Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Wednesday, September 12 Lecture: Market Applications

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1 Amherst College epartment of Economics Economics 111 ection 3 Fall 2012 Wednesday, eptember 12 Lecture: Market Applications Market emand and Market upply Curves Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were, given that everything else relevant to the demand for beer remains the same? Price of Beer ($/can) Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were, given that everything else relevant to the supply of beer remains the same? * uantity of Beer (cans) Equilibrium In equilibrium emand and supply are equal partners in determining the uantity emanded = uantity upplied equilibrium price and quantity. Why is the Equilibrium Price Important? Market Forces, the Equilibrium Price, and the Actual Price If Actual Price < Equilibrium Price If Actual Price > Equilibrium Price uantity emanded > uantity upplied uantity upplied > uantity emanded hortage exists urplus exists Actual Price rises Actual Price falls until the equilibrium is reached until the equilibrium is reached P surplus Market forces push the actual price toward its equilibrium level. Assuming that the actual price is free to move, the actual price will equal the equilibrium price in short order. shortage * hifts Versus Movements Along the emand and upply Curves hifts Movements Along Change in something OTHER Change in the price of beer ITELF THAN the price of beer ITELF The slopes of the demand and supply The demand curve for beer The supply curve of beer curves for beer capture the effect can HIFT ONLY if can HIFT ONLY if of a change in the BEER PRICE itself; something that affects something that affects a change in the price of beer leads demand OTHER THAN supply OTHER THAN to a MOVEMENT ALONG the the BEER PRICE changes. the BEER PRICE changes. demand and supply curves for beer.

2 2 traightforward Example: Electronic Pocket Calculators. While this example is dated, it is a good starting point since it is relatively easy to analyze. Our goal is to explain why the price and quantity of electronic pocket calculators changed as they did in the 1970 s: Calculators Production Cost ata Price uantity emiconductor isplay Assembly Year ($/calculator) (millions) chip ($/chip) ($/digit) time (min) Note that the price of calculators fell consistently while the quantity increased. Let us use the notions of demand and supply to understand why. First, plot the price-quantity combinations for each year. As a consequence of market forces, the price-quantity combination for each year represents the equilibrium for that year. Each point on the diagram to the right represents that year s equilibrium. Geometrically, each year s market demand and supply curve must intersect at that year s point. Now, let us focus on the demand curve. Recall that the market demand curve is a downward sloping curve. In view of where the points lie, the market demand curve could have remained stationary. The market demand curve remains stationary whenever all factors that affect demand, other than the price of the good itself, do not change. ince we have no information indicating that any other demand factors changed, we assume that no such changes occurred. The diagram to the right illustrates a stationary downward sloping demand curve that passes through all the points. P ($/calculator) (millions of calculators) P ($/calculator) (millions of calculators)

3 3 Next, what about the market supply curve? Recall that the market supply curve is a upward sloping curve. In view of where the points lie, the market supply curve had to shift to the right. How can we justify such a shift? Recall that we have some information relevant to the costs firms incur when they produce electronic calculators: emiconductor isplay Assembly Year chip ($/chip) ($/digit) time (min) The prices of semiconductor chips and the price of the digital displays used in the calculators fell dramatically; furthermore, less time was required to assemble the calculators. Recall that the market supply curve shifts only when some factor other than the price of the good itself changes that is relevant to the supply of the good. Clearly, production costs, something other than the price of pocket calculators themselves, have decreased. Pocket calculators have become a more profitable item for firms to produce. This is reflected by a rightward shift of the market supply curve. Now, let us put the demand and supply curves together. We have just completed a convincing explanation of why the price and quantity of calculators changed as they did form 1971 to P ($/calculator) (millions of calculators)

4 4 Project: Market for Personal Computers in the 1980's Revisited In 1977, the Apple II debuted on the personal computer market. Four years later, in 1981, IBM unveiled its PC. By today s standard, both computers were primitive. The IBM PC did not have a hard drive, only two 5-1/4 floppies with a capacity of 360 kilobytes each. Needless to say, the 1980 s saw tremendous changes in the personal computer market. The following table reports on some changes to the personal computer industry in the United tates from through 1988: Personal Computers Cost of 16 Bit New New Price uantity Processors Operating Word New Year ($ per PC) (millions) ($ per bit) ystems Processors preadsheets Wordtar Multiplan 1983 Windows Word Lotus Windows 1.0 WordPerfect Windows 2.0 Excel ata from Tables 1340 and 1342 of the tatistical Abstract of the United tates Focus on the price and quantity of personal computers. Between and : Price rose by uantity rose by four $200. million more than doubling. Between and : Price rose by uantity fell by $800. a half a million. Between and 1988: Price rose by uantity rose by $200. two and a half million. How can you explain the erratic behavior? As before, begin by plotting the price-quantity combinations for each year. As a consequence of market forces, the price-quantity combination for each year represents the equilibrium for that year. Each of the points on the diagram to the right represents the equilibrium for the indicated year. Geometrically, each year s market demand and supply curve must intersect at that year s point. Now, consider the market demand curve. No doubt, the demand curve shifted to the right during the 1980 s. The demand curve can shift only if some factor other than the price of the good itself that is relevant to demand changes. uring the 1980 s there were several other factors that caused the demand curve to shift to the right. For example, operating systems became more user friendly; furthermore, more and better software became available. In short, more and more people found personal computers useful causing the market demand curve to shift to the right. The diagram to the right illustrates the steady rightward shift of the market demand curve. 3,500 3,000 2,500 2,000 1,500 3,500 3,000 2,500 2,000 1,

5 5 Next, what about the supply curve? As with electronic calculators in the 1970 s, the price of processors will provide insights into PC production costs: 16 Bit Processor Year Cost ($ per bit) First, focus attention on and. Claim: the market supply curve shifted to the right. How can we justify this claim? The decline in the price of processors from $18 per bit to $12 per bit provides the rationale. ince processors became cheaper, PC production costs fell causing the supply curve for PC s to shift to the right Next, consider and. The price of processors went back up from $12 to $18 per bit. This caused the supply curve for PC s to shift back to the left. The supply curve for and the supply curve for were in about the same position What about to 1988? The price of processors fell from $18 to $9 per bit. This fifty percent reduction in price of processors, reduced PC production costs resulting in a rightward shift of the supply curve for PC s. Note that the supply curve for 1988 lies to the right of the supply curve for because processors were cheaper in 1988; the price of processors in 1988 were $9 per bit compared to $12 per bit in. Consequently, PC production costs were less in

6 6 Last, let us put demand and supply together. Now we can explain why the price and quantity of pocket calculators changed as they did What if the price is not free to move? Thus far, we have implicitly assumed that the price can move freely. When prices are free to move market forces promptly eliminate any P shortages or surpluses: If the actual price is less than the surplus equilibrium price, a shortage exists; when a shortage exists, the price rises. If the actual price is greater than the equilibrium price a surplus exists; when a surplus exists, the price falls. These market forces push the price toward its equilibrium level in short order. When prices are free to move we can confidently conclude that markets will be in equilibrium. The government sometimes limits the ability of prices to more freely, however, by imposing price ceilings or price floors. In these cases, the equilibrium may not be achieved and a shortage or surplus could persist. To understand the rationale behind and the ramifications of such policies, we shall consider two examples. Example of a persistent shortage - Rent Control in New York City Market for Apartment pace What are the appropriate units for the quantity here? Price ($/sq ft) The quantity should not simply be the number of apartments, but instead it should be square feet of apartment space. This reflects that fact that apartments can be subdivided. The price is therefore in terms of dollars per square foot of apartment space. The demand curve is downward sloping; as apartment space becomes more expensive, consumers demand less space. The supply curve may be steep, but it is not quite (sq ft) * vertical. As the price increases, we would expect the quantity of apartment space to increase. For example, if the price were high enough homeowners might place their unoccupied bedrooms on the market thereby increasing the quantity of apartment space supplied. In equilibrium, the quantity demanded equals the quantity supplied. is the equilibrium price and * the equilibrium quantity * shortage

7 7 Origin of Rent Control in New York City Price ($/sq ft) New York City originally adopted rent control as an * emergency measure during World War II so that transient wartime workers, who flocked to the city to take well-paying wartime jobs, could not outbid longtime city residents for apartments. After World War II ended, it was extended for a noble, wellmeaning reason: To help returning soldiers and their families by keeping rents low. The transient workers and returning soldiers shifted the demand for (sq ft) * apartment space to the right. Without rent control, rents would have increased dramatically. Consequently, New York City passed a law that more or less froze rents at their pre-war levels. In other words, landlords could not raise their rents. Roughly speaking, the price of apartment space could not rise above the old equilibrium price of. became the ceiling price, P C. ince the ceiling price was less than the new equilibrium price, a shortage of apartment space ensued. Without the law, market forces would had caused the price to rise to the new equilibrium, *, but the law made this illegal and the shortage persisted. Price ($/sq ft) * P C shortage Current Goal of Rent Control Legislation (sq ft) Obviously, rent control can no longer be justified as protecting longtime city residents from an influx of transient workers during World War II or returning World War II soldiers. Now, the justification is to make rental housing affordable for low-income households. In the absence of rent control, the price would rise to *, the new equilibrium. At the equilibrium price, *, all consumers who would choose to rent apartment space would be able to do so since the quantity demanded equals the quantity supplied. As a consequence of rent control, however, there is a shortage: at the rent control price, P C, the quantity of apartment space demanded exceeds the quantity of apartment space supplied. Not all people who would like to rent apartment space at the price ceiling, P C, can find an apartment to rent. For lack of a better term, let us call this group, frustrated tenants. Now, let us judge the effectiveness of rent control in achieving its objective by asking the following two questions: Who does rent control help? Tenants who are lucky enough to be renting an apartment at the rent control price. Who is not helped? Landlords; clearly, landlords receive less income from their rental properties than they would without rent control. The frustrated tenants, the tenants who have not been lucky enough to find an apartment at the rent control price; they do not even have the option of deciding if they would like to rent an apartment in New York City. The frustrated tenants are hurt. If all the tenants lucky enough to be renting an apartment at the rent control price were low income, then we could say that at least in part that the goal of rent control is being met.

8 8 Unfortunately, this is not the case. To uderstand why, consider the following question: What do Alistair Cooke, Mia Farrow, Cicely Tyson, former mayor avid inkens, and former mayor Ed Koch have in common? Answer: all of them either are renting or have rented rent-controlled apartments in New York City. Mia s overlooks Central Park. Ed s was in Greenwich Village. Price ($/sq ft) Long run impact of rent control Landlords realize that they could receive greater income if they could rent their buildings out as offices. Consequently, landlords try to convert their apartment space to office space. If they are unable to do this, some owners simply do maintain P C shortage their buildings properly. Over time these buildings become unfit for habitation. How does this affect the market for apartment space? The supply curve shifts to the left. At the fixed rent control price, the (sq ft) quantity supplied will decrease while the quantity demanded remains the same. This results in an even greater shortage; this means that fewer people will be lucky enough to be renting rent control apartments while there will be more frustrated tenants, those people who would like to rent an apartment but cannot find one.