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2012 Pearson Education

Prepared by: Fernando Quijano & Shelly TefftCASE FAIR OSTER

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4

Demand and SupplyApplications

CHAPTER OUTLINE

The Price System: Rationing and

Allocating Resources

Price Rationing

Constraints on the Market and

Alternative Rationing Mechanisms

Prices and the Allocation of Resources

Price Floors

Supply and Demand Analysis: An

Oil Import Fee

Supply and Demand and Market

Efficiency

Consumer Surplus

Producer Surplus

Competitive Markets Maximize the Sumof Producer and Consumer Surplus

Potential Causes of Deadweight Loss

from Under- and Overproduction

Looking Ahead

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price rationing The process by which the marketsystem allocates goods and services to consumerswhen quantity demanded exceeds quantity supplied.

The Price System: Rationing and Allocating Resources

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FIGURE 4.1 The Market for Wheat

Fires in Russia in the summer of

2010 caused a shift in the worlds

supply of wheat to the left, causing

the price to increase from $160 per

millions of metric tons to $247.

The equilibrium moved from Cto B.


Price Rationing

2010

160247.

C B.

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The adjustment of price is the rationing mechanism in free markets. Pricerationing means that whenever there is a need to ration a goodthat is, when ashortage existsin a free market, the price of the good will rise until quantitysupplied equals quantity demandedthat is, until the market clears.

It is very important to distinguishbetween the priceof a product andtotal expenditurefrom that product.

Total revenue or expenditure in a

market is simply the number ofunits sold multiplied by the price.

Prices and Total Expenditure: A Lesson from the Lobster Industryin 2008-2009 :2008-

2009

E C O N O M I C S I N P R A C T I C E

Lobster Prices Plummet As MaineFishermen Catch Way Too Many

Business Insider

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FIGURE 4.2 Market for a RarePainting

There is some price that will clear any

market, even if supply is strictly

limited.

In an auction for a unique painting,

the price (bid) will rise to eliminateexcess demand until there is only one

bidder willing to purchase the single

available painting.

Some estimate that the Mona Lisa

would sell for $600 million if

auctioned.

The Price System: Rationing and Allocating Resources :

Price Rationing

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()

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600.

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On occasion, both governments and private firms decide touse some mechanism other than the market system to rationan item for which there is excess demand at the current price.

Regardless of the rationale, two things are clear:

1. Attempts to bypass price rationing in the market and to usealternative rationing devices are more difficult and morecostly than they would seem at first glance.

2. Very often such attempts distribute costs and benefitsamong households in unintended ways.


Constraints on the Market and Alternative Rationing Mechanisms

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price ceiling A maximum pricethat sellers may charge for agood, usually set by government.

FIGURE 4.3 Excess Demand (Shortage)Created by a Price Ceiling

In 1974, a ceiling price of $0.57 cents per gallon

of leaded regular gasoline was imposed. If the

price had been set by the interaction of supply

and demand instead, it would have increased to

approximately $1.50 per gallon.At $0.57 per gallon, the quantity demanded

exceeded the quantity supplied. Because the

price system was not allowed to function, an

alternative rationing system had to be found to

distribute the available supply of gasoline.



Oil, Gasoline, and OPEC

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queuing Waiting in line as a means ofdistributing goods and services: a nonpricerationing mechanism.

favored customers Those who receivespecial treatment from dealers duringsituations of excess demand.

ration coupons Tickets or coupons thatentitle individuals to purchase a certain amount

of a given product per month.

black market A market in which illegal tradingtakes place at market-determined prices.



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FIGURE 4.4 Supply of and Demandfor a Concert at the Staples Center

At the face-value price of $50, there isexcess demand for seats to the concert.

At $50 the quantity demanded is

greater than the quantity supplied,

which is fixed at 20,000 seats.

The diagram shows that the quantity

demanded would equal the quantity

supplied at a price of $300 per ticket.


Constraints on the Market andAlternative Rationing Mechanisms

Rationing Mechanisms forConcert and Sports Tickets

50

20000

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No matter how good the intentions of privateorganizations and governments, it is very difficultto prevent the price system from operating andto stop willingness to pay from asserting itself.Every time an alternative is tried, the pricesystem seems to sneak in the back door. Withfavored customers and black markets, the finaldistribution may be even more unfair than what

would result from simple price rationing.



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Price changes resulting from shifts of demand inoutput markets cause profits to rise or fall. Profitsattract capital; losses lead to disinvestment. Higherwages attract labor and encourage workers to acquireskills. At the core of the system, supply, demand, andprices in input and output markets determine theallocation of resources and the ultimate combinationsof goods and services produced.


Prices and the Allocation of Resources

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price floor A minimum price belowwhich exchange is not permitted.

minimum wage A price floor setfor the price of labor.


Price Floor

A .

A .

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Every summer, New York City puts onfree performances of Shakespeare inthe Park.

The true cost of a ticket is $0 plus the

opportunity cost of the time spent inline.

Students can produce tickets relativelycheaply by waiting in line. They canthen turn around and sell those ticketsto the high-wage Shakespeare lovers.

The Price Mechanism at Work for Shakespeare

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FIGURE 4.5 The U.S. Market for Crude Oil, 1989

At a world price of $18, domestic production

is 7.7 million barrels per day and the total

quantity of oil demanded in the United States

is 13.6 million barrels per day.

The difference is total imports (5.9 million

barrels per day).

If the government levies a 33 1/3 percent tax on imports,

the price of a barrel of oil rises to $24.

The quantity demanded falls to 12.2 million barrels per day.

At the same time, the quantity supplied by domestic

producers increases to 9.0 million barrels per day and the

quantity imported falls to 3.2 million barrels per day.

Supply and Demand Analysis: An Oil Import Fee:

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consumer surplus The difference betweenthe maximum amount a person is willing topay for a good and its current market price.

Supply and Demand and Market Efficiency

Consumer Surplus

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FIGURE 4.6 Market Demand and Consumer Surplus

As illustrated in (a), some consumers (see point A) are willing to pay as much as $5.00 each for hamburgers.

Since the market price is just $2.50, they receive a consumer surplus of $2.50 for each hamburger that they consume.

Others (see point B) are willing to pay something less than $5.00 and receive a slightly smaller surplus.

Since the market price of hamburgers is just $2.50, the area of the shaded triangle in (b) is equal to total consumer surplus.


Consumer Surplus

()( A) 5.00.

$2.502.50.

(())5.00.

$2.50().

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FIGURE 4.7 Market Supply and Producer Surplus

As illustrated in (a), some producers are willing to produce hamburgers for a price of $0.75 each.

Since they are paid $2.50, they earn a producer surplus equal to $1.75.

Other producers are willing to supply hamburgers at a price of $1.00; they receive a producer surplus

equal to $1.50.

Since the market price of hamburgers is $2.50, the area of the shaded triangle in (b) is equal to total

producer surplus.


Producer Surplus

()0 75$. 2.501.75.

1.001.50.

$2.50().

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FIGURE 4.8 Total Producer and Consumer Surplus

Total producer and consumer surplus is greatest where supply and demand curves intersect at equilibrium.


Competitive Markets Maximize the Sum of Producer and Consumer Surplus

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deadweight loss The net loss of producer and consumersurplus from underproduction or overproduction.


Competitive Markets Maximize the Sum of Producer and Consumer Surplus

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Figure 4.9(a) shows the consequences of producing 4 million hamburgers per month instead of 7 million

hamburgers per month.

Total producer and consumer surplus is reduced by the area of triangle ABCshaded in yellow.

This is called the deadweight loss from underproduction.

Figure 4.9(b) shows the consequences of producing 10 million hamburgers per month instead of 7 million

hamburgers per month.

As production increases from 7 million to 10 million hamburgers, the full cost of production rises above

consumers willingness to pay, resulting in a deadweight loss equal to the area of triangle ABC.

FIGURE 4.9 Deadweight Loss


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When supply and demand interact freely, competitive marketsproduce what people want at least cost, that is, they are efficient.

There are a number of naturally occurring sources of marketfailure. Monopoly power gives firms the incentive to underproduceand overprice, taxes and subsidies may distort consumer choices,external costs such as pollution and congestion may lead to over-or underproduction of some goods, and artificial price floors andprice ceilings may have the same effects.


Potential Causes of Deadweight Loss from Under- and Overproduction

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We have now examined the basic forces of supply and demandand discussed the market/price system. These fundamentalconcepts will serve as building blocks for what comes next.

Whether you are studying microeconomics or macroeconomics,you will be studying the functions of markets and the behavior ofmarket participants in more detail in the following chapters.

Looking Ahead

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black market

consumer surplus

deadweight loss

favored customers

minimum wage

price ceiling

price floor

price rationing

producer surplus

queuing

ration coupons

R E V I E W T E R M S A N D C O N C E P T S

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