Macroeconomics

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 that one pays for some goods or
services.
• e.g. rent controls in certain cities
• 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 (or wage)
and quantity of labor.
Example: Consider how new
information technologies has
affected low-skill and high-skill
workers in the U.S. economy.
• From the perspective of
employers who demand
labor, these new technologies
are often a substitute for low-
skill laborers like file clerks who
used to keep file cabinets full
of paper records of
transactions.
• The same new technologies
are a complement to high-skill
workers like managers, who
benefit from the technological
advances by being able to
monitor more information,
communicate more easily,
and juggle a wider array of
responsibilities.
• How will the new technologies
affect the wages of high-skill
and low-skill workers?
• For this question, use the four-
step process of 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 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?
• What is the economic
effect of government
setting price ceilings
and floors?
Quick Review (cont.)
• Why does voluntary trade • How can you explain how
price floors and price ceilings
benefit both parties? lead to allocative inefficiency
and loss of social surplus?
• Why does voluntary trade • How can the theories of
lead to allocative supply & demand be applied
efficiency? to labor markets?
• How can the theories of
• How can you explain, supply & demand be applied
calculate, and illustrate to financial markets?
consumer surplus? • What is the four-step process
to predict how economic
• How can you explain, conditions cause a change in
supply, demand, and
calculate, and illustrate equilibrium?
producer surplus?
• How can you explain,
calculate, and illustrate
social surplus?