Transcript Price of Ice

Markets
• Markets are an important mechanism
for solving the problem of optimal use
of scarce resources
• Buyers and sellers
• Buyers:
- consumers, who buy goods and
services
- Firms, which buy labor, capital
equipment, etc.
Markets
• Sellers:
- Consumers as workers sell their labor
services
- Firms sell their goods and services
Markets
• Markets as a collection of buyers and
sellers of a particular product/products
• An industry is a collection of firms while
a market consists of both firms (as
sellers) and consumers (as buyers)
Markets
• Market definition (the extent of market)
can be important
• Market definition identifies which buyers
and sellers should be included in a
given market
• To determine which buyers and sellers
to include, we need to determine the
extent of a market
• Its boundaries – both geographically
and in terms of the range of products.
Market definition - Geographic
• Some markets have restrictive
geographic boundaries
• Consider market for housing
• It is city-specific
• Dwellers in a particular will not want to
stay in houses long distance away, even
though this may be cheaper
• Homes and land cannot be shifted
closer to cities
Market definition – range of products
Consider 35 mm SLR cameras
• Are digital cameras and Polaroid instant
cameras in the same market?
Consider cars
• Are petrol cars and fuel cell powered cars
(REVA) in the same market?
Sometimes the degree of substitution depends
on the current prices. Fuel cell powered cars
may not be substitutes for petrol-run cars at
current petrol prices, but may become
substitutes if the price of petrol increases
sufficiently.
Demand-supply Analysis
A market consists of the buyers and
sellers of a good or service: abstraction
from any concept of specific time and
location of a market.
The market demand schedule shows
the amounts of the commodity that
buyers are prepared to buy at different
prices.
Demand Schedule
The Demand Curve: The Relationship
between Price and Quantity Demanded
• Demand Curve
– The demand curve is a graph of the relationship
between the price of a good and the quantity
demanded.
Demand Schedule and Demand Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
in price ...
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
Copyright © 2004 South-Western
The downward sloping demand curve
obeys the law of demand: quantity
demanded decreases as price increases.

The slope is negative (but may not be
constant) at all points of the demand curve.

It is obvious from even casual observation
or introspection that demand depends on
many things.
In general, the quantity demanded
is expected to depend, in addition to the
own price, on




incomes
tastes and preferences
prices of “related” commodities
expectations, etc.
A change in any of these other factors thus leads
to a shift in the entire curve.
Changes in Quantity Demanded
Price of IceCream
Cones
B
$2.00
A tax that raises the
price of ice-cream
cones results in a
movement along the
demand curve.
A
1.00
D
0
4
8
Quantity of Ice-Cream Cones
Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
When we draw the demand curve, we are focusing only
on the relationship between price and quantity
demanded. We can do this by assuming that “everything
else” is being kept fixed at certain levels.
How do we expect the “other things” to influence
demand?

If I (income) increases, we expect
more to be demanded at every price – the
demand curve will shift to the right.
Price of IceCream Cone
Consumer Income
Normal Good
$3.00
2.50
Increase
in demand
An increase
in income...
2.00
1.50
1.00
0.50
D1
0 1
2 3 4 5 6 7 8 9 10 11 12
D2
Quantity of
Ice-Cream
Cones
However, there may be some ‘inferior’
goods whose demand falls as income
increases.
For example, an increase in the incomes
of poor farmers might lead them to buy
more of rice and wheat and less of
coarse cereals like ragi, jowar, and
bajra.
Price of IceCream Cone
Consumer Income
Inferior Good
$3.00
2.50
An increase
in income...
2.00
Decrease
in demand
1.50
1.00
0.50
D2
0 1
D1
2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
Cones
·
If T (tastes and preferences)
change such that buyers like a
commodity more, again the
same thing will happen.
Tastes and preferences can change for many
reasons:
Demographic changes
If population comes to consist of larger proportion of
older people, this will affect pattern of demand.
New Information
Dissemination of the information on harmful sideeffects of drugs can lead to a fall in demand for these
drugs.
Government decisions
Ban on advertising of certain goods can adversely
affect demand for such goods
Prices of related goods:
If the price of a substitute rises, we expect the
demand to rise, too (as price of coffee rises, the
demand curve for tea shifts upward and to the
right).
If the price of a complement rises, we expect
the demand to fall (as price of sugar rises, the
demand curve for tea shifts downward and to
the left).
• Prices of related goods contd.
Complements
• The dramatic fall in the price of computers
over the past twenty years has significantly
increased the demand for printers, monitors
and internet access.
• air travel and hotel rooms
• movies and popcorn
• bathing suits and sun tan lotion
• candy and dentistry
• Prices of related goods contd.
Substitutes
• computers and typewriters
• movies (in theaters) and sporting
events
• restaurants and dining at home
• holiday in Goa versus holiday in
Mussourie
• marijuana and alcohol
• economics courses and political science
courses
An expectation that prices will rise
in the future shifts the demand
curve to the right.
The simple thing to remember is:
a change in commodity’s own price by itself
can only represent a movement along the
demand curve and not a shift in the curve;
however, a change in any of the “other
things” will lead to a shift of the demand
curve.
A numerical example
Suppose that the demand function is
Qd = 1800 – 20P +0.6M – 50PR
Also suppose M = 20,000 and PR = 250
Then Qd = 1800 – 20P +0.6(20,000) – 50(250)
= 1800 – 20P + 12,000 – 12,500
Qd = 1300 – 20P
Note: (i) Any change in M or PR affects the demand
curve through the intercept term – shifts the
demand curve
(ii) The sign of the coefficient of PR is negative –
hence this is a complement
The market supply schedule shows the
amounts of the commodity that sellers
are prepared to sell at different prices.
Supply Schedule
The Supply Curve: The Relationship
between Price and Quantity Supplied
• Supply Curve
– The supply curve is the graph of the relationship
between the price of a good and the quantity
supplied.
Supply Schedule and Supply Curve
Price of
Ice-Cream
Cone
$3.00
1. An
increase
in price ...
2.50
2.00
1.50
1.00
0.50
0
1 2
3
4
5
6
7
8
9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
Copyright©2003 Southwestern/Thomson Learning
The upward sloping supply curve that
has been drawn exemplifies the law of
supply: quantity supplied increases as
price increases.
Like demand, supply also depends on
many things.
In general, the quantity supplied is expected to
depend on

own price

technological knowledge

input prices,

expectations, etc.
How do we expect the “other things” to
influence supply?
A change in technology that allows
the commodity to be produced more
cheaply should shift the supply curve
downwards and to the right.
If input prices increase, exactly the
opposite should happen.
As wages rise, the supply of goods and services is
reduced, because wages are the input price of labor.
Labor sometimes accounts for about two-thirds of
all input costs, and thus wage increases create
supply reductions (a higher price is necessary to
provide the same quantity) for most goods and
services.
Costs of materials of course increase the price of
goods using those materials. Petrol - crude oil
Another significant input in many industries is
capital. Increases in interest rates increase the cost of
production, and thus tend to decrease the supply of
goods.
A numerical example
• Suppose that the supply function is
Qs = 50 + 10P – 8PI + 5T
If PI = 50 and T = 90, then
Qs = 50 + 10P – 8(50) + 5(90)
= 50 + 10P – 400 + 450
Qs = 100 + 10P
Change in Quantity Supplied
Price of IceCream
Cone
S
C
$3.00
A rise in the price
of ice cream
cones results in a
movement along
the supply curve.
A
1.00
0
1
5
Quantity of
Ice-Cream
Cones
Shifts in the Supply Curve
• Change in Supply
– A shift in the supply curve, either to the left or
right.
– Caused by a change in a determinant other than
price.
Shifts in the Supply Curve
Price of
Ice-Cream
Cone
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Equilibrium
•
The demand and supply curves intersect
to determine the market equilibrium
• Equilibrium: a price-quantity pair
• Why call it equilibrium?
1. If the market is at (P*, Q*), there are no
forces to move it away from (P*, Q*)
2. If the market is not at equilibrium, it tends
to come back to equilibrium
SUPPLY AND DEMAND
TOGETHER
Demand Schedule
Supply Schedule
At $2.00, the quantity demanded
is equal to the quantity supplied!
The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
A numerical example
Equation of demand curve:
Qd = 1300 – 20P
Equation of supply curve:
Qs = 100 + 10P
At equilibrium Qd = Qs
1300 – 20P = 100 + 10P
Solving,
P = 40
Qd = Qs = 500
Equilibrium
• Surplus
– When price > equilibrium price, then quantity
supplied > quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales,
thereby moving toward equilibrium.
Equilibrium
• Shortage
– When price < equilibrium price, then quantity
demanded > the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many
buyers chasing too few goods, thereby moving
toward equilibrium.
P
S
D
Excess supply
P’
P*
P’’
Excess demand
S
0
D
Q*
Q
Just why is gas so expensive?
Shifts in equilibrium
• More interesting is the case where there
are shifts in supply and/or demand
curves
• As a result, the equilibrium shifts
• Sometimes, it is useful to predict the
direction of shift
Three Steps to Analyzing Changes in
•Equilibrium
Decide whether the event shifts the supply
or demand curve (or both).
• Decide whether the curve(s) shift(s) to the
left or to the right.
• Use the supply-and-demand diagram to see
how the shift affects equilibrium price and
quantity.
A war in the Middle East disrupts the supply of oil to
India.
At the same time, the minimum age for driving is
lowered to 16 years.
We would expect that
(a) both the price of petrol and the quantity
purchased would definitely rise.
(b) both the price and the quantity purchased of
petrol would definitely fall.
(c) the price of petrol might rise or fall, but the
quantity purchased would definitely fall.
(d) the quantity purchased of petrol might rise or
fall, but the price of petrol must rise.
P
D2
S2
D1
P2
S1
P1
D2
S2
0
S1
D1
Q1 Q2
Q
Pop Quiz
•
Consider the market for apples. What
would be effect on price and quantity of the
following events?
1. Scientists find that an apple a day does not
keep the doctor away and a drought shrinks
the apple crop to one quarter of its normal
size
2. The price of oranges triples and a new
insecticide eliminates pests in the apple
crop
P
D1
S2
D2
P1
S1
P2
D1
S2
0
D2
S1
Q2
Q1
Q
Government interventions
• Sometimes Governments try to correct
the the existing pattern of income
distribution.
• They often try to achieve the results
indirectly, by interfering with the market
processes.
• Examples are rent control laws and
minimum wage legislation.
Rent Control Laws
• Governments sometimes try to set a
ceiling on rents in the belief that rents
in free market equilibrium would be too
high for most people to afford renting
flats/apartments.
• Thus in the market for housing, the
maximum rent allowed is r’ which is less
than the equilibrium level r*
r
S
D
r*
r’
Excess demand
S
0
D
H
Rent Control Laws
• At r’, there will be excess demand for
housing.
• Who gains from this arrangement?
• The people who are able to get housing
at the low rents.
Rent Control Laws
• But the unsatisfied demand shows up in
various ways.
- First, landlords charge high deposits and
“pugrees”.
- Secondly, illegal transactions take place
in the form of charging high rents
without issuing corresponding receipts.
- Landlords also might use their discretion
to screen applicants, e.g., some landlords
might rent out flats only to vegetarians.
Rent Control Laws
• More importantly, in the long run, the
smaller value from housing as an asset
might discourage landlords from
providing adequate maintenance
services.
• Over time, funds are switched to other
types of investment and less funds are
deployed in the housing industry, thus
shifting the supply curve to the left,
(from SS to S'S') and aggravating the
initial condition of excess demand.
r
S’
S
D
r*
r’
S’
0
S
D
H
Rent Control Laws in India
• In India, different states have passed different
rent control acts.
• Generally, for pre-war buildings, rents are frozen
as of a specified year without any provision for
subsequent increases in rents.
• For post-war buildings, rents are determined on
the basis of specified returns on total
investment in housing.
• In many rent acts, there is a provision of a rent
control holiday on new buildings for 5-7 years
from the date of first letting out.
Rent Control Laws in India
• The gross returns that are allowed on postwar buildings vary from 6-8.25 per cent on
the total cost of land and building at the time
of construction.
• This is much less than returns from other
sources (e.g. fixed deposit interest rates till
recently could be 12-13 per cent).
• Moreover, some acts do not allow landlords
to recover the increase in local taxes and
rates from tenants.
Rent Control Laws in India
• It is clear that construction of housing for
rental is strongly discouraged under these acts.
- In all the major cities in India, housing for long
term rental is difficult to get. In Bombay, for
example, a system of “leave and license” has
developed, under which apartments are rented
out for 11 months at a time.
- Moreover, landlords have the incentive to
neglect maintenance, so that the housing
becomes unsafe and then can be pulled down
and the vacant land sold at a huge profit.
Minimum Wage Legislation
• Minimum wage legislation is undertaken
to ensure that wages paid to workers
do not fall below a certain minimum.
• Hence, in the labor market, a floor is
set on wages, i.e., wages are not
allowed to fall below a certain level.
w
S
D
Excess supply
w’
w*
S
0
D
L
Minimum Wage Legislation
• At wage rate w*, there is excess supply
of labor.
- Since some workers would have been
willing to work for lower wages, a
“contract” system of wages tends to
develop.
- Workers are employed for smaller periods
or in smaller numbers, so that the
minimum wage provision does not apply,
or they are not paid other benefits like
medical benefits, PF, gratuity, etc.
Minimum Wage Legislation
- In the longer run, employers might
switch to more machine-intensive
processes to economize on labor costs.
- This shifts the demand curve for labor
to the left and aggravates the initial
condition of excess supply.
Minimum Wage Legislation in India
• The Central Government in India sets
minimum wages for workers in different
employments at different rates for
different categories of workers (unskilled,
semi-skilled, skilled, etc.)
• The minimum wages also vary by
location, being the highest for the major
cities.
• In addition, the state governments also
fix minimum wages for certain
employments.
Conclusion
• Are interventions in the forms of price
ceilings or price floors always
undesirable?
• There is some gain from each of these
actions and there are some losses, and
these must be balanced by society
against each other.
• But when markets are not allowed to
operate freely, forces build up that tend
to bypass regulations, with unintended
and undesirable outcomes.