Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Demand and Supply: An Elaboration CHAPTER THREE

© 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: Explain the effects on equilibrium price and quantity traded of simultaneous changes in supply and demand. Explain why markets don’t always work well. Understand why price ceilings cause shortages. Understand that price floors cause surpluses. Ask some interesting “what if” questions concerning the shape of demand and supply curves.

© 2004 McGraw–Hill Ryerson Limited Simultaneous Changes in Demand and Supply Q1Q1 Q2Q2 D1D1 D2D2 S2S2 S1S1 Wage Rate Q W1W1 A simultaneous increase in demand and supply will lead to an increase in Q from Q1 to Q2 It is uncertain what will happen to wages. A simultaneous increase in demand and supply will lead to an increase in Q from Q1 to Q2 It is uncertain what will happen to wages. Figure 3.2

© 2004 McGraw–Hill Ryerson Limited Determinants of Demand and Supply Determinants of demand –Consumer preferences –Consumer incomes –Prices of related products –Expectations of future prices, incomes or availability –Population size, or income and age distribution Determinants of supply –Prices of productive resources –Business taxes –Technology –Prices of substitutes in production –Future expectations of suppliers –Number of suppliers

© 2004 McGraw–Hill Ryerson Limited Changes in Demand and Supply (I) A simultaneous increase in demand and supply causes: –An increase in equilibrium quantity –An indeterminate change in price A simultaneous decrease in demand and supply causes: –A decrease in equilibrium quantity –An indeterminate change in price

© 2004 McGraw–Hill Ryerson Limited Changes in Demand and Supply (II) An increase in demand and a decrease in supply causes: –An increase in equilibrium price –An indeterminate change in equilibrium quantity A decrease in demand and an increase in supply causes: –A decrease in equilibrium price –An indeterminate change in equilibrium quantity

© 2004 McGraw–Hill Ryerson Limited How Well Do Markets Work? Markets do not always adjust as quickly as we would like and this could be a problem Markets do not always produce equitable results –Resources and products are allocated according to demand and supply –The market does not allocate on the basis of who should or should not get things

© 2004 McGraw–Hill Ryerson Limited Price Controls They are government regulations to set either a maximum or minimum price for a product Price ceiling –A government regulation stipulating the maximum price that can be charged for a product Rent control –A government regulation making it illegal to rent accommodation above a stipulated level Price floor –A government regulation stipulating the minimum price that can be charged for a product

© 2004 McGraw–Hill Ryerson Limited Shortage equals 400 The Effects of a Price Ceiling on Butter S D Price ceiling Price Quantity of butter 3 7 Illegal market price above equilibrium A price ceiling causes a shortage. $7 is the maximum (illegal) market price at which 800 units could be sold A price ceiling causes a shortage. $7 is the maximum (illegal) market price at which 800 units could be sold Figure 3.7

© 2004 McGraw–Hill Ryerson Limited How to Allocate a Good in Short Supply? The market First come, first serve Producer preferences –An allocation system in which sellers are allowed to determine the method of allocation on the basis of their own preferences Rationing –A method of allocating products that are in short supply by the use of ration coupons issued by the government, guaranteeing a certain quantity per family

© 2004 McGraw–Hill Ryerson Limited The Effect of a Price Floor A price floor of $12 creates a surplus of 10 A price floor of $12 creates a surplus of 10 Surplus = Price Quantity D S Price floor Figure 3.8

© 2004 McGraw–Hill Ryerson Limited How to Deal With a Surplus? Store it Convert it Dump it –The sale of a product abroad for a lower price than is being charged in the domestic market or for a price below the cost of production Destroy it Stop producing it –Subsidy A payment made by the government to a firm (or others) which may be a lump sum grant or depend on the amount produced

© 2004 McGraw–Hill Ryerson Limited The Minimum Wage Surplus = 20 Minimum wage D S Number of workers Wages It is the lowest rate of pay per hour for workers, as set by government A minimum wage can create unemployment It is the lowest rate of pay per hour for workers, as set by government A minimum wage can create unemployment Figure 3.9

© 2004 McGraw–Hill Ryerson Limited Do All Demand Curves Slope Downward (I)? Price changes have no effect on the quantity demanded. Whatever the price happens to be, quantity remains at Q1 Price changes have no effect on the quantity demanded. Whatever the price happens to be, quantity remains at Q1 Price Quantity D Q1 P1P1 P2P2 Figure 3.10

© 2004 McGraw–Hill Ryerson Limited Do All Demand Curves Slope Downward (II)? D Q1Q1 Q2Q2 P1P1 P2P2 A higher price induces a higher quantity demanded. This is sometimes the case with jewellery, furs and perfumes. A higher price means that only an exclusive few can afford to buy A higher price induces a higher quantity demanded. This is sometimes the case with jewellery, furs and perfumes. A higher price means that only an exclusive few can afford to buy Figure 3.11

© 2004 McGraw–Hill Ryerson Limited A Free Product Price When supply is unlimited, price is zero. Demand plays no part in determining price When supply is unlimited, price is zero. Demand plays no part in determining price Q1 D Quantity S Zero price as a result of unlimited supply Figure 3.12

© 2004 McGraw–Hill Ryerson Limited The Demand for Water Price Q1 D Quantity S1S1 Figure 3.13 S2S2 S 1A S 2A

© 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember the effects on equilibrium price and quantity traded of simultaneous changes in supply and demand. why markets don’t always work well. why price ceilings cause shortages. that price floors cause surpluses. that there are some interesting “what if” questions concerning the shape of demand and supply curves