Chapter 4 – Demand and Supply Applications

Chapter Outline and Learning Objectives

1. The Price System: Rationing and Allocating Resources
• Understand how price floors and price ceilings work in the market place.
2. Supply and Demand Analysis: Tariffs
• Analyze the economic impact of tariffs.
3. Supply and Demand and Market Efficiency
• Explain how consumer and producer surplus are generated.
The Price System: Rationing and Allocating Resources
• Every society has a system of institutions that determines what is produced, how
it is produced, and who gets what is produced.
• In some societies, these decisions are made centrally, through planning agencies
or by government directive. However, in every society, many decisions are made
in a decentralized way, through the operation of markets.
• The market system, also called the price system, performs two important and
closely related functions.
1) it provides an automatic mechanism for distributing scarce goods and
services. That is, it serves as a price rationing device for allocating goods
and services to consumers when the quantity demanded exceeds the
quantity supplied.
2) the price system ultimately determines both the allocation of resources
among producers and the final mix of outputs.
• price rationing: The process by which the market system allocates goods and
services to consumers when quantity demanded exceeds quantity supplied.
• The adjustment of price is the rationing mechanism in free markets.
• Price rationing means that whenever there is a need to ration a good—that is,
when a shortage exists—in a free market, the price of the good will rise until
quantity supplied equals quantity demanded—that is, until the market clears.
 Figure 4.1 The Market for Wheat
• Fires in Russia in the summer of 2010 caused a shift
in the world’s supply of wheat to the left, causing the
price to increase from $160 per metric ton to $247.
• The equilibrium moved from C to B.
• The reduced supply caused the price of wheat to rise
sharply. As the price rises, the available supply is
“rationed.”
• As prices rise, wheat farmers also change their
behavior, though supply responsiveness is limited in
the short term. Quantity supplied increases from 35
million metric tons (point A) to 41.5 million tons
(point B). The price increase has encouraged farmers
who can to make up for part of the Russia wheat loss.
• The market has determined who gets the wheat: The
lower total supply is rationed to those who are
willing and able to pay the higher price!!!
• The “willingness to pay” is central to the distribution
of available supply, and willingness depends on both
desire (preferences) and income/wealth.
 Figure 4.2 Market for a Rare Painting
• There is some price that will clear any market, even if
supply is strictly limited.
• At a low price, there would be an enormous excess
demand for such an important painting.
• In an auction for a unique painting, the price (bid)
will rise to eliminate excess 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.
• If the product is in strictly scarce supply, as a single
painting is, its price is said to be demand-
determined.
 Think about a family heirloom. It is quite possible
that you would not sell it for any amount of money.
Does this mean that the market is not working?
Constraints on the Market and Alternative Rationing Mechanisms
• Both governments and private firms decide to use some mechanism other than
the market system to ration an item for which there is excess demand at the
current price.
• Policies designed to stop price rationing are commonly justified in a number of
ways, most often in the name of fairness.
• Regardless of the rationale, two things are clear:
i. Attempts to bypass price rationing in the market and to use alternative
rationing devices are more difficult and more costly than they would seem
at first glance.
ii. Very often such attempts distribute costs and benefits among households
in unintended ways.
Oil, Gasoline, and OPEC
• The Organization of the Petroleum Exporting Counties (OPEC) is an organization
of 12 countries (Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar,
Saudi Arabia, the United Arab Emirates, and Venezuela) that together produce
about one-third of the world’s oil today.
• Oil provides a good example of how markets work and how markets sometimes
fail (market failure).
• In 1973 and 1974, OPEC imposed an embargo on shipments of crude oil to the
United States. Congress responded by imposing a maximum price (price ceiling)
of $0.57 per gallon of leaded regular gasoline to keep gasoline “affordable”.
• This created a shortage as the price system was not allowed to function. >>>
fairness!
• Alternative rationing systems also occurred.

• price ceiling: A maximum price above which exchange is not permitted.

• price floor: A minimum price below which exchange is not permitted.
 Figure 4.3 Excess Demand (Shortage)
Created by a Price Ceiling
• 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.
• queuing: Waiting in line as a means of distributing goods and services: a nonprice
rationing mechanism.
• Under this system, gasoline went to those people who were willing to pay the most, but the
sacrifice was measured in hours and aggravation instead of dollars.
• favored customers: Those who receive special treatment from dealers during
situations of excess demand: a nonprice rationing mechanism.
• Side payments were offered to become “favored”. Owners also charged high prices for
service. By doing so, they increased the actual price of gasoline but hid it in service
overcharges to get around the ceiling.
• ration coupons: Tickets or coupons that entitle individuals to purchase a certain
amount of a given product per month.
• Everyone would get the same amount regardless of income. When ration coupons are used
with no prohibition against trading them, however, the result is almost identical to a system
of price rationing. suppose that you decide not to sell your ration coupon. What is the exact
cost?
• black market: A market in which illegal trading takes place at market-determined
prices.(e.g. Tickets).
Rationing Mechanisms for Concert and Sports Tickets
• Why a profit-maximizing enterprise would not charge the highest price it could?
• Who would get to buy the tickets?
• The true cost is what you give up to sit in the seat (opportunity cost).
• It is very difficult to prevent the price system from operating and to stop people’s
willingness to pay from asserting itself.
• Every time an alternative is tried, the price system seems to sneak in the back
door.
• With favored customers and black markets, the final distribution maybe even
more unfair than what would result from simple price rationing.
 Figure 4.4 Supply of and Demand for a
Concert at the Staples Center
• At the face-value price of $50, there is
excess demand for seats to the concert.
• At $50 the quantity demanded is greater
than the quantity supplied, which is fixed at
20,000 seats. Market-clearing price is $300
per ticket.
• Who would get to buy the $50 tickets? The
most common is queuing, waiting in line.
• Even if you get the ticket for the (relatively)
low price of $50, that is not the true cost.
The true cost is what you give up to sit in the
seat.
• If people on eBay, StubHub, or Ticketmaster
are willing to pay $300 for your ticket, that’s
what you must pay, or sacrifice, to go to the
concert.
Prices and the Allocation of Resources
Market determines more than just the distribution of final outputs.
It also determines what gets produced and how resources are allocated among
competing uses.

• Price changes resulting from shifts of demand in output markets cause profits to
rise or fall. Profits attract capital; losses lead to disinvestment.
• Higher wages attract labor and encourage workers to acquire skills.
• At the core of the system, supply, demand, and prices in input and output
markets determine the allocation of resources and the ultimate combinations of
goods and services produced.
Supply and Demand Analysis: Tariffs (Import Fee)
• A tax on goods produced outside the country, often called a tariff.
• In 2012 the United States imported 45 percent of its oil. Of the imports, 22
percent come from the Persian Gulf States. Given the political volatility of that
area of the world, many politicians have advocated trying to reduce the
dependence on foreign oil.
• One tool often suggested by both politicians and economists to accomplish this
goal has been an import oil tax or tariff.
• Supply and demand analysis makes the arguments of the import tax proponents
easier to understand.
 Figure 4.5 The U.S.
Market for Crude Oil,
• The world price of oil is $80, and the United 2012
States is assumed to be able to buy all the oil
that it wants at this price. So, domestic
producers cannot charge any more than $80 per
barrel.
• If the government levies a tax of 33.3% on
imported oil. New price will be $106.64.
• Note that the tax is paid only on imported oil.
• Movements along the demand and supply
curves end up with lower import.
• The tax also generates revenues for the federal
government (area of the trapezoid).
• However, the oil import fee would increase
domestic production and reduce overall
consumption.
 Supply and Demand and Market Efficiency
consumer surplus: The difference between the maximum amount a person is
willing to pay for a good and its current market price.
Figure 4.6 Market Demand and Consumer Surplus

• In this market,
consumers who
value a
hamburger at
$2.50 or more
will buy it, and
those who have
lower values will
do without.
 Supply and Demand and Market Efficiency
producer surplus: The difference between the current market price and the cost of
production for the firm.
• The supply curve in a
Figure 4.7 Market Supply and Consumer Surplus market shows the
amount that firms
willingly produce and
supply to the market
at various prices.

• Because the price is

sufficient to cover
the costs or the
opportunity costs of
production and give
producers enough
profit to keep them
in business.
 Competitive Markets Maximize the Sum of Producer and Consumer Surplus
Figure 4.8 Total Producer and Consumer Surplus • Total producer and consumer surplus is
greatest where supply and demand
curves intersect at equilibrium.
• Consider the result to consumers and
producers if production were to be
reduced to 4 million burgers.
• deadweight loss: The total loss of
producer and consumer surplus from
underproduction or overproduction.
Figure 4.9a Deadweight Loss
• Panel (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 ABC
shaded in yellow.
• This is called the deadweight loss from
underproduction.
Figure 4.9b Deadweight Loss
• Panel (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.
• This is called the deadweight loss from
overproduction.
Potential Causes of Deadweight Loss From Under- and Overproduction
• Competitive markets are efficient because when supply and demand interact
freely, markets produce what people want at the least cost.
• There are a number of sources of market failure:
i. Monopoly power gives firms the incentive to underproduce and overprice.
ii. Taxes and subsidies may distort consumer choices.
iii. External costs such as pollution and congestion may lead to over-or
underproduction of some goods.
iv. Artificial price floors and price ceilings may have the same effects.