Applications of

supply and demand

Comparative statics and
government policy

Comparative statics
„ The simple supply and demand model we have
developed can be used to analyze the effects of
many events on a market
„ Here, we will start by analyzing the impacts of
changes in supply and demand while holding
other factors fixed
… This type of analysis is called a “comparative static”
„ We will then use the model to examine how
government policy influences outcomes in the
market

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Shifts of the demand curve
„ Example:
… Beer and pizza are Pizza
complements P
… Suppose the price of beer S
falls.
P2 E2
„ This will result in an
increase in demand P1 E1
… “a shift of the demand curve”
„ Along with this will be an
increase in the quantity D21
supplied
Q1 Q2 Q
… “a movement along the supply
curve”

Shifts of the supply curve

„ Example:
P Apples
… Market for apples
… Suppose the price of wine S21
increases E2
„ This will result in a P2
decrease in supply P1 E1
… “a shift of the supply curve”
„ There is also a decrease in
the quantity demanded D1
… “a movement along the
demand curve” Q2 Q1 Q

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Simultaneous shifts
„ What if both demand and
supply shift?
P Tickets
„ Example:
S21
… Market for scalped tickets P2 E2
… An unexpected addition to the
concert
P1 E1
„ We know the price rises
„ Unclear what will happen to
the quantity exchanged D21
„ In this example: big
decrease in supply and a Q2 Q1 Q
small increase in demand
… Quantity falls

Shifts in the opposite direction

„ When supply and demand shift in opposite
directions we can predict what happens to
price but not quantity
… Effect on quantity depends on relative size of
shifts
„ When demand increases and supply
decreases price rises but the change in
quantity is ambiguous
„ When demand decreases and supply
increases price falls but the change in
quantity is ambiguous

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Shifts in the same direction
„ When supply and demand shift in the same
direction we can predict what happens to
quantity but not price
… Effect on price depends on relative size of shifts
„ When both demand and supply increase,
quantity rises but the change in price is
ambiguous
„ When demand and supply decrease
quantity falls but the change in price is
ambiguous

Government policy
„ Government sometimes attempts
alternative rationing mechanisms
„ Usually on the grounds of moral fairness
… Equilibrium price of necessities is too high
… Wages are too low to live on
… Price of produce is too low to support farming
„ Three mechanisms we will study are:
1. Price Ceilings/Floors
2. Taxes
3. Quotas

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Price ceiling
„ Suppose a price ceiling is
introduced below the
P
equilibrium price.
S
… Example: rent control
This causes:
„ Persistent shortage PE E

… Alternate rationing (black market)

„ Inefficiency shortage D
… Economic allocation - consumers
… Wasted resources QEC QE Q
… Inefficiently low quality

Price floor
„ Suppose a price floor is
introduced above the
P
equilibrium price.
S
… Example: minimum wage surplus

This causes:
„ Persistent surplus PE E
… Alternate rationing
„ Inefficiency
D
… Economic allocation – producers
… Wasted resources QEF QE Q
… Inefficiently high quality

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Equilibrium and efficiency
„ The demand curve tells you:
… At any given price, what is the quantity demanded?
„ But it also tells you:
… How much is a consumer willing to pay at most for
each unit of the good?
„ Similarly, the supply curve tells you:
… At any given price, what is the quantity supplied?
„ But it also tells you:
… What is the least amount the producer is willing to sell
each unit of the good for (minimum cost)?

Equilibrium and efficiency

„ If the market is not in
equilibrium, it’s inefficient. P
… Inefficient means some person S
could be made better off surplus
without making other people
worse off.
PE E
„ Example: price floor
… At least one consumer could
be made better off without
making others worse off. D
… But the price floor prevents
that trade (it would take place QEF QE Q
below the price floor).

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Taxes
„ We will study excise taxes
… An excise tax is a tax of a certain dollar amount on
each unit bought or sold
„ This can be imposed either on producers or on consumers
(the legal incidence of the tax)
… Tax on Producer
„ Government collects $T per unit sold
„ As though revenue per unit has fallen by $T
… Tax on Consumer
„ Government collects $T per unit purchased
„ As though the price per unit has increased by $T

An excise tax on producers

„ An excise tax on
producers of $T per unit P
shifts the supply curve S1
up. S2

… Each unit now costs $T PC

more to produce. T PE E
„ The economic incidence PP
of the tax is split between
D
consumers and
producers. QT QE Q

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An excise tax on consumers
„ An excise tax on
consumers of $T per unit P
shifts the demand curve S
down.
… For each unit consumers PC
are willing to pay $T less. T PE E
„ The economic incidence PP D2
of the tax is split between
D1
consumers and
producers. QT QE Q

Economic incidence of a tax

„ The economic incidence (who really pays the
tax) does not depend on whether consumers or
producers are legally responsible for paying the
tax.
… In our two examples, if we assume that the amount of
the tax (T) is the same, the results are exactly the
same
„ Same increase in price to consumers
„ Same decrease in price to producers
„ How exactly the tax is split up between
consumers and producers we will look at in the
next topic.

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Taxes and efficiency
„ Taxes create
inefficiency: P
S2
… At least one consumer S1
could be made better off
without making others
worse off. PC
… But the tax prevents that T PE E
trade (not the whole tax T PP
would be paid).
„ The tax “drives a wedge” D
between producers and
consumers QT QE Q

Quotas
„ A quota simply limits the
quantity of a good sold. P
… Achieved by selling quota S
licenses.
„ Quotas have the same PC

impact as an excise tax PL PE E

PP
„ The difference in the
price of the good is
D
exactly matched by the
price of a quota license. Q* QE Q

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 Supply and demand
and welfare
A story about happiness in
dollars: consumer and
producer surplus

Consumer surplus
„ The demand curve shows
the willingness to pay for
each unit of the good. P
„ The consumer who buys P1 S
the first unit of the good
would have been willing to
pay P1 but only has to pay PE E
PE.
… She experiences individual
consumer surplus of P1 – PE.
„ (Total) consumer surplus D
is the sum of each
individual’s consumer QE Q
surplus.

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Changes in consumer surplus
„ Suppose the
equilibrium price falls. P
… (Maybe because of an S1
S
increase in supply.) 2

„ Consumer surplus
increases for two P1 E1
reasons: P2 E2
… Increase to original
buyers D
… New consumer surplus
to new buyers Q1 Q2 Q

Producer surplus
„ The supply curve shows
the minimum cost for each
P
unit of the good.
„ The producer who sells the S
first unit of the good would
have been willing to sell for
P1 but actually gets PE. PE E
… She experiences individual
producer surplus of PE – P1.
„ (Total) producer surplus is P1 D
the sum of each
QE Q
individual’s producer
surplus.

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Changes in producer surplus
„ Suppose the
equilibrium price rises. P

… (Maybe because of an S
increase in demand.)
P2 E2
„ Producer surplus P1 E1
increases for two
reasons:
… Increase to original D21
buyers
Q1 Q2 Q
… New producer surplus
to new buyers

Total surplus

„ Total surplus is the

P
sum of (total) S
consumer surplus
and (total) producer PE E
surplus.
D

QE Q

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Taxes and efficiency

„ Taxes create
P Tax Deadweight
inefficiency (a loss of revenue loss
S
total surplus).
„ Available to society: PC

… Consumer surplus T PE E
PP
… Producer surplus
… Tax revenue (QT · T) D
„ Lost to society: QT QE Q
… Deadweight loss

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