Markets:  Supply and Demand

Market Analysis

Reading Assignment:  None

Putting Supply and Demand Together - When the Market "Clears"

    Also known by Deb as satisfactory inventory level -- why?

        Inventory costs: 

                1.

                2.

    So satisfactory inventory level is:

 Always Remember:  Markets are constantly changing -- so a price that satisfies a seller's inventory level today might not do so tomorrow!  The supply and demand model cannot really capture how dynamic markets really are.

Market Clearing or Satisfactory Inventory Level: A price quantity combination where Q_s = Q_d, and where P_s = P_d.

Analytically.  Suppose

Q_d = 100 - 4P +10I, and

Q_s = -10 + 6P - 3W

If W = 30, I =10, what are market clearing values of P and Q?

Q_d = 100 - 4P +10(10), and

Q_s = -10 + 6P - 3(30)

Q_d = 200 - 4P

Q_s = -100 + 6P

So: 200 - 4P = -100 + 6P

    200 + 100 = 4P + 6P

    300 = 10P

       30 = P

If P = $30, then

Quantity demanded = 200 - 4(30) = 80

Quantity supplied = -100 + 6(30) = 80 

So Setting Q_d = Q_s implies:       

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What if the price were $20 instead of $30 in this market?

Q demanded = 200 - 4(20) = 120

Q supplied = -100 + 6(20) = 20

So there is a shortage of 100 units!!

What if the price were $40 instead of $30 in this market?

Q demanded = 200 - 4(40) = 40

Q supplied = -100 + 6(40) = 140

So there would be a surplus of 100 units!!

The stability and desirability of market clearing.  Absent a tendency for markets to try to find the satisfactory inventory level (or given regulations which prevent such convergence), the surplus or shortages just discussed would be permanent (well, for a while anyway).  However, markets do "tend" to try to find the satisfactory inventory level as we discussed earlier because it minimizes costs associated with selling a good. 

Given excess supply the sellers have an incentive to reduce prices.   This price reduction prompts changes in quantity supplied and quantity demanded.  Similarly, given an excess demand, buyers have an incentive to bid prices up, again causing a change in quantity supplied and quantity demanded.

Why might this be "socially" desirable?   Given an absence of externalities, trade is mutually beneficial -- therefore wealth and efficiency enhancing.

    Remember though, we can't talk about "efficiency" from a social standpoint without including all costs/benefits.  So externalities are important. Koch says that creating a negative externality and trading is basically a fraudulent exchange.

Externalities: 

Market Regulation:  "Permanent" shortages and surpluses can be caused by regulation.

A price floor: A regulated minimum price, below which the market price cannot fall.  If the floor is below the market clearing price, the regulation exerts no effect.  If the floor is above the market clearing price, there is a permanent surplus that the market cannot eliminate.

a. Example.  A price floor:  Suppose the government refuses to let cheese be sold for less than $3.00 per pound.  Result: A permanent surplus, and one that cannot be resolved by the market - at least not by a change in the market price.

A price ceiling:  A regulated maximum price, above which the market price cannot rise.  If the floor is above the market clearing price, the regulation exerts no effect.  If the floor is below the market clearing price, there is a permanent shortage that the market cannot eliminate.

b. Example:  Rent control. Result:  A shortage of housing, and one that cannot be resolved by the market - at least not by a change in the market price.

Complications or unintended consequences: One solution by sellers is to ask for multiple purchases (e.g., ask people to agree to unusual lease terms, or to purchase other high cost items along with the lease).  In fact, it is possible that given rent controls, the non-monetary components associated with increasing the price of a good may generate a full price for each consumer that equals the total market consumer surplus.

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Or another way to put it - notice that when a price ceiling binds the market, the full economic price is the sum of the pecuniary plus the non-pecuniary price (e.g., the price of waiting, purchasing undesired packages of goods, etc.)  In general, with a price ceiling, buyers who purchase a good will pay the demand price, at the restricted quantity.   

  There are parallel examples in input markets (where the government acts more aggressively).

 Usury laws (a market for loanable funds)

 Minimum wage legislation.

Supplier Reactions to Changes in Supply and Demand

What about changes in supply and demand - which change the market clearing price (and satisfactory inventory level)?

Firms use the supply and demand model to predict changes in prices.

Single market changes.

Strategy: To find the new market clearing price, consider the old market clearing price, and the new supply and demand curves.   Then shortages or surpluses will motivate an adjustment.

a. Change in demand, supply stable.  Ceteris paribus.....

Example, suppose the price of coffee falls by half.  What should this do to the market for pastries?

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Example: What would a large increase in the price of gas do to the price and quantity of SUV's sold?

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b. Change in supply, demand stable.  Ceteris paribus....

Example:  Suppose a new process for manufacturing computers is developed that cuts production costs by 50%.  What is the predicted effect on the number of computers sold, and the price of computers?

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c. Change in supply and demand… (and ambiguous effects).

Example:  Suppose software prices fall, and that at the same time a new Pentium X chip is developed that can be installed by suppliers at half the cost as the old chip.  What is the net effect of these changes on the price and quantity of personal computers sold?

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Example: Consider the market for cheese produced by U.S. farmers.  Suppose that a new technology is developed in producing cheese. Suppose also that new environmental regulation increases production costs.  What are the net effects of these changes on the market for cheese produced by U.S. Farmers?

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A more complicated story variant: Consider the above problem, but suppose that at the outset the U.S. government imposed a price floor for cheese at the initial market clearing price. How does the price floor affect results?  Depends upon .......

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