MacroeconomicsECON 2301Spring 2011

Marilyn Spencer, Ph.D.

Professor of Economics

Chapter 4

AnnouncementAnnouncement The first exam is scheduled for Feb. 16.

More information will be provided in the Chapter 1-4 Review PPTs, uploaded with the other class notes.

Chapter 4: Extensions of Demand and Supply

Analysis

Learning Objectives1. Discuss the essential features of the price system

2. Evaluate the effects of changes in demand and supply on the market price and equilibrium quantity

3. Understand the rationing function of prices

4. Explain the effects of price ceilings

5. Explain the effects of price floors

6. Describe various types of government-imposed quantity restrictions on markets

Changes in Demand and Supply

Changes in supply and demand create a disequilibrium.

The market price and quantity adjust to a new equilibrium.

Review of The D Side of the Mkt.:

1. Price of related goods Substitutes Goods and services that can be used

for the same purpose. Complements Goods that are used together.

2. Income Normal good A good for which the demand

increases as income rises and decreases as income falls.

Inferior good A good for which the demand increases as income falls, and decreases as income rises.

Variables That SHIFT Market Demand

3. Tastes

4. Population and demographics

The Demand Side of the Market

Variables That Shift Market Demand

Demographics The characteristics of a population with respect to age, race, and gender.

5. Expectations

When two goods, X and Y, are complements, which of the following occurs? a. An increase in the price of good X leads to an

increase in the price of good Y.

b. An increase in the price of good X leads to a

decrease in the quantity demanded of good Y.

c. An increase in the price of good X leads to a

decrease in the quantity demanded of good Y.

d. An increase in the price of good X leads to an

increase in the quantity demanded of good Y.

The Demand Side of the Market

Variables That Shift Market DemandVariables That Shift MarketDemand Curves

3 - 1

The Demand Side of the Market

Variables That Shift Market DemandVariables That Shift MarketDemand Curves

3 - 1 (continued)

Refer to the graph below. Which of the following moves best describes what happens when a change in the price of printers affects the market demand for printers? a. A move from A to B. b. A move from A to C. c. Either move from A to B or A to C. d. None of the above.

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

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

Which of the following defines a supply curve?

a. The quantity of a good or service that a firm is willing to supply at a given price.

b. A table that shows the relationship between the price of a product and the quantity of the product supplied.

c. A curve that shows the relationship between the price of a product and the quantity of the product supplied.

d. None of the above.

The Supply Side of the Market

The Law of Supply

Law of supply Holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

The Supply Side of the Market

1. Price of inputs

2. Technological change

A positive or negative change in the ability of a

firm to produce a given level of output with a

given amount of inputs.

3. Prices of substitutes in production

4. Expected future prices

5. Number of firms in the market

Variables That Shift Supply

The Supply Side of the MarketVariables That Shift Supply

Variables That Shift MarketSupply Curves

3 - 2

The Supply Side of the MarketVariables That Shift Supply

Variables That Shift MarketSupply Curves3 - 2 (continued)

The Supply Side of the Market

Variables That Shift Supply

Refer to the graphs below. Each graph refers to the supply for printers. Which best describes the impact of an increase in productivity? a. The graph on the left. b. The graph on the right. c. Both graphs. d. Neither graph.

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

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

The Falling Price of

Large Flat-Screen Televisions

Corning’s breakthrough spurred the manufacture of LCD televisions in Taiwan, South Korea, and Japan, and an eventual decline in price.

Changes in Demand and Supply Changes in supply and demand create a

disequilibrium.

The market price and quantity adjust to a new equilibrium.

Changes in Demand and Supply (cont'd)

Summary

Increases in demand increase equilibrium price and quantity.

Decreases in demand decrease equilibrium price and quantity.

Increases in supply decrease equilibrium price and increase quantity.

Decreases in supply increase equilibrium price and decrease quantity.

When BOTH Demand & Supply Are Shifting: High Demand and Low Prices in the Lobster Market:

Supply and demand for lobster both increase in summer, but the supply increase EXCEEDS the demand increase; therefore, equilibrium price falls.

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

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

Remember: A Change in a Good’s Price Does Not Cause the Demand or Supply Curve to Shift.

Changes in Demand and Supply (cont'd)

Price Flexibility and Adjustment Speed

Prices quite flexible in unfettered markets can be less flexible in other market scenarios.May experience indirect adjustments such as

hidden payments, quality changes

May not reach equilibrium right away

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.

Example: Why Gasoline Prices Increased over the Past Year

One factor: an increase in international 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 equilibrium price of gasoline increased.

Prices are now falling. Why???

The Price System and Markets (cont'd)

Transaction Costs: The costs associated with exchange

Examples• Price shopping

• Determining quality

• Determining reliability

• Service availability

• Cost of contracting

The Rationing Function of Prices Methods of non-price rationing include:

Rationing by queues (waiting in line)Rationing by random assignment, and/or couponsFirst come, first served

Political powerPhysical forceRandom assignmentCoupons

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.

The Rationing Function of Prices (cont'd) Question

If price rationing is the most efficient is it the “best” way to ration?

AnswerEconomists cannot say which system is “best.”

They can say rationing via the price system leads to the most efficient use of available resources.

One Type of Government Policy: Imposed Price Controls

Price Controls Government-mandated minimum or maximum prices

Price Ceiling A legal maximum price

Price Floor A legal minimum price

Government-Imposed Price Controls (cont'd)

Price ceiling and illegal (black) markets

Price ceilings may prevent the equilibrium price from being achieved if it is above the ceiling price.

Black Market A market in which price-controlled goods are sold at an illegally high price

Figure 4-3 Black Markets

The Policy of Controlling Rents

The functions of rental prices:

1. Promote the efficient maintenance and construction of housing

2. Allocate existing housing

3. Ration the use of housing

The Policy of Controlling Rents (cont'd) Rent controls and construction

Controls discourage constructionWith 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.

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”

The Policy of Controlling Rents (cont'd) Attempts to evade rent controls

Forcing tenants to leave

Tenants subletting apartments

Housing courts

The Policy of Controlling Rents (cont'd) Who gains and who loses from rent controls?

Losers• Property owners

• Some low-income individuals

Gainers• Upper-income professionals

Price Floors in Agriculture Support Price The governmentally

established price floor Usually associated with agricultural productsLater we’ll study the minimum wage with this same

analysis

Figure 4-4 Agricultural Price Supports

Price Floors in Agriculture (cont'd) Questions

How could the government keep the price from falling?

Who benefits from agricultural price supports?

Policy Example: King Cotton Receives Royal Government Subsidies

Every year, the federal government gives a direct payment based on the average size of the farmer’s past planting.

After the crop is planted, the farmer can borrow from the government, using the newly sown cotton as collateral.

If the world price of cotton falls below a price floor of 65 cents per pound, the grower receives a payment from the government--compensating the farmer for surplus cotton the farmer has planted—equal to 13 cents per pound.

If the world price of cotton falls below 52 cents per pound, farmers turn their cotton over to the government, which sells the cotton at the world price and absorbs loan losses. Thus the government usually provides about 80% of all revenues received by cotton farmers.

What would happen to cotton farmers’ revenues if the price floor were raised? Lowered?

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

Figure 4-5 The Effect of Minimum Wages

Quantity Restrictions Governments can impose quantity

restrictions, with the most obvious being the banning of ownership or trading of a good

Human organs

Drugs

Hospital beds

Gold from 1933 to 1973

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

Summary 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, tending to minimize transactions costs.

Summary 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.

When both demand and supply shift at the same time, the result is indeterminate.

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.

Summary Discussion of Learning Objectives (cont'd)

The effects of price ceilingsA 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.

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.

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.

The effects of price ceilingsA 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.

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.

Government-imposed restrictions on market quantitiesBans on sale or ownershipLicensing restrictions Import quotas

Assignments to be completed before our next class:

Study for Exam 1!

Before our next regular class:

Pre-read Ch.6 & look over end-of-chapter questions:

14th ed: Problems 6-2, 6-4, 6-6, 6-10 & 6-12, pp. 156-158

15th ed: Problems 6-2, 6-4, 6-8, 6-12 & 6-14, pp. 156-158