Applying Supply And Demand

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Perloff 2.5, 3.5. WB 4.

Here we examine government interventions in competitive markets. The Krugman-Wells chapter linked below offers an excellent discussion of the issues.

All the skills used in analyzing the supply-and-demand model are needed here: graphing the model, computing equilibria, and predicting the effects of shifts in supply and demand curves. In addition, you will need to understand elasticities for the per-unit tax part.

Out of equilibrium, cont.

• How much is traded when Q_D>Q_S? Is this a shortage or a surplus?
• How much is traded when Q_S>Q_D? Is this a shortage or a surplus?

Price restrictions

An effective price restriction forces the market away from the equilibrium price. This creates a shortage or a surplus since quantities respond to price (the price-taking assumption).

A price ceiling keeps the market price below P^C; a price floor keeps the market price above P^F. A ceiling or floor is binding (or effective) if it moves the market away from the equilibrium price; and it is ineffective if it does not.

• Can a price ceiling/floor lead to a shortage? When?
• Can a price ceiling/floor lead to a surplus? When?
• Given a price ceiling/floor and formulas for supply and demand, calculate the shortage/surplus (if any) and the quantity traded.
• Given a price ceiling/floor and formulas for supply and demand, graph the curves, and identify the shortage/surplus (if any) and the quantity traded on the graph.

Quantity restrictions

Under a maximum quota, no more than Q^C can be traded. The quota is binding if it moves the market away from the equilibrium quantity.

• Can this lead to a shortage or a surplus? When?
• What are quota rents?
• Given a quota and formulas for supply and demand, calculate the price when the quota is binding?¹

What's so great about equilibrium?

Scarce products are all somehow rationed — distributed to those who want them.²

In competitive markets, the equilibrium price rations the product by giving it to those willing to pay the most for it. This rationing is efficient — no one can be made better off without making someone else worse off. When there is a shortage or a surplus, the product must be rationed by other means. This leads to some negative side effects.

Side-effects of shortages

In a shortage, the product itself is rationed.

1. Inefficient rationing — The people who get the good may not be those who value it most.
2. Frictions — Even if resale leads to efficient rationing, resources are wasted on the process.³
3. Inefficiently low quality — Producers are not “disciplined” by competition.
4. Illegal activities — Underground resale markets lead to worse things.

Side-effects of surpluses

In a surplus, the opportunity to supply the product is rationed.

1. Inefficiency — The firms that produce the good may not be those with the lowest costs.
2. Frictions — Even if the low-cost firms find buyers, resources will be wasted.
3. Inefficiently high quality — Producers must compete on “non-price dimensions.”
4. Illegal activity

Caveats

So, policies that induce shortages and surpluses are bad for competitive markets. However, real-world markets in which price restrictions are used are typically not competitive to begin with (rent controls, minimum wages). Comparing these to our supply-and-demand model of price-rationing is perhaps unfair. The supply-and-demand model only applies when

• No one has enough market power to change the price; consumers and suppliers act as price-takers.
• Consumers and suppliers act in their own best interests; they are rational.
• Everyone observes the same price, and there are no frictions.
• Everything traded is identical, and there are no quality differences.

Per-unit taxes and subsidies

How much of a tax on producers is “passed through” to consumers via higher prices? How much do producers lose when a tax is applied directly on the consumption of their product? For answers, we need (own-price) elasticities of Demand and Supply.

Given a per-unit tax on consumers/producers, and formulas for demand and supply…

• Calculate the no-tax equilibrium, and the equilibrium when the tax is applied.
• Calculate the elasticity of demand $\varepsilon$ and the elasticity of supply $\eta$ at the no-tax equilibrium price.
• What fraction of the tax is borne by consumers/producers?
• How would your answer be changed if the tax were on producers/consumers instead?

Subsidies are analogous. If producers are granted a per-unit subsidy, some of that benefit is “passed through” to consumers via lower prices; how much depends again on elasticities.

Losses to consumers and producers from a per-unit tax (as well as the other interventions described above) can also be measured another way, as we will see later.

More resources

• Perloff, Chapter 3 ``Applying the Supply-and-Demand Model''
  • Quizzes
  • Applications
• Stiglitz and Walsh, Chapter ``Using Demand and Supply''
  • Narrated lecture with graphs
  • Quizzes
  • FAQs and pitfalls
• Krugman and Wells, Chapter 4 “The Market Strikes Back”
  • Chapter text
  • Animated graphs
• Sloman's tax incidence graphs⁴

More information

• Price and quantity restrictions
  • Wikipedia: rationing
• Taxes and subsidies
  • An old debate on sugar subsidies, 1977 Sarasota Herald Tribune article
  • A recent debate on taxing ``sugary drinks,'' May 19, 2010 NY Times in anniversary of a May 19, 2009 NY Times article
  • Gas subsidies in Venezuela, Dec 7, 2006 NYT

Comments

Footnotes

1. Hint: It's a trick question.

2. The standard definition: a product is scarce if there is a shortage at a price of zero. A better definition: if something is not scarce, either it is a “bad” so no one wants it, or if there is a naturally infinite supply of it. For more on non-scarce goods, see externalities.

3. There is more jargon for this: transaction costs, search costs, side-payments.

4. If you are the publisher, please let me know if I need to take these slides down.