CH 4 - 1
CHAPTER 4
EXTENSIONS OF DEMAND AND SUPPLY ANALYSIS
CHAPTER OVERVIEW
The chapter begins by presenting an overview of the price system. A discussion of exchange and
markets and transactions costs follows along with an examination of the role of middlemen. The
examination of supply and demand analysis begins by first identifying what happens to equilibrium
price and quantity when demand changes with supply constant and then when supply changes with
demand constant. The analysis is pursued further by examining the effects of simultaneous changes in
supply and demand. The fact that changes in equilibrium usually take time, in practice, is addressed,
and, that prices may not even be equilibrium ones for quite some time in a free market is explained.
The concepts of rationing by price, waiting, lotteries, and coupons are discussed. Supply and demand
analysis is used to show the consequences of government price controls both in an abstract sense and
in the specific cases of black markets, rent controls, price supports, and the minimum wage. Finally,
the fact that the government places quantity restrictions on a market, by banning goods or imposing
import quotas, is discussed.
LEARNING OBJECTIVES
After studying this chapter students should be able to
1.
Discuss the essential features of the price system.
2.
Evaluate the effects on the market price and equilibrium quantity
of changes in demand and supply.
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.
CHAPTER OUTLINE
4-
THE PRICE SYSTEM: An economic system in which relative prices constantly change to
reflect changes in demand and supply. Prices act as signals of relative scarcity to everyone in the
system.
II.
EXCHANGE AND MARKETS: Exchanges in markets are voluntary. Voluntary exchange
is the act of trading between individuals on a voluntary basis, making both parties subjectively
better off. The terms of exchange is usually the price paid and is determined by supply and
demand.
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A.
Transaction costs: The costs of negotiating and enforcing contracts and of
acquiring and processing information about alternatives.
B.
III.
The Roll of Middlemen: Middlemen specialize in lowering transactions costs.
CHANGES IN SUPPLY AND DEMAND: When one or both curves shift, equilibrium price
and/or quantity change. When there is an increase in demand with supply stable, equilibrium
price and quantity increase. A decrease in demand with supply stable results in an equilibrium
price and quantity decrease. When there is an increase in supply with demand stable,
equilibrium price falls and the equilibrium quantity rises. A decrease in supply with demand
stable results in equilibrium price rises and the equilibrium quantity falls. (See Figure 4-1).
A.
When Both Demand and Supply Shift: When both supply and demand curves
shift, the outcome is indeterminate for either equilibrium price or equilibrium quantity.
When there is an increase in supply and demand, equilibrium quantity will rise, and
when there is a decrease in supply and demand, equilibrium quantity will fall. Price can
increase, decrease, or remain the same depending on relative changes in supply and
demand. In the event of a decrease in demand and increase in supply, equilibrium price
will fall. An increase in demand and a decrease in supply will cause the equilibrium
price to rise. In these last two situations quantity can increase, decrease, or remain
unchanged depending on the relative changes in supply and demand.
IV.
PRICE FLEXIBILITY AND ADJUSTMENT SPEED: When demand increases in a
market, a shortage develops and price rises. The shortage can be eliminated quickly or slowly,
depending on the characteristics of the market. There are markets where price flexibility may
take the form of indirect adjustments, such as by way of hidden payments or quality changes.
V.
THE RATIONING FUNCTION OF PRICES: The synchronization of decisions by buyers
and sellers that creates equilibrium is called the rationing function of prices. Prices are
indicators of relative scarcity and ration goods to those who are willing to pay the most. Goods
can also be rationed on a "first-come, first-served" basis, by the use of political power, by
physical force, by lotteries, by coupons, and by cultural, physical, and religious differences.
A.
Other Methods of Rationing:
1.
Rationing by Queues: Rationing by queues (lining up) occurs when prices do
not indicate relative scarcity. Those who are willing to wait in line get the
product. Rationing by queues also occurs when entrepreneurs are free to change
prices to equate quantity demanded with quantity supplied, but choose not to do
so. For example, queuing may also arise when the demand characteristics of a
market are subject to large or unpredictable fluctuations and the additional costs
of holding sufficient inventories, or providing excess capacity to cover peak
demands, are greater than the costs to consumers of waiting for the good.
2.
Lotteries: Goods and services are rationed by chance.
3.
Rationing by Coupons: People are given a limited number of
coupons by the government and they must pay a specified price and give up a
coupon.
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B.
The Essential Role of Rationing: Because of scarcity, it is not possible for
everyone to have everything they want. There must be some method of rationing.
Rationing by a freely functioning price system is the most efficient because all gains
from mutually beneficial trade will be exhausted.
VI.
THE POLICY OF GOVERNMENT-IMPOSED PRICE CONTROLS: The rationing
function of prices is often not allowed to operate when government sets price controls called
price floors (minimum legal prices) and price ceilings (maximum legal prices).
A.
Price Ceilings and Black Markets: When a price ceiling is below the market
clearing price a shortage occurs. The result is fewer exchanges. Whenever the price
system is not allowed to work, non-price rationing devices will evolve to ration the
affected goods and services. An obvious example is queuing. Typically, an effective
price ceiling leads to a black market in which the price-controlled good is sold at an
illegally high price (See Figure 4-3).
VII.
THE POLICY OF CONTROLLING RENTS: Rent control is the placement of price ceilings
on rents in particular municipalities.
A.
Functions of Rental Prices.
1.
Rent Controls and Construction: Rent controls have
discouraged the construction of new rental property by depressing the most
important long-term determinant of profitability—rent.
2.
Effects on the Existing Supply of Housing: When rental rates
are held below equilibrium levels, owners cannot recover through rents the cost
of maintenance, repairs and capital improvements so owners curtail repairs and
maintenance and quality declines. In some cases buildings are abandoned or
destroyed through arson so the owners can collect insurance money.
3.
Rationing the Current Use of Housing: Rent controls restrict
renter mobility and can causes cause housing gridlock.
B.
Attempts at Evading Rent Controls: Landlords will make life unpleasant for
tenants or evict them on the slightest pretense to be able to raise rents that can only be
changed if tenants change. Tenants try to sublet apartments at fees above their rental
payments. Rent courts or boards exist in some locations to prevent or restrict these activities.
C.
Who Gains and Who Loses From Rent Controls?: Landlords are the biggest
losers. Low-income persons lose because of "key money", an illegal payment charged
up front by some landlords and a reduced amount of housing. Upper income tenants
who occupy rent-controlled housing gain the most.
VIII. PRICE FLOORS IN AGRICULTURE
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A.
Price Supports: These are price floors. When a surplus develops, the
Commodity Credit Corporation buys the surplus and stores it or sells the surplus to
foreign countries at a reduced price (or free of charge) under the Food for Peace
program. (See Figure 4-4).
B.
Who Benefited From Agricultural Supports?: Owners of big farms with
which produce more output get a large percentage of subsidies. All of the benefits
derived from price support subsidies ultimately accrue to landowners on whose land
price-support crops can be grown.
IX.
PRICE FLOORS—THE CASE OF MINIMUM WAGES IN THE LABOR MARKET: A
minimum wage is a wage floor legislated by government below which it is usually illegal to
pay workers. The effect is to cause unemployment for some low skill workers and depressed
wages in areas not covered by the minimum wage. (See Figure 4-5).
X.
QUANTITY RESTRICTIONS: Governments can impose quantity restrictions on a market,
such as an outright ban on ownership or trading of goods (human organs and certain
psychoactive drugs). The most common quantity restrictions in international trade are import
quotas. A quota is a quantity restriction that prohibits the importation of more than a specified
quantity of a particular good in a one-year period. In the United States there are import quotas
on tobacco, sugar, immigrant labor and so on. The beneficiaries of quotas are importers who
get the quota rights and the domestic producers of the restricted good.
SELECTED REFERENCES
Barzel, Yoram, "A Theory of Rationing by Waiting," Journal of Law and Economics, (April 1974), pp.
73-95.
Boulding, Kenneth E., Economic Analysis, Vol. 1 Microeconomics, (New York: Harper & Row, 1966).
Friedman, Milton, Capitalism and Freedom, The Heritage Foundation, 1962.