Using Supply and Demand

Chapter 5

Laugher Curve
Q. How many conservative economists does it take to screw in a lightbulb? A. None. If the government would just leave it alone, it would screw itself in.

The Power of Supply and Demand

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

The Power of Supply and Demand

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

The Power of Supply and Demand

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

A Shift in Demand

A Shift in Supply

Six 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. Rice in Indonesia. Farm laborers. Christmas toys.

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.

Florida Freeze

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.

Financial Assets and the Baby Boomers

Financial Assets and the Baby Boomers

The same phenomenon occurred in the surging demand for housing among this group during the 1980s.

Excise Taxes
Congress imposed a 10 percent surtax on luxury boats.

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

Excise Taxes

Rice in Indonesia
Drought, pestilence, and the financial crisis shifted the supply curve to the left. The steep demand curve means that the quantity demanded does not change much with changes in price.

Rice in Indonesia
Responding to high prices, the government imported rice and distributed it to the market, causing the supply curve to shift to the right.

Rice in Indonesia

Farm Laborers
The compressed harvesting season increased the demand and increased INS patrols decreased supply. Demand shifted to the right and supply shifted to the left.

Farm Laborers
At the original price, the quantity of workers demanded exceeded the quantity supplied.

Farm Laborers
Price rises until the quantity demanded equaled the quantity supplied.

Farm Laborers
The effect on the number of laborers hired depended on the relative size of the supply shift.

Farm Laborers

Christmas Toys
A Christmas craze for Furbies shifts demand to the right. A shortage ensued along with a black market.

Christmas Toys
Finally the supplier produced more, shifting the supply curve to the right, causing the price to drop.

Christmas Toys

A Review

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

Price Ceilings
A price ceiling is a governmentimposed limit on how high a price can be charged.

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.

Rent Controls
The following were the consequences of rent control in Paris:

Rent Controls
The following were the consequences of rent control in Paris:

Rent Controls

Rent Controls
A similar situation occurred in New York City.

Price Floors
A price floor is a government-imposed limit on how low a price can be charged.

Minimum Wage
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.

Minimum Wage
The minimum wage creates winners and losers:

Minimum Wage
Economists disagree about the effects of the minimum wage.

Taxes, Tariffs, and Quotas

An excise tax is a tax that is levied on a specific good. A tariff is an excise tax on an imported good. Taxes and tariffs raise prices and reduce quantity.

The Effect of an Excise Tax on Price and Quantity

A 10 percent luxury tax on expensive boats was imposed in 1990.

The Effect of an Excise Tax on Price and Quantity

Because the luxury tax was imposed on the boat builders, the supply curve moved up by the amount of the tax.

The Effect of an Excise Tax on Price and Quantity

At a price equal to the original price plus the tax there was excess supply.

The Effect of an Excise Tax on Price and Quantity

The Effect of an Excise Tax on Price and Quantity

The tax was repealed in 1993 because of tax revenue shortfalls.

Quantity Restrictions: Quotas

A quota is a quantitative restriction on the amount that one nation can export to another.

Quantity Restrictions: Quotas

The U.S. government restricted imports of Japanese cars.

Quantity Restrictions: Quotas

The Relationship Between a Quota and a Tariff

Tariffs and quotas can both be used to reduce quantity and raise prices.

The Relationship Between a Quota and a Tariff

There is a difference between imposing a tariff and imposing a quota.

The Relationship Between a Quota and a Tariff

As a consequence, once quotas are instituted, Japanese firms competed intensely to get them.

The Relationship Between a Quota and a Tariff

The Limitations Of Supply And Demand Analysis

It is not enough to be able to explain what happens when supply or demand curves shift. It is necessary to understand the assumptions underlying the analysis.

The Limitations Of Supply And Demand Analysis

Other things don't remain constant.

The Limitations Of Supply And Demand 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.

The Limitations Of Supply And Demand Analysis

The other-things-constant assumption is likely not to hold true when one the goods represent a large percentage of the entire economy.

The Fallacy of Composition

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole.

The Fallacy of Composition

Thousands of small effects taken together add up to a large effect.

The Fallacy of Composition

When analyzing the aggregate, small effects that can be put aside in micro, can add up, and hence cannot be forgotten.

The Fallacy of Composition

Small effects comprise microeconomics while large effects comprise macroeconomics.

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.

Provide a Stable Set of Institutions and Rules

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

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.

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

Promote Effective and Workable Competition

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

Promote Effective and Workable Competition

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

Correct for Externalities

Unless they are required to do so, parties to any exchange are unlikely to take into account any externality.

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.

Correct for Externalities

The externality may be positive in which case society benefits even more than the two parties an example is education.

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.

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.

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.

Ensure Economic Stability and Growth

Most economists support these goals since they involve macroeconomic externalities.

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.

Provide for Public Goods

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

Provide for Public Goods

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

Provide for Public Goods

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.

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.

Adjust for Undesired Market Results

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

Adjust for Undesired Market Results

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

Adjust for Undesired Market Results

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

Adjust for Undesired Market Results

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.

Adjust for Undesired Market Results

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

Adjust for Undesired Market Results

Should government prohibit demerit goods and activities?

Adjust for Undesired Market Results

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

Adjust for Undesired Market Results

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

Market Failures and Government Failures

Market failures are the reason why government intervenes.

Market Failures and Government Failures

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

Market Failures and Government Failures

Government intervention, however, may make matters worse.

Market Failures and Government Failures

Government failures are situations where the government intervenes and makes the situation worse government is always failing in one way or another.

Market Failures and Government Failures

Real-world policy makers are left with the choice of selecting that which is least bad -- market failure or government failure.

Using Supply and Demand

End of Chapter 5