Zhigang Li University of Hong Kong

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Zhigang LiUniversity of Hong Kong
Supply and Demand
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Markets and Prices

• Why does Ming YAO earn more than construction
  workers?

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Markets and Prices

• Why do diamonds cost more than water?

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Markets and Prices

• Why do QiBaiShis (???) crabs sell for more than
  the real ones?

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Markets and Prices

• Why do the prices of paintings jump when their
  painters die?

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Markets and Prices

• Is it cost of production that determines prices
  (as Adam Smith thought)?

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Markets and Prices

• Or is it willingness to pay that determines
  prices (as Stanley Jevons thought)?

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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.

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Markets and Prices

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

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The market for lobsters

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

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The demand for lobsters

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

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Horizontal interpretation of the demand curve

• If buyers face a price of 4/lobster, they would
  want to purchase 4000 lobsters a day.

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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.

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Demand Curve

• The demand curve effectively represent the
  marginal benefit of an individuals consuming a
  certain amount of a good.

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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 cant
  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 buyers
  purchasing power

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The supply of lobsters

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

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Horizontal interpretation of the supply curve

• If sellers face a price of 4/lobster, they will
  wish to sell 2000 lobsters a day.

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Vertical interpretation of the supply curve

• If sellers are currently selling 2000 lobsters a
  day, the marginal cost of a lobster is 4.

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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.

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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.
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Excess supply

• A situation in which price exceeds its
  equilibrium value is called one of excess supply,
  or surplus.

At 8, there is an excess supply of 2000 lobsters
in this market.
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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.
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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..
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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
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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
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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.
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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.
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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.

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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.

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Example 3.2. Should Collegetown Rents Be
Regulated?

• Suppose the supply and demand curves for
  two-bedroom Collegetown rental apartments are as
  shown.

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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?

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Example 3.2. Should Collegetown Rents Be
Regulated?

• Rent Controls Produce Excess Demand in the
  Housing Market.

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Example 3.2. Should Collegetown Rents Be
Regulated?

• Responses to excess demand in a regulated housing
  market
• finders fees
• key deposits
• required furniture rental
• excessive damage deposits
• curtailed maintenance
• apartment conversion

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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

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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."

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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.

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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.

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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.

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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) .

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The Equilibrium Principle

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

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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

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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.

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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
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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.

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When market equilibrium is not social optimal

• Goods whose production generates toxic smoke

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When market equilibrium is not social optimal

• Goods whose production generates noise.

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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
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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
  producedthe sellers private marginal cost plus
  the marginal pollution cost borne by othersmust
  be higher than the benefit of the last unit
  produced.

Social marginal cost private marginal cost
marginal pollution cost
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When market equilibrium is not social optimal

• So when costs fall on people other than sellers,
  market equilibrium quantity gt 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.
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When market equilibrium is not social optimal

• Increases in production of some goods benefit
  people other than those who buy them.

More apple trees gt more honey
More bees gt more apples
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Correcting for marginal benefit enjoyed by
non-buyers

• To restore the socially optimal equilibrium,
  subsidies may be provided to buyers to compensate
  them for the social benefit they create in
  purchasing the goods.

Price
S
P
P
D
D
Quantity
Q
Q
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When market equilibrium is not social optimal

• But since producing such goods yields benefits in
  addition to those received by buyers, we know
  that the full marginal benefit of the last unit
  producedthe price paid by the marginal buyer
  plus the benefit received by nonbuyersmust be
  higher than the marginal cost of the last unit
  produced.
• Market equilibrium results in too little
  production of goods that generate external
  benefits.

Social marginal benefit private marginal
benefit
marginal benefit received by nonbuyers
Potentially, some public policy can be
implemented to encourage the production of this
kind of goods.
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Newspaper story

• Producers raised prices, and the resulting fall
  in demand caused prices to fall back to their
  original level.

True or False?
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Change in demand vs. Change in the quantity
demanded
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Newspaper story

• Producers raised prices, and the resulting fall
  in demand caused prices to fall back to their
  original level.

• WRONG!!
• A rise in price causes a fall in the quantity
  demanded, not a fall in demand.

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Change in supply vs. Change in the quantity
supplied
S
S
Price
Quantity
An increase in supply At every price, there
is an increase in the quantity supplied.
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Change in supply vs. Change in the quantity
supplied
Price (/lobster)
S
10
8
6
4
2
Quantity (1000 lobsters/day)
0
1
2
3
4
5
An increase in the quantity supplied For an
upward sloping supply curve, an increase in price
leads to an increase in the quantity supplied.
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Impact of an increase in demand

• An increase in demand will lead to an increase in
  both the equilibrium price and the equilibrium
  quantity.

Price
S
P
P
D
D
Quantity
Q
Q
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Impact of a decrease in demand

• A decrease in demand will lead to a reduction in
  both the equilibrium price and the equilibrium
  quantity.

Price
S
P
P
D
D
Quantity
Q
Q
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Impact of an increase in supply

• An increase in supply will lead to a decrease in
  the equilibrium price and an increase in the
  equilibrium quantity.

S
S
P
P
D
Quantity
Q
Q
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Impact of a decrease in supply

• A decrease in supply will lead to an increase in
  the equilibrium price and a reduction in the
  equilibrium quantity.

S
S
P
P
D
Quantity
Q
Q
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Determinants of Demand1. Incomes

• For most goods, the quantity demanded at any
  price will rise with income. Goods that have
  this property are called normal goods.

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Determinants of Demand1. Incomes

• For inferior goods, the quantity demanded at any
  price will fall with income. Example Ground
  beef with high fat content.

Consumers abandon inferior goods in favor of
higher quality substitutes (such as leaner grades
of meat in the ground beef case) as soon as they
can afford to.
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Determinants of Demand2. Tastes

• Example Following the release of Jurassic Park
  and The Lost World, tastes in childrens toys
  shifted toward designs involving prehistoric
  reptiles.

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Determinants of Demand3. Prices of substitutes
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Determinants of Demand3. Prices of substitutes
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Determinants of Demand3. Prices of substitutes
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Determinants of Demand4. Prices of complements
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Determinants of Demand4. Prices of complements
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Determinants of Demand4. Prices of complements
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Determinants of (Aggregate) DemandA summary

• Factors That Cause an Increase (rightward or
  upward shift) in Demand
• A decrease in the price of complements to the
  good or service
• An increase in the price of substitutes for the
  good or service
• An increase in income (for a normal good)
• An increased preference by demanders for the good
  or service
• An increase in the population of potential buyers
• An expectation of higher prices in the future

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Determinants of supply1. Technology
Example A more efficient lobster trap is
invented.
A more efficient lobster trap shifts supply to
the right
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Determinants of supply2. Factor prices
Example The price of gasoline rises.
Rising factor prices shift supply to the left.
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Determinants of supply2. Factor prices
Example Interest rates fall.
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Determinants of (aggregate) supplyA summary

• Factors That Cause an Increase (rightward or
  upward shift) in Supply
• A decrease in the cost of materials, labor, or
  other inputs used in the production of the good
  or service
• An improvement in technology that reduces the
  cost of producing the good or service
• An improvement in the weather, especially for
  agricultural products
• An increase in the number of suppliers
• An expectation of lower prices in the future

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Example 3.3

• Why do the prices of some goods, like apples, go
  down during the months of heaviest consumption,
  while others, like beachfront cottages, go up?

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Example 3.3

• The seasonal consumption increase is the result
  of a supply increase in the case of apples, a
  demand increase in the case of cottages.

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Example 3.4

• What will happen to the equilibrium price and
  quantity in the fresh seafood market if both of
  the following events occur
• a scientific report is issued saying that fish
  contains mercury, which is toxic to humans and
• the price of diesel fuel falls significantly?

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Example 3.4

• The equilibrium price will go down, but the
  equilibrium quantity may go either up (right
  panel) or down (left panel)

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Example 3.5. Sales Tax

• The Hong Kong government is considering to
  introduce a sales tax. What is the effect of a
  sales tax to the market equilibrium?

S
S
Price
Sales tax paid by sellers.
tax
P
Tax burden?
Buyers burden
P
Tax Revenue?
Sellers burden
D
Quantity
Q
Q
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Example 3.5. Sales Tax

• The Hong Kong government is considering to
  introduce a sales tax. What is the effect of a
  sales tax to the market equilibrium?

S
Price
Sales tax paid by buyers.
tax
Buyers burden
P
Tax burden?
P
Tax Revenue?
Sellers burden
D
D
Quantity
Q
Q
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Example 3.6

• Suppose there is a world-wide frenzy to buy the
  newly invented robot pets. The robot pets are
  made in Japan. Before this invention, the
  exchange rate of Japanese yen per US dollar was
  117 yen for each US dollar. Other things being
  equal, what is more likely to happen to the
  exchange rate?
• The exchange rate will remain unchanged.
• The exchange rate will rise (say, to 118 yen per
  US dollar).
• The exchange rate will fall (say, to 116 yen per
  US dollar).
• The exchange rate will be more unpredictable.

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Example 3.6

• Suppose there is a world-wide frenzy to buy the
  newly invented robot pets. The robot pets are
  made in Japan. Before this invention, the
  exchange rate of Japanese yen per US dollar was
  117 yen for each US dollar. Other things being
  equal, what is more likely to happen to the
  exchange rate?

S
S
Yen/USD
117
The exchange rate will fall (say, to 116 yen per
US dollar).
116
D
USD
Q
Q
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Example 3.7.

• An important determinant of the amount of grains
  harvested next year by Ethiopian farmers is the
  amount of seeds planted this year. Given that
  Western nations have guaranteed to donate five
  hundred tons of grain next year, this year the
  Ethiopian farmers will
• plant more seeds as the food aid established a
  minimum price for grain.
• plant more seeds as the farmers confidence is
  restored.
• plant the same amount of seeds as they would have
  without the food aid.
• plant less seeds as consumers demand for grain is
  completely price elastic.
• plant less seeds as the price of grain will be
  lower with the food aid.

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Example 3.7

• Donate five hundred tons of grain next year means
  that the demand for domestic production of grain
  will be lowered by the same amount at all prices?

500 tons
S
Price
Anticipating a lower market equilibrium price
next year, farmer would want to supply less
quantity next year.
P
They do so by planting less seeds this year.
P
D
D
Quantity (tons of grain)
Q
Q
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Example 3.7.

• An important determinant of the amount of grains
  harvested next year by Ethiopian farmers is the
  amount of seeds planted this year. Given that
  Western nations have guaranteed to donate five
  hundred tons of grain next year, this year the
  Ethiopian farmers will
• plant more seeds as the food aid established a
  minimum price for grain.
• plant more seeds as the farmers confidence is
  restored.
• plant the same amount of seeds as they would have
  without the food aid.
• plant less seeds as consumers demand for grain is
  completely price elastic.
• plant less seeds as the price of grain will be
  lower with the food aid.

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End