Supply and Demand

Supply and Demand is the essential issue of economics.

Economic agents: Households Economic agents: Business firms Markets for Outputs (products) Markets for Inputs (factors)

Market Equilibrium

Q*

S

Q

P

0

D

P*

Mathematical form of Mathematical form of The equilibrium stateThe equilibrium state

Equilibrium is the state where Equilibrium is the state where quantity demanded equals quantity quantity demanded equals quantity suppliedsupplied

QQdd = Q = Qss

Demand and supply can be Demand and supply can be represented by equationsrepresented by equations

ExampleExample

Suppose the TV market is described as Suppose the TV market is described as follows:follows:

The Demand FunctionThe Demand Function

QQdd = 95 - 50 P = 95 - 50 P The Supply FunctionThe Supply Function

QQss = - 10 + 100 P = - 10 + 100 P Find equilibrium price and quantityFind equilibrium price and quantity

Equilibrium Math FormEquilibrium Math Form

QQdd = Q = Qss

By substitution,By substitution,

95 - 50 P = - 10 + 100 P95 - 50 P = - 10 + 100 P

105 = 150 P105 = 150 P

P = 0.70 (Equilibrium price)P = 0.70 (Equilibrium price)

Q = 95 - 50 X 0.7 = 60 Q = 95 - 50 X 0.7 = 60

(Equilibrium quantity)(Equilibrium quantity)

Comparative static analysis in the Comparative static analysis in the equation form equation form

““Outside force” change the equation.Outside force” change the equation. Example, income changes causes the Example, income changes causes the

shift in the demand function toshift in the demand function to

QQdd = 120 - 50 P = 120 - 50 P Then we solve for the new Then we solve for the new

equilibrium price and equilibrium equilibrium price and equilibrium quantityquantity

Draw conclusionsDraw conclusions

CONTROLS ON PRICESCONTROLS ON PRICES

Are usually enacted when Are usually enacted when policymakers believe the market policymakers believe the market price is unfair to buyers or sellers. price is unfair to buyers or sellers.

Result in government-created price Result in government-created price ceilings and floors. ceilings and floors.

CONTROLS ON PRICESCONTROLS ON PRICES

Price CeilingPrice Ceiling – A legal A legal maximummaximum on the price at which on the price at which

a good can be sold. a good can be sold. Price FloorPrice Floor

– A legal A legal minimumminimum on the price at which a on the price at which a good can be sold.good can be sold.

How Price Ceilings Affect How Price Ceilings Affect Market OutcomesMarket Outcomes

If the price ceiling is set set below If the price ceiling is set set below the equilibrium price (called binding), the equilibrium price (called binding), leading to a shortage. leading to a shortage.

A Market with a Price Ceiling

Apartments available For rent

0

Rent ofApartment

Demand

Supply

800 PriceceilingShortage

7500

Quantitysupplied

12500

Quantitydemanded

Equilibriumprice

$2000

How Price Ceilings Affect How Price Ceilings Affect Market OutcomesMarket Outcomes

A (binding) price ceiling createsA (binding) price ceiling creates– Shortages because Shortages because QQDD > > QQSS..

Example: Gasoline shortage of the 1970sExample: Gasoline shortage of the 1970sExample: Usury law and interest rate controlExample: Usury law and interest rate controlShortage and repressed inflation in CPEsShortage and repressed inflation in CPEs

– Nonprice rationingNonprice rationingExamples: Long lines, discrimination by Examples: Long lines, discrimination by

sellerssellers

CASE STUDY: Lines at the Gas CASE STUDY: Lines at the Gas PumpPump

Economists blame government Economists blame government regulations that limited the regulations that limited the price oil companies could price oil companies could charge for gasoline.charge for gasoline.

In 1973, OPEC raised the price of crude In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the oil in world markets. Crude oil is the major input in gasoline, so the higher major input in gasoline, so the higher oil prices reduced the supply of oil prices reduced the supply of gasoline.gasoline.

What was responsible for the long gas What was responsible for the long gas lines?lines?

How Price Floors Affect Market How Price Floors Affect Market OutcomesOutcomes

When the government imposes a When the government imposes a price floor floor above the price floor floor above the equilibrium price, leading to a equilibrium price, leading to a surplus. surplus.

A Market with a Price FloorA Market with a Price Floor

Quantity of wheetThousands of bushels

0

Price ofWheet

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3

How Price Floors Affect Market How Price Floors Affect Market OutcomesOutcomes

A binding price floor causes . . .A binding price floor causes . . .– a surplus because a surplus because QQSS > > QQDD. .

– nonprice rationing is an alternative nonprice rationing is an alternative mechanism for rationing the good, using mechanism for rationing the good, using discrimination criteria.discrimination criteria.Examples: The minimum wage, agricultural Examples: The minimum wage, agricultural

price supports price supports Examples: Agricultural products Examples: Agricultural products

CASE STUDY: The Minimum CASE STUDY: The Minimum WageWage

An important example An important example of a price floor is the of a price floor is the minimum wage. minimum wage.

Minimum wage laws Minimum wage laws dictate the lowest dictate the lowest price possible for price possible for labor that any labor that any employer may pay.employer may pay.

How the Minimum Wage Affects How the Minimum Wage Affects the Labor Marketthe Labor Market

Quantity ofLabor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied

Equilibrium wage

A Can of WormsA Can of Worms

Favoritism and corruptionFavoritism and corruption UnenforceabilityUnenforceability Limit of volume of transactionsLimit of volume of transactions Misallocation of resources and Misallocation of resources and

inefficiencyinefficiency