Supply and Demand: Price Supply and Demand: Price and Quantity and Quantity

Determination in Determination in Competitive MarketsCompetitive Markets

The Economics The Economics Department, UMR Department, UMR Presents:Presents:

u Demand

u Supply

u Equilibrium and Disequilibrium

StarringStarring

FeaturingFeaturing

uuThe Law of DemandThe Law of DemanduuD = D(PENTE) D = D(PENTE) uuThe Tendency of SupplyThe Tendency of SupplyuuS = S(pent)S = S(pent)uuEquilibrium/Equilibrium/DisequilibriumDisequilibrium

In Four PartsIn Four Parts

DemandDemandSupplySupply

Equilibrium/DisequilibriumEquilibrium/Disequilibrium(current show)(current show)

Changes in EquilibriumChanges in Equilibrium

What Is Equilibrium?What Is Equilibrium?

uu It is a situation that exists in a market It is a situation that exists in a market when the plans of buyers are consistent when the plans of buyers are consistent with the plans of sellerswith the plans of sellers

uu Or, at the prevailing price, quantity Or, at the prevailing price, quantity demanded equals the quantity supplieddemanded equals the quantity supplied

uu Another, wider, view of equilibrium is Another, wider, view of equilibrium is when the action taken leads to when the action taken leads to consequences that are expected, there is consequences that are expected, there is no incentive to changeno incentive to change

Part 3

Notes About the Concept of Notes About the Concept of EquilibriumEquilibriumuu First, there should be no prior First, there should be no prior

judgement about whether a given judgement about whether a given equilibrium is good or badequilibrium is good or bad

uu Second, markets not in equilibrium are Second, markets not in equilibrium are in in DisequilibriumDisequilibriumvv Shortages, orShortages, orvv SurplusesSurpluses

The Ethics of EquilibriumThe Ethics of Equilibriumuu William Lynch’s (1742William Lynch’s (1742--1820) early 1820) early

American tribunals dispatched swift American tribunals dispatched swift results with bodies soon coming to rest results with bodies soon coming to rest (an equilibrium) but most have rejected (an equilibrium) but most have rejected this as a good form of justicethis as a good form of justice

uu Competitive equilibrium, under certain Competitive equilibrium, under certain conditions, is efficientconditions, is efficientvv Given scarcity, efficiency is a desirable Given scarcity, efficiency is a desirable

social objectivesocial objective

uu It is the consequences of equilibrium we It is the consequences of equilibrium we have to judge, not the state itselfhave to judge, not the state itself

Many Processes Are Not in Many Processes Are Not in EquilibriumEquilibrium

uu The one constant is changeThe one constant is changeuu In economics change is purposeful and In economics change is purposeful and

may often be modeled successfullymay often be modeled successfullyuu Equilibrium results from a given Equilibrium results from a given

change, an end state implied by these change, an end state implied by these modelsmodels

uu Many economic processes “tend Many economic processes “tend toward” equilibriumtoward” equilibrium

DisequilibriumDisequilibriumuu Usually markets are “tending toward Usually markets are “tending toward

equilibrium” driven by the forces of supply and equilibrium” driven by the forces of supply and demanddemandvv Prices are used as a rationing mechanismPrices are used as a rationing mechanism

uu Changing demand or supply conditions create Changing demand or supply conditions create incentives for buyers and sellers to change their incentives for buyers and sellers to change their behaviorbehavior

uu DisequilibriumDisequilibrium is characterized byis characterized byvv Excess demandExcess demand----a shortage, ora shortage, orvv Excess supplyExcess supply----a surplusa surplus

uu Price controls (ceilings or floors) lead to Price controls (ceilings or floors) lead to shortages or surplusesshortages or surpluses

ShortageShortage

uu Shortage Shortage -- when Qwhen QDD > Q> QSS at current at current market pricemarket pricevv Amount of shortage = QAmount of shortage = QDD -- QQSS

uu Note Note -- it is it is not not correctcorrect to say demand to say demand exceeds supply, but rather quantity exceeds supply, but rather quantity demanded exceeds quantity supplieddemanded exceeds quantity supplied

SurplusSurplusuu Surplus Surplus -- when Qwhen QSS > Q> QDD at current market at current market

priceprice•• Amount of surplus = QAmount of surplus = QSS -- QQDD

uu Note Note -- it is it is not not correctcorrect to say supply to say supply exceeds demand, but rather that quantity exceeds demand, but rather that quantity supplied exceeds quantity demandedsupplied exceeds quantity demanded

Price ControlsPrice Controls

There are two types of price controls There are two types of price controls --price ceilingsprice ceilings and and price floorsprice floors

Price CeilingsPrice Ceilingsuu Price ceilingPrice ceiling -- sets a maximum price that sets a maximum price that

is allowed by lawis allowed by lawuu Result of price ceilingResult of price ceiling

vv Stay at a permanent shortage situationStay at a permanent shortage situationuu Note that a price ceiling Note that a price ceiling cancan be any price be any price

the government chooses. It is, however the government chooses. It is, however only effective if it is only effective if it is belowbelow the the equilibrium priceequilibrium price

uu Examples include maximum rents for Examples include maximum rents for apartments and UMR parking permitsapartments and UMR parking permits

Price FloorsPrice Floorsuu Price floorPrice floor -- sets a minimum price that is sets a minimum price that is

allowed by lawallowed by lawuu Result of price floorResult of price floor

vv Stay at a permanent surplus situationStay at a permanent surplus situationuu Note that a price floor Note that a price floor cancan be any price be any price

the government chooses. It is, however the government chooses. It is, however only effective if it is only effective if it is aboveabove the the equilibrium priceequilibrium price

uu Examples include agriculture price Examples include agriculture price supports and the minimum wagesupports and the minimum wage

Equilibrium in the MarketEquilibrium in the Market

uu Equilibrium Equilibrium -- where quantity where quantity demanded equals quantity supplieddemanded equals quantity supplied

uu Equilibrium price (P*) Equilibrium price (P*) -- price where price where equilibrium occursequilibrium occurs

uu At PAt P** there is no incentive for buyers or there is no incentive for buyers or sellers to change their behavior. Their sellers to change their behavior. Their plans are consistentplans are consistent

Equilibrium, GraphicallyEquilibrium, Graphically

P

Q/t

S

D

E

P*

Q*0

Equilibrium in the MarketEquilibrium in the Market

What occurs at equilibriumWhat occurs at equilibriumuu Demand side Demand side -- those who get the good those who get the good

are those are those willing and ablewilling and able to pay the P*to pay the P*uu Supply side Supply side -- only those sellers which only those sellers which

are able to produce at or below the cost are able to produce at or below the cost of P* will remain in businessof P* will remain in business

uu Prices ration available supply to those Prices ration available supply to those who value the good highestwho value the good highest

Tendency Toward Tendency Toward Equilibrium in the MarketEquilibrium in the Marketuu Note that if the price is Note that if the price is

below P* then there will below P* then there will be a shortage causing be a shortage causing price to riseprice to rise

uu If the price is above P* If the price is above P* then there will be a then there will be a surplus causing price to surplus causing price to fallfall

uu Self interest generates Self interest generates these price changesthese price changes

P

Q/t

S

DP*

Q*0

An ExampleAn Example----UMR Student UMR Student ParkingParking

uu It is easiest to see the tendency toward It is easiest to see the tendency toward equilibrium by looking at a good that is equilibrium by looking at a good that is notnotrationed by pricerationed by price----student parkingstudent parking

uu First, ask whether demand and supply curves are First, ask whether demand and supply curves are typicaltypical

uu DemandDemand----is there an inverse relationship between is there an inverse relationship between the number of parking spots wanted by UMR the number of parking spots wanted by UMR students and the price of the slots? Clearly YES students and the price of the slots? Clearly YES

uu Upward sloping supply? Again yes, the more the Upward sloping supply? Again yes, the more the administration could extract from students, the administration could extract from students, the less important it would be for them to provide less important it would be for them to provide parking for staff and facultyparking for staff and faculty

UMR Student Parking Market UMR Student Parking Market in Equilibriumin Equilibrium

P

Q/t

S

D

P*

Q*0

Use the hypothetical P*

and Q* as benchmarks. Where are actual P and Q relative to P*

and Q*?

Where Are Actual P and Q Where Are Actual P and Q Relative to PRelative to P** and Qand Q*?*?

uu If you said “less than,” go If you said “less than,” go to the head of the classto the head of the class

uu Administration policy Administration policy regarding allocation of regarding allocation of scarce parking slots scarce parking slots creates a creates a shortageshortage

uu In effect there is a price In effect there is a price ceiling imposed by UMRceiling imposed by UMR

P

Q/t

S

D

P*

Q*0Pa

QD

ShortageShortage

uu There are a lot more students wanting There are a lot more students wanting to buy parking permits than UMR is to buy parking permits than UMR is willing to sellwilling to sell

uu Why? Because at the current price, the Why? Because at the current price, the quantity demanded is quite high. But quantity demanded is quite high. But UMR does not want to sell that many at UMR does not want to sell that many at such a low pricesuch a low price

Shortage Shown GraphicallyShortage Shown GraphicallyP

Q/t

S

D

0

Pa

QD

Amount of ShortageQa

P*

Q*

Note the quantity supplied is the quantity sold: QS = Qa

Pa = actual price

Qa = actual quantity sold

QS

When Price Is Not Used As a When Price Is Not Used As a Rationing Device Shortages Rationing Device Shortages Tend to PersistTend to Persistuu Students may act politicallyStudents may act politically

vv Letters to “Letters to “the minerthe miner””vv Through student governmentThrough student government

uu Students may exit the marketStudents may exit the market----transfer transfer to another schoolto another school

uu These are explicit reactions. An These are explicit reactions. An advantage of price rationing is it is done advantage of price rationing is it is done implicitlyimplicitly

How Price Rationing Eliminates How Price Rationing Eliminates ShortagesShortages

P

Q/t

S

D

EP*

Q*0

Pa

QS QD

Buyers who expected to buy are unsatisfied

Sellers find they have more buyers than supply

Shortage Eliminated Through Shortage Eliminated Through Price IncreasesPrice Increases

uu Sellers find little resistance to price increasesSellers find little resistance to price increasesuu Buyers can’t get all they want and are Buyers can’t get all they want and are

willing to pay morewilling to pay moreuu P will increaseP will increase

vv Quantity demanded will fallQuantity demanded will fallvv Quantity supplied will increaseQuantity supplied will increase

uu The process continues until an equilibrium The process continues until an equilibrium is established by price rationingis established by price rationing

How Price Rationing How Price Rationing Eliminates ShortagesEliminates Shortages

P

Q/t

S

D

EP*

Q*0

Pa

QS QD

Quantity demanded falls as price rises

Quantity supplied increases as price rises

Price continues to rise until:

QD = QS

The Role of PricesThe Role of Prices

uu Convey informationConvey informationvv When gasoline prices fell below $1.00 in When gasoline prices fell below $1.00 in

Rolla, it told us something about gasRolla, it told us something about gas----use use moremore

uu Rationing deviceRationing devicevv The price is what determines who can have The price is what determines who can have

the goodthe good

Student ParkingStudent Parking

uu Not rationed by price but by some type of Not rationed by price but by some type of administrative decisionadministrative decisionvv We use queuing (first comeWe use queuing (first come----first served)first served)

uu Other common rationing devisesOther common rationing devisesvv AlphabeticalAlphabeticalvv The government decides based on needThe government decides based on needvv HeightHeightvv GenderGendervv AgeAgevv LocationLocationvv Rank or positionRank or position

Advantages/disadvantages of Advantages/disadvantages of QueuingQueuing

uu Queuing typically favors those who Queuing typically favors those who value time less than those that value value time less than those that value time moretime more

uu Queuing leads to an outcome that is Queuing leads to an outcome that is inefficientinefficientvv Some student who get parking permits Some student who get parking permits

value them less than some students who value them less than some students who do not get permitsdo not get permits

Surplus, RevisitedSurplus, Revisiteduu Surplus Surplus -- when Qwhen QSS > Q> QDD at current market at current market

priceprice•• Amount of surplus = QAmount of surplus = QSS -- QQDD

uu Note Note -- it is it is not not correctcorrect to say supply to say supply exceeds demand, but rather that quantity exceeds demand, but rather that quantity supplied exceeds quantity demandedsupplied exceeds quantity demanded

Surplus Shown GraphicallySurplus Shown Graphically

P

Q/t

S

D

0

Pa

QD QS

Amount ofSurplus Pa = actual price

Qa = actual quantity sold

Note the actual quantity sold equals the quantity demanded

Qa = QD

Qa

Surplus Through Legislated Surplus Through Legislated Price FloorsPrice Floorsuu Price floor Price floor -- sets a minimum price that sets a minimum price that

is allowed by lawis allowed by lawuu Result of price floorResult of price floor

vv No tendency for price to play its rationing No tendency for price to play its rationing functionfunction

uu Note that a price floor can be set at any Note that a price floor can be set at any price, but is only effective if it is above price, but is only effective if it is above the equilibrium pricethe equilibrium price

Price Floor ExamplesPrice Floor Examples

uu Agriculture support pricesAgriculture support pricesvv Price of wheat supported at 80% of parityPrice of wheat supported at 80% of parity

uu 100% parity: setting the price of farm 100% parity: setting the price of farm commodities so they have the same purchasing commodities so they have the same purchasing power they had in the “golden age of power they had in the “golden age of agriculture” 1910agriculture” 1910--19141914

uu FAIR act of 1996FAIR act of 1996

uu Minimum wage legislationMinimum wage legislationvv The conventional storyThe conventional storyvv Renewed debateRenewed debate

Agriculture Price SupportsAgriculture Price Supports

uu FAIR: federal agricultural FAIR: federal agricultural improvement and reform act, signed by improvement and reform act, signed by president Clinton in 1996president Clinton in 1996vv FAIRFAIR: link to the U.S. Dept. Of agriculture : link to the U.S. Dept. Of agriculture

to find out moreto find out morevv The act moves to replace price supports The act moves to replace price supports

with direct subsidy of farm income phased with direct subsidy of farm income phased out over timeout over time

Price Support Maintained by Price Support Maintained by Government PurchasesGovernment Purchases

P

Q/t

S

D

0

Pa

QD QS

Amount ofSurplus

Pa = actual price, set at 80% of parity

QS = quantity farmers want to sell

Qa = quantity bought by consumers

One policy has taxpayers buying the surplus, QS - Qa paying Pa x (QS - Qa )

Qa

Farm Support Maintained by Deficiency Farm Support Maintained by Deficiency PaymentsPayments

P

Q/t

S

D

0

Pt

QD QS

Pt = target price, set at 80% of parity

Pa = market price

Qs = quantity farmers want to sell

Qa = QS = quantity bought by consumers

Deficiency payments are (Pt - Pa) x Qa )

Qa

Pa

Inefficiencies of Pre FAIR Act Inefficiencies of Pre FAIR Act Agriculture Policy Agriculture Policy (Gov. (Gov. Purchases)Purchases)uu Government purchases of surplusGovernment purchases of surplus

vv Perpetual surplusesPerpetual surplusesvv Price sends the wrong signal to farmersPrice sends the wrong signal to farmers

uu Consumers buy only amount they value at target Consumers buy only amount they value at target price, but farmers produce amount up to where price, but farmers produce amount up to where their marginal cost equal the target pricetheir marginal cost equal the target price

uu The surplus costs more to produce than its worth The surplus costs more to produce than its worth measured by consumers willingness to paymeasured by consumers willingness to pay

uu Consumers and taxpayers lose more than Consumers and taxpayers lose more than farmers gainfarmers gain

Inefficiencies of Pre FAIR Act Inefficiencies of Pre FAIR Act Agriculture Policy Agriculture Policy (Deficiency (Deficiency Payments)Payments)uu Government deficiency paymentsGovernment deficiency payments

vv Perpetual overproduction but no surplusesPerpetual overproduction but no surplusesvv Price sends the wrong signal to farmersPrice sends the wrong signal to farmers

uu Consumers buy all that is brought to market, Consumers buy all that is brought to market, but marginal cost (= target price) exceeds the but marginal cost (= target price) exceeds the value consumers put on the goodvalue consumers put on the good

uu On the margin the good costs more to produce On the margin the good costs more to produce than its worththan its worth

uu Taxpayers lose more than consumers Taxpayers lose more than consumers and farmers gainand farmers gain

Price Floors in the Unskilled Labor Price Floors in the Unskilled Labor MarketMarket----the Minimum Wagethe Minimum Wage

uu When we look at the labor market it is When we look at the labor market it is similar to other supply and demand similar to other supply and demand diagrams except for the labelsdiagrams except for the labels•• L L -- quantity of workers per periodquantity of workers per period•• W W -- wages (the price we pay workers)wages (the price we pay workers)

uu It is also different because the suppliers It is also different because the suppliers of labor are person, not firms and the of labor are person, not firms and the demanders of labor are firmsdemanders of labor are firms

Minimum Wage LegislationMinimum Wage Legislation----the Conventional Storythe Conventional Story

L*LD LS

Wage

# of Workers/t

S

D

w*

0

wfloor

Amount of Unemployed Workers

Winners and Losers of the Minimum Winners and Losers of the Minimum WageWage----the Conventional Storythe Conventional Story

uu Benefit Benefit -- those who get higher wagesthose who get higher wagesuu Losers Losers -- those who can’t find jobs at those who can’t find jobs at

the higher wagethe higher wageuu Losers Losers -- firms who must pay higher firms who must pay higher

wages and consumers who have to wages and consumers who have to pay higher prices due to the higher pay higher prices due to the higher costs of the firmcosts of the firm

uu Inefficient since the sum of the loses Inefficient since the sum of the loses exceeds the sum of the benefitsexceeds the sum of the benefits

The Minimum WageThe Minimum Wage----a New Debatea New Debateuu Any inefficiency that may be created is Any inefficiency that may be created is

small small uu Equity objectives are furthered by Equity objectives are furthered by

having a “livable” minimum wagehaving a “livable” minimum wageuu Due to market power possessed by Due to market power possessed by

firms hiring minimum wage workers, firms hiring minimum wage workers, an increase in the wage may increase an increase in the wage may increase employmentemployment

uu Increased wages increase labor Increased wages increase labor productivity by giving workers a productivity by giving workers a “stake” in their effort“stake” in their effort

Demand and Supply of Demand and Supply of Unskilled Labor Are “Steep”Unskilled Labor Are “Steep”uu Firms that hire unskilled labor are not Firms that hire unskilled labor are not

very sensitive to small changes in the very sensitive to small changes in the minimum wage, so the quantity minimum wage, so the quantity demanded will not change muchdemanded will not change much

uu Unskilled persons supply of labor are Unskilled persons supply of labor are not very sensitive to changes in their not very sensitive to changes in their wagewage

uu Thus any unemployment caused by Thus any unemployment caused by increases in the minimum wage will be increases in the minimum wage will be smallsmall

Unskilled Labor MarketUnskilled Labor Market

Wage

# of Workers/t

S

D

w*

0

wfloor

Amount of Unemployed Workers

Wage

# of Workers/t

S

D

w*

0

wfloor

Amount of Unemployed Workers

not this but this

Equity Vs. EfficiencyEquity Vs. Efficiency

uu Equity objectives are furthered by Equity objectives are furthered by having a “livable” minimum wagehaving a “livable” minimum wage

uu This “tradeThis “trade--off” is in society’s interest off” is in society’s interest as we seek to do something about the as we seek to do something about the growing inequality of incomes in the growing inequality of incomes in the united statesunited states

Monopsony PowerMonopsony Power

uu Due to market power possessed by Due to market power possessed by firms hiring minimum wage workers, firms hiring minimum wage workers, an increase in the wage may increase an increase in the wage may increase employmentemployment

uu You will discuss this in chapter 9You will discuss this in chapter 9

“Efficiency Wage”“Efficiency Wage”

uu Increased wages increase labor Increased wages increase labor productivity by giving workers a productivity by giving workers a “stake” in their effort“stake” in their effort

uu Increased productivity lowers cost Increased productivity lowers cost offsetting, at least partly the higher offsetting, at least partly the higher wages due to increases in the minimum wages due to increases in the minimum wagewage

How Price Rationing Eliminates How Price Rationing Eliminates SurplusesSurpluses

P

Q/t

S

D

P*

Q*0

Pa

QSQD

Sellers who expected to sell are unsatisfied

Buyers find they have more sellers to choose from

P

Q/t

S

D

0

Pa

QD QS

Amount ofSurplus

Qe

Pe

How Price Rationing Eliminates How Price Rationing Eliminates SurplusesSurpluses

Quantity demanded increases as price falls

Quantity supplied decreases as price falls

Price continues to fall until:

QD = QS

Surplus Eliminated Through Surplus Eliminated Through Price DecreasesPrice Decreasesuu Buyers find little resistance to lower price Buyers find little resistance to lower price

offersoffersuu Sellers can’t sell all they want and are Sellers can’t sell all they want and are

willing to accept lesswilling to accept lessuu P will fallP will fall

vv Quantity demanded will increaseQuantity demanded will increasevv Quantity supplied will decreaseQuantity supplied will decreasevv The process continues until an The process continues until an

equilibrium is established by price equilibrium is established by price rationingrationing

The End