ECON 211 Lecture Chapter Two, Spring 2015

1 of 26 PART I Introduction to Economics © 2012 Pearson Education 4 Demand and Supply Applications CHAPTER OUTLINE The Price System: Rationing and Allocating Resources Price Rationing Constraints on the Market and Alternative Rationing Mechanisms Prices and the Allocation of Resources Price Floors Supply and Demand Analysis: An Oil Import Fee Supply and Demand and Market Efficiency Consumer Surplus Producer Surplus Competitive Markets Maximize the Sum of Producer and Consumer Surplus Potential Causes of Deadweight Loss from Under- and Overproduction Looking Ahead 2 of 26 PART I Introduction to Economics © 2012 Pearson Education price rationing The process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied. The Price System: Rationing and Allocating Resources 3 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.1 The Market for Wheat Fires in Russia in the summer of 2010 caused a shift in the world‘s supply of wheat to the left, causing the price to increase from $160 per millions of metric tons to $247. The equilibrium moved from C to B. The Price System: Rationing and Allocating Resources Price Rationing Expected S Realized S 4 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.2 Market for a Rare Painting There is some price that will clear any market, even if supply is strictly limited. In an auction for a unique painting, the price (bid) will rise to eliminate excess demand until there is only one bidder willing to purchase the single available painting. Some estimate that the Mona Lisa would sell for $600 million if auctioned. The Price System: Rationing and Allocating Resources Price Rationing 5 of 26 PART I Introduction to Economics © 2012 Pearson Education Under normal circumstances, we would expect that most markets are more or less in equilibrium. To predict which prices rose post Hurricane Sandy, all we need to do is look at those businesses facing large shifts in either their demand or supply curves after the storm. With many people forced out of their homes, hotel rooms became scarce. The hotel industry saw a large outward shift of the demand curve in its market. Unable to quickly increase output levels, higher prices and price gouging were now possible. Complaints of price gouging were not only lodged against hotel businesses. You should be able to see how economics can help us predict what kinds of businesses are likely to be charged with the offense. Why Is My Hotel Room So Expensive? A Tale of Hurricane Sandy E C O N O M I C S I N P R A C T I C E 6 of 26 PART I Introduction to Economics © 2012 Pearson Education On occasion, both governments and private firms decide to use some mechanism other than the market system to ration an item for which there is excess demand at the current price. Regardless of the rationale (fairness, necessities), two things are clear: 1. Attempts to bypass price rationing in the market and to use alternative rationing devices are more difficult and more costly than they would seem at first glance. 2. Very often such attempts distribute costs and benefits among households in unintended ways. The Price System: Rationing and Allocating Resources Constraints on the Market and Alternative Rationing Mechanisms 7 of 26 PART I Introduction to Economics © 2012 Pearson Education price ceiling A maximum price that sellers may charge for a good, usually set by government.  FIGURE 4.3 Excess Demand (Shortage) Created by a Price Ceiling In 1974, a ceiling price of $0.57 cents per gallon of leaded regular gasoline was imposed. If the price had been set by the interaction of supply and demand instead, it would have increased to approximately $1.50 per gallon. At $0.57 per gallon, the quantity demanded exceeded the quantity supplied. Because the price system was not allowed to function, an alternative rationing system had to be found to distribute the available supply of gasoline. The Price System: Rationing and Allocating Resources Constraints on the Market and Alternative Rationing Mechanisms Oil, Gasoline, and OPEC 8 of 26 PART I Introduction to Economics © 2012 Pearson Education queuing Waiting in line as a means of distributing goods and services: a nonprice rationing mechanism. favored customers Those who receive special treatment from dealers during situations of excess demand. ration coupons Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. black market A market in which illegal trading takes place at market-determined prices. The Price System: Rationing and Allocating Resources Constraints on the Market and Alternative Rationing Mechanisms 9 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.4 Supply of and Demand for a Concert at the Staples Center At the face-value price of $50, there is excess demand for seats to the concert. At $50 the quantity demanded is greater than the quantity supplied, which is fixed at 20,000 seats. The diagram shows that the quantity demanded would equal the quantity supplied at a price of $300 per ticket. The Price System: Rationing and Allocating Resources Constraints on the Market and Alternative Rationing Mechanisms Rationing Mechanisms for Concert and Sports Tickets 10 of 26 PART I Introduction to Economics © 2012 Pearson Education No matter how good the intentions of private organizations and governments, it is very difficult to prevent the price system from operating and to stop willingness to pay from asserting itself. Every time an alternative is tried, the price system seems to sneak in the back door. With favored customers and black markets, the final distribution may be even more unfair than what would result from simple price rationing. The Price System: Rationing and Allocating Resources Constraints on the Market and Alternative Rationing Mechanisms 12 of 26 PART I Introduction to Economics © 2012 Pearson Education price floor A minimum price below which exchange is not permitted. minimum wage A price floor set for the price of labor. The Price System: Rationing and Allocating Resources Price Floor 13 of 26 PART I Introduction to Economics © 2012 Pearson Education The Price System: Rationing and Allocating Resources Price Floor in Soybeans Market Price Excess supply 400 Quantity (1000s of tons of soybeans) 200 400 14 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.5 The U.S. Market for Crude Oil, 2012 In 2012 the world market price for crude oil was approximately $80 per barrel. Domestic production in the United States that year averaged about 7 million barrels per day, while crude oil demand averaged just under 13 million barrels per day. The difference between production and consumption were made up of net imports of approximately 6 million barrels per day, as we see in panel (a). If the government imposed a tax in this market of 33.33%, or $26.64, that would increase the world price to $106.64. That higher price causes quantity demanded to fall below its original level of 13 million barrels, while the price increase causes domestic production to rise above the original level. As we see in panel (b), the effect is a reduction in import levels. Supply and Demand Analysis: An Oil Import Fee 15 of 26 PART I Introduction to Economics © 2012 Pearson Education consumer surplus The difference between the maximum amount a person is willing to pay for a good and its current market price. Supply and Demand and Market Efficiency Consumer Surplus 16 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.6 Market Demand and Consumer Surplus As illustrated in (a), some consumers (see point A) are willing to pay as much as $5.00 each for hamburgers. Since the market price is just $2.50, they receive a consumer surplus of $2.50 for each hamburger that they consume. Others (see point B) are willing to pay something less than $5.00 and receive a slightly smaller surplus. Since the market price of hamburgers is just $2.50, the area of the shaded triangle in (b) is equal to total consumer surplus. Supply and Demand and Market Efficiency Consumer Surplus 17 of 26 PART I Introduction to Economics © 2012 Pearson Education producer surplus The difference between the current market price and the full cost of production for the firm. Supply and Demand and Market Efficiency Producer Surplus 18 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.7 Market Supply and Producer Surplus As illustrated in (a), some producers are willing to produce hamburgers for a price of $0.75 each. Since they are paid $2.50, they earn a producer surplus equal to $1.75. Other producers are willing to supply hamburgers at a price of $1.00; they receive a producer surplus equal to $1.50. Since the market price of hamburgers is $2.50, the area of the shaded triangle in (b) is equal to total producer surplus. Supply and Demand and Market Efficiency Producer Surplus 19 of 26 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 4.8 Total Producer and Consumer Surplus Total producer and consumer surplus is greatest where supply and demand curves intersect at equilibrium. Supply and Demand and Market Efficiency Competitive Markets Maximize the Sum of Producer and Consumer Surplus 20 of 26 PART I Introduction to Economics © 2012 Pearson Education deadweight loss The net loss of producer and consumer surplus from underproduction or overproduction. Supply and Demand and Market Efficiency Competitive Markets Maximize the Sum of Producer and Consumer Surplus 21 of 26 PART I Introduction to Economics © 2012 Pearson Education Figure 4.9(a) shows the consequences of producing 4 million hamburgers per month instead of 7 million hamburgers per month. Total producer and consumer surplus is reduced by the area of triangle ABC shaded in yellow. This is called the deadweight loss from underproduction. Figure 4.9(b) shows the consequences of producing 10 million hamburgers per month instead of 7 million hamburgers per month. As production increases from 7 million to 10 million hamburgers, the full cost of production rises above consumers’ willingness to pay, resulting in a deadweight loss equal to the area of triangle ABC.  FIGURE 4.9 Deadweight Loss Supply and Demand and Market Efficiency 22 of 26 PART I Introduction to Economics © 2012 Pearson Education When supply and demand interact freely, competitive markets produce what people want at least cost, that is, they are efficient. There are a number of naturally occurring sources of market failure. Monopoly power gives firms the incentive to underproduce and overprice, taxes and subsidies may distort consumer choices, external costs such as pollution and congestion may lead to over- or underproduction of some goods, and artificial price floors and price ceilings may have the same effects. Supply and Demand and Market Efficiency Potential Causes of Deadweight Loss from Under- and Overproduction 23 of 26 PART I Introduction to Economics © 2012 Pearson Education We have now examined the basic forces of supply and demand and discussed the market/price system. These fundamental concepts will serve as building blocks for what comes next. Whether you are studying microeconomics or macroeconomics, you will be studying the functions of markets and the behavior of market participants in more detail in the following chapters. Looking Ahead 24 of 26 PART I Introduction to Economics © 2012 Pearson Education black market consumer surplus deadweight loss favored customers minimum wage price ceiling price floor price rationing producer surplus queuing ration coupons R E V I E W T E R M S A N D C O N C E P T S