Market Model

Supply and Demand

MarketsInstitutions that allow buyers and

sellers to exchange Demand Supply

Examples Posted-price Haggling Auctions

Equilibrium Price/Quantity

Demand CurveDemand: how much consumer are willing

and able to buy at different prices

Dew AuctionDew Auction

Market Equilibrium

quantity

price

D1

S1

P1

Q1

At P1: Qd = Qs

The market “clears”

Note: Change in Quantity Demanded: movement along curveChange in Demand: shift of entire curve

quantity

price

D1

S1

P1

Q1

PHi

PLo

QsQd

Surplus

QdQs

Shortage

Market Disequilibrium

At PHi: Qd < Qs

Surplus

Pressure on price to fall

At PLo: Qd > Qs

Shortage

Pressure on price to rise

Demand ShiftersPreferencesPopulationIncome

Normal goods Inferior goods

Price of Related Goods Substitutes Complements

Expectations

PreferencesPopulationIncome

Normal goods Inferior goods

Price of Related Goods Substitutes Complements

Expectations

If income rises, demand risesIf income rises, demand rises

If income rises, demand fallsIf income rises, demand falls

If Px rises, demand for Y risesIf Px rises, demand for Y rises

If Px rises, demand for Y fallsIf Px rises, demand for Y falls

Supply Shifters

Number of firmsCost of inputsTechnologyExpectations

Number of firmsCost of inputsTechnologyExpectations

In the fall of 1903 Ohio Tech students for the first time had to pay to attend university football games; as a result, every game had many empty seats. This decline in attendance suggests that:

0% 0%0%0%

a) the demand for football games declined. b) attending football games is an inferior good. c) attending football games is a normal good. d) the quantity demanded of football games fell.

a) the demand for football games declined. b) attending football games is an inferior good. c) attending football games is a normal good. d) the quantity demanded of football games fell.

A newspaper story recently reported that the price of new cars has increased, and the quantity of new cars sold has dropped. The price and quantity changes were probably caused by:

0% 0%0%0%

a) a decrease in buyers' incomes.b) an increase in buyers' incomes.c) an increase in production costs.d) a decrease in production costs.

a) a decrease in buyers' incomes.b) an increase in buyers' incomes.c) an increase in production costs.d) a decrease in production costs.

Consider the market for computers. Suppose that the price of plastic decreases and the income of consumers decreases. What may we conclude about the equilibrium price and quantity of computers?

0% 0%0%0%

a) price will fall and quantity is indeterminate.

b) quantity will rise and price is indeterminate.

c) quantity will rise and price will rise. d) both price and quantity will be

indeterminate.

a) price will fall and quantity is indeterminate.

b) quantity will rise and price is indeterminate.

c) quantity will rise and price will rise. d) both price and quantity will be

indeterminate.

Elasticityadding (quantitative) meat to the

bones of supply and demand

Suppose the price of gas rises by 10% over the next month. By how much will Ohio drivers cut back on their purchases of gasoline?

a) b) c) d) e)

0% 0% 0%0%0%

a) 0 percent (no cut back)b) 1 to 5 percentc) 6 to 10 percentd) 11 to 20 percente) More than 20 percent

a) 0 percent (no cut back)b) 1 to 5 percentc) 6 to 10 percentd) 11 to 20 percente) More than 20 percent

Price Elasticity of Demand Measures the price sensitivity of buyers

Ed = $

Gasoline

$2.50

$2.00

280 300

D

D%ΔQ%ΔP

%ΔQ

%ΔP

Midpoint Formula

Ed = =

Ed = = -0.32

avg

21

avg

21

PPP

QQQ

2.252.502.00

290280300

Degree of Sensitivity Elastic: |Ed| > 1 Unit: |Ed| = 1 Inelastic: |Ed| < 1

$

Gasoline

$2.50

$2.00

280 300

D

%ΔQ

%ΔP

22.0

07.0

a) -1.57; inelasticb) -1.57; elasticc) -0.64; inelasticd) -0.64; elastic

a) -1.57; inelasticb) -1.57; elasticc) -0.64; inelasticd) -0.64; elastic

When the price of an iPod Nano is $130, consumers buy 500 units per week. When the price rises to $150, consumers buy only 400 units per week. What is the midpoint elasticity of demand and how would you classify it?

Ed =

Ed = -.22/.14 = -1.57

150)/140(130400)/450(500

a) b) c) d)

0% 0%0%0%

Determinants of ElasticityNumber of substitutes

The greater the # substitutes, the greater the elasticity The narrower the definition of the market, the greater the

elasticity

Item’s share of consumer budget The greater the share of budget, the greater the elasticity

D1

D2

gasoline

$

P0

Q0

P1

Q1 Q2

short run

long run

Time: Short Run v. Long Run The longer the time horizon, the greater the elasticity

Gasoline Demand: ELR > ESR

Determinants of Elasticity

Perfectly Inelastic

Ed =

Examples?

Perfectly Elastic

Ed =

Examples?

$

Q

$

Q

D1

P1

P2

Q1

D1P1

0

∞

Extreme Cases of Price Elasticity

Good Price elasticity

Inelastic demand

Eggs - 0.10 Beef - 0.40 Stationery - 0.50 Gasoline - 0.50

Elastic demand

Housing - 1.20 Restaurant meals - 2.30 Airline travel - 2.40 Foreign travel - 4.10

Good Price elasticity

Inelastic demand

Eggs - 0.10 Beef - 0.40 Stationery - 0.50 Gasoline - 0.50

Elastic demand

Housing - 1.20 Restaurant meals - 2.30 Airline travel - 2.40 Foreign travel - 4.10

Some Estimated Price Elasticities of Demand

Suppose that the price elasticity of demand for a Marietta College education is estimated to be E = -0.80. Based on this information, if the college were to raise tuition by 5%, then:

a) b) c) d)

0% 0%0%0%

a) enrollment will fall by 6.25% and tuition revenues will increase.

b) enrollment will fall by 4% and tuition revenues will increase.

c) enrollment will fall by 6.25% and tuition revenues will decrease.

d) enrollment will fall by 4% and tuition revenues will decrease.

a) enrollment will fall by 6.25% and tuition revenues will increase.

b) enrollment will fall by 4% and tuition revenues will increase.

c) enrollment will fall by 6.25% and tuition revenues will decrease.

d) enrollment will fall by 4% and tuition revenues will decrease.

Elasticity and Total Revenue

Elastic Demand

P x Q = TR

P x Q = TR

Inelastic Demand

P x Q = TR

P x Q = TR

TR = P x Q Ed =D%ΔQ

%ΔP

Quantity effect dominates Price effect dominates

Suppose that the price elasticity of demand for a Marietta College education is estimated to be E = -0.80. Based on this information, if the college were to raise tuition by 5%, then:

a) b) c) d)

0% 0%0%0%

a) enrollment will fall by 6.25% and tuition revenues will increase.

b) enrollment will fall by 4% and tuition revenues will increase.

c) enrollment will fall by 6.25% and tuition revenues will decrease.

d) enrollment will fall by 4% and tuition revenues will decrease.

a) enrollment will fall by 6.25% and tuition revenues will increase.

b) enrollment will fall by 4% and tuition revenues will increase.

c) enrollment will fall by 6.25% and tuition revenues will decrease.

d) enrollment will fall by 4% and tuition revenues will decrease.

According to recent studies at M.I.T. and the University of Michigan, a 10% increase in the price of cigarettes leads to a 14% drop in sales to teenagers. What is the elasticity of demand for cigarettes among teenagers?

Would you expect it to be this high for older smokers? Explain.

Would you expect it to be this high for older smokers? Explain.

a) b) c) d)

0% 0%0%0%

a) -0.71b) -1.40c) +1.40d) +0.71

a) -0.71b) -1.40c) +1.40d) +0.71

Other Demand Elasticities

Cross-Price Elasticity

Exy =

Income Elasticity

EI =

Substitutes: Exy > 0

Complements: Exy < 0

Normal Goods: EI > 0

Inferior Goods: EI < 0

Y

X

ΔP%

ΔQ%

IΔ%

ΔQ%

Examples of cross-price elasticities

Commodity With respect to price of

Cross-Price elasticity

Beef Pork 0.28

Butter Margarine 0.67

Electricity Natural gas 0.20

Natural gas Fuel oil 0.44

Clothing Footwear - 0.01

Dairy products Meat products - 0.15

Entertainment Food - 0.72

Examples of income elasticities

Alcohol 1.54Housing (owner) 1.49Furniture 1.48Dental service 1.42Restaurant meals 1.40Medical insurance 0.92Gasoline and oil 0.48Butter 0.42Coffee 0.00Margarine -0.20Flour -0.36

Commodity Income elasticity

Automobiles 2.46

Furniture 1.48

Restaurant Meals 1.40

Water 1.02

Tobacco 0.64

Gasoline 0.48

Margarine -0.20

Pork -0.20

Public transportation -0.36

In August 1990, East German taxicab drivers were on strike demanding lower cab fares. What must the drivers have believed about the price elasticity of demand for taxi rides?

a) b) c) d)

0% 0%0%0%

a) The demand was elastic.b) The demand was inelastic.c) The demand was perfectly elastic.d) The demand was perfectly

inelastic.

a) The demand was elastic.b) The demand was inelastic.c) The demand was perfectly elastic.d) The demand was perfectly

inelastic.

Market Efficiency

Invisible Hand Theorem Adam Smith: Wealth of Nations (1776) Competitive, free markets will maximize

social welfare Social Welfare = ?

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.”

“...every individual…neither intends to promote the public interest, nor knows how much he is promoting it…he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

Adam Smith

Consumer Surplus Net gain to consumers from

buying at a single price CS = Buyer Value - Price

Demand

quantity5

$50

Buyer Values (or WTP)Price

$25

1

Consumer Surplus

Total Expenditure

Market price

Net gain to sellers from selling at a single price

PS = Price – Seller Cost

Producer Surplus

Supply

quantity

Price

3

$25

Total Cost

Producer SurplusSeller Costs

$10

Market price

Which of the following is an example of consumer surplus?

a) b) c) d)

0% 0%0%0%

a) Holly buys a hamburger for $2 and tells you she would not have paid a penny more.

b) Youtian believes the price he paid for his computer was too high.

c) Willy buys a paper tablet for $2 and finds the same good at another store for $1.50

d) Katelyn would have paid $20 for a new compact disc but paid only $15.

a) Holly buys a hamburger for $2 and tells you she would not have paid a penny more.

b) Youtian believes the price he paid for his computer was too high.

c) Willy buys a paper tablet for $2 and finds the same good at another store for $1.50

d) Katelyn would have paid $20 for a new compact disc but paid only $15.

Social Welfare

CS

Free Market Outcome: P*, Q* Maximizes social welfare: SW = CS + PS

Free Market Outcome: P*, Q* Maximizes social welfare: SW = CS + PS

Supply

Demand

quantity

Price

Q*

P*

PS

Deadweight Loss

Q

Adam Eve

12 0

9 3

5 5

4 8

0 12

Garden of Eden

Adam and Eve in the Garden of Eden, by Titian (c. 1550)

Which allocation would you choose?

1. Choice One2. Choice Two3. Choice Three4. Choice Four5. Choice Five 0% 0% 0%0%0%

Adam Eve

12 0

9 3

5 5

4 8

0 12

Tradeoff: Efficiency vs. Equity

Supply and Demand Step Functions

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Quantity

Pri

ce

Demand

Supply

Chart 3: Price Sequence

0

5

10

15

20

25

30

35

40

45

0 10 20 30 40 50 60 70 80 90 100 110 120

Contracts

Pri

ce

Session 1

Session 2

Session 3

Session 4

Government Intervention Why does government intervene?

Market failuresMonopolyExternalitiesPublic goods

Fairness

How does government intervene? Price Controls Quantity Controls Regulations

Why does government intervene? Market failures

MonopolyExternalitiesPublic goods

Fairness

How does government intervene? Price Controls Quantity Controls Regulations

All generate some DWL

Price Ceiling: Rent Control

Free Market: R1, Q1

Gov’t imposes rent ceiling at R0

At R0: QD > QS shortage

Non-Price Rationing? Black Market (Bribes) Discrimination Wait / Search Lottery

Free Market: R1, Q1

Gov’t imposes rent ceiling at R0

At R0: QD > QS shortage

Non-Price Rationing? Black Market (Bribes) Discrimination Wait / Search Lottery

Apartments

Rent

D1

S1

R1

Q1

R0

QS QD

Shortage

RF

DWL

Other Examples of Price Ceilings

Gasoline (1970s) Usury laws Diagnostic Related Groups (DRGs)

$0

$20

$40

$60

$80

$100

$120

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Do

llars

pe

r b

arr

el

Price of Oil

Nominal Price

Real Price

In 1979 a revolution overthrew the government of Iran, disrupting oil production and causing the price of crude oil to increase by 300 percent. In most of the world, which did not have price controls, this price increase:

0% 0%0%0%

a) led to severe shortages of gasoline

b) did not lead to shortagesc) led to substantial surplusesd) did not affect supply or demand

for gasoline substantially

Fair Labor Standards Act (1938) 1938: $0.25 2009: $7.25

Price Floor: Minimum Wage

Ohio’s minimum wage went up to $7.30 this past January

Ohio’s minimum wage went up to $7.30 this past January

States with minimum wage rates higher than the Federal rate

States with minimum wage rates the same as the Federal rate

States with minimum wage rates lower than the Federal rate

States with no minimum wage law

As of January 1, 2010

1950 1960 1970 1980 1990 2000 2010$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

$9.00

$10.00

$11.00

Federal Minimum Wage1950-2010

minimum wage in 2010 dollars

minimum wage in current dollars

0%

10%

20%

30%

40%

50%

60%

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Minimum Wage Relative to the Average Hourly Wage Rate

1965-2010

Characteristics of Minimum Wage Workers, 2009

At or Below $7.25 Total

# Hourly Workers 3.6 million 72.6 million

% Employment 4.9% 100%

Gender Male Female

38.062.0

48.551.5

Race White Black Hispanic Asian

80.013.917.43.3

80.712.817.5 3.7

Age 16-19 25 +

22.951.4

6.180.2

Hours of Work Part-time Full-time

63.935.6

27.672.2

Occupation Sales Service

20.563.0

27.424.4

Industry Retail Leisure & Hospitality Manufacturing

14.951.63.0

14.412.211.5

Education Less than HS HS only BA +

29.030.98.3

14.135.416.2

140m

2009 Poverty Guidelines (48 Contiguous States and DC)

Persons in Family Poverty Threshold

1 $10,830

2 $14,570

3 $18,310

4 $22,050

5 $25,790

6 $29,530

7 $33,270

8 $37,010For families with more than 8 persons, add $3,740 for each additional person.

Source: http://aspe.hhs.gov/poverty/09poverty.shtml

Labor Market

Free Market: W1, Q1

no unemployment: QD = QS

(full-time income?)

Gov’t imposes min. wage at W2

at W2: QD < QS

Unemployment occurs

How can employers offset impact? Reduce hours of work Reduce fringe benefits Raise price Reduce quality Hire illegal aliens

Free Market: W1, Q1

no unemployment: QD = QS

(full-time income?)

Gov’t imposes min. wage at W2

at W2: QD < QS

Unemployment occurs

How can employers offset impact? Reduce hours of work Reduce fringe benefits Raise price Reduce quality Hire illegal aliens

Labor

Wage

D1

S1

Q1

W2 = $7.25

unemployment

new entrantslayoffs

W1= $6

QD QS

WB

DWL

Suppose that the equilibrium wage in the low-skilled labor market is $8.00. Further, suppose the federal government raises the minimum wage to $7.75 an hour from its present level of $7.25. The government’s action of increasing the minimum wage will result in:

a) b) c) d)

0% 0%0%0%

a) a decrease in unemployment b) an increase in unemployment c) a shortage of low-skilled labor.d) neither a shortage nor a surplus of

labor in the low-skilled labor market.

a) a decrease in unemployment b) an increase in unemployment c) a shortage of low-skilled labor.d) neither a shortage nor a surplus of

labor in the low-skilled labor market.

Taxes Sales Tax: percentage of sales Excise Tax: fixed dollar amount per unit

Sin Taxes?

Suppose the government imposes a $10 excise tax on the sale of sweaters by charging suppliers $10 for each sweater sold. Based on economic analysis, we would predict that:

a) b) c) d) e)

0% 0% 0%0%0%

a) The price of sweaters will increase by $10.

b) The price of sweaters will increase by more than $10.

c) Consumers of sweaters will bear the entire burden of the tax.

d) The price of sweaters will increase by less than $10.

e) (a) and (c) are true.

a) The price of sweaters will increase by $10.

b) The price of sweaters will increase by more than $10.

c) Consumers of sweaters will bear the entire burden of the tax.

d) The price of sweaters will increase by less than $10.

e) (a) and (c) are true.

Excise Tax: Cigarettes

Free market: P = $4.00 Q = 27.4 b

Consumer Spending ≈ $110 b

Gov’t imposes tax = $1/pack

Supply shifts upward by $1 Price rises (by less than $1) Quantity falls

cigarettes

price

D1

S1

4.00

27.4

S2

4.40

3.40

tax = $1

buyer pays

seller keeps

25.8

Tax Revenue

(Billions of packs)

Assume that ED = -0.60

ED = = -0.60 %10

ΔQ% D

Economic burden of tax is split between buyers and sellers

%ΔQD = - 6.0%

Suppose the government imposes a $10 excise tax on the sale of sweaters by charging suppliers $10 for each sweater sold. Based on economic analysis, we would predict that:

a) b) c) d) e)

0% 0% 0%0%0%

a) The price of sweaters will increase by $10.

b) The price of sweaters will increase by more than $10.

c) Consumers of sweaters will bear the entire burden of the tax.

d) The price of sweaters will increase by less than $10.

e) (a) and (c) are true.

a) The price of sweaters will increase by $10.

b) The price of sweaters will increase by more than $10.

c) Consumers of sweaters will bear the entire burden of the tax.

d) The price of sweaters will increase by less than $10.

e) (a) and (c) are true.

In the figure below, the amount of tax revenue is:

2000 4000 6000 8000

0% 0%0%0%

a) $2000b) $4000c) $6000d) $8000

a) $2000b) $4000c) $6000d) $8000

Quantity Controls Quotas

International trade: agricultural goods, textiles Taxis, liquor licenses

Prohibition What goods and services are illegal to trade? Why prohibit trade?

Victimless crime? Immoral? Externalities?

DrugsProstitutionBody organsBabiesGunsExotic animalsGambling

War on Drugs Intrinsic Effects

Health Damages Spousal/Family abuse DUI Lower worker

productivity

Black Market Effects Crime

Property Murder

Overdose Uncertain product quality Binge consumption

Clogged prisons Corruption Reduced civil liberties

Tradeoff: Intrinsic Effects v. Black Market Effects

Alcohol: 125m users-----85,000 annual deathsTobacco: 70m users-----400,000 annual deathsMarijuana: 15m users-----0 annual deathsCocaine: 2m users----Heroin: 0.2m users---- 17,000 annual deaths

Marijuana Market

Prohibition: P1, Q1

Legalization: P2, Q2

Consumption will rise (how much?)

Prohibition: P1, Q1

Legalization: P2, Q2

Consumption will rise (how much?)

Marijuana(lbs.)

price

D1

S1

$2500 = P1

Q1

S2

Q2

P2Tradeoff:> More intrinsic costs > Less black market effects

Tradeoff:> More intrinsic costs > Less black market effects

What happens in the market for substitutes? What happens in the market for complements?

What happens in the market for substitutes? What happens in the market for complements?

a) the price of the good falls as does the quantity purchased.

b) the price of the good falls, but the quantity purchased may increase or decrease.

c) the price of the good rises, but the quantity purchased may increase or decrease.

d) the quantity purchased of the good decreases, but the price may rise or fall.

a) the price of the good falls as does the quantity purchased.

b) the price of the good falls, but the quantity purchased may increase or decrease.

c) the price of the good rises, but the quantity purchased may increase or decrease.

d) the quantity purchased of the good decreases, but the price may rise or fall.

When a government imposes penalties on both sellers and buyers of an illegal good,

a) b) c) d)

0% 0%0%0%