Introduction: Thinking Like an Economist 1 CHAPTER Using Supply and Demand It is by invisible hands that we are bent and tortured worst. Nietzsche CHAPTER.

Introduction: Thinking Like an Economist

1CHAPTER

Using Supply and Demand

It is by invisible hands that we are bent and tortured worst.

— Nietzsche

CHAPTER

5

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

1Using Supply and Demand5

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Chapter Goals

Apply the supply and demand model to real-word events

Explain the effect of excise taxes and tariffs on a market

Demonstrate the effect of a price ceiling and a price floor on a market

Explain the effect of quantity restrictions on a market

Explain the effect of a third-party payer system on equilibrium price and quantity

1Using Supply and Demand5

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Application: Apples in the United States

D0

Quantity

The hurricane damage caused the supply curve

to shift left

Hurricane Irene destroyed a significant portion of the

apple crop in the northeastern U.S.

S1

Price rose from P0 to P1

where quantity demanded = quantity supplied

Q1

P1

S0

Price

P0

Q0

Apples

Excess demand

1Using Supply and Demand5

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Application: Sales of SUVs in the U.S.

P0

Q1

P1

Increasing gas costs causes the demand curve

to shift left

Gasoline in the U.S. is increasingly expensive

Price for SUVs fell

from P0 to P1 where

Q demanded = Q supplied

S0

D0

Price

Quantity Q0

SUVs

Excess supply

D1

1Using Supply and Demand5

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Application: Edible Oils in the World

S0

D0

Price

Quantity

Growing middle class in Asia has increased demand for oilsS1

At the same time, U.S. farmers are growing more

corn and less soy (less soy oil)

Edible Oils

P0

P1

D1The result is increased prices

for edible oils

1Using Supply and Demand5

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A Review of Changes in Supply and Demand

No change in Supply

Supply increases Supply decreases

No change in Demand

P sameQ same

P downQ up

P up Q down

Demand increases

P upQ up

P ambiguous Q up

P upQ ambiguous

Demand decreases

P downQ down

P downQ ambiguous

P ambiguous Q down

1Using Supply and Demand5

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Government Intervention

• Price ceilings and price floors

• Third-party-payer markets

• Excise taxes and tariffs

• Quantity restrictions

The invisible hand is not the only factor in determining prices; social and political forces also determine price.

Other factors include:

1Using Supply and Demand5

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Government Intervention: Price Ceilings

When a government wants to hold prices down to favor buyers, it imposes a price ceiling

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

With price ceilings, existing goods are no longer rationed entirely by price so other methods of rationing arise

Price ceilings create shortages

Price ceilings below equilibrium price will have an effect on the market

1Using Supply and Demand5

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S0

D0

P(rental price per month)

Q (number of apartments)

$17

$2.50

QDQS

Shortage

Housing

The rent controls caused a housing shortage

After WWII, rent controls (a form of price ceiling)

were put in place

There would not be a shortage if rents had been allowed to increase to the equilibrium price of $17

Application: Rent Controls in Paris

1Using Supply and Demand5

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Government Intervention: Price Floors

When a government wants to prevent a price from falling below a certain level to favor suppliers, it imposes a price floor

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

Price floors above equilibrium price will have an effect on the market

Price floors create excess supply

1Using Supply and Demand5

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Application: A Minimum Wage

S0

D0

P (wage per hour)

Q (quantity of workers)

W0

Wmin

QD QS

Excess supply = unemployment

Labor

Minimum wages cause unemployment

A minimum wage is a type of price floor, it is the lowest wage a firm can legally pay an employee

Q0

1Using Supply and Demand5

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Government Intervention: Excise Taxes

An excise tax is a tax that is levied on a specific good

A tariff is an excise tax on an imported good

The result of taxes and tariffs is an increase in equilibrium prices and reduce equilibrium quantities

Government impacts markets through taxation

1Using Supply and Demand5

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Application: The Effect of an Excise Tax

S0

D0

Price

Quantity

$60,000

600510

The supply curve shifts up by the amount of the tax

Government imposes a $10,000 luxury tax on the suppliers of boats

S1

The price of boats rises by less than the tax to $65,000

Tax = $10,000

Luxury Boats

$65,000

420

$10,000

$70,000

1Using Supply and Demand5

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Government Intervention: Quantity Restrictions

Government regulates markets with licenses, which limit entry into a market

Many professions require licenses, such as doctors, financial planners, cosmetologists, electricians, or taxi cab drivers

The results of limited number of licenses in a market are increases in wages and an increases in the price of obtaining the license

1Using Supply and Demand5

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Application: The Effect of a Quantity Restriction

QR

D0

12,000

When the demand for taxi services increased, because

the number of taxi licenses was limited, wages increased

Successful lobbying by taxi cab drivers in NYC resulted in

quantity restrictions (medallions)

NYC Taxi Drivers

$15

P (wages per week )

Q (number of licensed taxis)

D1

1Using Supply and Demand5

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Application: The Effect of a Quantity Restriction

QR

D0

12,000

The demand for taxi medallions also increased

because wages were increasing. But because the number of taxi licenses was

limited, the price of a medallion also increased

NYC Taxis Medallions

$400,000

P (price of taxi medallion)

Q (number of taxi of medallions)

D1Initial Fee

1Using Supply and Demand5

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Government Intervention: Third-Party-Payer Markets

In third-party-payer markets, the person who receives the good differs from the person paying for the good

Equilibrium quantity and total spending can be much higher in third-party-payer markets

Under a third-party-payer system, the person who chooses how much to purchase doesn’t pay the entire cost

Goods from a third-party-payer system will be rationed through social and political means

1Using Supply and Demand5

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Application: Third-Party-Payer Markets

Demand

10

Health Care

$25

Price

Quantity

$45

$5

Supply

18

The consumer pays the entire cost

Total expenditures for 18 units of health care

With a copayment of $5, consumers demand 18 units

Sellers require $45 per unit for that quantity

…are greater than when…

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Chapter Summary

You can describe almost all events in terms of supply and demand

Price floors, government-imposed limits on how low a price can be charged, create surpluses

Price ceilings, government imposed limits on how high a price can be charged, create shortages

Taxes and tariffs paid by suppliers shift the supply curve up by the amount of the tax or tariff and increase equilibrium price and decrease quantity

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Chapter Summary

Quantity restrictions increase equilibrium price and reduce equilibrium quantity

In a third-party-payer market, the consumer and the one who pays the cost differ. Quantity demanded, price, and total spending are greater when a third party pays than when the consumer pays.