Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 4 Extensions of Demand and Supply Analysis

Introduction The global demand for water doubles every 20 years, so there will likely be pressure of its equilibrium price to rise. In fact, inflation-adjusted prices of water have barely increased because government controls keep water prices lower than they otherwise would be. In this chapter, you will learn why such regulations have contributed to shortages of water in some nations.

Learning Objectives Discuss the essential features of the price system Evaluate the effects of changes in demand and supply on the market price and equilibrium quantity Understand the rationing function of prices

Learning Objectives (cont'd) Explain the effects of price ceilings Explain the effects of price floors Describe various types of government- imposed quantity restrictions on markets

Chapter Outline The Price System and Markets Changes in Demand and Supply The Rationing Function of Prices The Policy of Government-Imposed Price Controls The Policy of Controlling Rents Price Floors in Agriculture Price Floors in the Labor Market Quantity Restrictions

Did You Know That... Nearly 90,000 U.S. residents seek kidney transplants each year, but only about 20,000 kidney transplants occur? Despite the high demand for kidney transplants, selling a kidney is illegal, so the maximum price of a kidney—called a price ceiling—is $0.

The Price System and Markets Price System or Market System – An economic system in which relative prices are constantly changing to reflect changes in supply and demand The prices are signals as to what is relatively scarce and relatively abundant Prices provide information to individuals and businesses

The Price System and Markets (cont'd) Voluntary Exchange – An act of trading between individuals in the price system – Makes both parties to the trade subjectively better off

The Price System and Markets (cont'd) Transaction Costs – All of the costs associated with exchange – Including: The informational costs of finding out the price and quality, service record, and durability of a product The cost of contracting and enforcing that contract

The Price System and Markets (cont'd) The role of middlemen – Middlemen (intermediaries) or brokers reduce transaction costs by providing information to buyers and sellers – Examples Real estate brokers Stock brokers Consignment shops Car dealerships

International Example: Assisting Scattered Emigrants Who Want to Help Kin at Home About 25 million people have left India to work in other nations around the globe. To assist Indian emigrants who desire to help family members back home, a company called Sahara Care House offers a suite of 60 products and services, including delivering flowers and dropping off good and clothing to emigrants’ families in India. By performing tasks for family members on behalf of Indian expatriates, this company acts as a middleman.

Changes in Demand and Supply Changes in supply and demand create a disequilibrium. The market price and quantity adjust to a new equilibrium.

Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (a)

Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (b)

Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (c)

Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (d)

Changes in Demand and Supply (cont'd) Summary – Increases in demand increase equilibrium price and quantity – Decreases in demand decrease equilibrium price and quantity

Changes in Demand and Supply (cont'd) Summary – Increases in supply decrease equilibrium price and increase equilibrium quantity – Decreases in supply increase equilibrium price and decrease equilibrium quantity

Changes in Demand and Supply (cont'd) When both demand and supply change – If both the supply and demand curves shift simultaneously, the outcome is indeterminate for either equilibrium price or equilibrium quantity – The resulting effect depends upon how much each curve shifts

Changes in Demand and Supply (cont'd) When both demand & supply increase – Change in equilibrium price is indeterminate – Equilibrium quantity increases unambiguously When both demand & supply decrease – Change in equilibrium price is indeterminate – Equilibrium quantity decreases unambiguously

Changes in Demand and Supply (cont'd) When supply decreases & demand increases – Equilibrium price increases – The change in the equilibrium quantity is uncertain without more information When supply increases & demand decreases – Equilibrium price decreases – The change in the equilibrium quantity is uncertain without more information

International Example: What Accounts for Rising Pork Prices in China? Since the early 2000s, Chinese pork prices have surged. Why? Pork is a normal good, so that rising Chinese incomes had raised the demand for pork. Meanwhile, rising prices of feed for hogs and higher prices of land to raise hogs contributed to a reduction in the supply of pork.

Figure 4-2 The Effects of a Simultaneous Decrease in Pork Supply and Increase in Pork Demand

Changes in Demand and Supply (cont'd) Price Flexibility Prices quite flexible in some markets can be less flexible in other market scenarios. – May take the form of subtle adjustments such as hidden payments, quality changes – May not reach equilibrium right away

Changes in Demand and Supply (cont'd) Adjustment speed – Market characteristics influence adjustment speed – Markets may overshoot in the adjustment process – Markets are subject to energy shocks, labor strikes, severe weather

The Rationing Function of Prices Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices

The Rationing Function of Prices (cont'd) Methods of non-price rationing – Rationing by queues (waiting in line) – Rationing by random assignment or coupons

The Rationing Function of Prices (cont'd) The essential role of rationing – Implied by the presence of scarcity – Price vs. non-price rationing mechanism: Price rationing leads to the most efficient use of available resources All gains from mutually beneficial trade are captured in a freely rationing price system

The Policy of Government-Imposed Price Controls Price Controls – Government-mandated minimum or maximum prices Price Ceiling – A legal maximum price Price Floor – A legal minimum price

The Policy of Government-Imposed Price Controls (cont'd) Price ceiling and black markets – A price ceiling may prevent the equilibrium price from being achieved if it is above the ceiling price – A price ceiling that is set below the market clearing price creates a shortage

The Policy of Government-Imposed Price Controls (cont'd) Non-Price Rationing Devices – All methods used to ration scarce goods that are price-controlled Black Market – A market in which price-controlled goods are sold at an illegally high price

Figure 4-3 Black Markets for Portable Electric Generators

International Example: The Rice Must Be White! In Venezuela, there is a legal ceiling price of white rice of about 1 cent per kilogram, which is about half of the price at which most Venezuelan rice sellers are willing to offer white rice. What would you suppose that rice sellers in Venezuela could do to avoid the effect of the government’s price controls on white rice?

The Policy of Controlling Rents The functions of rental prices 1.Promote the efficient maintenance and construction of housing 2.Allocate existing housing 3.Ration the use of housing

The Policy of Controlling Rents (cont'd) Rent controls and construction – Controls discourage construction With a 16% vacancy rate and no controls, Dallas recently built 11,000 new rental units With a 1.6% vacancy rate and controls, San Francisco recently built 2,000 new rental units

The Policy of Controlling Rents (cont'd) Effects on the existing supply of housing and current use of housing – Property owners cannot recover costs Maintenance, repairs, capital improvements – Rations the current use of housing Reduces mobility, e.g., New York’s “housing gridlock”

The Policy of Controlling Rents (cont'd) Attempts to evade rent controls – Forcing tenants to leave – Tenants subletting apartments – Housing courts

The Policy of Controlling Rents (cont'd) Who gains and who loses from rent controls? – Losers Property owners Low-income individuals – Gainers Upper-income professionals

Why Not … require owners of residential buildings to provide low-cost housing so that all U.S. residents can “afford” roofs over their heads? The result of a legal price ceiling for residential housing set lower than the market clearing price would be a shortage of residential housing. More people would want to purchase or rent housing at the ceiling price than owners of residential housing would desire to supply.

Price Floors in Agriculture Support Price – The government chooses a price floor for a product and then acts to ensure that the price of the product never falls below the support level Associated with many agricultural products A price floor that is set above the market clearing price results in a surplus.

Figure 4-4 Agricultural Price Supports

Price Floors in Agriculture (cont'd) Questions – How could the government keep the price from falling? – Who benefits from agricultural price supports?

Price Floors in the Labor Market Minimum Wage – A wage floor, legislated by government, setting the lowest hourly wage rate that firms may legally pay their workers

Figure 4-5 The Effect of Minimum Wages

Policy Example: Bad Timing for Increasing the Minimum Wage In 2007, Congress decided to increase the hourly minimum wage in 3 steps from $5.15 to $7.25 in By 2008, the unemployment rate was 5.8 percent. When the final $0.70-per hour increase was added in 2009, the U.S. economy was experiencing an economic downturn with a 9.4 unemployment rate. If the imposition of a minimum wage currently generates unemployment, what happens to the unemployment rate when the demand for labor declines?

Quantity Restrictions Governments can impose quantity restrictions, most obvious—banning ownership or trading of a good – Human organs – Drugs – Hospital beds – Gold from 1933 to 1973

Quantity Restrictions (cont'd) Government Prohibitions and Licensing Requirements – Some commodities cannot be purchased at all legally; others require a license Import Quota – Supply restriction that prohibits the importation of more than a specified quantity of a particular good

You Are There: “Cash for Clunkers” Subsidies and the Market for “Liquid Glass” “Liquid glass” is a sodium-silicate chemical that auto mechanics use for stopping leaks in engine gaskets. In 2009, that chemical rose from less than $2.50 per quart to nearly $3.50 per quart. What effect did the federal government’s “Cash for Clunkers” program, which offered subsidies for people to trade in energy-inefficient vehicles, have on the demand and the market clearing price of liquid glass?

Issues & Applications: Contemplating Two Ways to Tackle Water Shortages What can be done to help the roughly 20 percent of the world’s human population who are unable to obtain as much usable freshwater as they desire? Ending government-mandated price ceilings on of usable freshwater is one way to eliminate water shortages. Another way to cut shortages is to remove salt from seawater.

Figure 4-6 Two Methods of Eliminating a Water Shortage, panel (a)

Figure 4-6 Two Methods of Eliminating a Water Shortage, panel (b)

Summary Discussion of Learning Objectives Essential features of the price system – A price system (market system) allows prices to respond to changes in supply and demand for different commodities – Prices are communicated in markets that tend to minimize transactions costs

Summary Discussion of Learning Objectives (cont'd) How changes in demand and supply affect market price and equilibrium quantity – Increases in demand increase equilibrium price and quantity; decreases in demand decrease equilibrium price and quantity – Increases in supply decrease market price and increase equilibrium quantity; decreases in supply increase market price and decrease equilibrium quantity

Summary Discussion of Learning Objectives (cont'd) How changes in demand and supply affect equilibrium price and equilibrium quantity – When both demand and supply shift at the same time, the outcome is indeterminate for either equilibrium price or equilibrium quantity

Summary Discussion of Learning Objectives (cont'd) The rationing function of prices – In a market system, prices ration scarce goods and services – Other ways of rationing include first come, first served; political power; physical force; random assignment; and coupons

Summary Discussion of Learning Objectives (cont'd) The effects of price ceilings – A price ceiling set below the market clearing price results in a shortage The resulting shortage can lead to non-price rationing devices and black markets

Summary Discussion of Learning Objectives (cont'd) The effects of price floors – If the price floor is set above the market clearing price, a surplus results A price floor can take the form of a government- imposed price support or minimum wage

Summary Discussion of Learning Objectives (cont'd) Government-imposed restrictions on market quantities – Bans on sale or ownership – Licensing restrictions – Import quotas

Appendix B: Consumer Surplus Consumer Surplus – The difference between the total amount that consumers would have been willing to pay for an item and the total amount that they actually pay

Figure B-1 Consumer Surplus

Appendix B: Producer Surplus Producer Surplus – The difference between the total amount that producers actually receive for an item and the total amount that they would have been willing to accept for supplying that item

Figure B-2 Producer Surplus

Appendix B: Gains from Trade within a Price System Gains from trade – The sum of consumer surplus and producer surplus

Figure B-3 Consumer Surplus, Producer Surplus, and Gains from Trade

Appendix B: Price Controls and Gains from Trade How do price controls affect gains from trade? – Consumer surplus and producer surplus are both lower – Either a price ceiling or a price floor reduces gains from trade