Instructor's Manual  1
Chapter 4 Notes
I. DEMAND AND SUPPLY ANALYSIS
A. General Definitions and Comments
1. The law of demand states that consumers will purchase more of a good at lower prices and
less of a good at higher prices.
2. The law of supply states that producers will sell less of a good at lower prices and more of a
good at higher prices.
3. Equilibrium exists when there is no reason for a situation to change.
a. When equilibrium exists, the quantity people plan to buy is equal to the quantity that
producers plan to sell.
b. The laws of demand and supply cause the market to move to equilibrium.
B. Other Demand Factors
1. Changes in demand factors other than price of the good will result in a change in demand.
a. An increase in demand is depicted as a rightward shift of the demand curve.
b. An increase in demand means that consumers plan to purchase more of the good at each
possible price.
c. A decrease in demand is depicted as a leftward shift of the demand curve
d. A decrease in demand means that consumers plan to purchase less of the good at each
possible price.
2. The price of related goods is one of the other factors affecting demand.
a. Related goods are classified as either substitutes or complements.
1. A good that is used in the place of another good is a substitute.
a.
An increase in the price of a good will increase demand for its substitute, while
a decrease in the price of a good will decrease demand for its substitute.
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2. A good that is used with another good is a complement.
a.
An increase in the price of a good will decrease demand for its complement
while a decrease in the price of a good will increase demand for its
complement.
3. Income is another factor that can affect demand.
a. If a good is a normal good, increases in income will result in an increase in demand while
decreases in income will decrease demand.
b. If a good is an inferior good, increases in income will result in a decrease in demand
while decreases in income will increase demand.
c. Consumer preferences obviously can affect demand.
C. Other Supply Factors
1. Changes in other supply factors will result in a change in supply.
a. An increase in supply is depicted as a rightward shift of the supply curve.
b. An increase in supply means that producers plan to sell more of the good at each possible
price.
c. A decrease in supply is depicted as a leftward shift of the supply curve.
d. A decrease in supply means that producers plan to sell less of the good at each possible
price.
2. Other factors affecting supply include technology, the prices of inputs, and the prices of
alternative goods that could be produced.
a. An advance in technology, a decrease in the prices of inputs, or a decrease in the prices of
alternative goods that could be produced will result in an increase in supply.
b. A deterioration of technology, an increase in the prices of inputs, or an increase in the
prices of alternative goods that could be produced will result in a decrease in supply.
II. HOW CHANGES IN DEMAND AND SUPPLY AFFECT EQUILIBRIUM PRICE AND
QUANTITY
A. Change in Demand
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1. A change in demand will cause equilibrium price and output to change in the same direction.
a. A decrease in demand will cause a reduction in the equilibrium price and quantity of a
good.
1. The decrease in demand causes excess supply to develop at the initial price.
a.
Excess supply will cause price to fall, and as price falls producers are willing to
supply less of the good, thereby decreasing output.
b. An increase in demand will cause an increase in the equilibrium price and quantity of a
good.
1.
The increase in demand causes excess demand to develop at the initial price.
a.
B.
Excess demand will cause the price to rise, and as price rises producers are
willing to sell more, thereby increasing output.
Change in Supply
1. A change in supply will cause equilibrium price and output to change in opposite
directions.
a.
An increase in supply will cause a reduction in the equilibrium price and an increase in
the equilibrium quantity of a good.
1.
The increase in supply creates an excess supply at the initial price.
a.
b.
Excess supply causes the price to fall and quantity demanded to increase.
A decrease in supply will cause an increase in the equilibrium price and a decrease in the
equilibrium quantity of a good.
1. The decrease in supply creates an excess demand at the initial price.
a.
Excess demand causes the price to rise and quantity demanded to decrease.
C. Changes in Demand and Supply
1. If demand and supply change in opposite directions, then the change in the equilibrium price
can be determined, but the change in the equilibrium output cannot.
a. A decrease in demand and an increase in supply will cause a fall in equilibrium price, but
the effect on equilibrium quantity cannot be determined.
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1. For any quantity, consumers now place a lower value on the good, and producers are
willing to accept a lower price; therefore, price will fall. The effect on output will
depend on the relative size of the two changes.
b. An increase in demand and a decrease in supply will cause an increase in equilibrium
price, but the effect on equilibrium quantity cannot be determined.
1. For any quantity, consumers now place a higher value on the good, and producers
must have a higher price in order to supply the good; therefore, price will increase.
The effect on output will depend on the relative size of the two changes.
2. If demand and supply change in the same direction, the change in the equilibrium output can
be determined, but the change in the equilibrium price cannot.
a. If both demand and supply increase, there will be an increase in the equilibrium output,
but the effect on price cannot be determined.
1. If both demand and supply increase, consumers wish to buy more and firms wish to
supply more so output will increase. However, since consumers place a higher value
on each unit, but producers are willing to supply each unit at a lower price, the effect
on price will depend on the relative size of the two changes.
b. If both demand and supply decrease, there will be a decrease in the equilibrium output,
but the effect on price cannot be determined.
1. If both demand and supply decrease, consumers wish to buy less and firms wish to
supply less, so output will fall. However, since consumers place a lower value on
each unit, but producers are willing to supply each unit only at higher prices, the
effect on price will depend on the relative size of the two changes.
III. U.S. AGRICULTURE
A. Economic and Historical Characteristics
1. The percentage of workers in agriculture has fallen since 1800, and the number has fallen
since the 1920s.
a. The downsizing of agriculture employment has been accompanied by large reductions in
the number of farms.
2. Advances in technology are largely responsible for the downsizing of agriculture.
a. Technological advances have significantly increased the supply of agriculture products.
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b. Demand for agriculture products has not kept pace with the increases in supply.
1. Population has not grown at a fast enough rate to keep pace with the increase in
supply.
2. Income has increased, but it has not resulted in a proportionate increase in demand
for agriculture products.
3. The farm population is better off both relatively and absolutely than in previous time periods.
a. Changes in technology and decreases in the price of agriculture output has decreased the
demand for labor in agriculture.
b. Tremendous growth of opportunities have resulted in large decreases in the supply of
labor in agriculture.
c. Because the decreases in supply have outweighed the decreases in demand, wages in
agriculture have increased.
B. Competitive Markets and Economic Profits
1. Two important elements of agricultural markets are risk and competition.
2. Farmers face individual risk.
a. There is a long lag between the decision to produce and the harvesting of crops or selling
of livestock.
b. Changes in market conditions, bad weather, or disease can cause the operation to go
under.
3. Farmers face market risk.
a. Because both the supply and demand of agriculture products is not very sensitive to
changes in price, supply increases can result in large reductions in revenue.
1. If there is an increase in supply, there will be a large drop in price and farmers'
revenue will decrease.
a.
Revenues fall because the drop in price outweighs the increase in quantity
bought by consumers.
b. Changes in weather can cause frequent changes in the supply of agricultural products,
thereby leading to the instability of farm income.
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4. Farmers face intense competition in the market.
a. If farmers introduce a new crop, they may reap economic profits due to the risk
associated with bringing a new product to market.
b. Over time, the economic profits will be competed away as new suppliers enter the
market.
1. The economic profits are competed away because of the decrease in price that
accompanies increases in supply and because marginal cost increases as output is
expanded.
5. Government has attempted to decrease risk by regulation, by reducing price and income risk,
and by providing disaster relief.
a. Economic analysis shows that government intervention in these areas is unnecessary.
1. Farmers can reduce risk by purchasing crop insurance, diversifying crops, and using
commodity market techniques.
IV. U.S. FARM POLICY
A. The most visible and costly farm programs have been those designed to increase the price that
farmers receive for various agricultural commodities. The basic idea is that the government
guarantees a minimum price for the product. The government might
1. establish a minimum price-a price floor-and take appropriate action to maintain that price.
2. use regulation to control supply and thus support the price.
3. pay the farmer a deficiency payment, which is the difference between the market price and
some guaranteed price.
B. Price Floors
1. A price floor is an example of a price support.
a. A price floor sets a minimum price for a commodity; market price is not allowed to fall
below the price floor.
2. Price floors for commodities have several consequences.
a. The price floor creates an excess supply of the commodity.
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1. Government purchases this excess supply in the form of a nonrecourse loan.
b. The price floor increases the revenues of farmers because they sell more of the
commodity at a higher price.
c. Price floors mean that consumers spend more for the commodity.
1. More is spent because the price support causes price to be greater than the
equilibrium price and because government must raise taxes to purchase and store the
excess supply of the commodity.
d. In order to prevent increases in the excess supply of the commodity created by the
supports, government must restrict the flow of imports.
C. Output Constraints
1. In order to decrease either excess supply or deficiency payments, government may enact a
program of output constraints.
2. Output constraints require or induce farmers to limit their production.
3. Output constraints appeal to politicians because they shift part of the burden of supporting
farmers from taxpayers to consumers without causing excess supply.
4. Farmers take their less productive land out of production and use the remaining acreage more
intensively.
D. Target Prices and Deficiency Payments
1. Instead of enacting price supports, government enacts target prices for some agricultural
products.
a. A target price is simply a guaranteed price for a product.
2. Target prices have several consequences.
a. As with the price support system, farmers sell more output and receive more revenue.
b. Unlike price supports, there is no surplus associated with the target price.
1. A potential surplus does develop, but it is sold on the market at a price below the
market equilibrium price.
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c. Government must pay farmers the difference between the target price and the price for
which the product is sold by making a deficiency payment.
1. The money for this deficiency payment comes from the taxpayer.
d. Domestic buyers pay less for the product than they do under a system of price supports.
D. Rent Seeking
1. There are different types of rent-seeking.
a. Political rent-seeking is activity undertaken to gain an economic advantage through
government action.
b. Economic rent-seeking is activity undertaken to gain an economic advantage by
producing new, better products or by producing at a lower cost and selling for a lower
price.
2. Even though farm policies have undesirable consequences, they continue because of the
political rent-seeking activities of individuals.
3. A small group of committed individuals, say dairy farmers, who have a big stake in a certain
political action have a good chance of obtaining the desired action.
a. The cost of the action is spread over a large group so that no single individual bears a cost
large enough to attempt to defeat the action.
b. The benefit of the action is spread over a small group of individuals so that each one will
work to ensure the action's passage.