Chapter 4
Extensions
of Demand
and Supply
Analysis
Introduction
Shipping companies have found in recent
years that there has been a shortage of
available space at U.S. seaports. What
market condition would give rise to a
persistent shortage?
Slide 4-2
Learning Objectives
 Discuss the essential features
of the price system
 Evaluate the effects on the market
price and equilibrium quantity of
changes in demand and supply
 Understand the rationing function
of prices
Slide 4-3
Learning Objectives
 Explain the effects of price ceilings
 Explain the effects of price floors
 Describe various types of governmentimposed quantity restrictions on markets
Slide 4-4
Chapter Outline
 The Price System
 Exchange and Markets
 Changes in Demand and Supply
 Price Flexibility and Adjustment Speed
 The Rationing Function of Prices
Slide 4-5
Chapter Outline
 The Policy of Government-Imposed
Price Controls
 The Policy of Controlling Rents
 Price Floors in Agriculture
 Price Floors in the Labor Market
 Quantity Restrictions
Slide 4-6
Did You Know That...
 A shortage of flu vaccine arose in 2003?
 Persistent shortages and surpluses may
be observed in various markets?
 The model of supply and demand can
explain many of these instances of a
gap between quantity supplied and
quantity demanded?
Slide 4-7
The Price System
 Price System (market system)
– An economic system that allocates
resources based on relative prices
determined by supply and demand
– Prices signal what is relatively scarce
and relatively abundant
Slide 4-8
Exchange and Markets
 Markets
– Emphasize voluntary exchange
– Determine the terms of exchange
– Facilitate exchange
Slide 4-9
Exchange and Markets
 Voluntary Exchange
– Acts of trading between individuals
that make both parties to the trade
subjectively better off
 Terms of Exchange
– The prices we pay for the desired items
Slide 4-10
Exchange and Markets
 Transaction Cost
– The costs associated with exchange
– Examples
•
•
•
•
•
Price shopping
Determining quality
Determining reliability
Service availability
Cost of contracting
Slide 4-11
Exchange and Markets
 The role of middlemen
– Middlemen (intermediaries) or brokers
reduce transaction cost by providing
information to buyers and sellers.
– Examples
•
•
•
•
Real estate brokers
Stock brokers
Consignment shops
Car dealerships
Slide 4-12
Exchange and Markets
 Observation
– Consumers on the Internet rely on
intelligent shopping agents to act as
middlemen
 Question
– How has the increase in the number of
web pages affected the potential market
for shopbot services?
Slide 4-13
Changes in Demand and Supply
 Changes in supply and demand
create a disequilibrium
 The market price and quantity
adjust to a new equilibrium
Slide 4-14
Shifts in Demand and Supply:
Determinate Results
Increase Demand with Supply Constant
S
E1
P1
D1
Q1
Figure 4-1
Slide 4-15
Shifts in Demand and Supply:
Determinate Results
Increase Demand with Supply Constant
S
At price P1 quantity
demanded exceeds
quantity supplied—
a shortage exists
E1
P1
D2
D1
Q1
Figure 4-1
Q2
Slide 4-16
Shifts in Demand and Supply:
Determinate Results
Increase Demand with Supply Constant
S
E2
Equilibrium price
and quantity
increase to P2 and Q2
P2
E1
P1
D1
Q1
Figure 4-1
D2
Q2
Slide 4-17
Shifts in Demand and Supply:
Determinate Results
Decrease Demand with Supply Constant
E1
S
At price P1 quantity
supplied exceeds
quantity demanded—
a surplus exists.
P1
D1
D2
Q2
Figure 4-1
Q1
Slide 4-18
Shifts in Demand and Supply:
Determinate Results
Decrease Demand with Supply Constant
E1
S
Equilibrium price
and quantity decrease
to P3 and Q3
P1
E3
P3
D1
D3
Q3
Figure 4-1
Q1
Slide 4-19
Shifts in Demand and Supply:
Determinate Results
Increase Supply with Demand Constant
S1
E1
P1
D
Q1
Figure 4-1
Slide 4-20
Shifts in Demand and Supply:
Determinate Results
Increase Supply with Demand Constant
At price P1 quantity
supplied exceeds
quantity demanded—
a surplus exists
S1
S2
E1
P1
D
Q1
Figure 4-1
Q3
Slide 4-21
Shifts in Demand and Supply:
Determinate Results
Increase Supply with Demand Constant
Equilibrium price
decreases and quantity
increases to P2 and Q2
S1
S2
E1
P1
E2
P2
D
Q1
Figure 4-1
Q2
Slide 4-22
Shifts in Demand and Supply:
Determinate Results
Decrease Supply with Demand Constant
S3
S1
E1
At price P1 quantity
demanded exceeds
quantity supplied—
a shortage exists
P1
D
Q2
Figure 4-1
Q1
Slide 4-23
Shifts in Demand and Supply:
Determinate Results
Decrease Supply with Demand Constant
S3
E3
S1
P3
Equilibrium price
decreases and quantity
increases to P3 and Q3
E1
P1
D
Q3
Figure 4-1
Q1
Slide 4-24
Changes in Demand and Supply
 Summary
– Increases in demand increase equilibrium
price and quantity.
– Decreases in demand decrease
equilibrium price and quantity.
Slide 4-25
Changes in Demand and Supply
 Summary
– Increases in supply decrease equilibrium
price and increase equilibrium quantity.
– Decreases in supply increase equilibrium
price and decrease equilibrium quantity.
Slide 4-26
Changes in Demand and Supply
 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
Slide 4-27
Changes in Demand and Supply
 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
Slide 4-28
Changes in Demand and Supply
 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
Slide 4-29
Price Flexibility
and Adjustment Speed
 Flexibility and indirect adjustment
– Quality
– Service
– Rebates
Slide 4-30
Price Flexibility
and Adjustment Speed
 Adjustment speed
– Market characteristics influence
adjustment speed
– Markets may overshoot in the adjustment
process
Slide 4-31
Example:
Why Plywood Prices Have Soared
 The supply has decreased, due to
some lumber sellers going out of
business and to delays in timber
harvesting as a result of wet weather.
 Demand has increased both from the
private sector and from government
purchases for the military.
Slide 4-32
Example:
Why Plywood Prices Have Soared
Figure 4-2
Slide 4-33
The Rationing Function of Prices
 When surpluses and shortages exist,
the price adjusts to clear the market.
 This adjustment is the rationing
function of price.
Slide 4-34
The Rationing Function of Prices
 When prices cannot adjust non-price
rationing occurs
– Rationing by queues
– Rationing by lotteries
– Rationing by coupons
Slide 4-35
The Rationing Function of Prices
 The essential role of rationing
– With scarcity rationing must occur
– We must choose the rationing
mechanism: price or non-price
– Price rationing is the most efficient
• Further trades could not occur without making
somebody worse-off
Slide 4-36
The Rationing Function of Prices
 Question
– If price rationing is the most efficient
is it the best way to ration?
Slide 4-37
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
Slide 4-38
The Policy of Government-Imposed
Price Controls
 Price ceiling and black markets
– Price ceilings may prevent the equilibrium
price from being achieved if it is above
the ceiling price.
Slide 4-39
The Policy of Government-Imposed
Price Controls
 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
Slide 4-40
Black Markets
S’
Implicit supply schedule
at P1 < Pe
Price
P2
Pe
P1
Shortage
D
Qs
Figure 4-3
Qe
Qd
Quantity per Unit Time Period
Slide 4-41
Example:
Vaccine Shortages
 Government mandates have resulted
in a substantial portion of childhood
vaccines being sold at prices below the
market price.
 As a consequence, pharmaceutical
companies are cutting back on the
production of vaccines.
Slide 4-42
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
Slide 4-43
The Policy of Controlling Rents
 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.
Slide 4-44
The Policy of Controlling Rents
 Effects on the existing supply
of housing
– Property owners cannot recover costs
Slide 4-45
The Policy of Controlling Rents
 Rationing the current use of housing
– Reduces mobility
• New York’s “housing gridlock”
Slide 4-46
The Policy of Controlling Rents
 Attempts at evading rent controls
– Forcing tenants to leave
– Tenants subletting apartments
– Housing courts
Slide 4-47
The Policy of Controlling Rents
 Who gains and who loses
from rent controls?
– Losers
• Property owners
• Low-income individuals
– Benefits
• Upper-income professionals
Slide 4-48
Price Floors in Agriculture
 Support Price
– the governmentally established minimum
price farmers are to receive for a
particular agricultural product.
Slide 4-49
Agricultural Price Supports
Excess quantity
supplied
S
Dollars per Unit
Ps
Pe
E
D
Qd Qe
Figure 4-4
Qs
Quantity of Peanuts per Time Period
Slide 4-50
Price Floors in Agriculture
 Questions
– How could the government keep the price
from falling?
– Who benefits from agricultural price
supports?
Slide 4-51
Policy Example:
Agricultural Subsidies in the European Union
 The European Union pays farmers for
using environmentally sound
agricultural practices.
 In some cases, the preferred practice
may be not to farm at all.
 In effect, this is a program of
agricultural price supports.
Slide 4-52
Price Floors in the Labor Market
 Minimum Wage
– Lowest hourly wage rate that firms
may legally pay their workers
Slide 4-53
The Effect of Minimum Wages
S
A
Wage Rate per Unit
Wm
B
We
C
Excess quantity
supplied at
wage Wm
E
Reduction
in quantity
of labor
demanded
Increase in
quantity of labor
supplied
D
Qd
Qe
Qs
Quantity of Labor per Time Period
Figure 4-5
Slide 4-54
Quantity Restrictions
 Prohibitions on the ownership
or trading of a good
– Human organs
– Drugs
– Hospital beds
Slide 4-55
Quantity Restrictions
 Government Prohibitions or 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 in a one-year period
Slide 4-56
Policy Example:
U.S. Textile Quotas Abound
 There are legal restrictions on the
amount of textiles and the number of
apparel products that can be imported
into the U.S. each year.
 These numbers are specific to the
country of origin.
Slide 4-57
Issues and Applications:
Traffic Jams in U.S. Seaports
 Demand for dock space has increased due
to the increased volume of cruise travel.
 Fees charged for the use of such space are
government regulated. Regulators have
been slow to respond.
 A shortage has arisen because the price
remains below the market-clearing level.
Slide 4-58
Issues and Applications:
Traffic Jams in U.S. Seaports
Figure 4-7
Slide 4-59
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.
Slide 4-60
Summary Discussion
of Learning Objectives
 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.
Slide 4-61
Summary Discussion
of Learning Objectives
 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.
Slide 4-62
Summary Discussion
of Learning Objectives
 The rationing function of prices
– In a market system, prices ration
scarce goods and services.
 The effect of price ceilings
– A price ceiling set below the market
(equilibrium) price results in a shortage.
– The resulting shortage can lead to nonprice rationing devices and black markets.
Slide 4-63
Summary Discussion
of Learning Objectives
 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.
– Quantity restrictions can take the form
of import quotas.
Slide 4-64
Summary Discussion
of Learning Objectives
 Government-imposed restrictions
on market quantities
– Bans on sale or ownership
– Licensing restrictions
– Import quotas
Slide 4-65
End of
Chapter 4
Extensions
of Demand
and Supply
Analysis