market system distributes goods and services on the basis of willingness and ability to pay. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 24 C H A P T E R 4:Demand and Supply Applications Price Rationing © 2004 Prentice Hall Business Publishing • A decrease in supply creates a shortage at the original price. • The lower supply is rationed to those who are willing and able to pay the higher price. Principles of Economics, 7/e Karl Case, Ray Fair 4 of 24 C H A P T E R 4:Demand and Supply Applications Price Rationing © 2004 Prentice Hall Business Publishing • There is some price that will clear any market. • The price of a rare painting will eliminate excess demand until there is only one bidder willing to buy the single available painting. Principles of Economics, 7/e Karl Case, Ray Fair 5 of 24 C H A P T E R 4:Demand and Supply Applications Constraints on the Market © 2004 Prentice Hall Business Publishing • A price ceiling is a maximum price that sellers may charge for a good, usually set by government. • In 1974, the government set a price ceiling to distribute the available supply of gasoline. • At an imposed price of 57 cents per gallon, the result was excess demand. Principles of Economics, 7/e Karl Case, Ray Fair 6 of 24 C H A P T E R 4:Demand and Supply Applications Alternative Rationing Mechanisms • Queuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 24 C H A P T E R 4:Demand and Supply Applications Alternative Rationing Mechanisms • Favored customers are those who receive special treatment from dealers during situations when there is excess demand. • Ration coupons are tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8 of 24 C H A P T E R 4:Demand and Supply Applications Alternative Rationing Mechanisms © 2004 Prentice Hall Business Publishing • Attempts to restrict prices often result in the evolution of a black market. • A black market is a market in which illegal trading takes place at market-determined prices. Principles of Economics, 7/e Karl Case, Ray Fair 9 of 24 C H A P T E R 4:Demand and Supply Applications Alternative Rationing Mechanisms • The problem with rationing systems is that excess demand is created but not eliminated. • No matter how good the intentions of private organizations and governments, it is very difficult to prevent the price system from operating and to stop the willingness to pay from asserting itself. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 24 C H A P T E R 4:Demand and Supply Applications Prices and the Allocation of Resources • Price changes resulting from shifts of demand 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 24 C H A P T E R 4:Demand and Supply Applications Price Floors • A price floor is a minimum price below which exchange is not permitted. • The most common example of a price floor is the minimum wage, which is a floor set under the price of labor. • The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 24 C H A P T E R 4:Demand and Supply Applications Supply and Demand Analysis: An Oil Import Fee • At a world price of $18, imports • The tax on imports causes an increase in domestic production, are 5.9 million barrels per day. and quantity imported falls. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 24 C H A P T E R 4:Demand and Supply Applications Supply and Demand and Market Efficiency • Supply and demand curves can be used to illustrate the idea of market efficiency, an important aspect of “normative economics.” © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 24 C H A P T E R 4:Demand and Supply Applications Consumer Surplus • Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 24 C H A P T E R 4:Demand and Supply Applications Consumer Surplus © 2004 Prentice Hall Business Publishing • Some consumers are willing to pay as much as $5 each for hamburgers. • Since the price is only $2.50, they receive a consumer surplus of $2.50. Principles of Economics, 7/e Karl Case, Ray Fair 16 of 24 C H A P T E R 4:Demand and Supply Applications Consumer Surplus © 2004 Prentice Hall Business Publishing • Others are willing to pay something less than $5.00 but more than $2.50. • Consumer surplus is the area below the demand curve and above the price level. Principles of Economics, 7/e Karl Case, Ray Fair 17 of 24 C H A P T E R 4:Demand and Supply Applications Producer Surplus • Producer surplus is the difference between the maximum amount a producer is willing to accept to supply a good and its current market price. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 24 C H A P T E R 4:Demand and Supply Applications Producer Surplus © 2004 Prentice Hall Business Publishing • Some producers are willing to accept as little as 75 cents each for hamburgers. • Since the price is $2.50, they receive a producer surplus of $1.75 per hamburger. Principles of Economics, 7/e Karl Case, Ray Fair 19 of 24 C H A P T E R 4:Demand and Supply Applications Producer Surplus © 2004 Prentice Hall Business Publishing • Others producers are willing to receive something less than $5.00 but higher than 75 cents. • Producer surplus is the area above the supply curve and below the price level. Principles of Economics, 7/e Karl Case, Ray Fair 20 of 24 C H A P T E R 4:Demand and Supply Applications Markets Maximize the Sum of Producer and Consumer Surplus © 2004 Prentice Hall Business Publishing • Total producer and consumer surplus is highest where supply and demand curves intersect at equilibrium. • Consumers receive benefits in excess of what they pay and producers receive compensation in excess of costs. Principles of Economics, 7/e Karl Case, Ray Fair 21 of 24 C H A P T E R 4:Demand and Supply Applications Markets Maximize the Sum of Producer and Consumer Surplus © 2004 Prentice Hall Business Publishing • If the market produces too little, say 4 million instead of 7 million hamburgers per month, total producer and consumer surplus is reduced. This reduction (triangle ABC) is called a deadweight loss. Principles of Economics, 7/e Karl Case, Ray Fair 22 of 24 C H A P T E R 4:Demand and Supply Applications Potential Causes of Deadweight Loss From Under- and Overproduction © 2004 Prentice Hall Business Publishing • Deadweight losses can occur from under- and overproduction. • If the market produces 10 million instead of 7 million hamburgers per month, the cost of production rises above the willingness of consumers to pay, resulting in a deadweight loss. Principles of Economics, 7/e Karl Case, Ray Fair 23 of 24 C H A P T E R 4:Demand and Supply Applications Review Terms and Concepts black market price floor consumer surplus price rationing deadweight loss producer surplus favored customers queuing minimum wage ration coupons price ceiling © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24 of 24