Economics Today: Nineteenth Edition
Economics Today: Nineteenth Edition
Nineteenth Edition
Chapter 4
Extensions of Demand and
Supply Analysis
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Learning Objectives (1of 2)
• 4.1 Discuss the essential features of the price
system
• 4.2 Evaluate the effects of changes in demand
and supply on the market price and equilibrium
quantity
• 4.3 Understand the rationing function of prices
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Learning Objectives (2 of 2)
• 4.4 Explain the effects of price ceilings
• 4.5 Explain the effects of price floors and
government-imposed quantity restrictions
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Chapter Outline
• 4.1 The Price System and Markets
• 4.2 Changes in Demand and Supply
• 4.3 The Rationing Function of Prices
• 4.4 Price Ceilings
• 4.5 Price Floors and Quantity Restrictions
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Did You Know That ...
• in every year since 2011, shortages have
persisted for about 300 pharmaceuticals
manufactured for diverse purposes?
• Various U.S. laws prevent prices from rising
sufficiently to eliminate shortages for numerous
pharmaceuticals for which government programs
such as Medicare and Medicare provide funding.
• Therefore, these laws effectively generate legally
binding price ceilings in some markets.
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4.1 The Price System and Markets (1 of 4)
• Price system, or market system
– An economic system in which relative prices are
constantly changing to reflect changes in supply and
demand:
The prices are signals as to what is relatively scarce and
relatively abundant.
Prices provide information to individuals and businesses.
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4.1 The Price System and Markets (2 of 4)
• Voluntary exchange
– An act of trading between individuals in the price
system
– Makes both parties to the trade subjectively better off
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4.1 The Price System and Markets (3 of 4)
• Transaction costs
– All the costs associated with exchange, including:
The informational costs of finding out the price and quality,
service record, and durability of a product
The cost of contracting and enforcing that contract
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4.1 The Price System and Markets (4 of 4)
• The role of middlemen
– Middlemen (intermediaries) or brokers reduce
transaction costs by providing information to buyers
and sellers.
• Platform firms
– Companies whose services link people to other
individuals who share their interests or who seek to buy
firms’ products, often via networks that the companies
operate.
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Behavioral Example: Online Dating
Sites and Virtual Roses
• Some online dating companies provide each
customer with a small number of virtual roses that
can be attached to invitations to date other
customers.
• The roses induce a 20 percent increase in the
date acceptance rate as recipients regard those
roses as indicators of the seriousness of senders’
interest.
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4.2 Changes in Demand and Supply
• Changes in supply and demand create a
disequilibrium.
• The market price and quantity adjust to a new
equilibrium.
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Figure 4-1 Shifts in Demand and in Supply:
Determinate Results, Panel (a)
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Figure 4-1 Shifts in Demand and in Supply:
Determinate Results, Panel (b)
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Figure 4-1 Shifts in Demand and in Supply:
Determinate Results, Panel (c)
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Figure 4-1 Shifts in Demand and in Supply:
Determinate Results, Panel (d)
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4.2 Changes in Demand and Supply (1 of 7)
• Summary:
– Increases in demand increase equilibrium price and
quantity.
– Decreases in demand decrease equilibrium price and
quantity.
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4.2 Changes in Demand and Supply (2 of 7)
• Summary:
– Increases in supply decrease equilibrium price and
increase equilibrium quantity.
– Decreases in supply increase equilibrium price and
decrease equilibrium quantity.
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4.2 Changes in Demand and Supply (3 of 7)
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4.2 Changes in Demand and Supply (4 of 7)
• When both demand and supply increase:
– The change in equilibrium price is indeterminate.
– The equilibrium quantity increases unambiguously.
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4.2 Changes in Demand and Supply (5 of 7)
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4.2 Changes in Demand and Supply (6 of 7)
• Price flexibility:
– Prices that are quite flexible in some markets can be
less flexible in other market scenarios:
May take the form of subtle adjustments such as hidden
payments and quality changes
May not reach equilibrium right away
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4.2 Changes in Demand and Supply (7 of 7)
• Adjustment speed:
– Market characteristics influence adjustment speed.
– Markets may overshoot in the adjustment process.
– Markets are subject to energy shocks, labor strikes,
and severe weather.
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International Example: Why Are
Global Ship Rental Prices Dropping?
• Since 2010, the prices to rent ships that transport
goods across the world’s oceans have dropped by
more than 50 percent.
– One reason for this drop is the slow rebound of world
trade following the 2010 recession.
– Another reason is an increase in the supply of new
large freight ships.
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Figure 4-2 The Effects of a Simultaneous Increase
in the Supply of and Decrease in the Demand for
Ship Rentals
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4.3 The Rationing Function of Prices (1 of 3)
• Synchronization of decisions of buyers and sellers
that leads to equilibrium is called the rationing
function of prices.
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4.3 The Rationing Function of Prices (2 of 3)
• Methods of nonprice rationing:
– Rationing by queues (waiting in line)
– Rationing by random assignment or coupons
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Policy Example: Rationing Water
• In response to years of drought, the California
government announced a requirement for all cities
in the state to reduce their consumption of water
by 25 percent.
• The governments of many cities, such as San
Jose, effectively issue each household an
electronic coupon to ration water.
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4.3 The Rationing Function of Prices (3 of 3)
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4.4 Price Ceilings (1 of 8)
• Price controls
– Government-mandated minimum or maximum prices
• Price ceiling
– A legal maximum price
• Price floor
– A legal minimum price
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4.4 Price Ceilings (2 of 8)
• Price ceiling and black markets:
– A price ceilings may prevent the equilibrium price from
being achieved if it is above the ceiling price.
– A price ceiling that is set below the market clearing
price creates a shortage.
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4.4 Price Ceilings (3 of 8)
• Nonprice 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
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Figure 4-3 Black Markets for Portable Electric
Generators
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International Example: Looking for Hard-to-
Find in Venezuela? Ask for the Bachaqueros
• The Venezuelan government has established
maximum allowed “fair prices” that sellers can
charge for a wide range of items from coffee to
toilet paper.
• As a consequence, bachaqueros work together
like hordes of ant-like insects to quickly purchase
all items, from store shelves at the government-
mandated prices as soon as they become
available and then resell them at considerably
higher prices on the black market.
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4.4 Price Ceilings (4 of 8)
• The functions of rental prices:
– Promote the efficient maintenance and construction of
housing
– Allocate existing housing
– Ration the use of housing
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4.4 Price Ceilings (5 of 8)
• Rent controls and construction
– Controls discourage construction:
With a 16 percent vacancy rate and no controls, Dallas
recently built 11,000 new rental units.
With a 1.6 percent vacancy rate and controls, San Francisco
recently built 2,000 new rental units.
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4.4 Price Ceilings (6 of 8)
• Effects on the existing supply of housing and
current use of housing:
– Property owners cannot recover costs:
Maintenance, repairs, capital improvements
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4.4 Price Ceilings (7 of 8)
• Attempts to evade rent controls:
– Forcing tenants to leave
– Tenants subletting apartments
– Housing courts
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4.4 Price Ceilings (8 of 8)
• Who wins and who loses from rent controls?
– Losers:
Property owners
Low-income individuals
– Winners:
Upper-income professionals
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What If ... the government requires apartment
owners to set rents based on tenants’ incomes?
• More low-income households would seek those
rent-controlled apartments.
• As a consequence, shortages would occur in the
market for those apartments subject to price
ceilings.
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4.5 Price Floors and Quantity
Restrictions (1 of 5)
• Support price
– The government chooses a price floor for a product
and then acts to ensure that the price of the product
never falls below the support level:
Price floors are associated with many agricultural products.
A price floor that is set above the market clearing price results
in a surplus.
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Figure 4-4 Agricultural Price Supports
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4.5 Price Floors and Quantity
Restrictions (2 of 5)
• Questions:
– How could the government keep the price from falling?
– Who benefits from agricultural price supports?
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4.5 Price Floors and Quantity
Restrictions (3 of 5)
• Minimum wage
– A wage floor, legislated by government, that sets the
lowest hourly wage rate that firms may legally pay their
workers
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Figure 4-5 The Effect of Minimum Wages
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4.5 Price Floors and Quantity
Restrictions (4 of 5)
• Governments can impose quantity restrictions.
• The most obvious examples are banning
ownership or trading of goods:
– Human organs
– Drugs
– Hospital beds
– Gold from 1933 to 1973
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Example: Dramatic Responses to Cities’ Minimum
Wage Hikes: “Zeroing Out” Employment
• A number of cities, including Los Angeles, San
Francisco, and Seattle, have established a
minimum wage rate of $15 per hour, which is
higher than the $7.25-per-hour federal level.
• A number of firms and stores react to increased
minimum wage rates by shutting down, so their
quantity of labor demanded falls to zero.
• Such responses contribute to the upward
movement along a market labor demand curve.
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4.5 Price Floors and Quantity
Restrictions (5 of 5)
• 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
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International Policy Example: The European Union
Decides That the Costs of Milk Quotas Outweigh the
Benefits
• In 1984, the European Union (EU) established
quotas for dairy farmers, resulting in an upward
movement along the market demand curve.
• Despite the higher price received by dairy farmers,
they were unable to implement fully new
techniques to boost milk production and reduce
their costs.
• In response, the EU now has completed a
phased-in elimination of its dairy quotas.
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You Are There: Price Rationing via Changes
in the Number of Items Sold in a Package
• In response to higher costs of inputs used to
produce pepper, McCormick & Company has
reduced the amount of pepper in each tin can, a
practice known as non-functional slack fill.
• This practice, also common among firms that sell
food items in packages, effectively increases the
price per ounce of pepper in the process which is
rationing via the price system.
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Issues & Applications: Online Middlemen:
Customer Sales Reps Move to the Web
• For many people, the time and effort required to find and
choose among all the possibilities available to them
represent transaction costs of exchange.
• Consumers’ desires to reduce these transaction costs
provide opportunities for middlemen.
• A firm called Operator offers a digital-device app that can
connect a consumer with a network of customer service
representatives.
• Amazon’s “Home Services” site also gives consumers a
network of providers of specialized services.
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Summary Discussion of Learning
Objectives (1 of 6)
• 4.1 Discuss the essential features of the price
system
– A price system (market system) allows prices to
respond to changes in supply and demand for different
commodities.
– Prices are communicated in markets that tend to
minimize transaction costs.
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Summary Discussion of Learning
Objectives (2 of 6)
• 4.2 Evaluate the effects of changes in demand
and supply on the 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.
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Summary Discussion of Learning
Objectives (3 of 6)
• 4.2 Evaluate the effects of changes in demand
and supply on the market price and equilibrium
quantity
– When both demand and supply shift at the same time,
the outcome is indeterminate for either equilibrium
price or equilibrium quantity.
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Summary Discussion of Learning
Objectives (4 of 6)
• 4.3 Understand 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.
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Summary Discussion of Learning
Objectives (5 of 6)
• 4.4 Explain the effects of price ceilings
– A price ceiling set below the market clearing price
results in a shortage:
The resulting shortage can lead to nonprice rationing devices
and black markets.
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Summary Discussion of Learning
Objectives (6 of 6)
• 4.5 Explain the effects of price floors and
government-imposed quantity restrictions
– If the price floor is set above the market clearing price,
a surplus results:
A price floor can take the form of a government-imposed price
support or minimum wage.
– Bans on sale or ownership
– Licensing restrictions
– Import quotas
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Appendix B: Consumer Surplus, Producer
Surplus, and Gains from Trade within a Price
System (1 of 4)
• Consumer surplus
– The difference between the total amount that
consumers would have been willing to pay for an item
and the total amount that they actually pay
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Figure B-1 Consumer Surplus
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Appendix B: Consumer Surplus, Producer
Surplus, and Gains from Trade within a Price
System (2 of 4)
• Producer surplus
– The difference between the total amount that producers
actually receive for an item and the total amount that
they would have been willing to accept for supplying
that item
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Figure B-2 Producer Surplus
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Appendix B: Consumer Surplus, Producer
Surplus, and Gains from Trade within a Price
System (3 of 4)
• Gains from trade
– The sum of consumer surplus and producer surplus
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Figure B-3 Consumer Surplus, Producer Surplus,
and Gains from Trade
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Appendix B: Consumer Surplus, Producer
Surplus, and Gains from Trade within a Price
System (4 of 4)
• How do price controls affect gains from trade?
– Consumer surplus and producer surplus are both
lower.
– Either a price ceiling or a price floor reduces gains from
trade.
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Copyright
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