Principles of Macroeconomics

Thirteenth Edition

Chapter 4

Demand and Supply

Applications

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Chapter Outline and Learning
Objectives
4.1 The Price System: Rationing and Allocating
Resources
• Understand how price floors and price ceilings work in the
market place.
4.2 Supply and Demand Analysis: Tariffs
• Analyse the economic impact of tariffs.
4.3 Supply and Demand and Market Efficiency
• Explain how consumer and producer surplus are
generated.
Looking Ahead

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Chapter 4 Demand and Supply
Applications
• In every society, many decisions are made in a
decentralised way, through the operation of markets.
• In Chapter 3 we discussed how markets operate.
• This chapter continues to examine demand, supply, and
the price system.

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Learning Objective 4.1
The Price System: Rationing and Allocating Resources

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The Price System: Rationing and
Allocating Resources
Price Rationing
• 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.
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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.

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Figure 4.2
Market for a Rare Painting

• 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 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.

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Constraints on the Market and Alternative
Rationing Mechanisms (1 of 6)
• On occasion, 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 justified in a
number of ways, most often in the name of fairness.

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Constraints on the Market and Alternative
Rationing Mechanisms (2 of 6)
• Regardless of the rationale, two things are clear:
1. 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.
2. Very often such attempts distribute costs and benefits
among households in unintended ways.

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Constraints on the Market and Alternative
Rationing Mechanisms (3 of 6)
Oil, Gasoline, and O PEC
• The Organisation of the Petroleum Exporting Countries
(O PEC) is an organisation of 12 countries that together
produce about one-third of the world’s oil today.
• In 1973 and 1974, O PEC imposed an embargo on
shipments of crude oil to the United States. Congress
responded by imposing a maximum price of $0.57 per
gallon of leaded regular gasoline. This created a
shortage as the price system was not allowed to
function.
• Alternative rationing systems also occurred.

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

In 1974, a ceiling price of $0.57 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.

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Constraints on the Market and Alternative
Rationing Mechanisms (4 of 6)
• price ceiling A maximum price that sellers may charge
for a good, usually set by government.
• queuing Waiting in line as a means of distributing goods
and services: a nonprice rationing mechanism.
• favored customers Those who receive special treatment
from dealers during situations of excess demand.

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Constraints on the Market and Alternative
Rationing Mechanisms (5 of 6)
• ration coupons Tickets or coupons that entitle individuals
to purchase a certain amount of a given product per
month.
• black market A market in which illegal trading takes place
at market-determined prices.

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Economics In Practice (1 of 2)
Why Is My Hotel Room So Expensive? A Tale of Hurricane Sandy

To predict which prices rose after

Hurricane Sandy, all we need to
do is look at businesses facing
large shifts in either their demand
or supply curves after the storm.
The hotel industry saw a large
outward shift of the demand curve
in its market. Higher prices and
price gouging became possible.

CRITICAL THINKING
1. Gas prices rose after Sandy as supply shifted to the left, or inward,
given transport problems. Transport problems likely also affected the
delivery of Cheerios. Do you expect the price of Cheerios to also rise
substantially? Why or why not?
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Constraints on the Market and Alternative
Rationing Mechanisms (6 of 6)
Rationing Mechanisms for Concert and Sports Tickets
• 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 may be even more unfair than what would
result from simple price rationing.

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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.
The diagram shows that the
quantity demanded would
equal the quantity supplied at
a price of $300 per ticket.

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Prices and the Allocation of
Resources
• 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 labour 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.

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Price Floor
• price floor A minimum price below which exchange is not
permitted.
• minimum wage A price floor set for the price of labour.

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Learning Objective 4.2
Supply and Demand Analysis: Tariffs (Tax)

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Supply and Demand Analysis: Tariffs
(Tax)
• The basic logic of supply and demand is a powerful tool of
analysis.
• An example of the power of this logic is a tax on goods
produced outside the country, often called a tariff.
• Supply and demand analysis makes the arguments of the
import tax proponents easier to understand.

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Figure 4.5
The U.S. Market for Crude Oil, 2012
• In 2012 the world market price for crude oil was
approximately $80 per barrel.
• Domestic production in the United States that year
averaged about 7 million barrels per day, whereas
crude oil demand averaged just under 13 million
barrels per day.
• The difference between production and consumption
were made up of net imports of approximately 6 million
barrels per day, as we see in panel (a).
• If the government imposed a tax in this market of
33.33%, or $26.64, that would increase the world price
to $106.64.
• That higher price caused quantity demanded to fall
below its original level of 13 million barrels, while the
price increase caused domestic production to rise
above the original level.
• As we see in panel (b), the effect was a reduction in
import levels.

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Economics In Practice (2 of 2)
Every summer, New York City
puts on free performances of
Shakespeare in the Park.
The true cost of a ticket is $0 plus
the opportunity cost of the time
spent in line.
Students can produce tickets
relatively cheaply by waiting in
line. They can then turn around
and sell those tickets to high-
wage Shakespeare lovers.
CRITICAL THINKING

1. Many museums offer free admission one day a week, on a weekday.

On that day we observe that museumgoers are more likely to be
senior citizens than on a typical Saturday. Why?
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Learning Objective 4.3
Supply and Demand and Market Efficiency

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Supply and Demand and Market
Efficiency
• Supply and demand curves can be used to illustrate
market efficiency, which can be understood through the
concepts of consumer and producer surplus.
Consumer Surplus
• consumer surplus The difference between the maximum
amount a person is willing to pay for a product and its
current market price.

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Figure 4.6
Market Demand and Consumer Surplus

• As illustrated in panel (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.
• Because the market price of hamburgers is just $2.50, the area of the shaded triangle in
panel (b) is equal to total consumer surplus.

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Producer Surplus
• producer surplus The difference between the current
market price and the cost of production for the firm.

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Figure 4.7
Market Supply and Producer Surplus

• As illustrated in panel (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 prices less than
$2.50, and they also earn producer surplus. Because the market price
of hamburgers is $2.50, the area of the shaded triangle in panel (b) is
equal to total producer surplus.
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Competitive Markets Maximize the
Sum of Producer and Consumer
Surplus
• deadweight loss The total loss of producer and
consumer surplus from underproduction or
overproduction.

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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.
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Figure 4.9
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.
• 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.
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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:
– Monopoly power gives firms the incentive to
underproduce and overprice.
– Taxes and subsidies may distort consumer choices.
– External costs such as pollution and congestion may
lead to over- or underproduction of some goods.
– Artificial price floors and price ceilings may have the
same effects.

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Looking Ahead…

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Looking Ahead
• We have now examined the basic forces of supply and
demand and discussed the market/price system.
• These fundamental concepts 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 behaviour of market participants in more
detail in the following chapters.

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Review of Terms and Concepts

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Review Terms and Concepts
• black market
• consumer surplus
• deadweight loss
• favored customers
• minimum wage
• price ceiling
• price floor
• price rationing
• producer surplus
• queuing
• ration coupons

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