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ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 4: Extensions of Demand and Supply Analysis Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. The Price System 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. 2 Exchange and Markets Markets Emphasize voluntary exchange Determine the terms of exchange Facilitate exchange 3 Exchange and Markets Voluntary Exchange Acts of trading between individuals that make both parties to the trade subjectively better off Terms of Exchange The prices we pay for the desired items 4 Exchange and Markets Transaction Cost The costs associated with exchange Examples Price shopping Determining quality Determining reliability Service availability Cost of contracting 5 Exchange and Markets The role of middlemen Middlemen (intermediaries) or brokers reduce transaction cost by providing information to buyers and sellers. Examples Real estate brokers Stock brokers Consignment shops Car dealerships 6 Changes in Demand and Supply Changes in supply and demand create a disequilibrium The market price and quantity adjust to a new equilibrium 7 Shifts in Demand and Supply: Determine Results Increase Demand with Supply Constant S E1 P1 D1 Q1 Figure 4-1 8 Shifts in Demand and Supply: Determine Results Increase Demand with Supply Constant S At price P1 quantity demanded exceeds quantity supplied— a shortage exists E1 P1 D1 Q1 Figure 4-1 D2 Q2 9 Shifts in Demand and Supply: Determine Results Increase Demand with Supply Constant S E2 Equilibrium price and quantity increase to P2 and Q2 P2 E1 P1 D1 Q1 Figure 4-1 Q2 D2 10 Shifts in Demand and Supply: Determinate Results Decrease Demand with Supply Constant E1 S At price P1 quantity supplied exceeds quantity demanded— a surplus exists. P1 D1 D2 Q2 Figure 4-1 Q1 11 Shifts in Demand and Supply: Determinate Results Decrease Demand with Supply Constant E1 S Equilibrium price and quantity decrease to P3 and Q3 P1 E3 P3 D1 D3 Q3 Figure 4-1 Q1 12 Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant S1 E1 P1 D Q1 Figure 4-1 13 Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant At price P1 quantity supplied exceeds quantity demanded— a surplus exists S1 S2 E1 P1 D Q1 Figure 4-1 Q3 14 Shifts in Demand and Supply: Determinate Results Increase Supply with Demand Constant Equilibrium price decreases and quantity increases to P2 and Q2 S1 S2 E1 P1 E2 P2 D Q1 Figure 4-1 Q2 15 Shifts in Demand and Supply: Determinate Results Decrease Supply with Demand Constant S3 S1 E1 At price P1 quantity demanded exceeds quantity supplied— a shortage exists P1 D Q2 Figure 4-1 Q1 16 Shifts in Demand and Supply: Determinate Results Decrease Supply with Demand Constant S3 E3 S1 P3 Equilibrium price decreases and quantity increases to P3 and Q3 E1 P1 D Q3 Figure 4-1 Q1 17 Changes in Demand and Supply Summary Increases in demand increase equilibrium price and quantity. Decreases in demand decrease equilibrium price and quantity. 18 Changes in Demand and Supply Summary Increases in supply decrease equilibrium price and increase equilibrium quantity. Decreases in supply increase equilibrium price and decrease equilibrium quantity. 19 Changes in Demand and Supply 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 20 Changes in Demand and Supply 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 21 Changes in Demand and Supply 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 22 Change in demand or supply Demand Supply Price Quantity Increase Increase Increase Decrease Decrease Decrease Increase Decrease Increase Decrease Increase Decrease Change in both demand and supply Demand Supply Price Quantity Increase Increase Unknown Increase Increase Decrease Increase Unknown Decrease Increase Decrease Unknown Decrease Decrease Unknown Decrease 23 Price Flexibility and Adjustment Speed Prices quite flexible in unfettered markets can be less flexible in other market scenarios. May experience indirect adjustments such as hidden payments, quality changes May not reach equilibrium right away 24 Adjustment speed Market characteristics influence adjustment speed. Markets may overshoot in the adjustment process. Markets are subject to energy shocks, labor strikes, severe weather. 25 The Rationing Function of Prices When surpluses and shortages exist, the price adjusts to clear the market. Synchronization of decisions of buyers and sellers will lead to equilibrium. This adjustment is the rationing function of price. 26 The Rationing Function of Prices When prices cannot adjust non-price rationing occurs Rationing by queues Rationing by lotteries Rationing by coupons 27 The Rationing Function of Prices The essential role of rationing With scarcity rationing must occur We must choose the rationing mechanism: price or non-price Price rationing is the most efficient Further trades could not occur without making somebody worse-off 28 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 29 The Policy of Government-Imposed Price Controls Non-Price Rationing Devices All methods used to ration scarce goods that are price-controlled Black Market A market in which price-controlled goods are sold at an illegally high price 30 Black Markets The Policy of Controlling Rents The functions of rental prices Promote the efficient maintenance and construction of housing Allocate existing housing Ration the use of housing 32 The Policy of Controlling Rents Effects on the existing supply of housing Property owners cannot recover costs Rationing the current use of housing Reduces mobility New York’s “housing gridlock” 33 The Policy of Controlling Rents Who gains and who loses from rent controls? Losers Property owners Low-income individuals Benefits Upper-income professionals 34 Price Floors in Agriculture Support Price the governmentally established minimum price farmers are to receive for a particular agricultural product. 35 Agricultural Price Supports 36 Price Floors in the Labor Market Minimum Wage Lowest hourly wage rate that firms may legally pay their workers 37 The Effect of Minimum Wages 38 Quantity Restrictions Prohibitions on the ownership or trading of a good Human organs Drugs Hospital beds 39 Quantity Restrictions Government Prohibitions or 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 in a one-year period 40 ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 4: Extensions of Demand and Supply Analysis Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.