McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. USING DEMAND AND SUPPLY USING DEMAND AND SUPPLY Chapter 5

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-2 Today’s lecture will: Explain real-world events using supply and demand. Analyze the market for advertising with the supply and demand model. Discuss how exchange rates are determined using supply and demand.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-3 Today’s lecture will: Demonstrate the effect of a price ceiling and a price floor on a market. 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-4 The Market for Advertising In 2001, demand for advertising fell as the U.S. economy slowed down. The supply/demand model would predict that price and quantity would fall. Instead of lowering the price, the media offered higher quality advertising at the same price. Quantity of advertisements S Q0Q0 P0P0 D0D0 D1D1 Q1Q1 P1P1

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-5 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-6 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. $0.85 Quantity of Euros S D

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-7 The Price of a Foreign Currency The 12 members of the European Union began using a common currency, the euro, in The euro dropped from $1.17 to $0.85 in By 2004 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-8 The Price of a Foreign Currency Europeans buy fewer U.S. financial assets and ↓ supply of euros. Americans buy more European financial assets and ↑ demand for euros. The price of euros Increases to $1.30. $0.85 Quantity of Euros S0S0 D0D0 S1S1 D1D1 $1.30

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-9 Florida Freeze The crop-damaging freeze shifted the supply curve to the left. At P 0 quantity demanded > quantity supplied. Price rose to P 1 until the quantity demanded equaled the quantity supplied. D S0S0 Q1Q1 P1P1 P0P0 Q0Q0 S1S1 Excess Demand

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Burkhas in Afghanistan Once the Taliban was ousted, demand for burkhas fell as many women quit wearing them. At P 0 quantity supplied > quantity demanded. Price fell to P 1 until quantity demanded = quantity supplied. S P0P0 Q0Q0 Q1Q1 P1P1 D0D0 D1D1 Excess Supply

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Coffee Beans The supply of coffee increased as new growers entered the market, technology improved, and weather was favorable. Price decreased to P 1. Coffee growers attempted to increase demand and raise price to P 0 with a marketing campaign. S1S1 D0D0 S0S0 D1D1 P0P0 Q1Q1 Q0Q0 P1P1

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Price rises; Quantity falls. Review of Changes in Supply and Demand No change in supply Supply shifts out Supply shifts in No change in demand No change. Price falls; Quantity rises. Demand shifts out Price rises; Quantityrises. Quantity rises; Price could be high or lower. Price rises; Quantity could rise or fall. Demand shifts in Pricefalls; Quantity falls Price falls; Quantity could rise or fall. Quantity falls; Price could rise or fall.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shortage Rent Controls Rent control is a price ceiling on rents set by the government. Rent control in Paris after World War I created a housing shortage. The shortage would have been eliminated if rents had been allowed to rise to $17 per month. QSQS QDQD S D Rental Price (per month) Quantity of apartments $17.00

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Minimum Wage The minimum wage, a price floor, is set by government specifying the lowest wage a firm can legally pay. A minimum wage, W min, above the equilibrium wage, W e, helps those who are employed, Q 2, but hurts those who would have been employed at W e, but can no longer find employment, Q e - Q 2. W min WeWe Q2Q2 QeQe Q1Q1 S D Quantity of Workers Wage per hour

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Excise Taxes Quantity of luxury boats 0 Price of luxury boats 65, S1S1 D S0S0 A $10,000 excise tax on luxury boats shifts the supply curve up by $10, , $70, At $70,000, there is excess supply of = 180. The price of the boats rises by less than the tax to $65,000.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Quantity Restrictions In 1937 New York City limited the number of taxi licenses to 12,000 to increase the wages of taxi drivers. 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 Today, medallions sell for $300,000!

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 is much higher in third- party-payer markets.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Third-Party-Payer Markets S D With a co-payment of $5, consumers demand 18 units. sellers require $45 for that quantity. Total expenditures, shown by the entire shaded region, are much greater than when consumers pay the entire cost, shown by the dark shaded area.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-21Summary 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 5-22Summary 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 sales of large SUVs. Q S1S1 D1D1 S0S0 D0D0 P P0P0 P1P1 The decrease in production will decrease supply from S 0 to S 1. The increase in demand for SUVs (a complement) will increase demand from D 0 to D 1. Price increases from P 0 to P 1.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Review Question 5-2 Given the following demand and supply of pizza: Price Quantity Quantity per PizzaSuppliedDemanded $ What is the effect of a price floor of $8? A price floor of $8 will create a surplus of 200 – 60 = 140 Pizzas.