1 Using Supply and Demand Chapter 5. 2 The Power of Supply and Demand Changes in supply and demand will change equilibrium price and quantity. A shift

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Using Supply and Using Supply and DemandDemand


Chapter 5Chapter 5

2

The Power of Supply and Demand

• Changes in supply and demand will change equilibrium price and quantity.

• A shift in demand that moves the demand curve to the right causes equilibrium price and quantity to rise.

• A shift in supply that moves the supply curve to the left causes equilibrium price to rise and equilibrium quantity to fall.

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Pric

e (p

er c

ass e

tte)

A

S0

Quantity of cassettes (per week)

$2.50

2.25

0 98 10

Excess demand

D1

A Shift in Demand

D0

B

4

A

A Shift in SupplyP

rice

(per

cas

s ett

e)

Quantity of cassettes (per week)

$2.50

2.25

0 98 10

D0

S1S0

C

B Excess demand

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Real World Examples of

Supply and Demand• Supply and demand can shed light

on a variety of real-world events:– Florida freeze.– Financial assets and the baby

boomers.– Ten percent excise tax.

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Florida Freeze

• The crop-damaging freeze shifted the supply curve to the left.

• At the original price, quantity demanded exceeded quantity supplied.

• Price rose until the quantity demanded equaled the quantity supplied.

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Florida Freeze

Demand

S0

(c)

P1

Qe

P0

QDQS

S1

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Financial Assets and the Baby Boomers

• Demographic changes among baby boomers moved the demand curve for financial assets to the right.

• At the original price, quantity demanded exceeded quantity supplied.

• Price rose until the quantity demanded equaled the quantity supplied.

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S

(f)

D0

P1

Q1Q0

P0D1

QD

10


• The same phenomenon occurred in the surging demand for housing among this group during the 180s.

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Excise Taxes

• Congress imposed a 10 percent surtax on luxury boats.

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Excise Taxes

• A 10 percent surtax on luxury boats levied on suppliers shifts the supply curve to the left.

• After the tax is imposed, the quantity of boats demanded drops.

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Excise Taxes

S0

D0

P1

Q1

P0

Q0

S1

QD

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A Review

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Government Interferences

• Buyers look to government for ways to hold prices down. Sellers look to government for ways to hold prices up.

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Price Ceilings

• A price ceiling is a government-imposed limit on how high a price can be charged.

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Rent Controls

• Rent control is a price ceiling on rents set by government.

• An example is rent control in Paris following World War I and World War II.

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Rent Controls

• The following were the consequences of rent control in Paris:– A huge shortage of living quarters.

– New housing construction stopped.– Existing housing was allowed to

deteriorate.

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Rent Controls

• The following were the consequences of rent control in Paris:– For many, the only way to get living

quarters was to offer a huge bribe to the landlord.

– Many families had to double up with other family members.

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Rent Controls

QS QD

Supply

Demand

Ren

tal P

rice

(per

mon

th)

Quantity of apartments

2.50

$17.00 Shortage

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Minimum Wage• A price floor is a government-

imposed limit on how low a price can be charged.

• The minimum wage is an example of a price floor.

• A minimum wage is set by government specifying the lowest wage a firm can legally pay an employee.

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Minimum Wage• The effect of the minimum wage

depends on whether it is higher, lower, or the same as the market wage rate.

• If it is higher than the market wage then the minimum wage creates winners and losers:

– Those who can find work earn a higher wage.– Others become unemployed.– Production costs increase.– Consumers pay higher prices.

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Minimum WageThe minimum wage is a price floor. The MW law does not

prohibit paying more for labor…it only prohibits paying less than the minimum wage. In this example the market wage is higher than the minimum wage. Consequently,

the minimum wage is not binding here.

LaborSupply

QS QD

LaborDemand

Wag

e (p

er h

our)


5.50

$7.00

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Minimum WageIn this example the market wage is lower than the

minimum wage. Consequently, the minimum wage is binding here. More people want to work than employers are willing to hire at this wage, consequently we have

unemployment.

LaborSupply

QSQD

LaborDemand

Wag

e (p

er h

our)


5.50

$7.00

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The Limitations Of Supply And Demand

Analysis• Other things don't remain constant.

• Sometimes supply and demand are interconnected.

• Supply/demand analysis is the first step to analysis, not the complete analysis.

• Deciding whether the effects are significant to consider requires a knowledge of the structure of the economy because all actions have ripple or feedback effects.

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The Roles of Government• Provide a stable institutional

framework.• Promote effective and workable

competition.• Correct for externalities.• Ensure economic stability and growth.• Provide for public goods.• Adjust for undesired market results.

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Provide a Stable Set of Institutions and Rules

• Only the government can create a stable environment and enforce contracts through its legal system.

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Provide a Stable Set of Institutions and Rules

• When governments do not provide a stable environment, as is now happening in Russia, economic growth is difficult - usually such economies are stagnant.

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Promote Effective and Workable Competition

• Government promotes competition and protect against monopolies. – Monopoly power is the ability of

individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business

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• Monopoly power gives existing firms or individuals the power to raise prices.

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• Many players in the market insist on open competition except when it comes to themselves:

– Farmers like competition but still want price supports.

– Lawyers and architects like competition but still want licensing to prevent others from entering the market.

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Correct for Externalities• Unless they are required to do so,

parties to any exchange are unlikely to take into account any externality.

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Correct for Externalities• An externality is the effect that

an action may have on a third party that the person who undertook that action did not take into account.

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Correct for Externalities• The externality may be positive in

which case society benefits even more than the two parties – an example is education.

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Correct for Externalities• The externality may be negative in

which case society as a whole benefits less than the two parties – an example is pollution.

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Correct for Externalities• When there are externalities,

government has the potential role to change the rules so that the parties must take into account the effect of their actions on others.

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Ensure Economic Stability and Growth

• Most Americans agree that government should:– Prevent large fluctuations in economic

activity.– Maintain a relatively constant price

level.– Provide an economic environment

conducive to economic growth.

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Ensure Economic Stability and Growth

• Most economists support these goals since they involve macroeconomic externalities.

• Macroeconomic externalities are externalities that affect the levels of unemployment, inflation, and growth in the economy as a whole.

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Provide for Public Goods

• Public goods are those whose consumption by one individual does not prevent their consumption by other individuals – an example is a public park.

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• In contrast, a private good is one that, when consumed by one individual, cannot be consumed by other individuals – an example is an apple.

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• A free rider is a person who participates in something without having to pay for it.

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• Since most everyone would enjoy having public parks without having to pay for them, government requires that the public be taxed to pay for public parks, thereby eliminating free riders.

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Adjust for Undesired Market Results

• In an attempt to make the market fairer, the government, through taxes and expenditures, redistributes income among households.– The result is controversy.

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• For example, in trying to be fair, which type of tax should the government use?

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• A progressive tax, such as the U.S. income tax is one whose rates increase as a person's income increases.

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• A regressive tax such as a sales tax is one whose effect decrease as income rises.

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• A proportional tax, such as the Social Security tax, is one whose rates are constant at all income levels, regardless of the taxpayer's total annual income.

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• Another controversial role for government involves deciding what is best for people independently of their desires.

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• Should government prohibit demerit goods and activities?

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• Demerit goods and activities are things government believes are bad for you, although you may like them.

– Addictive drugs are a demerit good; using addictive drugs is a demerit activity.

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• Merit goods and activities are things the government believes are good for you, although you may not like them.

– Motorcycle helmets are a merit good; using helmets while driving a motorcycle is a merit activity.

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Market Failures and Government Failures

• Market failures are situations where the market does not lead to a desired result.

• The government sometimes intervenes in markets when market occurs.

• Government intervention, however, may make matters worse.

• Government failures are situations where the government intervenes and makes the situation worse

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Market Failures and Government Failures

• Real-world policy makers must choose the option which is least bad -- market failure or government failure – by weighing the costs and benefits of each.

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End of Chapter 5End of Chapter 5

Documents

1 Using Supply and Demand Chapter 5. 2 The Power of Supply and Demand Changes in supply and demand will change equilibrium price and quantity. A shift