Applications and Extensions of Supply and Demand

CHAPTER 3 BONUS WEB CHAPTERAPPLICATIONS AND EXTENSIONS OF

SUPPLY AND DEMAND ANALYSIS

CHAPTER OVERVIEWThis chapter provides students the opportunity to deepen and extend their understanding of supply and demand analysis. The many concrete examples help students appreciate the wide variety of useful applications for the theoretical models. It also extends the analysis to goods with preset prices and to nonpriced (common property) goods. Finally, the chapter introduces the concepts of consumer and producer surplus and efficiency gains and losses.

WHAT’S NEW?

The chapter itself is a new internet-only chapter (PDF file), but some of the material (for example, the “Pink Salmon” case) has appeared in previous editions of the textbook.

INSTRUCTIONAL OBJECTIVESAfter completing this chapter, students should be able to

1. Identify markets affected by everyday events, and analyze, using the tools of supply and demand, plausible effects of those events on price and quantity.

2. Explain how preset prices typically result in surpluses or shortages.

3. Explain why nonpriced (common) goods tend to be overconsumed and eventually exhausted if not rationed by nonprice means.

4. Define, measure, and graphically identify consumer surplus.

5. Define, measure, and graphically identify producer surplus.

6. Identify and explain efficiency losses using consumer and producer surplus.

7. Explain how the expiration of patents can create efficiency gains (Last Word).

COMMENTS AND TEACHING SUGGESTIONS1. The first part of the chapter contains cases that reinforce the material developed in Chapter 3.

Time constraints may not allow for full coverage of these examples, so you may want to select the subset that best fits the interest and personality of the class.

2. In discussing supply and demand examples, have the students play detective. Instead of simply presenting an example and asking students to determine how supply, demand, price, and quantity will change, begin with a result. For example, you might tell students that “over the years the price of computers has fallen (for a given amount of computing power), yet based on the number sold it appears that demand is rising. How could that be?”

3. Many students come to economics having observed that stores set prices, and customers react by voting with their dollars (purchasing goods) or their feet (leaving the store). Furthermore, students observe that stores often have clearance sales (reflecting a surplus of goods) and sometimes run out of goods (potentially reflecting shortages). The discussion of preset prices can help students understand, at least in the short term, how these imbalances occur. Except in markets where there are true auctions, prices tend to be preset. Only after observing consumer reaction to the prices do

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sellers adjust. In cases where prices are locked in by marketing campaigns (e.g., advertised prices for a set time period), imbalances may occur for an extended period. None of this denies that the forces of supply and demand interact to reach an equilibrium price and quantity in the market, but it does link theory with experience in such a way that students will better understand and accept the story of how markets work.

4. Some students will argue that there are some goods that should be nonpriced (i.e., price of zero) so that all can have access (water or other basic necessities). Encourage students to analyze that perspective using supply and demand (they should come up with something resembling Figure 3W.8b), and supplement with an article about a topic such as water shortages at the local, national, or international level.

5. As the text does, you will want to build up the concepts of consumer and producer surplus from the individual to the market. Students will understand, for example, that there are goods that they purchase for which they would pay more if necessary. To motivate producer surplus, you may want to appeal to the labor market decision. A student may be willing to work for $6.00 per hour but because of minimum wage laws or local labor market conditions earns $7.00 per hour. The additional $1.00 per hour represents the student’s producer surplus.

6. You may wish to extend the chapter’s discussion of consumer and producer surplus by demonstrating the impact (or having students work through them) of shifting supply and demand. It could provide a nice setup for issues discussed in later chapters, such as tax incidence analysis. Note, however, that changes in consumer and producer surplus resulting from supply and demand shifts do not necessarily imply efficiency loss. A shift in demand resulting from a change in preferences will alter the level of consumer and producer surplus, but the gains or losses are to the surpluses, not to efficiency.

7. It should be emphasized that efficiency losses result from the underproduction or overproduction of a good, not from changes in supply and demand resulting from normal market movements. A change in technology, for example, will alter the quantity, but it will move the market to a new efficient quantity, not create an efficiency loss.

8. The Last Word demonstrates that efficiency gains are also possible. This is important for later discussions of externalities, tax incidence, and other issues where government policy can alter the market quantity (for better or worse).

STUDENT STUMBLING BLOCKStudents sometimes confuse the vocabulary of consumer and producer “surplus” with a market surplus (quantity supplied exceeding quantity demanded) resulting from a price above equilibrium.

LECTURE NOTES

I. Changes in Supply and Demand -- Applications

A. Lettuce

1. Weather events affect agricultural markets, usually on the supply side.

2. Extreme weather that destroys crops will reduce the supply, raising equilibrium price and lowering equilibrium quantity.

B. American Flags

1. Events that inspire patriotism will affect the market for goods such as American flags.

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Applications and Extensions of Supply and Demand

2. The terrorist attacks on September 11, 2001, and subsequent military actions in Afghanistan and Iraq, increased the demand for American flags. We would expect this to increase price and quantity exchanged in the American flag market.

C. Pink Salmon

1. This is an example of simultaneous changes in both supply and demand.

2. An increase in supply occurs because of more efficient fishing boats, the development of fish farms, and new entrants to the industry.

3. There is a decrease in demand because of changes in consumer preference, and an increase in income shows pink salmon to be an inferior good.

4. Both changes put downward pressure on the price of pink salmon. Because we know that the increase in supply of pink salmon exceeded the decrease in demand, we can also determine that the quantity purchased increased.

D. Gasoline

1. There have been tremendous fluctuations of U.S. gas prices over the past few years, resulting from both market and traditionally noneconomic forces.

2. Middle East politics and military conflicts (both real and anticipated) have disrupted supply, tending to drive gas prices up.

3. Increased popularity of SUVs and other low-gas-mileage vehicles has increased the demand for gas, also tending to drive the price up.

4. While theoretically the affect on quantity is indeterminate, in reality the quantity purchased has increased, suggesting that the increase in demand exceeded the decrease in supply.

E. Sushi

1. Despite fast-growing popularity of sushi bars in the United States, prices have remained relatively constant.

2. The increase in demand can be attributed to an increased taste for sushi.

3. The opening of sushi bars in response to expected and realized demand has increased the supply of sushi, helping to keep the price stable.

II. Preset Prices

A. Preset prices are similar to price floors and ceilings in that they tend to result in shortages or surpluses. They differ from floors and ceilings in that they are set by sellers, not by government policy.

B. Olympic Figure Skating Finals

1. Prices for sporting events are commonly preset.

2. Despite the high preset prices for events such as the figure skating finals, shortages often result as people are willing to buy more tickets at that price than are available.

3. Shortages tend to result in legal or illegal secondary markets (e.g., ticket scalping).

C. Olympic Curling Preliminaries

1. Less popular sporting events (for which prices are still preset) tend to result in surpluses (empty seats at the arena)

III. Consider This … Taking Back a “Gift”

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Applications and Extensions of Supply and Demand

A. Historically, superstar musicians (rock stars) would price tickets below equilibrium.

1. Fans that received tickets benefited from the lower prices.

2. Fans that purchased secondary market tickets were willing to pay the higher prices.

3. “Scalpers” reaped the profits of secondary market sales.

4. The musicians themselves made millions from the free publicity of long ticket lines andperforming to sold out houses, mainly through increased sales of CDs.

B. Technological changes have reduced the incentive to offer lower ticket prices.

1. Illegal downloading has reduced the sales of CDs and associated royalty payments.

2. The economic value of the publicity of long lines has been reduced.

IV. Nonpriced Goods: The American Bison

A. Definition -- Nonpriced goods are goods owned in common by society and available for the taking on public lands.

1. These goods are not exchanged in markets.

2. The price is effectively zero (although consumers must bear the cost of acquiring the good).

3. The analysis extends to resource markets.

B. The American Bison

1. Before the American West was heavily populated, there was a surplus of bison even at a price of zero. The local population, primarily Native Americans, could satisfy their demand without threatening the sustainability of the population.

2. Increases in population raised the demand for bison, pushing the demand curve to the right and creating a shortage at a price of zero. In other words, bison were hunted beyond the limits that would sustain their population.

3. Because bison were a nonpriced good, markets failed to ration them to a sustainable level.

4. Government protection and private initiatives have increased the price and stabilized the population, in some cases possibly going too far.

V. Consumer and Producer Surplus

A. Consumer Surplus

1. Definition – the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price.

2. The surplus, measurable in dollar terms, reflects the extra utility gained from paying lower price than what is required to obtain the good.

3. Consumer surplus can be measured by calculating the difference between the maximum willingness to pay and the actual price for each consumer, and then summing those differences.

4. Consumer surplus is measured and represented graphically by the area under the demand curve and above the equilibrium price.

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Applications and Extensions of Supply and Demand

5. Consumer surplus and price are inversely related – all else equal, a higher price reduces consumer surplus.

B. Producer Surplus

1. Definition – the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price.

2. Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences.

3. Producer surplus is measured and represented graphically by the area above the supply curve and below the equilibrium price.

4. Producer surplus and price are directly related – all else equal, a higher price increases producer surplus.

VI. Efficiency Revisited

A. Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized.

1. Consumers receive utility up to their maximum willingness to pay, but only have to pay the equilibrium price.

2. Producers receive the equilibrium price for each unit, but it only costs the minimum acceptable price to produce.

3. Allocative efficiency occurs at quantity levels where three conditions exist:

a. MB = MC

b. Maximum willingness to pay = minimum acceptable price.

c. Combined consumer and producer surplus is at a maximum.

B. Efficiency Losses

1. Underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity.

2. Overproduction causes inefficiency because past the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to

pay.

VII. LAST WORD: “Efficiency Gains from Generic Drugs”

A. Patents give monopoly power to pharmaceutical companies, allowing them to charge higher-than-competitive prices. These higher prices encourage R&D expenditures but reduce consumer surplus.

B. Expiration of patents increases competition by providing substitutes (generics). The lower prices increase efficiency by increasing consumer surplus.

C. Conclusion: Patents provide necessary protection to encourage innovation, and their eventual expiration increases efficiency and benefits consumers.

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ANSWERS TO END-OF-CHAPTER QUESTIONS

3W-1 Suppose the supply of apples sharply increases because of perfect weather conditions throughout the growing season. Assuming no change in demand, explain the effect on the equilibrium price and quantity of apples. Explain why quantity demanded increases even though demand does not change.

The increase in supply will lower the equilibrium price and increase the equilibrium quantity of apples. Quantity demanded increases without a shift in the demand curve because the greater supply causes price to fall.

3W-2 Assume the demand for lumber suddenly rises because of a rapid growth of demand for new housing. Assume no changes in supply. Why does the equilibrium price of lumber rise? What would happen if the price did not rise under the demand and supply circumstances described?

Buyers are willing to purchase more new housing, causing price and quantity to increase in that market. In order to satisfy the increased demand for new housing, more lumber (and other building materials) is needed. The greater willingness to pay for housing implies a greater willingness to pay for the materials and labor needed to produce that housing. As the resources become increasingly scarce (because of a given supply and increasing demand), the price rises.

If something prevented an increase in the price of lumber (e.g., a price control by government), a shortage of lumber would result and not all of the new houses demanded could be built.

3W-3 Suppose both the demand for olives and the supply of olives decline by equal amounts over some period of time. Use graphical analysis to show the effect on equilibrium price and quantity.

The supply and demand curves would shift left by an equal amount, reducing the equilibrium quantity and leaving the equilibrium price unchanged.

3W-4 Assume that both the supply of bottled water and the demand for bottled water rise during the summer but that supply increases more rapidly than demand. What can you conclude about the directions of the impacts on equilibrium price and equilibrium quantity.

The equilibrium price will fall and the equilibrium quantity will rise. Whenever supply and demand both increase, equilibrium quantity will rise. Equilibrium price falls because the increase in supply is greater than the increase in demand.

3W-5 For each stock in the stock market, the number of shares sold daily equals the number of shares purchased. That is, the quantity of each firm’s shares demanded equals the quantity of its shares supplied. So, if this equality always occurs, why do the prices of stock shares ever change?

What is reported from the stock market is the closing price, change in price, and number of shares traded. What is not explicitly reported is how many buy orders at a given price (demand) there were compared to the number of sell orders (supply). When the number of sell orders exceeds the number of buy orders at a given price, sellers must offer their shares for a lower price. This attracts those who want to buy when the price drops to or below a certain level. Likewise, if buyers can’t find enough shares from sellers at a given price, they must bid up the price until enough are persuaded to sell. It is the discrepancy between number of buy and sell orders at a given price that gives rise to price movements.

3W-6 Why are shortages or surpluses more likely with preset prices, such as those on tickets, than flexible prices, such as those on gasoline?

Preset prices, rather than responding to demand conditions, attempt to predict the level of demand that will produce an equilibrium quantity. If these predictions are incorrect, there will be an imbalance between the quantity supplied and the quantity demanded.

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Applications and Extensions of Supply and Demand

Preset prices often apply to one-time-only events, versus something like gasoline that is sold regularly and repeatedly. Sellers can learn from experience how to adjust prices to best meet demand.

In some cases, preset prices are intended to result in shortages or surpluses. As demonstrated in the “Consider This” box, event promoters may set prices in an attempt to create a shortage and gain publicity from the visibly long lines.

3W-7 Use this table to answer the questions that follow:

Quantity Demanded, Thousands

PriceQuantity Supplied,

Thousands80757065605550

$25 35

455565

7585

60606060606060

a. If this table reflects the supply of and demand for tickets to a particular World Cup soccer game, what is the stadium capacity?

b. If the preset ticket price were $45, would we expect to see a secondary market for tickets? Explain why or why not. Would the price of a ticket in the secondary market be higher than, the same as, or lower than the price in the primary (original) market?

c. Suppose for some other World Cup game the quantities of tickets demanded are 20,000 lower at each ticket price than shown in the table. If the ticket price remains $45, would the event be a sellout? Explain.

(a) Stadium capacity is 60,000

(b) Yes, we would expect to see a secondary market. At a preset price of $45, there would be a shortage of 10,000 tickets, meaning that a number of fans would be willing to pay more than the preset price. Assuming no enforceable legal constraints, we would expect the price in the secondary market to be higher than in the primary market.

(c) No, a ticket price of $45 would not produce a sellout. At a price of $45, only 50,000 tickets are demanded, but 60,000 seats are available. There would be a surplus of 10,000.

3W-8 Advanced Analysis Most scalping laws make it illegal to sell—but not to buy—tickets at prices above those printed on the tickets. Assuming that is the case, use supply and demand analysis to explain why the equilibrium ticket price in an illegal secondary market tends to be higher than in a legal secondary market.

Ticket prices tend to be higher in illegal secondary markets because sellers face higher costs (thus reducing supply relative to what it would be in a legal secondary market). The additional costs include the higher transactions costs (finding secret locations to transact, monitoring for law enforcement, screening clients, etc.) and compensation for the risk of getting caught (with the associated costs of legal services, fines, incarceration, etc.).

3W-9 States in the Great Plains have for years fought (often through lawsuits) over the amounts of water each is entitled to use from the shared Missouri River for various purposes such as

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Applications and Extensions of Supply and Demand

irrigation, maintaining river levels for navigation, and providing recreational opportunities in reservoirs. Use supply and demand analysis to explain why such battles have occurred.

Because the Missouri River is owned in common and therefore a nonpriced good, the price for its use is effectively zero. As illustrated in Figure 3W.8b, quantity demanded often exceeds quantity supplied for nonpriced goods, resulting in shortages. The inability of markets to ration adequately use of the river use leads to legal battles, as would-be user seek alternative rationing methods.

3W-10 Why are there legal daily “limits” on the number of fish that can be caught in the nation’s public waters whereas there are no such limits on the number of fish that can be bought at a fish market or grocery store?

Fish in the nation’s public waters are not explicitly priced, and the effective price of zero would result in over fishing if an alternative method of rationing were not imposed. While there are no limits on the number of fish that can be bought at a fish market, there may still be limits on how many can be caught (and therefore sold) for market. The resulting nonzero price rations fish to those willing to pay. In the case of farmed fish (aquaculture), there are no effective legal limits to production, which is why farmed fish tend to have a lower price than their “wild” counterparts.

3W-11 Distinguish between the terms “maximum willingness to pay” and “minimum acceptable price.” How do they relate, respectively, to consumer and producer surplus?

“Maximum willingness to pay” refers to the highest price a consumer is willing to offer to purchase a unit of a good. “Minimum acceptable price” refers to the lowest price a seller is willing to accept in exchange for a unit of the good offered to the market. Consumer surplus measures the difference between the maximum willingness to pay and the market price. Producer surplus measures the differences between the market price and the minimum acceptable price.

3W-12 “Freely made exchanges in competitive markets benefit both buyers and sellers.” Use the concepts of consumer surplus and producer surplus to verify this statement.

Consumers will not buy goods unless the market price is equal to or less than their maximum willingness to pay for the good. Likewise, suppliers will not sell unless the market price is equal to or greater than their minimum acceptable price. Those consumers paying less than their maximum willingness to pay receive consumer surplus and benefit from the exchange. Sellers receiving more than their minimum acceptable price receive producer surplus and also benefit.

3W-13 Draw a supply and demand graph and identify the areas of consumer and producer surplus. Given the demand curve, what impact will an increase in supply have on the amount of consumer surplus shown in your diagram? Explain why.

The graph will look like Figure 3W.11 in the chapter. An increase in supply will lower the price and increase the amount of consumer surplus for a given demand curve. Any individual that was receiving consumer surplus before the change in supply will realize an increase in consumer surplus as the price falls and the difference between their maximum willingness to pay and the market price widens.

3W-14 Refer to Table 3W.1. If the six people listed in the table are the only consumers in the market and the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market generate?

The total consumer surplus will be $3 ($2 for Bob, $1 for Barb, $0 for Bill; and Bart, Brent, and Jenny will not purchase the good at a price of $11).

3W-15 Refer to Table 3W.2. If the six people listed in the table are the only producers in the market and the equilibrium price is $6 (not the $8 shown), how much producer surplus will the market generate?

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The total producer surplus will be $6 ($3 for Carlos, $2 for Courtney, $1 for Chuck, $0 for Cindy, and Craig and Chad will not sell at a price of $6).

3W-16 Use the ideas of marginal benefit and marginal cost and the idea of consumer surplus and producer surplus to explain why economists say competitive markets are efficient. Why are below- or above-equilibrium levels of output inefficient, according to these two sets of ideas?

Demand curves represent the marginal benefit from each unit of a good consumers might wish to purchase. Supply curves represent the marginal cost to firms and society of producing each unit. In competitive markets potential buyers will offer payment for goods so long as the utility to be gained equals or exceeds the price of obtaining the good. Likewise, firms will sell as long as the price received equals or exceeds the cost of producing the good. The result is an efficient market in that MB = MC, buyers can gain no more utility by altering their purchases, and firms can generate no more profits by altering the quantity they sell.

When the consumers’ utility exceeds the price paid, consumer surplus is generated. Likewise, when producers receive a price greater than marginal cost, producer surplus is created. By producing up to the point where MB = MC, the maximum potential consumer surplus and producer surplus is generated. Producing less than the equilibrium level means that potential surplus is left unrealized. Overproduction subtracts from the surplus because society values the use of the additional resources in other pursuits more than it values them in consumption of that good.

3W-17 (Last Word) How does a generic drug differ from its brand name, previously patented equivalent? Explain why the price of a brand-name drug typically declines when an equivalent generic drug becomes available. Explain how that drop in price affects consumer surplus and allocative efficiency.

A generic drug is a copy of a brand-name drug. It can only be produced after the patent has expired on the original drug. Because the research and development costs have already been borne by the pharmaceutical company inventing the drug, generic drugs are cheaper to produce (do not require the high start-up costs) and can be sold at a lower price. As generics enter the market, the brand-name producers must lower the price in order to compete against their generic counterparts. The lower price increases consumer surplus as buyers already in the market, willing to pay more, realize an increase in the gap between their willingness to pay and the actual market price. This increased consumer surplus increases allocative efficiency.

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