Market Model
Supply and Demand
Markets
Institutions that allow buyers and
sellers to exchange
 Demand
 Supply
Examples
 Posted-price
 Haggling
 Auctions
Equilibrium Price/Quantity
Demand Curve
Demand: how much consumer are willing
and able to buy at different prices
Dew Auction
Market Equilibrium
price
At P1: Qd = Qs
The market “clears”
S1
P1
D1
Q1
quantity
Note:
Change in Quantity Demanded: movement along curve
Change in Demand: shift of entire curve
Market Disequilibrium
Surplus
price
S1
Surplus
At PHi: Qd < Qs
 Pressure on price to fall
Shortage
PHi
P1
PLo
At PLo: Qd > Qs
 Pressure on price to rise
D1
Shortage
Qsd
Q1
Qs Qd
quantity
Demand Shifters
Preferences
Population
Income
 Normal goods
 Inferior goods
If income rises, demand rises
If income rises, demand falls
Price of Related Goods
 Substitutes If P rises, demand for Y rises
 Complements If P rises, demand for Y falls
x
x
Expectations
Supply Shifters
Number of firms
Cost of inputs
Technology
Expectations
In the fall of 1903 Ohio Tech students for the first time had to pay to
attend university football games; as a result, every game had many
empty seats. This decline in attendance suggests that:
the demand for football games declined.
attending football games is an inferior good.
attending football games is a normal good.
the quantity demanded of football games fell.
0%
d)
0%
c)
0%
b)
0%
a)
a)
b)
c)
d)
A newspaper story recently reported that the price of new cars
has increased, and the quantity of new cars sold has dropped.
The price and quantity changes were probably caused by:
a decrease in buyers' incomes.
an increase in buyers' incomes.
an increase in production costs.
a decrease in production costs.
0%
d)
0%
c)
0%
b)
0%
a)
a)
b)
c)
d)
Consider the market for computers. Suppose that the price
of plastic decreases and the income of consumers
decreases. What may we conclude about the equilibrium
price and quantity of computers?
a)
b)
c)
d)
price will fall and quantity is
indeterminate.
quantity will rise and price is
indeterminate.
quantity will rise and price will rise.
both price and quantity will be
indeterminate.
0%
a)
0%
0%
b)
c)
0%
d)
Elasticity
adding (quantitative) meat to the
bones of supply and demand
Suppose the price of gas rises by 10% over the next
month. By how much will Ohio drivers cut back on
their purchases of gasoline?
a)
b)
c)
d)
e)
0 percent (no cut back)
1 to 5 percent
6 to 10 percent
11 to 20 percent
More than 20 percent
0%
0%
0%
0%
0%
a)
b)
c)
d)
e)
Price Elasticity of Demand
 Measures the price sensitivity of buyers
Ed = % Δ Q D
$
%ΔP
$2.50
%ΔP
$2.00
D
280
300
%ΔQ
Gasoline
Midpoint Formula
Q1  Q2
Ed =
Q avg
P1  P2
Pavg
Ed =

0 . 07
0 . 22
300  280
=
$
290
2.00  2.50
2.25
$2.50
%ΔP
= -0.32
$2.00
D
280
Degree of Sensitivity
Elastic:
|Ed| > 1
Unit:
|Ed| = 1
Inelastic: |Ed| < 1
300
%ΔQ
Gasoline
When the price of an iPod Nano is $130, consumers buy 500
units per week. When the price rises to $150, consumers buy
only 400 units per week. What is the midpoint elasticity of
demand and how would you classify it?
a)
b)
c)
d)
-1.57;
-1.57;
-0.64;
-0.64;
inelastic
elastic
inelastic
elastic
Ed = (500  400)/450
(130  150)/140
Ed = -.22/.14 = -1.57
0%
a)
0%
0%
b)
c)
0%
d)
Determinants of Elasticity
 Number of substitutes
 The greater the # substitutes, the greater the elasticity
 The narrower the definition of the market, the greater the
elasticity
 Item’s share of consumer budget
 The greater the share of budget, the greater the elasticity
Determinants of Elasticity
 Time: Short Run v. Long Run
 The longer the time horizon, the greater the elasticity
$
Gasoline Demand: ELR > ESR
P1
P0
D1
long run
D2 short run
Q1
Q2 Q0
gasoline
Extreme Cases of Price Elasticity
$
 Perfectly Inelastic
D1
P2
 Ed =
0
P1
 Examples?
Q1
Q
 Perfectly Elastic
$
 Ed =
∞
 Examples?
P1
D1
Q
Some Estimated Price Elasticities of Demand
Good
Price elasticity
 Inelastic demand
Eggs
Beef
Stationery
Gasoline
- 0.10
- 0.40
- 0.50
- 0.50
 Elastic demand
Housing
Restaurant meals
Airline travel
Foreign travel
-
1.20
2.30
2.40
4.10
Suppose that the price elasticity of demand for a Marietta
College education is estimated to be E = -0.80. Based on
this information, if the college were to raise tuition by 5%,
then:
a)
b)
c)
d)
enrollment will fall by 6.25% and
tuition revenues will increase.
enrollment will fall by 4% and
tuition revenues will increase.
enrollment will fall by 6.25% and
tuition revenues will decrease.
enrollment will fall by 4% and
tuition revenues will decrease.
0%
a)
0%
0%
b)
c)
0%
d)
Elasticity and Total Revenue
TR = P x Q
Elastic Demand
P
x
Q
= TR
P
x
Q
= TR
Quantity effect dominates
Ed =
% Δ QD
%ΔP
Inelastic Demand
P
x
Q
= TR
P
x
Q
= TR
Price effect dominates
Suppose that the price elasticity of demand for a Marietta
College education is estimated to be E = -0.80. Based on
this information, if the college were to raise tuition by 5%,
then:
a)
b)
c)
d)
enrollment will fall by 6.25% and
tuition revenues will increase.
enrollment will fall by 4% and
tuition revenues will increase.
enrollment will fall by 6.25% and
tuition revenues will decrease.
enrollment will fall by 4% and
tuition revenues will decrease.
0%
a)
0%
0%
b)
c)
0%
d)
According to recent studies at M.I.T. and the University of
Michigan, a 10% increase in the price of cigarettes leads to a 14%
drop in sales to teenagers. What is the elasticity of demand for
cigarettes among teenagers?
a)
b)
c)
d)
-0.71
-1.40
+1.40
+0.71
0%
Would you expect it to be this high for
older smokers? Explain.
a)
0%
0%
b)
c)
0%
d)
Other Demand Elasticities
Cross-Price Elasticity
 Exy =
% ΔQ
X
% ΔP Y
Substitutes:
Exy > 0
Complements: Exy < 0
Income Elasticity
 EI =
% ΔQ
Normal Goods:
EI > 0
%ΔI
Inferior Goods:
EI < 0
Examples of cross-price elasticities
Commodity
With respect to
price of
Cross-Price
elasticity
Beef
Pork
0.28
Butter
Margarine
0.67
Electricity
Natural gas
0.20
Natural gas
Fuel oil
0.44
Clothing
Footwear
- 0.01
Dairy products
Meat products
- 0.15
Entertainment
Food
- 0.72
Examples of income elasticities
Commodity
Income
elasticity
Automobiles
2.46
Furniture
1.48
Restaurant Meals
1.40
Water
1.02
Tobacco
0.64
Gasoline
0.48
Margarine
-0.20
Pork
-0.20
Public transportation
-0.36
In August 1990, East German taxicab drivers were on strike
demanding lower cab fares. What must the drivers have believed
about the price elasticity of demand for taxi rides?
a)
b)
c)
d)
The demand
The demand
The demand
The demand
inelastic.
was
was
was
was
elastic.
inelastic.
perfectly elastic.
perfectly
0%
0%
0%
a)
b)
c)
0%
d)
Market Efficiency
 Invisible Hand Theorem
 Adam Smith: Wealth of Nations (1776)
 Competitive, free markets will maximize
social welfare
 Social Welfare = ?
“It is
not from the benevolence
“...every
individual…neither
intends to
of the
the brewer,
the
promote
thebutcher,
public interest,
nor or
knows
baker,he
that
we expect our
dinner,
how much
is promoting
it…he
intends
his
ownregard
gain, to
and
he is in
butonly
from
their
their
this, as
in many
other
own
interest.
We cases,
addressled by an
invisible
hand tonot
promote
end which
ourselves,
to theiran
humanity
was no part of his intention…By
but to their self-love, and never
pursuing his own interest he frequently
talk to
them
of our
necessities
promotes
that
of the
society
more
but ofthan
theirwhen
advantages.”
effectually
he really intends
to promote it.”
Adam Smith
Consumer Surplus
 Net gain to consumers from
buying at a single price
 CS = Buyer Value - Price
Price
Buyer Values (or WTP)
$50
$25
Consumer Surplus
Market price
Demand
Total Expenditure
1
5
quantity
Producer Surplus
 Net gain to sellers from selling at a
single price
 PS = Price – Seller Cost
Price
$25
Supply
Market price
Producer Surplus
Seller Costs
$10
Total Cost
3
quantity
Which of the following is an example of consumer
surplus?
a)
b)
c)
d)
Holly buys a hamburger for $2 and
tells you she would not have paid a
penny more.
Youtian believes the price he paid
for his computer was too high.
Willy buys a paper tablet for $2 and
finds the same good at another
store for $1.50
Katelyn would have paid $20 for a
new compact disc but paid only $15.
0%
a)
0%
0%
0%
b)
c)
d)
Social Welfare
Price
Deadweight Loss
Supply
CS
P*
PS
Demand
Q
Q*
quantity
 Free Market Outcome: P*, Q*
 Maximizes social welfare: SW = CS + PS
Garden of Eden
Adam
Eve
12
0
9
3
5
5
4
8
0
12
Adam and Eve in the Garden of Eden, by Titian (c. 1550)
Which allocation would you choose?
ic
e
ho
C
0%
0%
Fi
ve
0%
ic
e
Tw
o
O
ic
e
ho
Tradeoff: Efficiency vs. Equity
0%
ho
0%
ur
12
C
0
Fo
8
ic
e
4
ho
5
re
e
5
C
3
Th
9
ic
e
0
ho
12
C
One
Two
Three
Four
Five
ne
Choice
Choice
Choice
Choice
Choice
Eve
C
1.
2.
3.
4.
5.
Adam
Supply and Demand Step Functions
70
65
Supply
60
55
50
Price
45
40
35
30
25
20
15
10
Demand
5
0
0
1
2
3
4
5
6
7
8
9
Quantity
10
11
12
13
14
15
16
Chart 3: Price Sequence
45
40
35
30
Price
Session 4
Session 2
25
Session 1
20
Session 3
15
10
5
0
0
10
20
30
40
50
60
70
Contracts
80
90
100
110
120
Government Intervention
 Why does government intervene?
 Market failures
Monopoly
Externalities
Public goods
 Fairness
All generate some DWL
 How does government intervene?
 Price Controls
 Quantity Controls
 Regulations
Price Ceiling: Rent Control
 Free Market: R1, Q1
 Gov’t imposes rent ceiling at R0
At R0: QD > QS  shortage
 Non-Price Rationing?




Black Market (Bribes)
Discrimination
Wait / Search
Lottery
Rent
S1
DWL
RF
R1
R0
D1
QS
Q1
Shortage
QD
Apartments
Other Examples of Price Ceilings
 Gasoline (1970s)
Price of Oil
 Usury laws
 Diagnostic Related Groups (DRGs)
$120
Real Price
Dollars per barrel
$100
$80
$60
$40
$20
Nominal Price
$0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
In 1979 a revolution overthrew the government of Iran,
disrupting oil production and causing the price of crude oil to
increase by 300 percent. In most of the world, which did not
have price controls, this price increase:
led to severe shortages of gasoline
did not lead to shortages
led to substantial surpluses
did not affect supply or demand
for gasoline substantially
0%
d)
0%
c)
0%
b)
0%
a)
a)
b)
c)
d)
Price Floor: Minimum Wage
 Fair Labor Standards Act (1938)
 1938: $0.25
 2009: $7.25
Ohio’s minimum wage went
up to $7.30 this past January
As of January 1, 2010
States with minimum wage rates higher than the Federal rate
States with minimum wage rates the same as the Federal rate
States with minimum wage rates lower than the Federal rate
States with no minimum wage law
Federal Minimum Wage
1950-2010
$11.00
$10.00
minimum wage in
2010 dollars
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
minimum wage in
current dollars
$2.00
$1.00
$0.00
1950
1960
1970
1980
1990
2000
2010
Minimum Wage Relative to the
Average Hourly Wage Rate
1965-2010
60%
50%
40%
30%
20%
10%
0%
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
Characteristics of Minimum Wage Workers, 2009
At or Below $7.25
Total
3.6 million
72.6 million
% Employment
4.9%
100%
Gender
Male
Female
38.0
62.0
48.5
51.5
Race
White
Black
Hispanic
Asian
80.0
13.9
17.4
3.3
80.7
12.8
17.5
3.7
Age
16-19
25 +
22.9
51.4
6.1
80.2
Hours of Work
Part-time
Full-time
63.9
35.6
27.6
72.2
Occupation
Sales
Service
20.5
63.0
27.4
24.4
Industry
Retail
Leisure & Hospitality
Manufacturing
14.9
51.6
3.0
14.4
12.2
11.5
Education
Less than HS
HS only
BA +
29.0
30.9
8.3
14.1
35.4
16.2
# Hourly Workers
140m
2009 Poverty Guidelines
(48 Contiguous States and DC)
Persons in Family
Poverty Threshold
1
$10,830
2
$14,570
3
$18,310
4
$22,050
5
$25,790
6
$29,530
7
$33,270
8
$37,010
For families with more than 8 persons, add $3,740 for
each additional person.
Source: http://aspe.hhs.gov/poverty/09poverty.shtml
Labor Market

Free Market: W1, Q1
 no unemployment: QD = QS
(full-time income?)

S1
W2 = $7.25
Gov’t imposes min. wage at W2
 at W2: QD < QS
 Unemployment occurs

unemployment
Wage
DWL
W1= $6
How can employers offset impact?





Reduce hours of work
Reduce fringe benefits
Raise price
Reduce quality
Hire illegal aliens
D1
QD
B
W
layoffs
Q1
QS
new entrants
Labor
Suppose that the equilibrium wage in the low-skilled labor market is
$8.00. Further, suppose the federal government raises the minimum
wage to $7.75 an hour from its present level of $7.25. The government’s
action of increasing the minimum wage will result in:
a)
b)
c)
d)
a decrease in unemployment
an increase in unemployment
a shortage of low-skilled labor.
neither a shortage nor a surplus of
labor in the low-skilled labor market.
0%
a)
0%
0%
b)
c)
0%
d)
Taxes
 Sales Tax: percentage of sales
 Excise Tax: fixed dollar amount per unit
Sin Taxes?
Suppose the government imposes a $10 excise tax on the sale
of sweaters by charging suppliers $10 for each sweater sold.
Based on economic analysis, we would predict that:
a)
b)
c)
d)
e)
The price of sweaters will increase
by $10.
The price of sweaters will increase
by more than $10.
Consumers of sweaters will bear
the entire burden of the tax.
The price of sweaters will increase
by less than $10.
(a) and (c) are true.
0%
0%
0%
0%
0%
a)
b)
c)
d)
e)
Excise Tax: Cigarettes
 Free market:
S2
 P = $4.00
 Q = 27.4 b
price
S1
buyer pays
 Consumer Spending ≈ $110 b
4.40
 Gov’t imposes tax = $1/pack
4.00
Tax Revenue
tax = $1
3.40
 Supply shifts upward by $1
 Price rises (by less than $1)
 Quantity falls
Assume that ED = -0.60
ED =
% ΔQ
D
= -0.60
10 %
%ΔQD = - 6.0%
seller keeps
D1
25.8 27.4
cigarettes
(Billions of packs)
Economic burden of tax is split
between buyers and sellers
Suppose the government imposes a $10 excise tax on the sale
of sweaters by charging suppliers $10 for each sweater sold.
Based on economic analysis, we would predict that:
a)
b)
c)
d)
e)
The price of sweaters will increase
by $10.
The price of sweaters will increase
by more than $10.
Consumers of sweaters will bear
the entire burden of the tax.
The price of sweaters will increase
by less than $10.
(a) and (c) are true.
0%
0%
0%
0%
0%
a)
b)
c)
d)
e)
In the figure below, the amount of tax revenue is:
a)
b)
c)
d)
$2000
$4000
$6000
$8000
0%
2000
0%
0%
4000
6000
0%
8000
Quantity Controls
 Quotas
 International trade: agricultural goods, textiles
 Taxis, liquor licenses
 Prohibition
 What goods and services are illegal to trade?
 Why prohibit trade?
 Victimless crime?
 Immoral?
 Externalities?
Drugs
Prostitution
Body organs
Babies
Guns
Exotic animals
Gambling
War on Drugs
 Intrinsic Effects




Health Damages
Spousal/Family abuse
DUI
Lower worker
productivity
 Black Market Effects
 Crime
 Property
 Murder
 Overdose
 Uncertain product quality
 Binge consumption
 Clogged prisons
 Corruption
 Reduced civil liberties
Alcohol: 125m users-----85,000 annual deaths
Tobacco: 70m users-----400,000 annual deaths
Marijuana: 15m users-----0 annual deaths
Cocaine: 2m users---Heroin: 0.2m users---- 17,000 annual deaths
Tradeoff: Intrinsic Effects v. Black Market Effects
Marijuana Market
 Prohibition: P1, Q1
 Legalization: P2, Q2
S1
price
S2
 Consumption will rise
(how much?)
$2500 = P1
Tradeoff:
> More intrinsic costs
> Less black market effects
P2
D1
Q1
 What happens in the market for substitutes?
 What happens in the market for complements?
Q2
Marijuana
(lbs.)
When a government imposes penalties on both sellers and
buyers of an illegal good,
0%
0%
0%
0%
d)
d)
c)
c)
b)
b)
the price of the good falls as does
the quantity purchased.
the price of the good falls, but the
quantity purchased may increase
or decrease.
the price of the good rises, but
the quantity purchased may
increase or decrease.
the quantity purchased of the
good decreases, but the price may
rise or fall.
a)
a)