Microconomics

Module 4: Applications of Supply and Demand

Applications of Supply and Demand

Demand and Supply Model

• Economists believe there are a small number of fundamental
principles that explain how economic agents respond in different
situations. Two of these principles, are the laws of demand and
supply.
• Governments can pass laws affecting market outcomes, but no
law can negate these economic principles.
• The laws of supply and demand often become apparent in
sometimes unexpected ways, which may undermine the intent
of the government policy.
Price Ceilings

Price Ceilings: a legal maximum price for a product.

• Keeps a price from rising above a certain level (the “ceiling”).
• Governments typically set a price ceiling to protect consumers
by making necessary products affordable, but you’ll come to see
how this sometimes backfires by creating a market shortage.
• Consumers, who are also potential voters, sometimes unite
behind a political proposal to hold down a certain price.
Price Ceilings (cont.)

Five major consequences of price

ceilings:
• Shortages
• Reduced quality
• Wasted time and resources
• Deadweight loss, or a loss of gains
from trade
• Misallocation of resources
Price Floors
Price Floor: a legal minimum price for a
product.
• Price floors are sometimes called “price
supports,” because they support a price
by preventing it from falling below a
certain level.
• An example of a price floor is the
minimum wage, which is based on the
view that someone working full time
should be able to afford a basic standard
of living.
• Most common way price supports work is
the government enters the market and
buys up the product, adding to demand to
keep prices higher than they otherwise
would be.
Price Floors (cont.)

Price Control: government laws to

regulate prices instead of letting
market forces determine price.
• Neither price ceilings nor price
floors cause demand or supply to
change.
• They simply set a price that limits
what can be legally charged in the
market.
Price Controls Example: Katrina

Water after Katrina Example

• The problem originates from the
fact that the demand for the good
increases suddenly and
dramatically.
• The question is how to deal with the
shortage. How to allocate the
limited supply of bottled water
among competing needs and
wants.
• When a price ceiling reduces the
legal price of a product, businesses
have less incentive to supply the
product.
Price Controls Example: Katrina (cont.)

Water after Katrina Example

Who gets the limited supply?
• It could be first come, first serve
• It could be friends of the seller.
• In many cases, what results are under-the-table
payments by consumers willing to violate the law.
• What is certain is that less bottled water gets to
consumers than would be the case if the price
were allowed to rise.
Trade and Efficiency

Getting a Good Deal or Making

a Good Deal
• People make transactions
because they value the same
goods differently at the margin.
• Marginal Analysis: comparing
the benefits and costs of
choosing a little more or a little
less of a good.
Trade and Efficiency (cont.)

Getting a Good Deal or Making a Good Deal

• Law of Diminishing Marginal Utility: as we consume more of
a good or service, the utility we get from additional units of the
good or service tend to become smaller than what we received
from earlier units.
• Allocative Efficiency: when benefits of trade are maximized
and the mix of goods being produced represents the mix that
society most desires.
Consumer & Producer Surplus

Consumer Surplus, Producer Surplus,

Social Surplus
• Consumer Surplus: if we add up the gains
at every quantity, we can measure the
consumer surplus as the area under the
demand curve up to the equilibrium quantity
and above the equilibrium price.
• Producer Surplus: the value to producers
of their sales above their cost of production.
• Social (or economic or total)
Surplus: the sum of consumer and producer
surplus at some quantity and price of output.
Consumer & Producer Surplus (cont.)

• The market is efficient and both consumer and producer surplus

are maximized at the equilibrium point of $5.
• If the government establishes a price ceiling, a shortage results,
which also causes the producer surplus to shrink, and results in
inefficiency called deadweight loss
• Deadweight Loss: the loss in social surplus that occurs when
a market produces an inefficient quantity.
• If government implements a price floor, there is a surplus in the
market, the consumer surplus shrinks, and inefficiency produces
deadweight loss.
Consumer & Producer Surplus: Graph

Calculate Consumer Surplus

• Step 1 Define the base and

height of the consumer
surplus triangle.

• Step 2 Apply the values for

base and height to the
formula for the area of a
triangle.
Inefficiency of Price Floors and Price Ceilings
Price Ceiling Inefficiency
• An inefficient outcome occurs and the total
surplus of society is reduced.
• Loss in social surplus occurs when the
economy produces at an inefficient
quantity, called deadweight loss.
• When deadweight loss exists, it is possible
for both consumer and producer surplus to
be higher, in this case because the price
control is blocking some suppliers and
demanders from transactions that would be
beneficial to both.
• Like a law establishing rent controls, it will
transfer some producer surplus to consumers
—which helps to explain why consumers often
favor them.
Inefficiency of Price Floors and Price Ceilings
(cont.)
Price Floor Inefficiency
• The imposition of a price floor
prevents a market from adjusting
to its equilibrium price and
quantity, and will create an
inefficient outcome.
• Price floor will transfer some
consumer surplus to producers,
which explains why producers
often favor them.
Consumer surplus: The gap
between the price that consumers
are willing to pay, based on their
preferences, and the market
equilibrium price.
Labor and Financial Markets

The theories of supply and demand

do not apply just to markets for
goods. They apply to any market,
even markets for labor and financial
services.
• Labor Markets: supply and
demand for jobs.
• Financial Markets: supply and
demand for financial services; i.e.
saving & borrowing.
Labor and Financial Markets (cont.)
Supply and Demand in Labor Markets
Economic events can change the • The same new technologies are a
equilibrium salary (or wage) and complement to high-skill workers like
quantity of labor. managers, who benefit from the
technological advances by being able
Example: Consider how new
to monitor more information,
information technologies has affected
communicate more easily, and juggle
low-skill and high-skill workers in the
a wider array of responsibilities.
U.S. economy.
• How will the new technologies affect
• From the perspective of employers
the wages of high-skill and low-skill
who demand labor, these new
workers?
technologies are often a substitute
for low-skill laborers like file clerks • For this question, use the four-step
who used to keep file cabinets full process of analyzing how shifts in
of paper records of transactions. supply or demand affect a market.
Labor and Financial Markets: Labor
TECHNOLOGY AND WAGE INEQUALITY: THE FOUR-STEP PROCESS
• Step 1. What did the markets for low-skill labor and high-skill labor look like
before the arrival of the new technologies?
• Step 2. Does the new technology affect the supply of labor from households or
the demand for labor from firms?
• Step 3. Will the new technology increase or decrease demand?
• Step 4. Compare the new equilibrium price and quantity to the original
equilibrium price.
Labor and Financial Markets (cont. II)
Supply and Demand in Financial
See how the
Markets
theories of supply and • How would increased U.S. public
demand also affect financial markets. debt affect the equilibrium price
• Example: Imagine the U.S. and quantity for capital in U.S.
economy became viewed as a less financial markets?
desirable place for foreign • In a modern, developed economy,
investors to put their money financial capital often moves
because of fears about the growth invisibly through electronic
of the U.S. public debt. transfers between one bank
• Using the four-step process for account and another.
analyzing how changes in supply • These flows of funds can be
and demand affect equilibrium analyzed with the same tools of
outcomes. demand and supply as markets for
goods or labor.
Labor and Financial Markets: Financial

THE EFFECT OF GROWING U.S. DEBT: THE

FOUR-STEP PROCESS
• Step 1. Draw a diagram showing demand
and supply for financial capital that
represents the original scenario in which
foreign investors are pouring money into
the U.S. economy.
• Step 2. Will the diminished confidence in
the U.S. economy as a place to invest affect
demand or supply of financial capital?
• Step 3. Will supply increase or decrease?
• Step 4. Compare the new equilibrium price
and quantity to the original equilibrium
price.
Quick Review
• What are the consequences of • What are the consequences
the government setting a binding of a price floor’s economic
price ceiling? impact on price, quantity
• What are the consequences of a demanded and quantity
price ceiling’s economic impact supplied?
on price, quantity demanded and • How do you compute and
quantity supplied?
demonstrate the market
• How can you compute and surplus resulting from a price
demonstrate the market shortage floor?
resulting from a price ceiling?
• What is the economic effect
• What are the consequences of of government setting price
the government setting a binding
ceilings and floors?
price floor?
Quick Review (cont.)
• Why does voluntary trade • How can you explain how price
benefit both parties? floors and price ceilings lead to
• Why does voluntary trade lead allocative inefficiency and loss of
to allocative efficiency? social surplus?
• How can you explain, • How can the theories of supply &
calculate, and illustrate demand be applied to labor
consumer surplus? markets?
• How can you explain, • How can the theories of supply &
calculate, and illustrate demand be applied to financial
producer surplus? markets?
• How can you explain, • What is the four-step process to
calculate, and illustrate social predict how economic conditions
surplus? cause a change in supply, demand,
and equilibrium?