Chapter 4. Introduction. Learning Objectives. Extensions of Demand and Supply Analysis

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1 Chapter 4 Extensions of Demand and Supply Analysis Introduction Water covers 71% of the Earth, but only 2.5% is fresh water. People in many locales complain of shortages of safe drinking water. In this chapter you will learn more about shortages. Copyright 2008 Pearson Addison Wesley. All rights reserved. 4-2 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

2 Learning Objectives (cont'd) Explain the effects of price ceilings Explain the effects of price floors Describe various types of governmentimposed quantity restrictions on markets Copyright 2008 Pearson Addison Wesley. All rights reserved. 4-4 Chapter Outline The Price System and Markets Changes in Demand and Supply The Rationing Function of Prices The Policy of Government-Imposed Price Controls Copyright 2008 Pearson Addison Wesley. All rights reserved. 4-5 Chapter Outline (cont'd) The Policy of Controlling Rents Price Floors in Agriculture Price Floors in the Labor Market Quantity Restrictions Copyright 2008 Pearson Addison Wesley. All rights reserved

3 Did You Know That... The inflation-adjusted value of the U.S. minimum wage peaked at about $8 in 1964? We can use supply and demand analysis to analyze effects of the minimum wage? The model of supply and demand can explain instances of a gap between quantity supplied and quantity demanded? Copyright 2008 Pearson Addison Wesley. All rights reserved. 4-7 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 Prices signal what is relatively scarce and relatively abundant. Prices provide information to individuals and businesses. Copyright 2008 Pearson Addison Wesley. All rights reserved. 4-8 The Price System and Markets (cont'd) Markets Emphasize voluntary exchange Determine the terms of exchange Facilitate exchange Copyright 2008 Pearson Addison Wesley. All rights reserved

4 The Price System and Markets (cont'd) 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 Copyright 2008 Pearson Addison Wesley. All rights reserved The Price System and Markets (cont'd) Transaction Costs The costs associated with exchange Examples Price shopping Determining quality Determining reliability Service availability Cost of contracting Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

5 Policy Example: Profiting by Lowering Transaction Costs of Junking Computers Transaction costs can be lowered by middlemen (intermediaries). Consumers and businesses can dispose of old computer equipment. Intermediaries can refurbish old computers. Useable parts and computer upgrades can be resold. Copyright 2008 Pearson Addison Wesley. All rights reserved Changes in Demand and Supply Changes in supply and demand create a disequilibrium. The market price and quantity adjust to a new equilibrium. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (a) Copyright 2008 Pearson Addison Wesley. All rights reserved

6 Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (b) Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (c) Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (d) Copyright 2008 Pearson Addison Wesley. All rights reserved

7 Changes in Demand and Supply (cont'd) Summary Increases in demand increase equilibrium price and quantity. Decreases in demand decrease equilibrium price and quantity. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Changes in Demand and Supply (cont'd) 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 curve shifts. Either equilibrium price or quantity will be indeterminate. Copyright 2008 Pearson Addison Wesley. All rights reserved

8 Changes in Demand and Supply (cont'd) 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Changes in Demand and Supply (cont'd) 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Example: Why Gasoline Prices Have Increased One factor an increase in demand, shown by a rightward shift in the demand curve Another factor a reduction in supply, shown by a leftward shift in the supply curve As a result, the market clearing price of gasoline increased. Copyright 2008 Pearson Addison Wesley. All rights reserved

9 Figure 4-2 The Effects of a Simultaneous Decrease in Gasoline Supply and Increase in Gasoline Demand Copyright 2008 Pearson Addison Wesley. All rights reserved Price Flexibility and Adjustment Speed Prices quite flexible in unfettered markets can be less flexible in other market scenarios. May experience indirect adjustments such as hidden payments, quality changes May not reach equilibrium right away Copyright 2008 Pearson Addison Wesley. All rights reserved Price Flexibility and Adjustment Speed (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. Copyright 2008 Pearson Addison Wesley. All rights reserved

10 The Rationing Function of Prices Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices. Copyright 2008 Pearson Addison Wesley. All rights reserved The Rationing Function of Prices (cont'd) Methods of non-price rationing Rationing by queues (waiting in line) Rationing by random assignment, and/or coupons Copyright 2008 Pearson Addison Wesley. All rights reserved The Rationing Function of Prices (cont'd) The essential role of rationing (with scarcity rationing must occur) We must choose the rationing mechanism: price or non-price. Price rationing leads to most efficient use of available resources; all gains from mutually beneficial trade are captured. Copyright 2008 Pearson Addison Wesley. All rights reserved

11 The Rationing Function of Prices (cont'd) Question If price rationing is the most efficient is it the best way to ration? Answer Economists cannot say which system is best. They can say rationing via the price system leads to the most efficient use of available resources. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved The Policy of Government-Imposed Price Controls (cont'd) Price ceiling and black markets Price ceilings may prevent the equilibrium price from being achieved if it is above the ceiling price. Copyright 2008 Pearson Addison Wesley. All rights reserved

12 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 4-3 Black Markets Copyright 2008 Pearson Addison Wesley. All rights reserved Example: Preventing Price Gouging Promotes Black Markets in Florida Florida s antigouging law penalizes a seller for selling an item for a high price during an emergency. After a hurricane, temporary shortages exist, causing prices to rise, but antigouging laws prevent price increases from occurring. When prices are fixed, producers have less incentive to deliver, and a parallel, or black, market develops. So who wins and who loses? Copyright 2008 Pearson Addison Wesley. All rights reserved

13 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

14 The Policy of Controlling Rents (cont'd) Attempts to evade rent controls Forcing tenants to leave Tenants subletting apartments Housing courts Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Price Floors in Agriculture Support Price The governmentally established price floor Associated with agricultural products Copyright 2008 Pearson Addison Wesley. All rights reserved

15 Figure 4-4 Agricultural Price Supports Copyright 2008 Pearson Addison Wesley. All rights reserved Price Floors in Agriculture (cont'd) Questions How could the government keep the price from falling? Who benefits from agricultural price supports? Copyright 2008 Pearson Addison Wesley. All rights reserved International Policy Example: The High Cost of European Sugar Subsidies Sugar is most efficiently extracted from sugar cane grown in warm, moist climates. Extracting sugar from beets is four times more costly. European taxpayers pay $1.5 billion per year to subsidize beet sugar production. Why do you suppose governments in developing countries complain? Copyright 2008 Pearson Addison Wesley. All rights reserved

16 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 4-5 The Effect of Minimum Wages Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

17 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Coping with a Growing Global Demand for Fresh Water Today, about 2.5 billion people have safe drinking water; nearly 4 billion do not, resulting in 2 million deaths annually. Price controls make a scarce resource, such as water, harder to obtain. What rationing method do you think can best ensure greater access to safe drinking water? Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 4-6 How to Generate a Water Shortage Copyright 2008 Pearson Addison Wesley. All rights reserved

18 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) How changes in demand and supply affect market price and equilibrium quantity When both demand and supply shift at the same time, the result is indeterminate. Copyright 2008 Pearson Addison Wesley. All rights reserved

19 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The effects 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

20 Summary Discussion of Learning Objectives (cont'd) Government-imposed restrictions on market quantities Bans on sale or ownership Licensing restrictions Import quotas Copyright 2008 Pearson Addison Wesley. All rights reserved End of Chapter 4 Extensions of Demand and Supply Analysis 20