Economics Today Chapter 4 Extensions of Demand and Supply Analysis Roger LeRoy Miller Economics Today Chapter 4 Extensions of Demand and Supply Analysis

Introduction Young athletes and computer science students are leaving college before graduation to take very high-paying jobs. Are they grabbing near-term gains at the expense of lower future earnings?

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

Learning Objectives 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 Exchange and Markets Changes in Demand and Supply Price Flexibility and Adjustment Speed The Rationing Function of Prices

Chapter Outline 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... According to the U.S. Customs Service, the second most serious smuggling problem along the Mexican border involves the refrigerant freon? When an older U.S. air conditioner needs fixing, it is often cheaper to pay a relatively high price for illegally smuggled freon than to modify the unit?

The Price System Price System (market system) An economic system that allocates resources based on relative prices determined by supply and demand Prices signal what is relatively scarce and relatively abundant

Exchange and Markets Markets Emphasize voluntary exchange Determine the terms of exchange Facilitate exchange

Exchange and Markets Voluntary Exchange Terms of Exchange Acts of trading between individuals that make both parties to the trade subjectively better off Terms of Exchange The prices we pay for the desired items

Exchange and Markets Transaction Cost The costs associated with exchange Examples Price shopping Determining quality Determining reliability Service availability Cost of contracting

Exchange and Markets The role of middlemen Middlemen (intermediaries) or brokers reduce transaction cost by providing information to buyers and sellers. Examples Real estate brokers Stock brokers Consignment shops Car dealerships

Exchange and Markets Observation Question Middle men flourish on the Internet Question Since anyone connected to the Internet can find the same information as an Internet middleman, or a shopbot, why would someone pay for the services of an Internet middleman?

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

The Upside of the Yo-Yo Cycle Observations Yo-yo’s are very popular again. Yo-yo manufacturers cannot keep up with the demand at current prices. There is a shortage of yo-yo’s. Question What is likely to happen to yo-yo prices?

Responses to a Shift in Yo-Yo Demand Figure 4-2

Shifts in Demand and Supply: Determinate Results Increase Demand with Supply Constant S D1 P1 Q1 E1

Shifts in Demand and Supply: Determinate Results Increase Demand with Supply Constant D2 Q3 S E1 At price P1 quantity demanded exceeds quantity supplied— a shortage exists P1 D1 Q1

Shifts in Demand and Supply: Determinate Results Increase Demand with Supply Constant S Q2 E2 Equilibrium price and quantity increase to P2 and Q2 P2 E1 P1 D1 D2 Q1

Shifts in Demand and Supply: Determinate Results Decrease Demand with Supply Constant D1 S E1 Q1 P1 D2 At price P1 quantity supplied exceeds quantity demanded— a surplus exists. Q2

Shifts in Demand and Supply: Determinate Results Decrease Demand with Supply Constant S E1 Equilibrium price and quantity decrease to P3 and Q3 P1 P3 Q3 E3 D1 D2 Q1

Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant S1 D P1 Q1 E1

Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant At price P1 quantity supplied exceeds quantity demanded— a surplus exists S1 S2 E1 P1 D Q1 Q3

Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant S1 Equilibrium price decreases and quantity increases to P2 and Q2 S2 E1 P1 P2 Q2 E2 D Q1

Shifts in Demand and Supply: Determinate Results Decrease Supply with Demand Constant Q2 S3 At price P1 quantity demanded exceeds quantity supplied— a shortage exists S1 D E1 Q1 P1

Shifts in Demand and Supply: Determinate Results Decrease Supply with Demand Constant S3 Equilibrium price decreases and quantity increases to P3 and Q3 Q3 E3 S1 P3 E1 P1 D Q1

Changes in Demand and Supply Summary Increases in demand increase equilibrium price and quantity. Decreases in demand decrease equilibrium price and quantity.

Changes in Demand and Supply 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 When both demand and supply shift Simultaneous changes in demand and supply put conflicting pressure on price or quantity The resulting effect depends upon how much each shift Either equilibrium price or quantity will be indeterminate

Shifts in Demand and Supply: Shortage Increase Demand > Increase Supply D2 S1 S2 D1 P1 Q1 E1

Shifts in Demand and Supply: Shortage Increase Demand > Increase Supply S1 S2 At price P1 quantity demanded exceeds quantity supplied— a shortage exists E1 P1 D1 D2 Q1 Qs Qd

Shifts in Demand and Supply: Shortage Increase Demand > Increase Supply S1 S2 Equilibrium price increases and quantity decreases to P2 and Q2 P2 E1 Q2 E2 P1 D1 D2 Q1

Shifts in Demand and Supply: Shortage Decrease Demand < Decrease Supply S2 S1 D1 D2 Qd Qs At price P1 quantity demanded exceeds quantity supplied— a shortage exists P1 Q1 E1

Shifts in Demand and Supply: Shortage Decrease Demand < Decrease Supply S2 S1 Equilibrium price increases and quantity decreases to P2 and Q2 P2 Q2 E2 E1 P1 D2 D1 Q1

Shifts in Demand and Supply: Shortage Increase Demand > Decrease Supply S2 S1 D2 D1 P1 Q1 E1

Shifts in Demand and Supply: Shortage Increase in Demand > Decrease in Supply S2 S1 At price P1 quantity demanded exceeds quantity supplied— a shortage exists E1 P1 D1 D2 Qs Q1 Qd

Shifts in Demand and Supply: Shortage Increase Demand > Decrease in Supply S2 S1 Q2 E2 P2 Equilibrium price increases and quantity decreases to P2 and Q2 E1 P1 D1 D2 Q1

Shifts in Demand and Supply: Shortage Increase Demand < Decrease in Supply S2 S1 D1 D2 P1 Q1 E1

Shifts in Demand and Supply: Shortage Increase Demand < Decrease in Supply S2 S1 At price P1 quantity demanded exceeds quantity supplied— a shortage exists E1 P1 D1 D2 Qs Q1 Qd

Shifts in Demand and Supply: Shortage Increase Demand < Decrease in Supply S2 S1 Q2 E2 P2 Equilibrium price increases and quantity decreases to P2 and Q2 E1 P1 D1 D2 Q1

Shifts in Demand and Supply: Surplus Increase Supply > Increase in Demand S1 S2 D1 D2 P1 Q1 E1

Shifts in Demand and Supply: Surplus Increase Supply > Increase in Demand S1 S2 E1 P1 At price P1 quantity supplied exceeds quantity demanded— a surplus exists D1 D2 Q1 Qd Qs

Shifts in Demand and Supply: Surplus Increase Supply > Increase in Demand S1 S2 E1 P1 Q2 E2 Equilibrium price decreases and quantity increases to P2 and Q2 P2 D1 D2 Q1

Shifts in Demand and Supply: Surplus Decrease Demand > Decrease in Supply S2 S1 D1 D2 Q1 E1 P1

Shifts in Demand and Supply: Surplus Decrease Demand > Decrease in Supply S2 S1 At price P1 quantity supplied exceeds quantity demanded— a surplus exists E1 P1 D1 D2 Qd Qs Q1

Shifts in Demand and Supply: Surplus Decrease Demand > Decrease in Supply S2 S1 Equilibrium price decreases and quantity decreases to P2 and Q2 E1 P1 E2 Qd P2 D1 D2 Q1

Shifts in Demand and Supply: Surplus Increase Supply > Decrease in Demand S1 D1 S2 D2 Q1 E1 P1

Shifts in Demand and Supply: Surplus Increase Supply > Decrease in Demand S1 S2 E1 P1 At price P1 quantity supplied exceeds quantity demanded— a surplus exists D1 D2 Qd Q1 Qs

Shifts in Demand and Supply: Surplus Increase Supply > Decrease in Demand S1 S2 E1 P1 P2 Equilibrium price decreases and quantity decreases to P2 and Q2 Q2 E2 D1 D2 Q1

Shifts in Demand and Supply: Surplus Increase Supply < Decrease in Demand D1 S1 S2 D2 Q1 E1 P1

Shifts in Demand and Supply: Surplus Increase Supply < Decrease in Demand S1 S2 E1 At price P1 quantity supplied exceeds quantity demanded— a surplus exists P1 D2 D1 Qd Q1 Qs

Shifts in Demand and Supply: Surplus Increase Supply < Decrease in Demand S1 S2 E1 P1 Equilibrium price decreases and quantity decreases to P2 and Q2 P2 Q2 E2 D2 D1 Q1

Changes in Demand and Supply When both demand and supply increase Change in price is indeterminate Quantity will increase When both demand and supply decrease Quantity will decrease

Changes in Demand and Supply When supply decreases and demand increases Price will increase Change in quantity is indeterminate When supply increases and demand decreases Price will decrease

Price Flexibility and Adjustment Speed Flexibility and indirect adjustment Quality Service Rebates

Price Flexibility and Adjustment Speed Market characteristics influence adjustment speed Markets may overshoot in the adjustment process

The Rationing Function of Prices When surpluses and shortages exist price adjusts to clear the market. This adjustment is the rationing function of price.

The Rationing Function of Prices When prices cannot adjust non-price rationing occurs Rationing by queues Rationing by lotteries Rationing by coupons

The Rationing Function of Prices The essential role of rationing With scarcity rationing must occur We must choose the rationing mechanism: price or non-price Price rationing is the most efficient Further trades could not occur without making somebody worse-off

The Rationing Function of Prices Question If price rationing is the most efficient is it the best way to ration?

The Policy of Government-Imposed 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 Price ceiling and black markets Price ceilings may prevent the equilibrium price from being achieved if it is above the ceiling price.

The Policy of Government-Imposed Price Controls 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

Black Markets Figure 4-3

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

The Policy of Controlling Rents 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 Effects on the existing supply of housing Property owners cannot recover costs

The Policy of Controlling Rents Rationing the current use of housing Reduces mobility New York’s “housing gridlock”

The Policy of Controlling Rents Attempts at evading rent controls Forcing tenants to leave Tenants subletting apartments Housing courts

The Policy of Controlling Rents Who gains and who loses from rent controls? Losers Property owners Low-income individuals Benefits Upper-income professionals

Price Floors in Agriculture Support Price the governmentally established minimum price farmers are to receive for a particular agricultural product.

Agricultural Price Supports Figure 4-4

Price Floors in Agriculture Questions How could the government keep the price from falling? Who benefits from agricultural price supports?

Price Floors in the Labor Market Minimum Wage Lowest hourly wage rate that firms may legally pay their workers

The Effect of Minimum Wages Figure 4-5

Quantity Restrictions Prohibitions on the ownership or trading of a good Human organs Drugs Hospital beds

Quantity Restrictions Import Quota Supply restriction that prohibits the importation of more than a specified quantity of a particular good in a one-year period

Quantity Restrictions Policy example Should the legal quantity of cigarettes supplied be set at zero? 1603—Japan prohibited the “evil weed” 17th century—Bans on tobacco existed in Bavaria, Saxony, Zurich, Turkey, and Russia Why not ban tobacco in the United States?

Issues and Applications: Computer Science Students, Like Everyone Else, Respond to Incentives Despite increasing enrollments, fewer computer science students are finishing their degrees. Rising Salaries for IT specialists attract students before they finish their degrees. Question What is likely to happen to wages for IT specialists over time?

The Market for Computer Science Specialists Figure 4-6, Panel (a)

The Market for Computer Science Specialists Figure 4-6, Panel (b)

Web Links The following Web link appears in the margin of this chapter in the textbook: http://www.epfnet.org

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. The terms of exchange—prices—are communicated in markets that tend to minimize transactions costs.

Summary Discussion of Learning Objectives 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 How changes in demand and supply affect market price and equilibrium quantity When both demand and supply shift at the same time, indeterminate results occur.

Summary Discussion of Learning Objectives The rationing function of prices In a market system, prices ration scarce goods and services. The effect of price ceilings A price ceiling set below the market (equilibrium) price results in a shortage. The resulting shortage can lead to non-price rationing devices and black markets.

Summary Discussion of Learning Objectives The effects of price floors If the price floor is set above the market price, a surplus results. A price floor can take the form of a government-imposed price support or minimum wage. Quantity restrictions can take the form of import quotas.

Summary Discussion of Learning Objectives Government-imposed restrictions on market quantities Bans on sale or ownership Licensing restrictions Import quotas

Shifts in Demand and in Supply: Determinate Results Figure 4-1

End of Chapter Chapter 4 Extensions of Demand and Supply Analysis