LEARNING ACTIVITY # 11

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Activity Title : SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Learning Target : Examine the effects of government policies that place a ceiling on prices

Concept Notes: DO NOT COPY

How Production Costs Affect Supply

A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris
paribus, so that no other economically relevant factors are changing. If other factors relevant to
supply do change, then the entire supply curve will shift. Just as a shift in demand is represented by a
change in the quantity demanded at every price, a shift in supply means a change in the quantity
supplied at every price.

In thinking about the factors that affect supply, remember what motivates firms: profits, which are the
difference between revenues and costs. Goods and services are produced using combinations of
labor, materials, and machinery, or what we call inputs (also called factors of production). If a firm
faces lower costs of production, while the prices for the good or service the firm produces remain
unchanged, a firm’s profits go up. When a firm’s profits increase, it’s more motivated to
produce output (goods or services), since the more it produces the more profit it will earn. So, when
costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. This
can be shown by the supply curve shifting to the right.

Take, for example, a messenger company that delivers packages around a city. The company may
find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will
find it can deliver packages more cheaply than before. Since lower costs correspond to higher profits,
the messenger company may now supply more of its services at any given price. For example, given
the lower gasoline prices, the company can now serve a greater area, and increase its supply

Economists have two roles. As scientists, they develop and test theories to explain the world around them. As
policy advisers, they use their theories to help change the world for the better. The focus of the preceding two
chapters has been scientific. We have seen how supply and demand determine the price of a good and the
quantity of the good sold. We have also seen how various events shift supply and demand and thereby change
the equilibrium price and quantity. This chapter offers our first look at policy. Here we analyze various types of
government policy using only the tools of supply and demand. As you will see, the analysis yields some
surprising insights. Policies often have effects that their architects did not intend or anticipate. We begin by
considering policies that directly control prices. For example, rentcontrol laws dictate a maximum rent that
landlords may charge tenants. Minimum wage laws dictate the lowest wage that firms may pay workers.

A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the price
ceiling is below the equilibrium price, the quantity demanded exceeds the quantity supplied. Because of the
resulting shortage, sellers must in some way ration the good or service among buyers.
LEARNING ACTIVITY # 11
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Activity Title : SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Learning Target : Examine the effects of government policies that place a ceiling on prices

◆ A price floor is a legal minimum on the price of a good or service. An example is the minimum wage. If the
price floor is above the equilibrium price, the quantity supplied exceeds the quantity demanded. Because of the
resulting surplus, buyers’ demands for the good or service must in some way be rationed among sellers

ANSWER THE FOLLOWING

1. Give an example of a price ceiling and an example of a price floor.

2. Which causes a shortage of a good—a price ceiling or a price floor? Which causes a surplus?

3. What mechanisms allocate resources when the price of a good is not allowed to bring supply and demand
into equilibrium?

4. Explain why economists usually oppose controls on prices.

5. What is the difference between a tax paid by buyers and a tax paid by sellers?
LEARNING ACTIVITY # 12
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Activity Title : SUPPLY AND DEMAND I: HOW MARKETS WORK

Learning Target : Examine the effects of government policies that put a floor under prices

Concept Notes: DO NOT COPY :

The Basics of Demand and Supply: Although a complete discussion of demand and supply curves has to
consider a number of complexities and qualifications, the essential notions behind these curves are
straightforward. The demand curve is based on the observation that the lower the price of a product, the more
of it people will demand. There may be occasional exceptions to this behavior (and indeed economists have
developed the theoretical possibility of such an exception), but they are so few and transient that economists
refer to the negative relationship between price and quantity demanded as the “law of demand.” Because of
the law of demand, demand curves (such as D in the figure) are always shown as downward sloping, with the
price on the vertical axis and the quantity demanded (over some period) on the horizontal axis.

The basic notion behind the supply curve is that the higher the price of a product, the more of it producers will
supply. In other words, as with the curve S in the figure, supply curves are upward sloping. A justification for
this upward-sloping relationship between price and quantity supplied is that the cost of producing additional
units of the product increases as more is produced. So it takes a higher price to motivate additional output. But
this is not necessarily the case when there is time for new firms to enter an industry, or for existing firms to
expand their plant size. Such long-run adjustments to a higher price can permit more of the product to be
made available at the original cost (or even a lower cost), in which case the supply is horizontal (or negatively
sloped). But over periods of time that can extend to several months or more, it is reasonable to assume that
supply curves slope upward….

The economy is governed by two kinds of laws: the laws of supply and demand and the laws enacted by
governments. In this chapter we have begun to see how these laws interact. Price controls and taxes are
common in various markets in the economy, and their effects are frequently debated in the press and among
policymakers. Even a little bit of economic knowledge can go a long way toward understanding and evaluating
these policies. In subsequent chapters we will analyze many government policies in greater detail. We will
examine the effects of taxation more fully, and we will consider a broader range of policies than we considered
here. Yet the basic lessons of this chapter will not change: When analyzing government policies, supply and
demand are the first and most useful tools of analysis.

When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a
market shrinks the size of the market.
LEARNING ACTIVITY # 12
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Activity Title : SUPPLY AND DEMAND I: HOW MARKETS WORK

Learning Target : Examine the effects of government policies that put a floor under prices

Answer the following

1. Lovers of classical music persuade Congress to impose a price ceiling of $40 per ticket. Does this policy
get more or fewer people to attend classical music concerts?

2. The government has decided that the free-market price of cheese is too low.

a. Suppose the government imposes a binding price floor in the cheese market. Use a supply-anddemand
diagram to show the effect of this policy on the price of cheese and the quantity of cheese sold. Is there a
shortage or surplus of cheese?

b. Farmers complain that the price floor has reduced their total revenue. Is this possible? Explain.

c. In response to farmers’ complaints, the government agrees to purchase all of the surplus cheese at the price
floor. Compared to the basic price floor, who benefits from this new policy? Who loses?

3. A senator wants to raise tax revenue and make workers better off. A staff member proposes raising the
payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by workers. Would
this accomplish the senator’s goal?
LEARNING ACTIVITY # 13
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Activity Title : CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

Learning Target : Examine the link between buyers’ willingness to pay for a good and the
demand curve

Concept Notes: DO NOT COPY :

Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a
cost on another.
If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing
costs on others.
Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences
—and the market equilibrium price.
Producer surplus is the gap between the price for which producers are willing to sell a product—based on their
costs—and the market equilibrium price.
Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium
quantity and price than it will be at any other quantity and price.
Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.

This chapter introduced the basic tools of welfare economics—consumer and producer surplus—and used them
to evaluate the efficiency of free markets. We showed that the forces of supply and demand allocate resources
efficiently. That is, even though each buyer and seller in a market is concerned only about his or her own
welfare, they are together led by an invisible hand to an equilibrium that maximizes the total benefits to buyers
and sellers. A word of warning is in order. To conclude that markets are efficient, we made several assumptions
about how markets work. When these assumptions do not hold, our conclusion that the market equilibrium is
efficient may no longer be true. As we close this chapter, let’s consider briefly two of the most important of
these assumptions

ANSWER THE FOLLOWING

1. Explain how buyers’ willingness to pay, consumer surplus, and the demand curve are related.

2. Explain how sellers’ costs, producer surplus, and the supply curve are related.

3. In a supply-and-demand diagram, show producer and consumer surplus in the market equilibrium.

4. What is efficiency? Is it the only goal of economic policymakers?

4. What does the invisible hand do?

6. Name two types of market failure. Explain why each may cause market outcomes to be inefficient.
 LEARNING ACTIVITY # 14
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Activity Title : CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

Learning Target : Learn how to define and measure consumer surplus

Concept Notes: DO NOT COPY :

Market power and externalities are examples of a general phenomenon called market failure—the inability of
some unregulated markets to allocate resources efficiently. When markets fail, public policy can potentially
remedy the problem and increase economic efficiency. Microeconomists devote much effort to studying when
market failure is likely and what sorts of policies are best at correcting market failures. As you continue your
study of economics, you will see that the tools of welfare economics developed here are readily adapted to that
endeavor.
◆ Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it, and
it measures the benefit buyers get from participating in a market. Consumer surplus can be computed by
finding the area below the demand curve and above the price.
◆ Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it
measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding
the area below the price and above the supply curve.

ANSWER THE FOLLOWING

1.An early freeze in California sours the lemon crop. What happens to consumer surplus in the market for
lemons? What happens to consumer surplus in the market for lemonade? Illustrate your answers with
diagrams.

2. Suppose the demand for French bread rises. What happens to producer surplus in the market for French
bread? What happens to producer surplus in the market for flour? Illustrate your answer with diagrams.

3. It is a hot day, and Bert is very thirsty. Here is the value he places on a bottle of water:
Value of first bottle

$7 Value of second bottle

5 Value of third bottle
3 Value of fourth bottle 1

a. From this information, derive Bert’s demand schedule. Graph his demand curve for bottled water.

b. If the price of a bottle of water is $4, how many bottles does Bert buy? How much consumer surplus does
Bert get from his purchases? Show Bert’s consumer surplus in your graph.

c. If the price falls to $2, how does quantity demanded change? How does Bert’s consumer surplus change?
Show these changes in your graph.
 LEARNING ACTIVITY # 15
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Activity Title : ELASTICITY AND ITS APPLICATION

Learning Target : Examine what determines the elasticity of demand

THE ELASTICITY OF DEMAND

When we discussed the determinants of demand in Chapter 4, we noted that buyers usually demand
more of a good when its price is lower, when their incomes are higher, when the prices of substitutes
for the good are higher, or when the prices of complements of the good are lower.

THE PRICE ELASTICITY OF DEMAND AND ITS DETERMINANTS

The law of demand states that a fall in the price of a good raises the quantity demanded. The price
elasticity of demand measures how much the quantity demanded responds to a change in price.
Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in
the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in
the price.

Answer the following

1. Define the price elasticity of demand and the income elasticity of demand.

2. List and explain some of the determinants of the price elasticity of demand.

3. If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals 0, is demand
perfectly elastic or perfectly inelastic?

4. On a supply-and-demand diagram, show equilibrium price, equilibrium quantity, and the total
revenue received by producers.

5. If demand is elastic, how will an increase in price change total revenue? Explain.