1. Lecture 4 Extensions of Demand and Supply Analysis

2. 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?

3. 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

4. Exchange and Markets Markets –Emphasize voluntary exchange –Determine the terms of exchange –Facilitate exchange

5. Exchange and Markets Voluntary 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

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

7. 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

8. Exchange and Markets Observation –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?

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

10. 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?

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

12. Shifts in Demand and Supply: Determinate Results Increase Demand with Supply Constant D1D1 S P1P1 Q1Q1 E1E1

13. At price P 1 quantity demanded exceeds quantity supplied— a shortage exists Shifts in Demand and Supply: Determinate Results Increase Demand with Supply Constant D1D1 S P1P1 Q1Q1 E1E1 D2D2 Q3Q3

14. Shifts in Demand and Supply: Determinate Results Increase Demand with Supply Constant P1P1 Q1Q1 S E1E1 D2D2 Equilibrium price and quantity increase to P 2 and Q 2 Q2Q2 E2E2 P2P2 D1D1

15. At price P 1 quantity supplied exceeds quantity demanded— a surplus exists. Q2Q2 D2D2 S Shifts in Demand and Supply: Determinate Results Decrease Demand with Supply Constant D1D1 E1E1 Q1Q1 P1P1

16. Shifts in Demand and Supply: Determinate Results Decrease Demand with Supply Constant P1P1 Q1Q1 S E1E1 D2D2 Equilibrium price and quantity decrease to P 3 and Q 3 D1D1 Q3Q3 E3E3 P3P3

17. S1S1 Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant D P1P1 Q1Q1 E1E1

18. At price P 1 quantity supplied exceeds quantity demanded— a surplus exists Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant P1P1 Q1Q1 E1E1 D Q3Q3 S2S2 S1S1

19. Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant P1P1 Q1Q1 E1E1 D Q2Q2 E2E2 P2P2 S2S2 S1S1 Equilibrium price decreases and quantity increases to P 2 and Q 2

20. At price P 1 quantity demanded exceeds quantity supplied— a shortage exists Shifts in Demand and Supply: Determinate Results Decrease Supply with Demand Constant D S1S1 E1E1 Q1Q1 P1P1 Q2Q2 S3S3

21. Shifts in Demand and Supply: Determinate Results Decrease Supply with Demand Constant P1P1 Q1Q1 E1E1 D S3S3 S1S1 Equilibrium price decreases and quantity increases to P 3 and Q 3 Q3Q3 E3E3 P3P3

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

23. 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.

24. 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

25. D1D1 Shifts in Demand and Supply: Shortage Increase Demand > Increase Supply S1S1 P1P1 Q1Q1 E1E1 D2D2 S2S2

26. Shifts in Demand and Supply: Shortage P1P1 Q1Q1 E1E1 S2S2 S1S1 D2D2 D1D1 At price P 1 quantity demanded exceeds quantity supplied— a shortage exists Increase Demand > Increase Supply QsQs QdQd

27. Shifts in Demand and Supply: Shortage Increase Demand > Increase Supply P1P1 Q1Q1 S2S2 S1S1 D2D2 Q2Q2 E2E2 P2P2 Equilibrium price increases and quantity decreases to P 2 and Q 2 E1E1 D1D1

28. Shifts in Demand and Supply: Shortage Decrease Demand < Decrease Supply D1D1 QdQd QsQs At price P 1 quantity demanded exceeds quantity supplied— a shortage exists S1S1 D2D2 P1P1 Q1Q1 E1E1 S2S2

29. Shifts in Demand and Supply: Shortage Decrease Demand < Decrease Supply P1P1 Q1Q1 S2S2 S1S1 D2D2 D1D1 E1E1 Q2Q2 E2E2 Equilibrium price increases and quantity decreases to P 2 and Q 2 P2P2

30. Shifts in Demand and Supply: Shortage Increase Demand > Decrease Supply S1S1 D2D2 D1D1 P1P1 Q1Q1 E1E1 S2S2

31. Shifts in Demand and Supply: Shortage Increase in Demand > Decrease in Supply P1P1 Q1Q1 S2S2 S1S1 D2D2 E1E1 D1D1 QdQd QsQs At price P 1 quantity demanded exceeds quantity supplied— a shortage exists

32. Shifts in Demand and Supply: Shortage Increase Demand > Decrease in Supply P1P1 Q1Q1 S2S2 S1S1 D2D2 E1E1 D1D1 Q2Q2 E2E2 Equilibrium price increases and quantity decreases to P 2 and Q 2 P2P2

33. Shifts in Demand and Supply: Shortage Increase Demand < Decrease in Supply S1S1 D1D1 D2D2 P1P1 Q1Q1 E1E1 S2S2

34. Shifts in Demand and Supply: Shortage Increase Demand < Decrease in Supply P1P1 Q1Q1 S2S2 S1S1 D2D2 E1E1 D1D1 QdQd QsQs At price P 1 quantity demanded exceeds quantity supplied— a shortage exists

35. Shifts in Demand and Supply: Shortage Increase Demand < Decrease in Supply P1P1 Q1Q1 S2S2 S1S1 D2D2 E1E1 D1D1 Equilibrium price increases and quantity decreases to P 2 and Q 2 Q2Q2 E2E2 P2P2

36. D1D1 Shifts in Demand and Supply: Surplus Increase Supply > Increase in Demand S2S2 S1S1 D2D2 P1P1 Q1Q1 E1E1

37. Shifts in Demand and Supply: Surplus Increase Supply > Increase in Demand P1P1 Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 QdQd QsQs At price P 1 quantity supplied exceeds quantity demanded— a surplus exists

38. Shifts in Demand and Supply: Surplus Increase Supply > Increase in Demand P1P1 Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 Q2Q2 E2E2 Equilibrium price decreases and quantity increases to P 2 and Q 2 P2P2

39. Shifts in Demand and Supply: Surplus Decrease Demand > Decrease in Supply S1S1 D1D1 D2D2 S2S2 Q1Q1 E1E1 P1P1

40. Shifts in Demand and Supply: Surplus Decrease Demand > Decrease in Supply Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 P1P1 QdQd QsQs At price P 1 quantity supplied exceeds quantity demanded— a surplus exists

41. Shifts in Demand and Supply: Surplus Decrease Demand > Decrease in Supply Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 P1P1 E2E2 QdQd P2P2 Equilibrium price decreases and quantity decreases to P 2 and Q 2

42. Shifts in Demand and Supply: Surplus Increase Supply > Decrease in Demand S1S1 D1D1 D2D2 S2S2 Q1Q1 E1E1 P1P1

43. Shifts in Demand and Supply: Surplus Increase Supply > Decrease in Demand Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 P1P1 QdQd QsQs At price P 1 quantity supplied exceeds quantity demanded— a surplus exists

44. Shifts in Demand and Supply: Surplus Increase Supply > Decrease in Demand Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 P1P1 Equilibrium price decreases and quantity decreases to P 2 and Q 2 Q2Q2 E2E2 P2P2

45. Shifts in Demand and Supply: Surplus Increase Supply < Decrease in Demand S1S1 D1D1 Q1Q1 E1E1 P1P1 D2D2 S2S2

46. Shifts in Demand and Supply: Surplus Increase Supply < Decrease in Demand Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 P1P1 QdQd QsQs At price P 1 quantity supplied exceeds quantity demanded— a surplus exists

47. Shifts in Demand and Supply: Surplus Increase Supply < Decrease in Demand Q1Q1 S1S1 S2S2 D2D2 E1E1 D1D1 P1P1 Equilibrium price decreases and quantity decreases to P 2 and Q 2 Q2Q2 E2E2 P2P2

48. 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 –Change in price is indeterminate –Quantity will decrease

49. 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 –Change in quantity is indeterminate

50. Price Flexibility and Adjustment Speed Flexibility and indirect adjustment –Quality –Service –Rebates

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

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

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

54. 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

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

56. 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

57. 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.

58. 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

59. Black Markets Figure 4-3

60. 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

61. 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

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

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

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

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

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

67. Agricultural Price Supports Figure 4-4

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

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

70. The Effect of Minimum Wages Figure 4-5

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

72. 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

73. 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?

74. 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? Issues and Applications: Computer Science Students, Like Everyone Else, Respond to Incentives

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

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

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

78. 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.

79. 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.

80. 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.

81. 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.

82. 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.

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

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

85. End of Chapter Chapter 4 Extensions of Demand and Supply Analysis