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Extensions of Demand and Supply Analysis

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.

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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

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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

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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?

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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 demandPrices signal what is relatively scarce and

relatively abundant.

Prices provide information to individuals and businesses.

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The Price System and Markets (cont'd)

• Markets

Emphasize voluntary exchange

Determine the terms of exchange

Facilitate exchange

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The Price System and Markets (cont'd)

• Voluntary Exchange Acts of trading between individuals that

make both parties to the trade better off

• Terms of Exchange The prices we pay for the desired items

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The Price System and Markets (cont'd)

• Transaction Costs

The costs associated with exchange

ExamplesPrice shoppingDetermining qualityDetermining reliabilityService availabilityCost of contracting

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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

ExamplesReal estate brokersStock brokersConsignment shopsCar dealerships

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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.

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Changes in Demand and Supply

• Changes in supply and demand can create a disequilibrium.

• The market price and quantity can/will adjust to a new equilibrium.

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

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

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

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

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Changes in Demand and Supply (cont'd)

• Summary

Increases in demand increase equilibrium price and quantity.

Decreases in demand decrease equilibrium price and quantity.

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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.

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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.

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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

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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

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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.

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Figure 4-2 The Effects of a Simultaneous Decrease in Gasoline Supply and Increase in Gasoline Demand

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The Rationing Function of Prices

• Synchronization of decisions of buyers and sellers that leads to equilibrium is called the rationing function of prices.

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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

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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.

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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.

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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

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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.

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The Policy of Controlling Rents

• Effects on the existing supply of housing and current use of housing

Property owners cannot recover costsMaintenance, repairs, capital improvements

Rations the current use of housingReduces mobility, e.g., New York’s

“housing gridlock”

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Price Floors in Agriculture

• Support Price

The governmentally established price floor

Associated with agricultural products

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Figure 4-4 Agricultural Price Supports

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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

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Figure 4-5 The Effect of Minimum Wages

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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

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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

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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

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Figure 4-6 How to Generate a Water Shortage

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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.

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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.

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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.

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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.

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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.

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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.

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Summary Discussion of Learning Objectives (cont'd)

• Government-imposed restrictions on market quantities

Bans on sale or ownership

Licensing restrictions

Import quotas