CHAPTER 5 Using Supply and Demand It is by invisible hands that we are bent and tortured worst. Nietzsche McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Supply and Demand If we are talking about a change in price and everything else remains constant, we are talking about a shift up/down the curve Anything other than price will shift S or D and we will have a new curve McGraw-Hill/Irwin Colander, Economics 2
What happens when S and D both Shift? When both supply and demand shift we can get a change in price but little change in quantity OR a change in quantity but little change in price McGraw-Hill/Irwin Colander, Economics 3
A Review of Changes in Supply and Demand No change in Supply Supply increases Supply decreases No change in Demand No Change Price falls, Quantity rises Price rises, Quantity falls Demand increases Price rises, Quantity rises Quantity rises, Price could rise or fall Price rises, Quantity could rise or fall Demand decreases Price falls, Quantity falls Price falls, Quantity could rise or fall Quantity falls, Price could rise or fall 5-4
Double Shifting Scenario: Consumers prefer to buy fuel efficient cars and technology to make more fuel efficient cars improves. Analyze the market for fuel efficient cars. What are the S+D shift factors? D=consumer tastes and preferences S=technology McGraw-Hill/Irwin Colander, Economics 5
Double Shifting Which way is the demand curve shifting? D is increasing Which way is the supply curve shifting? Supply is increasing Graph each shift independently to determine how P and Q are impacted McGraw-Hill/Irwin Colander, Economics 6
Double Shifting P Demand P Supply S 1 S 1 S 2 P 2 P 1 P 1 D 2 P 2 D 1 Q Q 1 Q 2 Q 1 Q 2 D 1 Q P Q P Q McGraw-Hill/Irwin Colander, Economics 7
Double Shifting What is the impact on P and Q for both of these shifts? Look at the arrows for P and Q that you graphed: Price is indeterminate and Q increases McGraw-Hill/Irwin Colander, Economics 8
Government Intervention in the Market The invisible hand is not the only factor in determining prices, social and political forces also determine price Other factors include: Price Excise taxes Third-party-payer markets Quantity restrictions 5-9
Price Ceiling When a government wants to hold prices down to favor buyers, it imposes a price ceiling A price ceiling is a government-imposed limit on how high a price can be charged Creates a shortage Generally affects the market when set below equilibrium price Leads to other methods of rationing goods 5-10
Drawing the Graph: Price Ceiling P S P C (price ceiling) Shortage D Q S Q D Q McGraw-Hill/Irwin Colander, Economics 11
Application: Rent Controls in Paris P(rent) Housing S 0 After WWII, rent controls (a form of price ceiling) were put in place $17 $2.50 Shortage D 0 The rent controls caused a housing shortage There would not be a shortage if rents had been allowed to increase to the equilibrium price of $17 Q S Q D Q(housing) 5-12
Price Floor When a government wants to prevent a price from falling below a certain level to favor suppliers, it imposes a price floor A price floor is a government-imposed limit on how low a price can be charged Creates excess supply Generally affects the market when set above equilibrium price 5-13
Drawing the Graph: Price Floor P Surplus S P F (price floor) D Q D Q S Q McGraw-Hill/Irwin Colander, Economics 14
Application: A Minimum Wage P(wage) Labor W min Excess supply = unemployment S 0 A minimum wage is a type of price floor, it is the lowest wage a firm can legally pay an employee W 0 Minimum wages cause unemployment D 0 Q D Q S Q(of workers) 5-15
Excise Taxes Government impacts markets through taxation An excise tax is a tax that is levied on a specific good A tariff is an excise tax on an imported good Taxes and tariffs increase equilibrium price and reduce equilibrium quantities 5-16
Application: The Effect of an Excise Tax P Luxury Boats S1 Government imposes a $10,000 luxury tax on the suppliers of boats S0 $70,000 $65,000 Tax = $10,000 The distance between the supply curves represents the amount of the tax ($10,000) $60,000 420 510 D0 Q The new equilibrium price of boats rises by less than the tax to $70,000 (More on this in CH 7) 5-17
Quantity Restrictions Government regulates markets with licenses, which limit entry into a market Many professions require licenses, such as doctors, financial planners, cosmetologists, electricians, or taxi cab drivers The results of limited number of licenses in a market are increases in wages and an increases in the price of obtaining the license 5-18
Drawing the Graph: Quantity Restrictions P Q R Q R shows us that only a certain quantity can be produced. In this instance, supply is limited to 250 units. Q R is the supply curve and will always be completely vertical. D 1 250 Q McGraw-Hill/Irwin Colander, Economics 19
Application: The Effect of a Quantity Restriction P(wage) NYC Taxi Drivers Q R Successful lobbying by taxi cab drivers in NYC resulted in quantity restrictions (medallions) $15 D 1 When the demand for taxi services increased, because the number of taxi licenses was limited, wages increased 12,000 D 0 Q(of drivers) 5-20
Application: The Effect of a Quantity Restriction P NYC Taxis Medallions $400,000 QR The demand for taxi medallions also increased because wages were increasing. But because the number of taxi licenses was limited, the price of a medallion also increased Initial Fee D1 12,000 D0 Q(of medallions) 5-21
Third-Party-Payer Markets In third-party-payer markets, the person who receives the good differs from the person paying for the good Under a third-party-payer system, the person who chooses how much to purchase doesn t pay the entire cost Equilibrium quantity and total spending can be much higher in third-party-payer markets Goods from a third-party-payer system will be rationed through social and political means 5-22
Third-Party-Payer Markets Think health care: You have insurance and don t pay the total cost of your medical needs You only pay the co-pay Ex. Medicaid In a third-party-payer system quantity demanded will be higher than it would normally be McGraw-Hill/Irwin Colander, Economics 23
Application: Third-Party-Payer Markets P Health Care With a copayment of $5, consumers demand18 units $45 $25 S0 Sellers require $45 per unit for that quantity Total expenditures for 18 units of health care are greater than when $5 10 18 D0 Q The consumer pays the entire cost 5-24