1. Extensions of Demand and Supply Analysis
Chapter 4
Extensions of Demand and Supply Analysis

2. Introduction
The global demand for water doubles every 20 years, so there will likely be pressure of its equilibrium price to rise.
In fact, inflation-adjusted prices of water have
barely increased because government controls keep water prices lower than they otherwise would be.
In this chapter, you will learn why such regulations have contributed to shortages of water in some nations.

3. 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

4. Learning Objectives (cont'd)
Explain the effects of price ceilings
Explain the effects of price floors
Describe various types of government- imposed quantity restrictions on markets

5. Chapter Outline The Price System and Markets
Changes in Demand and Supply
The Rationing Function of Prices
The Policy of Government-Imposed Price Controls
The Policy of Controlling Rents
Price Floors in Agriculture
Price Floors in the Labor Market
Quantity Restrictions

6. Did You Know That ...
Nearly 90,000 U.S. residents seek kidney transplants each year, but only about 20,000 kidney transplants occur?
Despite the high demand for kidney transplants, selling a kidney is illegal, so the maximum price of a kidney—called a price ceiling—is $0.

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
The prices are signals as to what is relatively scarce and relatively abundant
Prices provide information to individuals and businesses

8. The Price System and Markets (cont'd)
Voluntary Exchange
An act of trading between individuals in the price system
Makes both parties to the trade subjectively better off

9. The Price System and Markets (cont'd)
Transaction Costs
All of the costs associated with exchange
Including:
The informational costs of finding out the price and quality, service record, and durability of a product
The cost of contracting and enforcing that contract

10. 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

11. International Example: Assisting Scattered Emigrants Who Want to Help Kin at Home
About 25 million people have left India to work in other nations around the globe.
To assist Indian emigrants who desire to help family members back home, a company called Sahara Care House offers a suite of 60 products and services, including delivering flowers and dropping off good and clothing to emigrants’ families in India.
By performing tasks for family members on behalf of Indian expatriates, this company acts as a middleman.

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

13. Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (a)

14. Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (b)

15. Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (c)

16. Figure 4-1 Shifts in Demand and in Supply: Determinate Results, Panel (d)

17. Changes in Demand and Supply (cont'd)
Summary
Increases in demand increase equilibrium price and quantity
Decreases in demand decrease equilibrium price and quantity

18. 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

19. Changes in Demand and Supply (cont'd)
When both demand and supply change
If both the supply and demand curves shift simultaneously, the outcome is indeterminate for either equilibrium price or equilibrium quantity
The resulting effect depends upon how much each curve shifts

20. Changes in Demand and Supply (cont'd)
When both demand & supply increase
Change in equilibrium price is indeterminate
Equilibrium quantity increases unambiguously
When both demand & supply decrease
Equilibrium quantity decreases unambiguously

21. Changes in Demand and Supply (cont'd)
When supply decreases & demand increases
Equilibrium price increases
The change in the equilibrium quantity is uncertain without more information
When supply increases & demand decreases
Equilibrium price decreases

22. International Example: What Accounts for Rising Pork Prices in China?
Since the early 2000s, Chinese pork prices have surged. Why?
Pork is a normal good, so that rising Chinese incomes had raised the demand for pork.
Meanwhile, rising prices of feed for hogs and higher prices of land to raise hogs contributed to a reduction in the supply of pork.

23. Figure 4-2 The Effects of a Simultaneous Decrease in Pork Supply and Increase in Pork Demand

24. Changes in Demand and Supply (cont'd)
Price Flexibility
Prices quite flexible in some markets can be less flexible in other market scenarios.
May take the form of subtle adjustments such as hidden payments, quality changes
May not reach equilibrium right away

25. Changes in Demand and Supply (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

26. The Rationing Function of Prices
Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices

27. The Rationing Function of Prices (cont'd)
Methods of non-price rationing
Rationing by queues (waiting in line)
Rationing by random assignment or coupons

28. The Rationing Function of Prices (cont'd)
The essential role of rationing
Implied by the presence of scarcity
Price vs. non-price rationing mechanism:
Price rationing leads to the most efficient use of available resources
All gains from mutually beneficial trade are captured in a freely rationing price system

29. The Policy of Government-Imposed Price Controls
Government-mandated minimum or maximum prices
Price Ceiling
A legal maximum price
Price Floor
A legal minimum price

30. The Policy of Government-Imposed Price Controls (cont'd)
Price ceiling and black markets
A price ceiling may prevent the equilibrium price from being achieved if it is above the ceiling price
A price ceiling that is set below the market clearing price creates a shortage

31. 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

32. Figure 4-3 Black Markets for Portable Electric Generators

33. International Example: The Rice Must Be White!
In Venezuela, there is a legal ceiling price of white rice of about 1 cent per kilogram, which is about half of the price at which most Venezuelan rice sellers are willing to offer white rice.
What would you suppose that rice sellers in Venezuela could do to avoid the effect of the government’s price controls on white rice?

34. The Policy of Controlling Rents
The functions of rental prices
Promote the efficient maintenance and construction of housing
Allocate existing housing
Ration the use of housing

35. 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

36. 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”

37. The Policy of Controlling Rents (cont'd)
Attempts to evade rent controls
Forcing tenants to leave
Tenants subletting apartments
Housing courts

38. 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

39. Why Not … require owners of residential buildings to provide low-cost housing so that all U.S. residents can “afford” roofs over their heads?
The result of a legal price ceiling for residential housing set lower than the market clearing price would be a shortage of residential housing.
More people would want to purchase or rent housing at the ceiling price than owners of residential housing would desire to supply. 39

40. Price Floors in Agriculture
Support Price
The government chooses a price floor for a product and then acts to ensure that the price of the product never falls below the support level
Associated with many agricultural products
A price floor that is set above the market clearing price results in a surplus.

41. Figure 4-4 Agricultural Price Supports

42. Price Floors in Agriculture (cont'd)
Questions
How could the government keep the price from falling?
Who benefits from agricultural price supports?

43. 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

44. Figure 4-5 The Effect of Minimum Wages

45. Policy Example: Bad Timing for Increasing the Minimum Wage
In 2007, Congress decided to increase the hourly minimum wage in 3 steps from $5.15 to $7.25 in
By 2008, the unemployment rate was 5.8 percent. When the final $0.70-per hour increase was added in 2009, the U.S. economy was experiencing an economic downturn with a 9.4 unemployment rate.
If the imposition of a minimum wage currently generates unemployment, what happens to the unemployment rate when the demand for labor declines?

46. 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

47. 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

48. You Are There: “Cash for Clunkers” Subsidies and the Market for “Liquid Glass”
“Liquid glass” is a sodium-silicate chemical that auto mechanics use for stopping leaks in engine gaskets.
In 2009, that chemical rose from less than $2.50 per quart to nearly $3.50 per quart.
What effect did the federal government’s “Cash for Clunkers” program, which offered subsidies for people to trade in energy-inefficient vehicles, have on the demand and the market clearing price of liquid glass? 48

49. Issues & Applications: Contemplating Two Ways to Tackle Water Shortages
What can be done to help the roughly 20 percent of the world’s human population who are unable to obtain as much usable freshwater as they desire?
Ending government-mandated price ceilings on of usable freshwater is one way to eliminate water shortages.
Another way to cut shortages is to remove salt from seawater.

50. Figure 4-6 Two Methods of Eliminating a Water Shortage, panel (a)

51. Figure 4-6 Two Methods of Eliminating a Water Shortage, panel (b)51

52. 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
Prices are communicated in markets that tend to minimize transactions costs

53. 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

54. Summary Discussion of Learning Objectives (cont'd)
How changes in demand and supply affect equilibrium price and equilibrium quantity
When both demand and supply shift at the same time, the outcome is indeterminate for either equilibrium price or equilibrium quantity

55. 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

56. Summary Discussion of Learning Objectives (cont'd)
The effects of price ceilings
A price ceiling set below the market clearing price results in a shortage
The resulting shortage can lead to non-price rationing devices and black markets

57. Summary Discussion of Learning Objectives (cont'd)
The effects of price floors
If the price floor is set above the market clearing price, a surplus results
A price floor can take the form of a government-imposed price support or minimum wage

58. Summary Discussion of Learning Objectives (cont'd)
Government-imposed restrictions on market quantities
Bans on sale or ownership
Licensing restrictions
Import quotas

59. Appendix B: Consumer Surplus
The difference between the total amount that consumers would have been willing to pay for an item and the total amount that they actually pay 59

60. Figure B-1 Consumer Surplus60

61. Appendix B: Producer Surplus
The difference between the total amount that producers actually receive for an item and the total amount that they would have been willing to accept for supplying that item 61

62. Figure B-2 Producer Surplus62

63. Appendix B: Gains from Trade within a Price System
The sum of consumer surplus and producer surplus 63

64. Figure B-3 Consumer Surplus, Producer Surplus, and Gains from Trade64

65. Appendix B: Price Controls and Gains from Trade
How do price controls affect gains from trade?
Consumer surplus and producer surplus are both lower
Either a price ceiling or a price floor reduces gains from trade 65