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 Q d > Q s at current market price. – Amount of Shortage = Q d – Q s

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

P Q 0

P Q D 0

P Q S D 0

P Q S D 0 P sh QsQs QdQd Amount of Shortage

Results of Shortage P Q S D 0 P sh QsQs QdQd

Results of Shortage P Q S D E P* Q* 0 P sh QsQs QdQd

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 Q s > Q d at current market price. Amount of surplus = Q s - Q d 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, Q d increases and Q s decreases P will decrease

Surplus

P Q 0

P Q S 0

P Q S D 0

P Q S D 0 P sur QdQd QsQs Amount of Surplus

Results of Surplus P Q S D 0 P sur QdQd QsQs Amount of Surplus

Results of Surplus P Q S D E P* Q* 0 P sur QdQd QsQs Amount of Surplus

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 Q S D E P* Q* 0

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

P Q 0

P Q 0 D

P Q S D 0

P Q S D EP* Q* 0

Increase in Demand P Q S D EP* Q* 0 D’

Increase in Demand P Q S D EP* Q* 0 D’ E’ P*’ 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

P Q 0

P Q D 0

P Q S D 0

P Q S D EP* Q* 0

Increase in Supply P Q S D EP* Q* 0 S’

Increase in Supply P Q S D EP* Q* 0 S’ P*’ Q*’ E’

Increase in Supply and Demand

P Q 0

P Q S 0

P Q S D 0

P Q S D E P* Q* 0

Increase in Supply and Demand P Q S D E P* Q* 0 D’

Increase in Supply and Demand P Q S D E P* Q* 0 D’ S’

Increase in Supply and Demand P Q S D E P* Q* 0 D’ E’ P*’ Q*’ S’

Increase in Supply and Demand

P Q 0

P Q D 0

P Q S D 0

P Q S D E P* Q* 0

Increase in Supply and Demand P Q S D E P* Q* 0 S’

Increase in Supply and Demand P Q S D E P* Q* 0 D’ S’

Increase in Supply and Demand P Q S D E P* Q* 0 D’ E’ P*’ Q*’ S’

Increase in Supply and Demand

P Q 0

P Q S 0

P Q S D 0

P Q S D E P* Q* 0

Increase in Supply and Demand P Q S D E P* Q* 0 S’

Increase in Supply and Demand P Q S D E P* Q* 0 D’ S’

Increase in Supply and Demand P Q S D E P* Q* 0 D’ E’ P*’= Q*’ S’

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

P Q 0

P Q S 0

P Q S D 0

P Q S D P* Q* 0

Rent Controlled Apartments P Q S D P* ($900) Q* 0 P ceiling ($600) Q s (20) Q d (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

Wage # of Workers 0

Minimum Wage Legislation Wage # of Workers S 0

Minimum Wage Legislation Wage # of Workers S D 0

Minimum Wage Legislation Wage # of Workers S D w* L* 0

Minimum Wage Legislation Wage # of Workers (millions of workers) S D w* ($4.50) L* (4) 0 W floor ($5.15) L d (2) L s (6) Amount of Unemployed 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 Q S D E P* Q* 0