4 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Demand and Supply Applications

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 24 The Price System: Rationing and Allocating Resources The market system, performs two important and closely related functions: 1. Resource allocation: the market system determines the allocation of resources among produces and the final mix of outputs.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 24 The Price System: Rationing and Allocating Resources The market system, performs two important and closely related functions: 2. Price rationing: the market system distributes goods and services on the basis of willingness and ability to pay.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 24 Price Rationing A decrease in supply creates a shortage at the original price. The lower supply is rationed to those who are willing and able to pay the higher price.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 24 Price Rationing There is some price that will clear any market. The price of a rare painting will eliminate excess demand until there is only one bidder willing to buy the single available painting.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 24 Constraints on the Market A price ceiling is a maximum price that sellers may charge for a good, usually set by government. In 1974, the government set a price ceiling to distribute the available supply of gasoline. At an imposed price of 57 cents per gallon, the result was excess demand.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 24 Alternative Rationing Mechanisms Queuing is a nonprice rationing system that uses waiting in line as a means of distributing goods and services.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 24 Alternative Rationing Mechanisms Favored customers are those who receive special treatment from dealers during situations when there is excess demand. Ration coupons are tickets or coupons that entitle individuals to purchase a certain amount of a given product per month.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 24 Alternative Rationing Mechanisms Attempts to restrict prices often result in the evolution of a black market. A black market is a market in which illegal trading takes place at market-determined prices.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 24 Alternative Rationing Mechanisms The problem with rationing systems is that excess demand is created but not eliminated. No matter how good the intentions of private organizations and governments, it is very difficult to prevent the price system from operating and to stop the willingness to pay from asserting itself.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 24 Prices and the Allocation of Resources Price changes resulting from shifts of demand cause profits to rise or fall. Profits attract capital; losses lead to disinvestment. Higher wages attract labor and encourage workers to acquire skills. At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 24 Price Floors A price floor is a minimum price below which exchange is not permitted. The most common example of a price floor is the minimum wage, which is a floor set under the price of labor. The result of setting a price floor will be excess supply, or higher quantity supplied than quantity demanded.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 24 Supply and Demand Analysis: An Oil Import Fee At a world price of $18, imports are 5.9 million barrels per day. The tax on imports causes an increase in domestic production, and quantity imported falls.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 24 Supply and Demand and Market Efficiency Supply and demand curves can be used to illustrate the idea of market efficiency, an important aspect of “normative economics.”

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 24 Consumer Surplus Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 24 Consumer Surplus Some consumers are willing to pay as much as $5 each for hamburgers. Since the price is only $2.50, they receive a consumer surplus of $2.50.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 24 Consumer Surplus Others are willing to pay something less than $5.00 but more than $2.50. Consumer surplus is the area below the demand curve and above the price level.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 24 Producer Surplus Producer surplus is the difference between the maximum amount a producer is willing to accept to supply a good and its current market price.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 24 Producer Surplus Some producers are willing to accept as little as 75 cents each for hamburgers. Since the price is $2.50, they receive a producer surplus of $1.75 per hamburger.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 24 Producer Surplus Others producers are willing to receive something less than $5.00 but higher than 75 cents. Producer surplus is the area above the supply curve and below the price level.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 24 Markets Maximize the Sum of Producer and Consumer Surplus Total producer and consumer surplus is highest where supply and demand curves intersect at equilibrium. Consumers receive benefits in excess of what they pay and producers receive compensation in excess of costs.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 24 Markets Maximize the Sum of Producer and Consumer Surplus If the market produces too little, say 4 million instead of 7 million hamburgers per month, total producer and consumer surplus is reduced. This reduction (triangle ABC) is called a deadweight loss.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 24 Potential Causes of Deadweight Loss From Under- and Overproduction Deadweight losses can occur from under- and overproduction. If the market produces 10 million instead of 7 million hamburgers per month, the cost of production rises above the willingness of consumers to pay, resulting in a deadweight loss.

C H A P T E R 4:Demand and Supply Applications © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 24 Review Terms and Concepts black market black market consumer surplus consumer surplus deadweight loss deadweight loss favored customers favored customers minimum wage minimum wage price ceiling price ceiling price floor price floor price rationing price rationing producer surplus producer surplus queuing ration coupons ration coupons