Applications of Supply & Demand Theory
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APPLICATIONS OF SIMPLE SUPPLY AND DEMAND THEORY:
Price Controls: A Little Bit of Economic History
Back in the Dark Ages, in 1971, then President Richard Nixon introduced Phase 1 of his "New
Economic Policy" in response to the inflation and balance
of payments crises that resulted from the expenditures
needed to finance the Vietnam War.
As part of this policy, he set price controls on a number of
goods and services ... let's see what economics has to say
P
D
S
about the effects of price controls.<Given the market for
P1
Pe
one of the many commodities affected, let's introduce a
P2
price ceiling, P1 ...what is the effect of this ceiling?> No
S2
P
P1
D
D2
Q
effect if the price is above market equilibrium.
<Lower the price ceiling to P2?> There is Excess demand at
that price, and for the actual quantity supplied the demand
price is much higher. With price controls the price does
not serve the important function of allocating the available
supply among the would-be purchasers.
Digression: U.S. in 1966...Johnson was heating up the war but he forgot one important
thing...didn't tell his council of economic advisers. Government demand for goods and
services rose markedly. <How do we show this on a graph?... Demand curve shifts right ...
in short run supply is fixed...get pure inflation as price system attempts to allocate scarce
resources.
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P
P2
D'
S
D
P1
S1
S2
Q
In response to the inflation President Nixon instituted price controls: <In the face of excess
demand at a given price how do producers respond? How can a seller get around a price
control system?>
{ Make private deals with buyers to sell with a "surcharge." After WW II automobiles
were in short supply. Dealers sold them to individuals willing to make deals and pay
surcharges. <Has anyone tried to buy a Saturn which has been in short supply and
been asked to pay above list?>
{ Raise the price implicitly by lowering the quality of the product. In the Nixon-era
price control system, car manufacturers raised the price of cars by reducing their
warranty periods and limiting warranty lengths. Cars were provided with fewer
standard features. A number of analysts argue that the U.S. car industry got into
trouble vis a vis the Japanese when they let automobile quality decline between 1972 -1980 at the very time that the Japanese were perfecting their quality control systems.
Attention to quality declined in the U.S. in part because of the price controls in place in
the early 1970's.
Another example of price controls leading to quality decline is the New York housing market.
A large share of the apartments are under rent control,
which leads to rents far below the market price. <Do you
think that a black market has developed?> Yes, landlords
charge exorbitant amounts for "extra" services such as, say,
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a doorman, janitorial service. Furthermore, the landlord
contrives to give the customers a lower quality product:
heating and hot water systems allowed to deteriorate;
elevators are left out of commission; repair work in
apartments is almost impossible to get; tenants tend to take
care of these thing themselves by doing their own repairs,
etc. The landlord implicitly raises the rent by shifting some
costs onto the consumers
Price Controls With Fixed Supply Systems
Oftentimes governments institute price controls during wartime or other emergency situations
when the supply of a commodity to the market must be
artificially limited. <<Let’s suppose that the government
wants to restrict supply of a commodity to a given
maximum amount. How could we show the supply
restriction on a graph?>>
P
S(restricted)
Pc
D
Qmax
Q
Generally the shortage leads to high prices, and, in the interests of “fairness” the authorities may
impose a price ceiling, say at price Pc. This leads to excess
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demand at that price. <<What is the result of the excess
demand?>>
{ First come -- first serve ... long lines, housewives
rushing all over the city...etc. Looks a lot like the
former Soviet Union.
{ Sellers preferences ... one has to be a "regular" at the
store ... UK ... Wilkinson sword edges ... seller can
use any criterion.
{ Rationing system: government who decides who gets
right to purchase commodities and in what amounts
...
Central authority's preferences determine who
gets what
In general the price controls come first and then when everybody is thoroughly disgusted
with system, rationing system is added.
S
P
D
Pr
Effect of rationing
( shifts D' in )
D'
Q
Black Markets:
Is an effective price control system a stable system? <That is, will it work over the long run?
How would economic theory lead us to predict the
breakdown of the system?> At the controlled price P2 the
demand far exceeds supply.
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Some consumers are willing to pay much more. <How much more?> P1. Obviously a Black
Market develops A more ethically neutral term might be
"resale market". In rationing system people take their
coupons to black marketeer who pays them either money or
in other goods. The graph shows a system in which all of
the supply is sold to the black market and resold at the
demand price. The black marketeer makes his profit by
buying at a price somewhat higher than the controlled price
and selling at demand price.
P
D
S
P1
P2
Q
As far as I know there has never been a case in which effective price controls have not
been accompanied by a black market. <Why can a black market work?>
In general it's easy to control the quantity of a commodity produced -- factories and plants are
few in number and well defined; however, there are
literally thousands of retailers and they are exceedingly
difficult to police. Once once the commodity is sold,
however, the purchaser himself may enter the black market.
At the retail level it's virtually impossible to police the
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prices as we saw during the the Nixon-era price control
period.
A couple of other examples:
{ Before the Smith Center opened and the basketball
team played in Carmichael, a season ticket holder
could pay for the entire season by selling the ticket to
one game, if it was a biggie. <<How would we draw
the market graph for Carmichael? For the Smith
Center?>>
P
D
Charmichael
Smith Ctr.
Official Price
Q
{ Passing through Dallas a couple of summers ago I
read a newspaper article about how Garth Brooks
fans who had waited in line for hours for tickets were
closed out at the box office or got lousy seats. Yet
the commercial ticket agencies were all selling prime
tickets at triple or quadruple the going rates? <How
did they get access to these tickets?> They hired
homeless people to arrive at the box office before
sunrise to wait in line and buy large blocks of tickets!
This is a great example of two basic principles: (1)
it's almost impossible to stop a resale market from
developing in a fixed-supply, fixed-price, excess
demand situation; (2) It was cheaper for the ticket
agencies to hire the homeless, whose opportunity cost
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is low, than it was for regular fans to arrive before
daylight.
How can we evaluate black market systems?
The problem with a black market system is that those who can pay will get all the goods. If your
goal is an equitable distribution of goods this is bad. If
your goal is mainly restricted to limiting total supply of a
commodity, then price controls plus black market work
fairly well.
<Anybody got an example of peace-time price controls their effects?> How about the tuition
levels at UNC-Chapel Hill. At an in-state tuition cost
(fall 2009) of about $3,865 total, and an out-of-state tuition
cost of about $21,753 an undergraduate education at UNC
is priced far below the
S
P
D
Duke cuts its prices:
Demand for UNC shifts
down (i n )
Pr
D'
Excess Demand
for UNC
Q
cost of comparable quality educations elsewhere (e.g.,
Duke @ $39,075 fall 2009). The low price leads to
tremendous excess demand for admissions, especially from
out of state where only about 500 out of maybe 10,000
applicants is admitted. The admissions office is subjected
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to tremendous pressure to admit students. Potential
applicants make use of influential friends, offer to make
large donations to the school, and so on. It got so bad at
the Law School that the Admissions Office had to resort to
a strict numerical rating system in order to reduce the
pressure from influential friends of applicants. <What
would happen to this pressure if the price were high enough
to equate supply with demand?>
MINIMUM WAGE LEGISLATION:
In a given market if the minimum wage is below the equilibrium level, it has no effect on
the market. If the law is effective however:
Wage
W/yes
ND
NS
( Effective )
We
W/no
(Ineffe ctive )
Q
{ It will raise wages of those who remain in employment.
{ It will lower the actual amount of employment in industry governed by employment.
{ It will create a surplus of labor that would like to but cannot obtain jobs.
{ It will create an incentive for some workers to try to evade the law by offering to
work at wages below the legal minimum.
Here’s a map from August 2006, showing the differences in state minimum wages: {next
slide}
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Time Magazine 8/21/2006
Illegal Markets: Drug Policy
Let’s apply supply-demand analysis to the current national policy on illegal drugs. The current
U.S. policy is to work very hard to stop drugs at the source,
before they get to the consumer. There are, in fact, two
types of policies that might be followed:
; Reduce Demand
Y Severe penalties for use ... long prison terms,
confiscation of property, midnight raids on
households, etc.
Y Education as to the evils of drugs.
Y Therapy for users to wean them from drugs.
; Reduce Supply by undertaking a number of repressive
tactics:
Y Send the police aggressively after dealers in the
U.S.
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Y Use the Army or National Guard in the “war on
drugs”
Y Build a big fence on the Mexican border.
Y Attack growing areas in foreign countries. Offer
growers there alternatives.
<< How well do these different types of policies work?>>
Demand Side Policies:
D'-c
S-cocaine
P
P'
D-cocaine
Q'
Q
Clearly, demand reduction policy has the effect of making the market much less attractive for
suppliers as it reduces demand and the market price.
However, the use of punishment seems not to have had
much of a negative effect. Use remains high, and many
civil rights are getting trampled in the process.
Supply Side Policies:
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S'-cocaine
P'
S-cocaine
P
D-cocaine
Q'
Q
For the supply side policies, the quantity effect is negative, but how much depends upon the
elasticity of demand for cocaine. Note, however, the price
rises, making it even more attractive to be a supplier.
Given the penalties of being caught and the rewards for
succeeding, suppliers become even more ruthless in their
attempts to supply the product. The result: more violence.
The police may react in two ways:
Y Anger & frustration lead to extreme measures and
excessive force that trample on the rights of citizens.
Y Police and judiciary become cynical and corrupt,
knowing they can’t beat the pushers, they decide to
cash in.
The current system has turned the basic public health problem of drug dependency into a
two-pronged problem of drug dependency and
crime/corruption. We have produced the worst of all
possible worlds.
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So, what’s the solution? Legalize drugs? State take over distribution to drive the price low and
remove the profits from the sale and distribution?
What are the up- and down-sides of legalization?
The Chlorofluorocarbon (CFC) Trade
<<How many people in the room are driving cars 1994 or older?>> If you are, you’re probably
driving a car with an air conditioner that uses refrigerants
that are now banned from production in the United States.
Operating under a grandfather clause, certain developing
countries, notably India and Mexico, are still allowed to
produce CFCs. Because the U.S. supply of CFCs is now
drying up, their price has started to skyrocket, as you can
imagine would happen when 80 million U.S. automobiles
are still using them. It now costs an average of $80 to
recharge an automobile airconditioner. Moreover it can
cost up to $300 to have one’s car retrofitted to use the new
refrigerants.
Federal oficials now estimate that the smuggling of CFCs is the second ranking, following only
the narcotics trade. As the domestic supply of CFCs
disappears, you can imagine how attractive the black
market will be to consumers and to the black marketeers.