Zhigang Li University of Hong Kong

1. Zhigang LiUniversity of Hong Kong Supply and Demand

2. Markets and Prices • Why does Ming YAO earn more than construction workers?

3. Markets and Prices • Why do diamonds cost more than water?

4. Markets and Prices • Why do QiBaiShi’s (齊白石)crabs sell for more than the real ones?

5. Markets and Prices • Why do the prices of paintings jump when their painters die?

6. Markets and Prices • Is it cost of production that determines prices (as Adam Smith thought)?

7. Markets and Prices • Or is it willingness to pay that determines prices (as Stanley Jevons thought)?

8. 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.

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

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

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

12. Horizontal interpretation of the demand curve • If buyers face a price of $4/lobster, they would want to purchase 4000 lobsters a day.

13. 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.

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

15. 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

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

17. Horizontal interpretation of the supply curve • If sellers face a price of $4/lobster, they will wish to sell 2000 lobsters a day.

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

19. 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.

20. 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.

21. 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.

22. 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.

23. 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..

24. 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

25. 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

26. 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.

27. 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.

28. 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.

29. 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.

30. Example 3.2.Should Collegetown Rents Be Regulated? • Suppose the supply and demand curves for two-bedroom Collegetown rental apartments are as shown.

31. 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?

32. Example 3.2.Should Collegetown Rents Be Regulated? • Rent Controls Produce Excess Demand in the Housing Market.

33. 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

34. 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

35. 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."

36. 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.

37. 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.

38. 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.

39. 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) .

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

41. 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

42. 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.

43. 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

44. 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.

45. When market equilibrium is not social optimal • Goods whose production generates toxic smoke

46. When market equilibrium is not social optimal • Goods whose production generates noise.

47. 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

48. 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

49. 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.

50. 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