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Zhigang Li University of Hong Kong. Supply and Demand. Markets and Prices. Why does Ming YAO earn more than construction workers?. Markets and Prices. Why do diamonds cost more than water? . Markets and Prices. Why do QiBaiShi ’ s ( 齊白石 ) crabs sell for more than the real ones? .

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Zhigang li university of hong kong

Zhigang LiUniversity of Hong Kong

Supply and Demand


Markets and prices
Markets and Prices

  • Why does Ming YAO earn more than construction workers?


Markets and prices1
Markets and Prices

  • Why do diamonds cost more than water?


Markets and prices2
Markets and Prices

  • Why do QiBaiShi’s (齊白石)crabs sell for more than the real ones?


Markets and prices3
Markets and Prices

  • Why do the prices of paintings jump when their painters die?


Markets and prices4
Markets and Prices

  • Is it cost of production that determines prices (as Adam Smith thought)?


Markets and prices5
Markets and Prices

  • Or is it willingness to pay that determines prices (as Stanley Jevons thought)?


Markets and prices6
Markets and Prices

  • Alfred Marshall (Principles of Economics, 1890) was the first to explain clearly how both costs and willingness to pay interact to determine market prices.


Markets and prices7
Markets and Prices

  • The market for any good or service consists of all (actual or potential) buyers or sellers of that good or service.


The market for lobsters
The market for lobsters

  • The market for lobsters in Portland, Maine, on July 20, 2004.


The demand for lobsters
The demand for lobsters

  • The demand curve is the set of all price-quantity pairs for which buyers are satisfied.


Horizontal interpretation of the demand curve
Horizontal interpretation of the demand curve

  • If buyers face a price of $4/lobster, they would want to purchase 4000 lobsters a day.


Vertical interpretation of the demand curve
Vertical interpretation of the demand curve

  • If buyers are currently buying 4000 lobsters a day, the demand curve tells us that buyers would be willing to pay at most $4 for one additional lobster.


Demand curve
Demand Curve

  • The demand curve effectively represent the marginal benefit of an individual’s consuming a certain amount of a good.


Demand curves slope downward for two reasons
Demand curves slope downward for two reasons

  • As the good becomes more expensive, people switch to substitutes. (Substitution effect)

    • The Substitution Effect is the change in the quantity demanded of a good that results because buyers switch to substitutes when the price of the good changes

  • As the good becomes more expensive, people can’t afford to buy as much of it. (Income effect)

    • Income effect is the change in the quantity demanded of a good that results because a change in the price of a good changes the buyer’s purchasing power


The supply of lobsters
The supply of lobsters

  • The supply curve is the set of price-quantity pairs for which sellers are satisfied.


Horizontal interpretation of the supply curve
Horizontal interpretation of the supply curve

  • If sellers face a price of $4/lobster, they will wish to sell 2000 lobsters a day.


Vertical interpretation of the supply curve
Vertical interpretation of the supply curve

  • If sellers are currently selling 2000 lobsters a day, the marginal cost of a lobster is $4.


Supply curves slope upward for one reason
Supply curves slope upward for one reason

  • The low-hanging-fruit principle.

    • Harvest the lobsters closest to shore first.

  • More generally, as we expand the production of any good, we turn first to those whose opportunity costs of producing that good are lowest, and only then to others with higher opportunity costs.


Market equilibrium quantity and price
Market Equilibrium Quantity and Price

  • Equilibrium occurs at the price-quantity pair for which both buyers and sellers are satisfied.

At the market equilibrium price of $6 per lobster, buyers and sellers are each able to buy or sell as many lobsters as they wish to.


Excess supply
Excess supply

  • Asituation in which price exceeds its equilibrium value is called one of excess supply, orsurplus.

At $8, there is an excess supply of 2000 lobsters in this market.


Excess demand
Excess Demand

  • A situation in which price lies below its equilibrium value is referred to as one of excess demand.

At a price of $4 in this lobster market, there is an excess demand of 2000 lobsters.


Zero excess supply and demand
Zero excess supply and demand

  • Equilibrium occurs at the price-quantity pair for which both buyers and sellers are satisfied.

At the market equilibrium price of $6, both excess demand and excess supply are exactly zero..


Example 3 1
Example 3.1.

  • At a price of $2 in this hypothetical lobster market, how much excess demand for lobsters will there be? How much excess supply will there be at a price of $10?

Price ($/lobster)

D

S

10

8

6

4

2

D

S

Quantity

(1000 lobsters/day)

0

1

2

3

4

5


The trading locus
The Trading Locus

  • When price differs from the equilibrium price, trading in the marketplace will be constrained-- by the behavior of buyers if the price lies above equilibrium, by the behavior of sellers if below.

Trading locus


From disequilibrium to equilibrium
From disequilibrium to equilibrium

At prices above equilibrium, sellers are not selling as much as they want to. The impulse of a dissatisfied seller is to reduce his price.


From disequilibrium to equilibrium1
From disequilibrium to equilibrium

At prices below the equilibrium value, buyers cannot obtain the quantities they wish to purchase. Some buyers adjust by offering slightly higher prices.


From disequilibrium to equilibrium2
From disequilibrium to equilibrium

  • An extraordinary feature of this equilibrating process is that no one consciously plans or directs it.

  • The actual steps that consumers and producers must take to move toward equilibrium are often indescribably complex.

    • Suppliers looking to expand their operations, for example, must choose from a bewilderingly large menu of equipment options.

    • Buyers, for their part, face literally millions of choices about how to spend their money.


From disequilibrium to equilibrium3
From disequilibrium to equilibrium

  • And yet the adjustment toward equilibrium results more or less automatically from the natural reactions of self-interested individuals facing either surpluses or shortages.


Example 3 2 should collegetown rents be regulated
Example 3.2.Should Collegetown Rents Be Regulated?

  • Suppose the supply and demand curves for two-bedroom Collegetown rental apartments are as shown.


Example 3 2 should collegetown rents be regulated1
Example 3.2.Should Collegetown Rents Be Regulated?

  • The city council is concerned that many students cannot afford the equilibrium rent of $1000 per month and is considering a regulation forbidding landlords from charging more than $500.

  • What will be the likely consequences of adopting this regulation?


Example 3 2 should collegetown rents be regulated2
Example 3.2.Should Collegetown Rents Be Regulated?

  • Rent Controls Produce Excess Demand in the Housing Market.


Example 3 2 should collegetown rents be regulated3
Example 3.2. Should Collegetown Rents Be Regulated?

  • Responses to excess demand in a regulated housing market:

    finder’s fees

    key deposits

    required furniture rental

    excessive damage deposits

    curtailed maintenance

    apartment conversion


Alternative to helping the poor students
Alternative to helping the poor (students?)

  • There are much more effective ways to help poor people than to give them apartments and other goods at artificially low prices.

    For example, income transfers:

    Wage subsidies

    Public service jobs


Cash on the table
Cash on the Table

  • When a regulation prevents the price of an apartment, or any other good, from reaching its equilibrium level, the total economic surplus (economic benefits less opportunity costs) available for buyers and sellers is diminished.

  • Mutually beneficial exchanges are always possible when a market is out of equilibrium.

  • When people have failed to take advantage of all mutually beneficial exchanges, there is "cash on the table."


Cash on the table1
Cash on the Table

  • At a rent of $500 in the rent-control example, there were tenants willing to pay as much as $1500 for an apartment.

  • Similarly, there were landlords for whom the opportunity cost of supplying an additional apartment was only $500.

  • The difference— $1000 per apartment— is the additional economic surplus that would accrue to any seller who could rent an additional apartment for the price that tenants would be willing to pay.


Social optimality
Social optimality

  • The socially optimal quantity of any good is the quantity that maximizes the total economic surplus that results from producing and consuming the good.

  • Cost-benefit principle

    • keep expanding production of the good as long as its marginal benefit is at least as great as its marginal cost.

  • Socially optimal quantity is that level for which the marginal cost and marginal benefit of the good are the same.


Social optimality1
Social optimality

  • Does the market equilibrium quantity also maximize total economic surplus?

  • In market equilibrium, the cost to the seller of producing an additional unit of the good is the same as the benefit to the buyer of having an additional unit.

  • The equilibrium quantity also maximizes total economic surplus

    • if all costs of producing the good are borne directly by sellers, and

    • if all benefits from the good accrue directly to buyers.


Social optimality2
Social optimality

  • At the equilibrium quantity of 2000 apartments/month, the marginal cost to the seller of supplying an additional apartment ($1000) is the same as the benefit to the buyer of the next apartment (also $1000) .


The equilibrium principle
The Equilibrium Principle

  • A market in equilibrium leaves no unexploited opportunities for individuals, but may not exploit all gains achievable through collective action.


Examples of price control in hong kong
Examples of price control in Hong Kong?

  • Rent control

    • Cheung, S.N.S. (1979), “Rent Control and Housing Reconstruction: The Postwar Experience of Prewar Premises in Hong Kong”, Journal of Law & Economics, 22 (1), pp. 27-53.

  • Designated LPG pump stations

  • Brokerage fee of trading stock

  • Public housing

  • Taxi fare


Taxi regulations
Taxi regulations

  • Taxi is in excess supply at the regulated taxi fare.

    • Every day, a lot of taxi line up at the airport for customers. Some of them have to wait several hours for business.

    • Some offer discount to customers.

  • Number of taxi license is also regulated.


Taxi fare
Taxi Fare

Economy in a recession:

Excess supply

S

Taxi Fare

Economy in a boom:

Excess demand

Regulated fare

D2

(economy in a boom)

D1 (economy in a recession)

Taxi services


When market equilibrium is not social optimal
When market equilibrium is not social optimal

  • The market equilibrium price and quantity are socially optimal

    • when all relevant production costs are incurred by sellers, and

    • when all relevant product benefits accrue to buyers.

  • Production of some goods entails costs that fall on people other than those who sell the good.

  • In other cases, some of the benefits of producing a good accrue to persons other than the buyers.


When market equilibrium is not social optimal1
When market equilibrium is not social optimal

  • Goods whose production generates toxic smoke


When market equilibrium is not social optimal2
When market equilibrium is not social optimal

  • Goods whose production generates noise.


Correcting for marginal cost borne by non sellers
Correcting for marginal cost borne by non-sellers

  • To restore the socially optimal equilibrium, extra fees (or tax) may be charged on firms on behalf of the people who bear the cost but are not paid.

Social

Supply Curve

Private

Supply Curve

P’

P

D

Quantity

Q’

Q


When market equilibrium is not social optimal3
When market equilibrium is not social optimal

  • In the market equilibrium for such goods whose production generate pollution, the benefit to buyers of the last good produced is, as before, equal to the cost incurred by sellers to produce that good.

  • But since producing that good also resulted in the costs of the associated pollution, we know that the full marginal cost of the last unit produced—the seller’s private marginal cost plus the marginal pollution cost borne by others—must be higher than the benefit of the last unit produced.

Social marginal cost = private marginal cost + marginal pollution cost


When market equilibrium is not social optimal4
When market equilibrium is not social optimal

  • So when costs fall on people other than sellers, market equilibrium quantity > socially optimal quantity.

  • Total economic surplus would be higher if output of the good were lower.

  • Yet neither sellers nor buyers have any incentive to alter their behavior.

Potentially, some public policy can be implemented to discourage the production of this kind of goods.


When market equilibrium is not social optimal5
When market equilibrium is not social optimal

  • Increases in production of some goods benefit people other than those who buy them.

More apple trees

=> more honey

More bees

=> more apples


Correcting for marginal benefit enjoyed by non buyers
Correcting for marginal benefit enjoyed by non-buyers

  • To restore the socially optimal equilibrium, subsidies may be provided to buyers to compensate them for the “social benefit” they create in purchasing the goods.

Price

S

P’

P

D’

D

Quantity

Q

Q’


When market equilibrium is not social optimal6
When market equilibrium is not social optimal

  • But since producing such goods yields benefits in addition to those received by buyers, we know that the full marginal benefit of the last unit produced—the price paid by the marginal buyer plus the benefit received by nonbuyers—must be higher than the marginal cost of the last unit produced.

  • Market equilibrium results in too little production of goods that generate external benefits.

Social marginal benefit = private marginal benefit

+ marginal benefit received by nonbuyers

Potentially, some public policy can be implemented to encourage the production of this kind of goods.


Newspaper story
Newspaper story

  • “Producers raised prices, and the resulting fall in demand caused prices to fall back to their original level.”

True or False?


Change in demand vs change in the quantity demanded
Change in demand” vs. “Change in the quantity demanded”


Newspaper story1
Newspaper story

  • “Producers raised prices, and the resulting fall in demand caused prices to fall back to their original level.”

WRONG!!

  • A rise in price causes a fall in the quantity demanded, not a fall in demand.


Change in supply vs change in the quantity supplied
Change in supply” vs. “Change in the quantity supplied”

S’

S

Price

Quantity

“An increase in supply”: At every price, there is an increase in the quantity supplied.


Change in supply vs change in the quantity supplied1
Change in supply” vs. “Change in the quantity supplied”

Price ($/lobster)

S

10

8

6

4

2

Quantity

(1000 lobsters/day)

0

1

2

3

4

5

“An increase in the quantity supplied”: For an upward sloping supply curve, an increase in price leads to an increase in the quantity supplied.


Impact of an increase in demand
Impact of an increase in demand

  • An increase in demand will lead to an increase in both the equilibrium price and the equilibrium quantity.

Price

S

P’

P

D’

D

Quantity

Q

Q’


Impact of a decrease in demand
Impact of a decrease in demand

  • A decrease in demand will lead to a reduction in both the equilibrium price and the equilibrium quantity.

Price

S

P

P’

D

D’

Quantity

Q’

Q


Impact of an increase in supply
Impact of an increase in supply

  • An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity.

S’

S

P

P’

D

Quantity

Q

Q’


Impact of a decrease in supply
Impact of a decrease in supply

  • A decrease in supply will lead to an increase in the equilibrium price and a reduction in the equilibrium quantity.

S

S’

P’

P

D

Quantity

Q’

Q


Determinants of demand 1 incomes
Determinants of Demand1. Incomes

  • For most goods, the quantity demanded at any price will rise with income. Goods that have this property are called normal goods.


Determinants of demand 1 incomes1
Determinants of Demand1. Incomes

  • Forinferior goods, the quantity demanded at any price will fall with income. Example: Ground beef with high fat content.

Consumers abandon inferior goods in favor of higher quality substitutes (such as leaner grades of meat in the ground beef case) as soon as they can afford to.


Determinants of demand 2 tastes
Determinants of Demand2. Tastes

  • Example: Following the release of Jurassic Park and The Lost World, tastes in children’s toys shifted toward designs involving prehistoric reptiles.


Determinants of demand 3 prices of substitutes
Determinants of Demand3. Prices of substitutes


Determinants of demand 3 prices of substitutes1
Determinants of Demand3. Prices of substitutes


Determinants of demand 3 prices of substitutes2
Determinants of Demand3. Prices of substitutes


Determinants of demand 4 prices of complements
Determinants of Demand4. Prices of complements


Determinants of demand 4 prices of complements1
Determinants of Demand4. Prices of complements


Determinants of demand 4 prices of complements2
Determinants of Demand4. Prices of complements


Determinants of aggregate demand a summary
Determinants of (Aggregate) DemandA summary

  • Factors That Cause an Increase (rightward or upward shift) in Demand

    • A decrease in the price of complements to the good or service

    • An increase in the price of substitutes for the good or service

    • An increase in income (for a normal good)

    • An increased preference by demanders for the good or service

    • An increase in the population of potential buyers

    • An expectation of higher prices in the future


Determinants of supply 1 technology
Determinants of supply1. Technology

Example: A more efficient lobster trap is invented.

A more efficient lobster trap shifts supply to the right


Determinants of supply 2 factor prices
Determinants of supply2. Factor prices

Example: The price of gasoline rises.

Rising factor prices shift supply to the left.


Determinants of supply 2 factor prices1
Determinants of supply2. Factor prices

Example: Interest rates fall.


Determinants of aggregate supply a summary
Determinants of (aggregate) supplyA summary

  • Factors That Cause an Increase (rightward or upward shift) in Supply

    • A decrease in the cost of materials, labor, or other inputs used in the production of the good or service

    • An improvement in technology that reduces the cost of producing the good or service

    • An improvement in the weather, especially for agricultural products

    • An increase in the number of suppliers

    • An expectation of lower prices in the future


Example 3 3
Example 3.3

  • Why do the prices of some goods, like apples, go down during the months of heaviest consumption, while others, like beachfront cottages, go up?


Example 3 31
Example 3.3

  • The seasonal consumption increase is the result of a supply increase in the case of apples, a demand increase in the case of cottages.


Example 3 4
Example 3.4

  • What will happen to the equilibrium price and quantity in the fresh seafood market if both of the following events occur:

    • a scientific report is issued saying that fish contains mercury, which is toxic to humans; and

    • the price of diesel fuel falls significantly?


Example 3 41
Example 3.4

  • The equilibrium price will go down, but the equilibrium quantity may go either up (right panel) or down (left panel)


Example 3 5 sales tax
Example 3.5. Sales Tax

  • The Hong Kong government is considering to introduce a sales tax. What is the effect of a sales tax to the market equilibrium?

S

S’

Price

Sales tax paid by sellers.

tax

P’

Tax burden?

Buyer’s burden

P

Tax Revenue?

Seller’s burden

D

Quantity

Q’

Q


Example 3 5 sales tax1
Example 3.5. Sales Tax

  • The Hong Kong government is considering to introduce a sales tax. What is the effect of a sales tax to the market equilibrium?

S

Price

Sales tax paid by buyers.

tax

Buyer’s burden

P

Tax burden?

P’

Tax Revenue?

Seller’s burden

D

D’

Quantity

Q’

Q


Example 3 6
Example 3.6

  • Suppose there is a world-wide frenzy to buy the newly invented robot pets. The robot pets are made in Japan. Before this invention, the exchange rate of Japanese yen per US dollar was 117 yen for each US dollar. Other things being equal, what is more likely to happen to the exchange rate?

    • The exchange rate will remain unchanged.

    • The exchange rate will rise (say, to 118 yen per US dollar).

    • The exchange rate will fall (say, to 116 yen per US dollar).

    • The exchange rate will be more unpredictable.


Example 3 61
Example 3.6

  • Suppose there is a world-wide frenzy to buy the newly invented robot pets. The robot pets are made in Japan. Before this invention, the exchange rate of Japanese yen per US dollar was 117 yen for each US dollar. Other things being equal, what is more likely to happen to the exchange rate?

S’

S

Yen/USD

117

The exchange rate will fall (say, to 116 yen per US dollar).

116

D

USD

Q

Q’


Example 3 7
Example 3.7.

  • An important determinant of the amount of grains harvested next year by Ethiopian farmers is the amount of seeds planted this year. Given that Western nations have guaranteed to donate five hundred tons of grain next year, this year the Ethiopian farmers will:

  • plant more seeds as the food aid established a minimum price for grain.

  • plant more seeds as the farmers’ confidence is restored.

  • plant the same amount of seeds as they would have without the food aid.

  • plant less seeds as consumers demand for grain is completely price elastic.

  • plant less seeds as the price of grain will be lower with the food aid.


Example 3 71
Example 3.7

  • Donate five hundred tons of grain next year means that the demand for domestic production of grain will be lowered by the same amount at all prices?

500 tons

S

Price

Anticipating a lower market equilibrium price next year, farmer would want to supply less quantity next year.

P

They do so by planting less seeds this year.

P’

D

D’

Quantity (tons of grain)

Q’

Q


Example 3 72
Example 3.7.

  • An important determinant of the amount of grains harvested next year by Ethiopian farmers is the amount of seeds planted this year. Given that Western nations have guaranteed to donate five hundred tons of grain next year, this year the Ethiopian farmers will:

  • plant more seeds as the food aid established a minimum price for grain.

  • plant more seeds as the farmers’ confidence is restored.

  • plant the same amount of seeds as they would have without the food aid.

  • plant less seeds as consumers demand for grain is completely price elastic.

  • plant less seeds as the price of grain will be lower with the food aid.