04 Mill Micro1ce PPT ch04

Economics Today
A Canadian Perspective Microeconomics, First Edition
Chapter 4
Extensions of Demand and
Supply Analysis
Copyright © 2023 Pearson Canada Inc. 4-1

Introduction
• The Canadian government regulates the price
pharmaceutical companies can charge on prescription
medicines.
• Drug spending has increased significantly. Health Canada
has proposed a number of regulatory changes. These
changes will significantly lower the prices for these
medications.
• So, while consumers may pay a lower price for their
prescribed medications, they may end up paying higher
costs in other, less transparent ways. In this chapter, you
will learn why this occurs.

Learning Objectives
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
4.4 Explain the effects of price ceilings
4.5 Explain the effects of price floors and government-
imposed quantity restrictions

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

Did You Know That ...
• In Canada’s largest cities, construction of new rental
housing has failed to keep up with demand, creating
significant shortages.
• In cities that have experienced these shortages, rental
rates have risen considerably. As a consequence, these
cities have seen significant increases in apartment and
condo construction. and shortages are forecasted to ease.
• In some areas, however, legally binding price ceilings
prevent rental rates from increasing in response to an
excess of quantity demanded over quantity supplied. The
consequence has been that substantial shortages of
middle-priced apartments have persisted.
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.

• Voluntary exchange
– An act of trading, done on a mutually agreed upon
basis between individuals in the price system
– Makes both parties to the trade subjectively better off

• 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

AI—Decision Making Through Data:
Transaction Costs and “Price Stickiness”
• Alberto Cavallo of the Massachusetts Institute of
Technology has utilized data analytics to examine
more than 60 million different prices.
• He concluded that transaction costs induced firms to
make few price changes over given intervals of time—
about every 9 months in the U.S.
• He interpreted this as a considerable degree of
transaction-cost-generated “price stickiness.”

• 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.
Copyright © 2023 Pearson Canada Inc. 4 - 10

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.

Figure 4-1 Shifts in Demand and in Supply:
Determinate Results, Panel (a)
In panel (a), supply is unchanged at S. The demand curve shifts rightward from to D1 to D2. The
equilibrium price and quantity rise from P1, Q1 to P2, Q2, respectively.

Determinate Results, Panel (b)
In panel (b), the supply curve is unchanged at S. The demand curve shifts leftward from D1 to D3. Both
equilibrium price and equilibrium quantity fall.

Determinate Results, Panel (c)
In panel (c), demand now remains unchanged at D. The supply curve shifts from S1 to S2. The equilibrium
price falls from P1 to P2. The equilibrium quantity increases, however, from Q1 to Q2.

Determinate Results, Panel (d)
In panel (d), demand is unchanged at D. The supply curve shifts leftward from S1 to
S3. The market clearing price increases from P1 to P3. The equilibrium quantity falls from Q1 to Q3.

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.

• Summary:
– Increases in supply decrease equilibrium price and
increase equilibrium quantity.
– Decreases in supply increase equilibrium price and
decrease equilibrium quantity.

• When both demand and supply change:

– If both the supply and demand curves shift
simultaneously, the outcome is indeterminate for either
equilibrium price or equilibrium quantity.
– The resulting effect depends upon how much each
curve shifts.

• When both demand and supply increase:

– The change in equilibrium price is indeterminate.
– The equilibrium quantity increases unambiguously.
• When both demand and supply decrease:
– The change in equilibrium price is indeterminate.
– The equilibrium quantity decreases unambiguously.

• When supply decreases and demand increases:

– The equilibrium price increases.
– The change in the equilibrium quantity is uncertain
without more information.
• When supply increases and demand decreases:
– The equilibrium price decreases.
– The change in the equilibrium quantity is uncertain
without more information.

• 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

• Adjustment speed:
– Market characteristics influence adjustment speed.
– Markets may overshoot in the adjustment process.
– Markets are subject to energy shocks, labour strikes,
and severe weather.

Example: The Effects of a Simultaneous Decrease
in the Supply of and an Increase in the Demand for
Vinyl Records
• A substantial increase in the price of machines used
to press vinyl records has resulted in an increase in
the cost of producing vinyl records, shifting the supply
curve to the left.
• Meanwhile, consumers have developed a renewed
taste for “vinyl,” substantially raising the demand for
vinyl records.
• As a consequence, the market clearing price of a vinyl
record has unambiguously increased and on net, the
equilibrium quantity has also increased.

Figure 4-2 The Effects of a Simultaneous Decrease in the
Supply of and Increase in the Demand for Vinyl Records
A renewed taste for phonograph-generated sounds has resulted in an increase in the demand for vinyl
phonograph records, as shown by the shift in the demand curve from D1 to D2. At the same time, the
higher cost of machines used to press vinyl records has generated decreases in the supply of vinyl
records, depicted by the leftward shift in the supply curve from S1 to S2. On net, the equilibrium quantity
of records has increased, from 11 million to about 25 million. The price of a vinyl record has increased
from $30 to about $40.

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.

• Methods of nonprice rationing:
– Rationing by queues (waiting in line)
– Rationing by random assignment or coupons
– Rationing by power
– Rationing by physical force

International Example: Customers of eWater Prefer
Price Rationing over First Come, First Served at a
Zero Price
• In villages of the African nations of Gambia and
Tanzania, almost one of three water pumps placed by
governments and charitable organizations was
inoperable due to overuse or misuse.
• A British company called eWater introduced
dispensers that charge people a fee to purchase
water.
• The operations have expanded rapidly as people do
not have to wait long to access the water and they
seek to avoid spilling.

• The essential role of rationing:
– Necessary due to scarcity
– Price versus nonprice rationing mechanism:
 Price rationing leads to the most efficient use of available
resources.
 All gains from mutually beneficial trade are captured in a
freely rationing price system.

4.4 Price Ceilings (1 of 8)
• Price controls
– Government-mandated minimum or maximum prices
that may be charged for goods and services
• Price ceiling
– A legal maximum price that may be charged for a
particular good or service
• Price floor
– A legal minimum price below which a good or service
may not be sold

• Price ceiling and black markets:
– A price ceiling will take effect if it is below the
equilibrium price.
– A price ceiling that is set below the market clearing
price creates a shortage.

• 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

Figure 4-3 Black Markets for Portable Electric
Generators
The demand curve is D. The supply curve is S. The equilibrium price is $1,000. The government,
however, steps in and imposes a maximum price of $600. At that lower price, the quantity
demanded will be 15,000, but the quantity supplied will be only 5,000. There is a “shortage.” If the
price ceiling is fully enforced, the implicit supply curve becomes the vertical line Sʹ, and the effective
price (including time costs) tends to increase to $1,400. If black markets arise, as they generally will,
the equilibrium black market price will end up somewhere between $600 and $1,400.

• The functions of rental prices:
– Promote the efficient maintenance and construction of
housing
– Allocate existing housing
– Ration the use of housing

• Rent controls and construction
– Controls discourage construction:
 A 2019 study reduced the supply of available rental
housing by 15% in San Francisco.
 A 2020 study conducted by KPMG confirmed rent control
leads to a decrease in rental study.

• Effects on the existing supply of housing and current
use of housing:
– Property owners cannot recover costs:
 Maintenance, repairs, capital improvements
– Rations the current use of housing:
 Reduces tenant mobility leading to “housing gridlock”

• Attempts to evade rent controls:
– Forcing tenants to leave
– Tenants subletting apartments
– Housing courts

• Who wins and who loses from rent controls?
– Losers:
 Property owners
 Low-income individuals
– Winners:
 Upper-income professionals

What Happens When ... the price of a gram of cannabis
purchased from a government-approved retailer costs
almost twice as much that from an illegal source?
• On October 17, 2018, recreational cannabis use became
legal in Canada. A goal of legalization was to take a
significant part of the market share away from organized
crime.
• Since legalization, a gram of cannabis purchased from
government-approved retailers cost $10.30 in the fourth
quarter of 2019 while the same product from an illegal
source cost only $5.73.
• A consequence of this large price difference is that 4 in 10
Canadians continue to buy at least some of their cannabis
from illegal sources.

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.

Figure 4-4 Agricultural Price Supports
Free market equilibrium occurs at E, with an equilibrium price of $1.00 per litre and an equilibrium
quantity of 31.5 million hectolitres. When the government sets a support price at $1.50 per litre, the
quantity demanded is 27.3 million hectolitres and the quantity supplied is 49.8 million hectolitres.
The difference is the surplus, which the government buys.

• Questions:
– How could the government keep the price from falling?
– Who benefits from agricultural price supports?

• Minimum wage
– A wage floor, legislated by government, that sets the
lowest hourly wage rate that firms may legally pay their
workers

Figure 4-7 The Effect of Minimum Wages
The market clearing wage rate is We. The market clearing quantity of employment is Qe, determined
by the intersection of supply and demand at point E. A minimum wage equal to Wm is established.
The quantity of labour demanded is reduced to Qd. The reduction in employment from Qe to Qd is
equal to the distance between B and A. That distance is smaller than the excess quantity of labour
supplied at wage rate Wm. The distance between B and C is the increase in the quantity of labour
supplied, to Qs, that results from the higher minimum wage rate.

• Governments can impose quantity restrictions.
• The most obvious restriction is an outright ban on the
ownership or trading of a good.
Examples are banning ownership or trading of goods:
– Psychoactive drugs such as cocaine, heroin

Example: “99-Seat Theatres” in Los Angeles
Adapt to a Minimum Wage Requirement
• In Los Angeles, many struggling actors perform at low
wages in so-called 99-seat theatres—stages hosting
productions of plays funded by ticket receipts of small
crowds of patrons.
• In response to a minimum wage of $15 per hour, a union—
Actor’s Equity Association—ruled that actors at 99-seat
theatres had to earn an hourly wage of at least $15.
• As a result, some theatres use actors as unpaid
volunteers, others only hire non-union actors, some have
stopped producing high-cast plays, and others have closed
their doors.

• Government prohibitions and licensing requirements
– Some commodities cannot be purchased at all legally;
others require a licence.
• Import quota
– Supply restriction that prohibits the importation of more
than a specified quantity of a particular good

Behavioural Example: Experimental Evidence
Verifies Predictions about the Effects of Imposing a
Price Floor in a Labour Market
• A recent experimental study imposed minimum hourly
wages on firms that posted job openings in an online
labour market.
• As predicted by the theory of price floors, firms
subjected to the minimum wage requirement
responded by cutting back on hiring and by reducing
the number of work hours for hired workers.

Economic in Your Life: A Mayor Favours the
Minimum Wage until Confronting Its
Consequences
• During her campaign for the mayor of the city of
Baltimore, Catherine Pugh supported a plan of
gradually increasing the citywide minimum hourly
wage rate from $9.25 to $15 by 2022.
• However, after major employers in the city told her
that they would respond by reducing their hiring of
new workers, she eventually vetoed the city council’s
action to approve the new minimum wage plan.

Issues & Applications: Why Shortages of Some
Pharmaceuticals Generate Higher Prices for
Other Drugs
• Shortages exist in Canadian markets for prescription drugs
as governmental price controls hold down drug prices.
• Drug manufacturers typically respond to a price ceiling by
cutting back or even halting production, resulting in a
shortage of drugs.
• When faced with drug shortages, physicians and
pharmacists look to alternative medications to substitute
(i.e., Medication B) that perform similar functions to
Medication A.
• The demand curve for Medication B shifts rightward,
resulting in an increase in its market clearing price.
Figure 4-8 How a Shortage of Medication A Can Push Up
the Price of a Substitute Medication B
In panel (a), the market clearing price of Medication A is $50 per unit. The legal ceiling price, however,
is $40 per unit. At this ceiling price, the quantity of Medication A demanded by patients is 25,000 units,
but the quantity supplied by manufacturers is only 15,000 units. Many patients’ physicians respond to
the resulting 10,000-unit shortage of Medication A by providing prescriptions for a substitute, Medication
B. As a result, as shown in panel (b), the demand for Medication B increases, from D1 to D2. The
resulting upward movement along the supply curve generates an increase in the equilibrium quantity of
Medication B, from 15,000 units to 18,000 units, and a rise in market clearing price of Medication B, from
$35 per unit to $45 per unit.

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.
– Intermediaries reduce transaction costs by bringing
buyers and sellers together.

Objectives (2 of 6)
– 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.

Objectives (3 of 6)
– When both demand and supply shift at the same time,
the outcome is indeterminate for either equilibrium
price or equilibrium quantity.

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.

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.

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

Appendix C: Consumer Surplus and
Producer Surplus 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

Figure C-1 Consumer Surplus

• 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

Figure C-2 Producer Surplus

• Gains realized by consumers and producers from

engaging in voluntary trade
– The sum of consumer surplus and producer surplus is
the total value generated by the mutually beneficial
voluntary exchange

Appendix C: Consumer Surplus and Producer
Surplus within a Price System

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Economics Today

A Canadian Perspective Microeconomics, First Edition

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• When both demand and supply change:

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• When both demand and supply increase:

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• When supply decreases and demand increases:

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