Economics

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 equilibrium salary • The same new technologies are a complement
(or wage) and quantity of labor. to high-skill workers like managers, who
benefit from the technological advances by
Example: Consider how new information
being able to monitor more information,
technologies has affected low-skill and high-skill
communicate more easily, and juggle a wider
workers in the U.S. economy.
array of responsibilities.
• From the perspective of employers who demand
• How will the new technologies affect the
labor, these new technologies are often a
wages of high-skill and low-skill workers?
substitute for low-skill laborers like file clerks
who used to keep file cabinets full of paper • For this question, use the four-step process of
records of transactions. analyzing how shifts in 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 Markets
See how the theories of supply and demand
also affect financial markets.
• Example: Imagine the U.S. economy
became viewed as a less desirable place for
foreign investors to put their money
because of fears about the growth of the
U.S. public debt.
• Using the four-step process for analyzing
how changes in supply and demand affect
equilibrium outcomes.
• How would increased U.S. public debt affect
the equilibrium price and quantity for capital
in U.S. financial markets?
• In a modern, developed economy, financial
capital often moves invisibly through
electronic transfers between one bank
account and another.
• These flows of funds can be analyzed with
the same tools of 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 the
government setting a binding price
ceiling?
• What are the consequences of a price
ceiling’s economic impact on price,
quantity demanded and quantity supplied?
• How can you compute and demonstrate
the market shortage resulting from a price • What is the economic effect of
ceiling?
• What are the consequences of the
government setting a binding price floor?
• What are the consequences of a price
floor’s economic impact on price,
quantity demanded and quantity
supplied?
• How do you compute and
demonstrate the market surplus
resulting from a price floor?
government setting price ceilings and
floors?
Quick Review (cont.)
• Why does voluntary trade benefit both
parties?
• Why does voluntary trade lead to
allocative efficiency?
• How can you explain, calculate, and
illustrate consumer surplus?
• How can you explain, calculate, and
illustrate producer surplus?
• How can you explain, calculate, and
illustrate social surplus?
• How can you explain how price floors and
price ceilings lead to allocative inefficiency
and loss of social surplus?
• How can the theories of supply & demand be
applied to labor markets?
• How can the theories of supply & demand be
applied to financial markets?
• What is the four-step process to predict how
economic conditions cause a change in supply,
demand, and equilibrium?