Extensions of Demand and Supply Analysis
Water covers 71% of the Earth, but only
2.5% is fresh water.
People in many locales complain of
“shortages” of safe drinking water.
In this chapter you will learn more
about shortages.
4-1
Learning Objectives
• Discuss the essential features of the
price system
• Evaluate the effects of changes in
demand and supply on the market price
and equilibrium quantity
• Understand the rationing function
of prices
4-2
Learning Objectives (cont'd)
• Explain the effects of price ceilings
• Explain the effects of price floors
• Describe various types of governmentimposed quantity restrictions
on markets
4-3
Did You Know That...
• The inflation-adjusted value of the U.S.
minimum wage peaked at about $8 in 1964?
• We can use supply and demand analysis to
analyze effects of the minimum wage?
• The model of supply and demand can explain
instances of a gap between quantity supplied
and quantity demanded?
4-4
The Price System and Markets
• Price System or Market System
 An economic system in which relative
prices are constantly changing to reflect
changes in supply and demand
 Prices
signal what is relatively scarce and
relatively abundant.
 Prices
provide information to individuals
and businesses.
4-5
The Price System
and Markets (cont'd)
• Markets
 Emphasize voluntary exchange
 Determine the terms of exchange
 Facilitate exchange
4-6
The Price System
and Markets (cont'd)
• Voluntary Exchange
 Acts of trading between individuals that
make both parties to the trade better off
• Terms of Exchange
 The prices we pay for the desired items
4-7
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
4-8
The Price System
and Markets (cont'd)
• The role of middlemen
 Middlemen (intermediaries) or brokers
reduce transaction costs by providing
information to buyers and sellers
 Examples
 Real estate brokers
 Stock brokers
 Consignment shops
 Car dealerships
4-9
Policy Example: Profiting by Lowering
Transaction Costs of Junking Computers
• Transaction costs can be lowered by
middlemen (intermediaries).
 Consumers and businesses can dispose of
old computer equipment.
• Intermediaries can refurbish
old computers.
 Useable parts and computer upgrades can
be resold.
4-10
Changes in Demand and Supply
• Changes in supply and demand can
create a disequilibrium.
• The market price and quantity can/will
adjust to a new equilibrium.
4-11
Figure 4-1 Shifts in Demand and in
Supply: Determinate Results, Panel (a)
4-12
Figure 4-1 Shifts in Demand and in
Supply: Determinate Results, Panel (b)
4-13
Figure 4-1 Shifts in Demand and in
Supply: Determinate Results, Panel (c)
4-14
Figure 4-1 Shifts in Demand and in
Supply: Determinate Results, Panel (d)
4-15
Changes in Demand
and Supply (cont'd)
• Summary
 Increases in demand increase equilibrium
price and quantity.
 Decreases in demand decrease
equilibrium price and quantity.
4-16
Changes in Demand
and Supply (cont'd)
• Summary
 Increases in supply decrease equilibrium
price and increase equilibrium quantity.
 Decreases in supply increase equilibrium
price and decrease equilibrium quantity.
4-17
Changes in Demand
and Supply (cont'd)
• 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.
4-18
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
4-19
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
4-20
Example: Why Gasoline Prices
Have Increased
• One factor—an increase in 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 market clearing price of
gasoline increased.
4-21
Figure 4-2 The Effects of a Simultaneous
Decrease in Gasoline Supply and Increase
in Gasoline Demand
4-22
The Rationing Function of Prices
• Synchronization of decisions of buyers
and sellers that leads to equilibrium is
called the rationing function of prices.
4-23
The Rationing Function
of Prices (cont'd)
• Methods of non-price rationing
 Rationing by queues (waiting in line)
 Rationing by random assignment,
and/or coupons
4-24
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.
4-25
The Rationing Function
of Prices (cont'd)
• Question
 If price rationing is the most efficient is it
the “best” way to ration?
• Answer
 Economists cannot say which system is
“best.” They can say rationing via the price
system leads to the most efficient use of
available resources.
4-26
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
4-27
The Policy of Government-Imposed
Price Controls (cont'd)
• Price ceiling and black markets
 Price ceilings may prevent the equilibrium
price from being achieved if it is above
the ceiling price.
4-28
The Policy of Controlling Rents
• 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”
4-29
Price Floors in Agriculture
• Support Price
 The governmentally established price floor
 Associated
with agricultural products
4-30
Figure 4-4
Agricultural Price Supports
4-31
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
4-32
Figure 4-5
The Effect of Minimum Wages
4-33
Quantity Restrictions
• Governments can impose quantity
restrictions, most obvious—banning
ownership or trading of a good
 Human organs
 Drugs
 Hospital beds
 Gold from 1933 to 1973
4-34
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
4-35
Issues and Applications: Coping with a
Growing Global Demand for Fresh Water
• Today, about 2.5 billion people have
safe drinking water; nearly 4 billion do
not, resulting in 2 million deaths
annually.
• Price controls make a scarce resource,
such as water, harder to obtain
4-36
Figure 4-6
How to Generate a Water Shortage
4-37
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.
4-38
Summary Discussion
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.
4-39
Summary Discussion
of Learning Objectives (cont'd)
• 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.
4-40
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.
4-41
Summary Discussion
of Learning Objectives (cont'd)
• The effects of price ceilings
 A 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.
4-42
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.
4-43
Summary Discussion
of Learning Objectives (cont'd)
• Government-imposed restrictions
on market quantities
 Bans on sale or ownership
 Licensing restrictions
 Import quotas
4-44