Chapter 5 Demand and Supply in Action

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					Chapter 5: Demand and Supply in Action

I. Price Controls

A. Equilibrium prices and quantities will result in the absence of price controls. Q and P will be determined on the graph by the intersection of the Supply (S) and Demand (D) curves. The quantity suppliers bring to market will equal the quantity consumers demand. Qs=Qd.

B. If the government sets a binding price floor (requiring a price above equilibrium) or a binding price ceiling (requiring a price below equilibrium) the market for that good will be in disequilibrium. 1. With a binding price floor, Excess supply will exist. Firms will have unsold output they must store. This is a surplus. 2. With a binding price ceiling, Excess demand will exist. Not enough of the good will be made available by suppliers to satisfy all the demand at the government-enforced low price. This is a shortage. i. Price Ceilings predictably induce the presence of a black market. This means illegal purchases of the good, at prices above the ceiling, will take place since many consumers are willing to pay more than the ceiling, as indicated by the entire demand curve that is above the ceiling. C. One way a government can set price at disequilibrium levels is through its power to make laws, setting the price and making it illegal to sell at a price that is above the ceiling or below the floor. The other method is promising to buy any excess output in order to maintain a given price floor.

D. In disequilibrium, the number of goods exchanged will be whichever is fewer, Qs or Qd at that price.

E. Short- and Long-term rent control results

Rent controls are a common type of price ceiling which provide various examples in communities where they have been implemented of how economic theory correctly predicts an outcome. 1. Black Markets arise, and renters either end up making under-thetable payments to landlords or living in illegal housing, that is, housing zoned as non-residential. Renters are the Demand and Landlords are the Supply in this market. 2. In the short-term, supply of housing (like units in apartment buildings) is rather fixed, a vertical curve, and highly inelastic. Some shortage does result solely due to excess demand that exists at the newly imposed price ceiling 3. In the long-term, however, Supply is more elastic; new construction will stop and existing buildings will be converted to other uses that are not subject to the rent control restrictions. Landlords will allow maintenance to be ignored and some may even abandon the buildings altogether. 4. Families that would have otherwise moved for a larger place, better job or due to losing a job will more likely stay in a rentcontrolled unit. This prevents new tenants who would be ideal for those units from moving in.


5. The primary beneficiaries of rent control are existing tenants who get to continue living in their unit, at the rent-controlled price, which would be at a savings compared to the market rate they had been paying. Not only do they get to pay a below-equilibrium rental price, but “security-of-tenure” laws often are enacted along with rent control that give the current renter seniority over any new tenants the landlord wants to bring in. 6. Those who lose out under rent control are: i. Landlords make less revenue on rentals and now own buildings that have fallen in value due to their decreased revenue expectations. Building values also fall as landlords neglect to maintain them, as sometimes results from rent control. ii. Potential future tenants: people may be attracted by the low rents from various outlying areas, but they will only find there is a shortage of housing. The gap between Qs and Qd under rent control represents the number of housing units people seek to rent unsuccessfully.

F. Agriculture and the Farm Problem 1. The farm problem is twofold: farm income is falling relative to urban income, and it is highly volatile, meaning it changes drastically from year to year and is unpredictable.

2. The long-term trend of farm income falling relatively has many causes. Farm productivity in the U.S. and globally skyrocketed in the last century.

Domestic demand for agricultural goods also shifted right, but less rapidly. The combination of these two means excess supply has been growing. Exports were a boon to farmers in the first half of the century; by the 70’s, developing countries experienced significant increases in food production, and by 1980 U.S. food exports were weak. Food prices have only increased 27 percent in the span from 19751998, which is much les than the 200% increase in all other prices. Relative to other prices, the price of farm products fell drastically.

3. One short-term fluctuation affecting farming income is the weather. It can shift supply to the left (bad weather) or right (good weather). How this affects total farm “receipts” or revenue depends on the demand curve, but since demand for farm products is relatively inelastic, generally a bad farming season (supply decreases) will result in more total farming revenue, and a good farming season will reduce total revenue.

Supply is inelastic in agriculture because resources are not easily shifted to produce alternative (non-agricultural) goods and back again. Therefore a decrease in demand will severely reduce total revenue for that industry.


4. An alternative to the government buying excess production to stabilize and increase farm revenue would be to institute a quota. A quota on production means no one can produce the good without a government-issued “quota.” The quota drives price above its freemarket level by restricting output. (A binding quota is set at less than Qe)

5. U.S. farm policy has been to maintain above-market prices for farm products, with the government buying excess supply. This represents a shift of wealth from taxpayers to the agricultural sector. Often the excess that is purchased either goes unused or must be unloaded at steeply reduced prices. Resources that would be more valuable producing in other sectors are compelled to remain in the less viable farm sector due to price supports. Note that both forms of gov’t intervention require alternative distribution mechanisms to the price system. With a shortage (excess demand) either consumers have to wait in line (first come, first served) or the government has to ration goods. In rent control, tenure laws (aka security-of-tenure) are required to prevent landlords from evicting tenants. With a surplus (excess supply) the government may have to arrange for the excess to be stored as well as a program by which the surplus is purchased by taxpayers.


II. Foreign Trade (imports and exports) A. The “law of one price” states that when a good can be transported relatively cheaply to anywhere in the world, it will tend to have a single price everywhere – the world price.

B. If the world price is higher than the price that would exist domestically in the absence of foreign trade, the country will export that good. If the world price is lower than the price that would exist domestically in the absence of foreign trade, the country will import that good. See pages 492-495.