Ch. 6: Demand, Supply and Prices

The Interaction of Demand and Supply Market equilibrium – a situation in which the quantity demanded of a good or service at a particular price is equal to the quantity supplied at that price Equilibrium price – is the price at which the quantity of a product demanded by consumers and the quantity supplied by producers are equal

Example: Market Demand and Supply Schedule Karen – sandwich shop near office park new lunch line – salads makes 40, offers for $10 – sells 10 next makes 15, offers for $4 – sells all but 35 customers want more continues to experiment until - makes 25, offers for $6 – sells all Market equilibrium – quantity demanded and quantity supplied are in balance Price per Salad ($) Quantity Demanded Quantity Supplied 10 40 8 15 35 6 25 4 2

Figure 6.1 – shows data gathered combined market demand and supply schedule where #’s are the same – market equilibrium at $6 Karen wants to make more profit – but she will not make much profit if any if she sold at the price the office workers want and vice versa

Example: Market Demand and Supply Curves Possible to graph a combined market demand and supply schedule figure 6.2 – Karen’s market demand and supply schedule vertical – various prices salads sold at horizontal – quantity of salads (quantity demanded or quantity supplied) demand curve is plotted using prices and quantities demanded supply curve is plotted using the prices and quantities supplied from combined schedule curves intersect at one point – market equilibrium

Market Demand and Supply Curve

Reaching the Equilibrium Price Markets do not arrive at equilibrium price instantly – need trial and error Surplus – which is the result of quantity supplied being greater than quantity demanded – usually b/c prices are too high Shortage – the result of quantity demanded being greater than quantity supplied – usually b/c prices are too low

Example: Surplus, Shortage, and Equilibrium Figure 6.3. – equilibrium when neither a shortage nor a surplus surplus shown in the orange area – measured by horizontal distance between the curves when a surplus, prices tend to fall until surplus is sold and equilibrium reached shortage show in the blue area – measured by horizontal distance between the curves when a shortage, producers raise prices to try to balance quantity supplied and quantity demanded also may try to increase quantity supplied to meet the quantity demanded at the lower price

Surplus, Shortage & Equilibrium

Example: Holiday Toys Shortage most apparent for toys during holiday season toys are fads and tastes change rapidly difficult to know how much to supply and at what price overestimate – surplus, underestimate – shortage 1996 – Tickle Me Elmo by Tyco Toys Inc. expected toy to be popular ordered 500,000 at $30 – sales started slow then TV personalities promote it sales took off – ran into a shortage

Equilibrium Price in Real Life Disequilibrium – when there is an imbalance between quantity demanded and quantity supplied real world relationship between demand and supply is very complex

Example: Change in Demand and Equilibrium Price Price for athletic shoes change in demand for one of 6 reasons : income, market size, consumer expectations, consumer taste, substitute goods, and complementary goods – prompts consumers to change the quantity demanded at every price

Figure – 6.4 – equilibrium at $75 and 3000 shoes change in taste causes a ↓in demand – curve shifts left – new EP - $65 when consumers demand fewer goods and services at every price, EP will fall and suppliers will sell fewer units – even though the price is lower

Figure 6.5 - equilibrium at $75 and 3000 shoes change in # of young adults causes ↑ in demand – curves shifts right – new EP - $90 when consumers demand more goods and services at every price – EP will ↑ and suppliers will sell more, even at higher prices

Example: Change in Supply and Equilibrium Price Change in supply for one of 6 reasons: input costs, labor productivity, technology, govt. action, producer expectations, number of producers figure 6.6 – equilibrium at $75 and 3,000 shoes price of raw materials ↑, then a ↓ in supply – curve shifts left – new EP - $90 fewer goods and services at every price – EP will rise

Figure 6.7 - equilibrium at $75 and 3,000 shoes new technology causes ↑ in supply – curve shifts right – new EP - $55 when more goods and services available at every price, EP will fall EP falls when there is an ↓ in demand or an ↑ in supply when consumers want less or producers supply more – prices ↓ EP rises when there is an ↑ in demand or a ↓ in supply when consumers want more or producers a supply less – prices ↑

Sec. 2 : Prices as Signals and Incentives

How the Price System Works Competitive pricing – occurs when producers sell goods and services at prices that best balance the twin desires of making the highest profit and luring customers away from rival producers by entering at lower prices – a new supplier can add customers and maintain overall profits by selling more units

Example: Competitive Pricing Snow shovels at Elm Street Hardware - $20 Uptown Automotive enters market – increases supply – price $13 lower profit margin but hopes to sell more to maintain profit Elm Street can lower price or lose customers

Example: Characteristics of the Price System 1. It is neutral – prices do not favor either the producer or consumer b/c both make choices that help to determine the EP. The free interaction of the producers and consumers determines the EP in the market 2. It is market driven – market forces determine prices – so the system has no oversight or administration. The price system runs itself.

3. It is flexible – when market conditions change, prices are able to change quickly in response. Surpluses and shortages motivate producers to change prices to reach equilibrium. 4. It is efficient – prices will adjust until the maximum # of goods and services are sold. Producers choose to use their resources to produce certain goods and services based on the profit they can make by doing so.

Prices Motivate Producers and Consumers Consumers and producers have different attitudes toward price consumers want low prices and producers want high prices incentives encourage consumers and producers to act in certain ways consistent with their best interests

Example: Prices and Producers For producers – price system has 2 advantages: information – by acting as a signals to producers whether good time to enter or leave a particular market motivation – rising prices and expectations of profit – motivate producer to enter Falling prices and possibility or losses motivate to leave a market

Example: Prices and Producers Shortage signals that consumer demand is not being met by existing suppliers producers see shortage as opportunity to raise prices higher prices act as incentive for producers to enter a market Example – the prospect of selling goods at higher prices encourages producers to offer products for that market

Example: Prices and Producers More producers motivated by higher prices to enter market – quantity supplied ↑ prices too high relative to consumer demand – surplus Producers can reduce prices or reduce production to bring in line with quantity demanded at particular price falling prices signal good time to leave a market Some producers leave market completely due to increased competition and lower prices drive them out of business most shift their business to focus on opportunities in markets with higher potential profits

Example: Prices and Producers When a market is growing and there is unmet demand – producer may enter with a price lower than competitor new producer can still earn profit by selling more units at lower price it is expectation of profits or possibilities of losses that motivate producers to enter or leave a market

Economic Pacesetters: Michael Dell: Using Price to Beat the Competition b. – Feb. 23, 1965 – Chairman of Dell Began assembling and selling computers as a freshman in college 1984 – so successful – quit college to focus on business – sales worth $6 million 1st year Approach to marketing and production was key to success Sold over the phone to knowledgeable computer users & govt. computers built to customer requirement & assembled after ordered lower costs – low price leader in the market

Sales in 1986 - $69.5 million to $258 million in 1989 pioneer in internet sales as well Maintained close contact with customers, adjusts prices as per market competitors in retail stores had higher costs By 2005 – leading supplier of PC’s – sales at $50 billion a yr. Now looking to move into consumer electronics

Sec. 3: Intervention in the Price System

Imposing Price Ceilings Some think it is a good idea to interfere with the pricing system to keep the price of a good or service from going too high Price ceiling – an established maximum price that sellers may charge for a good or service is set below the market equilibrium so a shortage will result

Example: Football Tickets and Price Ceiling Ticket prices for college football games Trenton U. – prints 30,000 tickets for each game for $15 each – 60,000 fans want them, shortage of 30,000 for every game could let the price rise until quantity demanded and quantity supplied are equal president wants tickets affordable for students Game day – scalpers sell tickets for $50 or more

Example: Rent Control as a Price Ceiling In the past – rent control laws to keep housing affordable for low income families control when rent can be raised, by how much, no matter the market unexpected consequences from rent control no incentive to increase the supply of rental housing – shortage occurs Landlords reluctant to invest money in property maintenance – conditions worsen By 2005 – rent control less common due to making housing shortages worse

Example: Rent Control as a Price Ceiling Santa Monica – late 1990’s – new law on rent controls law allows property owners to let market determine initial rent on new tenant city would regulate yearly rent increases Effect – rents increases 40% to 85% - showing apartments had been priced artificially low

Setting Price Floors Govt. sometimes intervenes in the price system to increase income to certain producers Price floor – is an established minimum price that buys must pay for a good or service goal – is to encourage farmers to produce an abundant supply of food

Example: Minimum Wage as a Price Floor Minimum wage – the minimum legal price that an employer may pay a worker for one hour of work 1st minimum wage started in 1938 – 1930s a period of low wages – govt. hoped to increase the income of workers if minimum wage set above equilibrium price for jobs in a market, employers may decide paying higher wages is not profitable – may employ fewer workers – unemployment increase if minimum wage below equilibrium price – no effect

Rationing Resources and Products Market uses prices to allocate goods and services Rationing – is a system in which the govt. allocates goods and services using factors other than price can be rationed on first come first served basis, a lottery generally – a system of coupons allowing a person a certain amount of a good Some try to skirt the rules to get goods and services – creating a black market Black market – goods and services are illegally bought and sold in violation of price controls or rationing

Example: Rationing Resources During WWII – US govt. empowered Office of Price Administration (1941) to ration scarce goods hope to distribute goods to everyone, not just those who could afford the higher market prices of a shortage allocated resources in ways that favored the war effort led consumers to look for substitutes – ex. – margarine

Example: Rationing Resources North Korea maintained strict rationing from 1946 to 2002 staples – meat, rice, cabbage strictly rationed – but system inefficient & corrupt amount of rationing depended on who you knew, where you lived, your occupation govt. officials in cities often got more than their allotment, while majority of people got by with less

Example: Rationing Resources Between 1996 -2000 – famine made situation worse ration coupons given but the rations were not a million may have died due to the famine The people established market to trade handicrafts for food govt. legalized in 2002 – result – prices rose, wages increased 2005 – skeptical govt. considering going back to rationing

Example: Black Markets – An Unplanned Result of Rationing When rationing starts – black markets start during WWII – meat, sugar, gas – using stolen or counterfeit ration coupons North Korea – free trade in grain forbidden – prices high in markets that did exist 1985 – cost half the average monthly salary to by a chicken on the black market even after 2002 – black market flourished b/c forms of private property were illegal some start to smuggle items from China to sell in North Korea