Ch 4 - Extensions of Supply and Demand

Introduction

• U.S. government sometimes imposes price ceilings on pharmaceutical drugs to curb price inflation.

  • Leads to shortages of the controlled drug (Medication A).

  • Patients shift to substitutes (Medication B).

  • Demand for substitutes rises, pushing their equilibrium price upward (see later discussion of Figure 4-6).

• Chapter 4 extends basic demand–supply analysis to show how market interventions (price ceilings, floors, quotas) disturb equilibrium and trigger secondary effects.

4.1 The Price System and Markets

• Price system / market system

  • Network of continuously changing relative prices that reflect current information about scarcity & abundance.

  • Prices act as signals and incentives for producers and consumers.

• Voluntary exchange

  • Trade that both parties enter because they expect to be subjectively better off.

• Transaction costs

  • All costs of arranging and carrying out exchange.

  • Information search (price, quality, service record, durability).

  • Drafting, monitoring, enforcing contracts.

• AI/Big-data evidence on transaction costs & price stickiness

  • Alberto Cavallo (MIT) analyzed >60 million prices.

  • Typical U.S. firm changes list prices roughly every 9 months.

  • Interpretation: high transaction costs → sticky prices despite underlying supply–demand shifts.

• Middlemen / intermediaries / brokers

  • Reduce transaction costs by matching buyers and sellers, supplying information, smoothing logistics.

• Platform firms

  • Digital networks that link individuals or link buyers to sellers (e.g., Airbnb, eBay).

  • Act as large-scale, technologically enabled middlemen.

4.2 Changes in Demand and Supply

• A shift in either curve → disequilibrium → price & quantity adjust until a new equilibrium is reached.

• Single-curve shifts (determinant results)

  • Demand ↑ → P^ ↑ and Q^ ↑.

  • Demand ↓ → P^ ↓ and Q^ ↓.

  • Supply ↑ → P^ ↓ and Q^ ↑.

  • Supply ↓ → P^ ↑ and Q^ ↓.

• Simultaneous shifts (indeterminate outcomes without size info)

  • Both D & S ↑: Q^ ↑ unambiguously; P^ ambiguous.

  • Both D & S ↓: Q^ ↓ unambiguously; P^ ambiguous.

  • S ↓ & D ↑: P^ ↑ unambiguously; Q^ ambiguous.

  • S ↑ & D ↓: P^ ↓ unambiguously; Q^ ambiguous.

• Price flexibility varies across markets.

  • Adjustment may appear via hidden fees, quality changes, or slow posted-price movement.

• Adjustment speed influenced by:

  • Market structure, expectations, shocks (energy, strikes, weather).

  • Markets can overshoot before settling at equilibrium.

• Illustrative example: Vinyl records

  • Costly new pressing machines → S ↓.

  • Consumer nostalgia → D ↑.

  • Result: P{vinyl} ↑ (certain) & Q{vinyl} ↑ (net increase documented empirically).

4.3 The Rationing Function of Prices

• Rationing function: market prices synchronise decisions of buyers & sellers so that quantity supplied = quantity demanded.

• Non-price rationing methods (used when prices can’t freely adjust):

  1. Queues (waiting in line).

  2. Random assignment or coupons.

  3. Use of power, status, or political influence.

  4. Physical force.

• International case – eWater in Gambia and Tanzania

  • Free community pumps broke down (≈ 33 % inoperable).

  • eWater installed metered pumps charging a fee; queues disappeared, spillage fell.

  • Households preferred price rationing over “first-come, first-served at zero price.”

• Efficiency claim

  • Price rationing maximizes gains from trade; all mutually beneficial exchanges occur.

4.4 Price Ceilings

• Price control = government-mandated maximum (ceiling) or minimum (floor) price.

• Binding price ceiling

  • Set below equilibrium P^*.

  • Creates excess demand (shortage).

  • Spurs non-price rationing & black markets (illegal high-price resale).

  • Example figure: portable electric-generator market (Figure 4-3) shows shortage & implicit supply schedule in black market.

• Rental-housing market

  • Functions of rental prices:

  1. Encourage maintenance & new construction.

  2. Allocate existing units among renters.

  3. Ration the intensity of use (household size, subletting).

  • Rent controls discourage new construction

  • Dallas (no controls, 16 % vacancy) built 11,000 new units.

  • San Francisco (1.6 % vacancy, with controls) built only 2,000.

  • Effects on existing stock

  • Owners cannot fully recover maintenance & improvement costs → deterioration.

  • Reduced mobility (“housing gridlock” in NYC).

  • Evasion tactics

  • Landlords force tenants out (to reset rent).

  • Tenants sublet at higher rates.

  • Proliferation of housing courts.

  • Winners vs. losers

  • Losers: property owners; low-income households who cannot find units.

  • Winners: Upper-income professionals who secure controlled apartments.

• Black-market cigarettes in NYC

  • U.S. average price ≈ \$7/pack.

  • NYC policies raise legal minimum to \$13.

  • Result: >50 % of cigarettes consumed in NYC purchased illegally.

4.5 Price Floors and Quantity Restrictions

• Support price / price floor: legal minimum enforced by government.

  • Binding if set above equilibrium P^* → surplus.

  • Common in agriculture (e.g., peanuts, Figure 4-4).

• Policy tools to maintain floor

  1. Government purchase & storage.

  2. Destruction of excess (plow-downs, dumping).

  3. Production quotas or acreage allotments.

• Incidence / beneficiaries of supports

  • Farmers receiving higher prices.

  • Political constituencies in rural areas.

• Minimum wage – a labor-market price floor

  • Definition: legal lower bound on hourly wage.

  • Predicted effects (Figure 4-5):

  • Wage rises from We to Wm.

  • Quantity of labor demanded falls from Qe to Qd (job loss).

  • Quantity supplied rises to Q_s (excess labor = unemployment).

• Real-world illustrations

  • Los Angeles 99-seat theaters: $15 minimum led to closures, volunteer labor, non-union casting.

  • Baltimore mayor Catherine Pugh reversed support for $15 plan after firms vowed to cut hiring.

  • Experimental online-labor-market study: minimum wage reduced hiring & hours.

• Quantity restrictions / bans / licenses

  • Prohibited goods: human organs, certain drugs.

  • Licensing: physicians, taxis, hospital beds.

  • Import quota: cap on quantity of a foreign good; acts like vertical supply limit, raising domestic price.

Applications & Case Studies

• Pharmaceutical shortages & substitute price hikes (Issues & Applications)

  • Price ceiling on Medication A → manufacturer cuts production → shortage.

  • Doctors prescribe substitute Medication B → D_B shifts right.

  • Equilibrium P_B rises (Figure 4-6).

• City apartment shortages (Did-You-Know box)

  • Net loss of middle-price units due to demolition > construction.

  • Where rents free to rise, shortages decline; where ceilings remain, shortages persist.

Appendix B – Consumer Surplus, Producer Surplus & Gains from Trade

• Consumer surplus (CS)

  • CS = \text{Willingness to pay} - \text{Amount actually paid}.

  • Graphically: area below demand curve and above market price up to Q^* (Figure B-1).

  • Formal integral: CS = \int{0}^{Q^} \big( PD(q) - P^ \big)\,dq.

• Producer surplus (PS)

  • PS = \text{Amount received} - \text{Minimum acceptable}.

  • Graphically: area above supply curve & below price up to Q^* (Figure B-2).

  • Formal integral: PS = \int{0}^{Q^} \big( P^ - PS(q) \big)\,dq.

• Gains from trade (GFT)

  • GFT = CS + PS (Figure B-3).

• Effect of price controls

  • Both CS & PS fall; deadweight loss emerges; total gains shrink.

Review of Learning Objectives

• LO 4.1 Essential features of price system: flexible relative prices, middlemen lowering transaction costs.

• LO 4.2 Effects of demand/supply shifts: direction of P^ and Q^ changes summarised above; simultaneous shifts often indeterminate.

• LO 4.3 Rationing function: prices versus queues, coupons, force, or power; efficiency of price rationing.

• LO 4.4 Price ceilings: if below P^* → shortage, non-price rationing, black markets; rent control specifics.

• LO 4.5 Price floors & quantity restrictions: if above P^* → surplus; examples include agricultural supports, minimum wage, quotas, bans, licences.

Numerical & Statistical References (all from transcript)

• Cavallo price-change frequency: ≈ 9 months in U.S. retail.

• MIT database size: 60 million prices.

• Dallas vs. San Francisco apartment construction: 11,000 vs. 2,000 units; vacancy rates 16 % vs. 1.6 %.

• NYC cigarette legal minimum: \$13 vs. U.S. average \$7.

• Vinyl record case: qualitative but notes cost up for pressing machines & demand surge.