USING SUPPLY AND DEMAND Chapter 5 USING SUPPLY AND DEMAND

Today’s lecture will: Explain real-world events using supply and demand. Discuss how exchange rates are determined using supply and demand. Demonstrate the effect of a price ceiling and a price floor on a market.

Today’s lecture will: Explain the effects of excise taxes and tariffs on equilibrium price and quantity. Explain the effect of a third-party-payer system on equilibrium price and quantity.

Bananas in Australia The crop-damaging cyclone shifted the supply curve to the left. At P0 ($1) quantity demanded > quantity supplied. Price rose to P1 ($2) until quantity demanded = quantity supplied. S1 S0 P1 P0 Excess Demand D Q1 Q0

The Market for Used SUVs At P0 quantity supplied > quantity demanded. Price fell to P1 until quantity demanded = quantity supplied. S D1 P0 Q0 Excess Supply Q1 P1 D0

The Market for Coffee Beans The supply of coffee increased as new growers entered the market, technology improved, and weather was favorable. Price decreased to P1. Coffee growers attempted to increase demand and raise price to P0 with a marketing campaign. S0 S1 P0 Q1 P1 D1 D0 Q0

The Price of a Foreign Currency The market for foreign exchange is called the foreign exchange (forex) market. The exchange rate is the price of one currency in terms of another one. People demand currencies to buy those countries’ goods and assets. Exchange rates are determined by supply and demand.

The Price of a Foreign Currency

The Price of a Foreign Currency The 13 members of the European Union use a common currency, the euro. The value of a euro was $0.85 in 2001. By the early 2000s the euro had risen to $1.30 because: U.S. interest rates decreased and Europeans bought fewer U.S. financial assets, so the supply of euros decreased. Americans increased their demand for euros in order to buy European financial assets.

The Supply and Demand for Euros The quantity of euros is on the horizontal axis. The price of the currency is on the vertical axis, measured in terms of dollars (how many dollars it takes to buy or sell one euro). The supply of euros represents people who want to sell euros and buy dollars, while the demand for euros represents people who want to buy euros and sell dollars. S Price of euros $0.85 D Quantity of Euros

The Price of a Foreign Currency Europeans buy fewer U.S. financial assets and ↓supply of euros. S1 D1 S0 $1.30 Price of euros Americans buy more European financial assets and ↑demand for euros. $0.85 The price of euros Increases to $1.30. D0 Quantity of Euros

Review of Changes in Supply and Demand No change in Supply shifts Supply shifts supply out in No change Price falls; Price rises; No change. in demand Quantity rises. Quantity falls. Quantity rises; Price rises; Demand Price rises; Price could be Quantity could shifts out Quantity rises . high or lower. rise or fall. Price falls ; Price falls; Quantity falls; Demand Quantity falls Quantity could Price could shifts in rise or fall. rise or fall.

Government Intervention in the Market Buyers look to the government for ways to hold prices down. A price ceiling is a government-imposed limit on how high a price can be charged. Sellers look to the government for ways to hold prices up. A price floor is a government-imposed limit on how low a price can be charged.

Rent Controls S A rent control is a price ceiling on rents set by the government. Rent control set at $2.50 per month in Paris after World War II created a housing shortage. The shortage would have been eliminated if rents had been allowed to rise to $17 per month. $17.00 2.50 Shortage Rental Price (per month) D QS QD Quantity of apartments

Minimum Wage S The minimum wage, a price floor, is set by government specifying the lowest wage a firm can legally pay. A minimum wage, Wmin, above the equilibrium wage, We, helps those who are employed, Q2, but hurts those who would have been employed at We, but can no longer find employment, Qe- Q2. Wmin We Wage per hour D Q2 Qe Q1 Quantity of Workers

Excise Taxes An excise tax is a tax that is levied on a specific good. A tariff is an excise tax on an imported good. Taxes and tariffs raise prices and reduce quantity.

Excise Taxes A $10,000 excise tax on luxury boats shifted the supply curve up by $10,000. D S1 420 $70,000 S0 65,000 60,000 At $70,000, there was excess supply of 600- 420 = 180. Price of luxury boats The price of the boats rose by less than the tax to $65,000. 510 600 Quantity of luxury boats

Quantity Restrictions Because taxi medallions were limited in supply, as demand for taxi services rose, so did the demand for medallions, increasing their price to $2500 by 1947. Today, medallions sell for $400,000! In 1937 New York City limited the number of taxi licenses to 12,000 to increase the wages of taxi drivers.

Third-Party-Payer Markets In third-party-payer markets, the person who receives the good differs from the person paying for the good. Equilibrium quantity and total spending can be much higher in third-party-payer markets.

Third-Party-Payer Markets With a co-payment of $5, consumers demand 18 units. Sellers require $45 for that quantity. S Total expenditures, shown by the entire shaded region, are much greater than when consumers pay the entire cost, shown by the dark shaded area. D

Summary Almost all events can be explained in terms of shifts of and movements along demand and supply curves. Supply and demand analysis is used to determine exchange rates – prices of currencies. Price ceilings, government imposed limits on how high a price can be charged, create shortages. Price floors, government-imposed limits on how low a price can be charged, create surpluses.

Summary Taxes and tariffs paid by suppliers shift the supply curve up by the amount of the tax or tariff and increase equilibrium price and decrease quantity. Quantity restrictions increase equilibrium price and reduce equilibrium quantity. In a third-party-payer market, the consumer and the one who pays the cost differ. Quantity demanded, price, and total spending are greater when a third party pays.

Review Question 5-1 Use a graph to explain the likely impact on the price of gasoline of a decrease in OPEC oil production due to instability in Iraq and an increase in vacation travel during the summer. S1 D1 S0 D0 P P0 P1 The decrease in production will decrease supply from S0 to S1. The increase in demand for gasoline for vacation travel will increase demand from D0 to D1. Price increases from P0 to P1. Q

Review Question 5-2 Given the following demand and supply of pizza: Price Quantity Quantity per Pizza Supplied Demanded $8 200 60 7 150 80 6 100 100 5 50 120 4 0 140 What is the effect of a price floor of $8? A price floor of $8 will create a surplus of 200 – 60 = 140 pizzas.