V Lecture Notes For Sept 19, 2007, Prob Set #1 Due, #2 Distributed Using Market Equilibrium to Solve Economic Problems I. Determination of Equilibrium Price in a Market II. Implications of S&D: Don't Confuse Problems with Solutions IV. Effects of Shifts in Market Demand &/or Supply V. Effects of a Price Ceiling or Floor I. Determination of Equilibrium Price in a Market A. Goldilocks and the 3 price levels...high, low, just right B. How firms spot excess supply and demand 1. If inventory is rising, cut price QD < QS 2. If inventory is falling, raise price QD > QS 3. If inventory constant, maintain price QD = QS C. From firm supply to market supply: adding horizontally II. Implications of S&D: Don't Confuse Problems with Solutions A. Is fever a problem or a solution? 1. Fever is NOT the disease it is the way our bodies try to fight the disease! B. Farmers have a very good growing season but the price of crops falls and farm income declines. Is this a problem or a solution? C. There are lots of unsold SUV's at the end of the model year. Automobile dealers offer incentives that cut prices $7,000. Is this a problem or a solution? D. If gasoline stations run out of gasoline or have VERY long lines after a hurricane? Is this a problem or a solution? E. In Canada individual experiencing back or neck pain often have to wait months to get an MRI? Is this a problem or a solution? F. Teachers are paid $30,000 per year to start and $70,000 per year after 20 years are teachers paid too much or too little? G. Price and the "Theory of Value" in Economics 1. Equilibrium price: is it the marginal value that consumers
place on the last unit purchased? 2. Equilibrium price: is it the marginal opportunity cost of the last unit produced by firms? III. Effects of Shifts in Demand & Supply (short run) A. Effect of increase in demand; P & Q B. rise Effect of increase in supply; P falls & Q rises C. Effect of increase in supply & demand; Q rises, P? D. Effects of a decrease in both supply & demand Q falls, P? E. Effects of increase in demand & decrease in supply Q?, P rises F. Effects of decrease in demand & increase in supply Q?, P falls IV. Effects of A Price Ceiling Or Price Floor A. Price ceiling makes it illegal to sell for higher price 1. The supply curve is cut off at the price ceiling 2. Non-binding price ceiling P NB equilibrium at P*, Q* 3. Binding price ceiling results in excess demand - P B, QB 4. Example of rent control, gasoline? Effects of a Price Ceiling Shown on a Marshalian Cross Diagram $/Q S P NB P* PB D QB Q* Q
B. Price floor market it illegal to sell for low price 1. The demand curve is cut off at the price floor but suppliers produce at the intersection of the price floor and the supply curve
resulting in excess supply if the ceiling is binding. 2. Non-binding price floor P NB, produce at P*, Q* 3. Binding price floor results in excess supply because price is at P B and output is QB but quantity supplied will be at Q'B so that excess supply is Q'B - QB . Effects of a Price Floor Shown on a Marshalian Cross Diagram $/Q S PB P* P NB D QB Q* Q'B Q
C. This raises the problem:What to do with the excess supply? 1. Government can purchase the surplus and either destroy it or sell it abroad. 2. Require the surplus output to be sold for another purpose...Milk is reduced to power and stored in caves, or fed to cattle, or producers must use it to make cheese, butter, and ice cream rather than sell as whole milk. ** Historical note... 1996 Farm Bill said milk price supports were to be phased out by 2000. In fact there was no phase out and the 2002 Farm Bill reversed the phase out plan. D. Using the Marshalian Cross to show black markets illegal drugs.