Chapter 4
Extensions of Demand and Supply Analysis
◼ Overview
The chapter begins by presenting an overview of the price system. There is a discussion of exchange and
markets, transaction costs, and the role of middlemen. The examination of supply and demand analysis
begins by first identifying what happens to equilibrium price and quantity when demand changes with
supply constant and then when supply changes with demand constant. The analysis is pursued further by
◼ Learning Objectives
After studying this chapter students should be able to:
• 4.1 Discuss the essential features of the price system
• 4.2 Evaluate the effects of changes in demand and supply on the market price and equilibrium quantity
◼ Outline
I. The Price System and Markets: An economic system in which relative prices constantly change
to reflect changes in demand and supply. Prices act as signals of relative scarcity to persons in the
system.
A. Exchange and Markets: Exchanges in markets are voluntary. Voluntary exchange is the act
B. Transaction Costs: All of the costs associated with exchange, including the informational
costs plus the costs of negotiating and enforcing contracts and of acquiring and processing
information about alternatives
Chapter 4 Extensions of Demand and Supply Analysis 49
C. The Role of Middlemen: Middlemen specialize in lowering transaction costs by bringing
II. Changes in Demand and Supply: Market equilibrium can change when there is a shock caused by
a change in the ceteris paribus conditions for demand or supply. A shock can be represented by a
shift in the supply curve, the demand curve, or both curves.
A. Effects of Changes in Either Demand or Supply: Whenever one curve shifts and the other
B. Situations in Which Both Demand and Supply Shift: When both supply and demand curves
shift, the outcome is indeterminate for either equilibrium price or equilibrium quantity.
1. Changes of Demand and Supply in the Same Direction: When there is an increase in
2. Changes of Demand and Supply in Opposite Directions: In the event of a decrease in
demand and increase in supply, equilibrium price will fall. An increase in demand and a
C. Price Flexibility and Adjustment Speed: When demand increases in a market, a shortage
III. The Rationing Function of Prices: The synchronization of decisions by buyers and sellers that
creates equilibrium is called the rationing function of prices. Prices are indicators of relative
scarcity and ration goods to those who are willing to pay the most. First come, first served, political
power, physical force, and cultural, religious, and physical differences have been and are being used
as rationing methods throughout the world.
1. Rationing by Waiting: Also called rationing by queues, whoever is willing to wait in line the
2. Rationing by Random Assignment or Coupons: Random assignment means being given the
A. The Essential Role of Rationing: Because of scarcity, it is not possible for everyone to
50 Miller • Economics Today, Nineteenth Edition
IV. Price Ceilings: The rationing function of prices is often not allowed to operate when government
sets price controls called price floors (minimum legal prices) and price ceilings (maximum legal
prices).
A. Price Ceilings and Black Markets: When a price ceiling is below the market-clearing price,
a shortage occurs. The result is fewer exchanges.
1. Nonprice Rationing Devices: Whenever the price system is not allowed to work, nonprice
2. Black Markets: Typically, an effective price ceiling leads to a black market in which the
B. The Policy of Rent Ceilings: Rent control is the placement of price ceilings on rents in
particular municipalities.
1. The Functions of Rental Prices
a. Rent Controls and Construction: Rent controls have discouraged the construction of
new rental property by depressing the most important long-term determinant of
profitability—rent.
b. Effects on the Existing Supply of Housing: When rental rates are held below
equilibrium levels, owners cannot recover through rents, the cost of maintenance,
2. Attempts to Evade Rent Ceilings: Property owners will make life unpleasant for tenants
3. Who Loses and Who Gains from Rent Ceilings? Property owners are the biggest losers.
4. Why Both Landlords and Some Tenants Lose: Low-income persons lose because of
5. Beneficiaries of Rent Controls: Upper-income tenants who occupy rent-controlled
V. Price Floors and Quantity Restrictions
A. Price Floors and Price Supports in Agriculture: In 1933, the federal government established
a system of price supports for many agricultural products, including wheat, feed grains, cotton,
soybeans, and dairy products.
1. Implementing Agricultural Price Supports: The government chooses a support price of
2. An Effective Agricultural Price Floor: When the government sets the support price
3. Who Benefits from Agricultural Price Supports? Owners of big farms that produce more
output get a large percentage of subsidies. All of the benefits derived from price support
subsidies ultimately accrue to landowners on whose land price-support crops can be grown.
a. Keeping Price Supports Alive under a New Name: Congress appeared to intend to
b. The Main Beneficiaries of Agricultural Subsidies: The government seeks to cap
B. Price Floors in the Labor Market: A minimum wage is a wage floor legislated by
government below which it is usually illegal to pay workers. The effect is to cause
unemployment for some low-skill workers and depressed wages in areas not covered by the
minimum wage. (See Figure 4-5.)
1. Minimum Wages in the United States: The federal minimum wage began in 1938 at
2. Economic Effects of a Minimum Wage: When the minimum wage exceeds the market–
clearing wage, the quantity of labor supplied exceeds the quantity of labor demanded.
There are fewer workers employed at the higher minimum wage, but those who are
employed earn a higher than market-clearing wage. (See Figure 4-5.)
a. Explaining the Overall Decrease in Employment: At the minimum wage, the overall
decrease in employment is smaller than the excess quantity of labor supplied because
b. Summing Up the Effects of an Above-Equilibrium Minimum Wage: On the one
C. Quantity Restrictions: Governments can impose quantity restrictions on a market, such
as a ban on ownership or trading of goods (human organs and certain psychoactive drugs).
◼ Points to Emphasize
Equilibrium Price and Quantity Changes When There Are Changes
in Supply and Demand
When one curve shifts and the other is stable, it is possible to predict what will happen to equilibrium
price and quantity. For example, the effect of an increase in demand is to raise equilibrium price and
quantity. When both curves shift, the effect on either price or quantity is a priori indeterminate. An
52 Miller • Economics Today, Nineteenth Edition
Adjustment Speed
The graphic presentation of changes in supply and demand often leads to the conclusion that price and
quantity adjustments are relatively smooth and rapid. Although this sometimes happens, it is often true
that some markets do not get back into equilibrium immediately. All the analysis does is show what
equilibrium price and quantity will ultimately be, given a demand curve and a supply curve. An analysis
Rationing
Different methods exist to ration or allocate an available good or service to people. Pick a scarce good
or service generally viewed as a necessity and ask how to allocate it. Considerable controversy has arisen
over how to allocate human organs for transplanting. The current allocation method is essentially a first-
come, first-served rationing by queuing system using donated organs from relatives or from people who
Price Ceilings
Price controls represent maximum legal prices (price ceilings) and minimum legal prices (price floors).
Price ceilings are supposed to protect buyers from high prices. One way to help low-income persons,
according to some people, is to keep rents low (price ceiling). This is the reason for rent control, in which
some local governments tell landlords how much rent to charge. In fact, just the opposite happens. The
Price Floors
In addition to increasing the unemployment rate among those subject to the minimum wage, the minimum
wage results in those unemployed workers losing opportunities to increase their human capital from on-
the-job training and work experience. Thus, the minimum wage has the effect of preventing some low–
productivity workers from increasing their human capital by enough to qualify for a minimum-wage job.
Chapter 4 Extensions of Demand and Supply Analysis 53
◼ For Those Who Wish to Stress Theory
The Process of Adjustment
The adjustment process from one equilibrium price and quantity to another can be interesting. The
method in the text is one in which a change in supply or demand occurs, and then the final equilibrium
is shown and compared to the initial one. A dynamic adjustment process may be more interesting. The
Cobweb Model proposes that sellers respond in the current period to the previous period’s price. The
model shows how a market can converge on equilibrium after a series of surpluses and shortages.
When a good’s price is set below equilibrium or is distributed for free, much, perhaps all of it will be
distributed by queuing. Yoram Barzel (see Selected References) argues that with price below
◼ Further Questions for Class Discussion
1. Because the problems associated with price ceilings are discussed in detail in the text, it is useful to
look at the effects of a price floor. Many developing countries have been lobbying at recent
meetings of the World Trade Organization for an end to agricultural subsidies by developed
countries. Why would these developing countries that also produce many of these same agricultural
products wish to have these subsidies ended?
When the U.S. government makes up the difference between the world market price and the price
in the United States, then U.S. farmers can sell their crops on the world market and still enjoy a
2. A major issue in the 2008 presidential campaign in the United States was the high price of gasoline
and crude oil. The price of crude oil rose rapidly in 2007 and 2008, despite increases in production
by Organization of Petroleum Exporting Countries (OPEC). Part of the reason is that the Chinese
and Indian economies had been growing at very high rates. This growth has fueled demand for
3. Opponents of legalized marijuana argue that legalizing the drug would result in more marijuana
being consumed. Is this result predicted by the supply and demand model? Yes. Buyers and sellers
4. The text argues that economists can analyze and compare the efficiency of different rationing
systems but cannot say which one is best. Doesn’t it seem reasonable to accept that the most
efficient system, the price system, is the best? No. As economists we can analyze the operation of
5. In 1974, the cutback in oil production by the OPEC cartel created shortages of oil in the world
market. In the United States, price controls prevented oil and gasoline prices from rising to world
market levels. In Europe and Canada, oil and gasoline prices rose to world market levels. In the
◼ Answers to Questions for Critical Analysis
Online Dating Sites and Virtual Roses (p. 77)
Why do you suppose that online dating companies provide each customer with only a small set of
virtual roses to attach to date invitations? (Hint: If people could attach a virtual rose to every
invitation they extend, how useful would seeing a rose attachment be to recipients?)
Rationing Water (p. 81)
How might California cities alternatively have developed a rationing by queues approach using the
Internet?
Chapter 4 Extensions of Demand and Supply Analysis 55
Looking for Hard-to-Find Items in Venezuela? Ask for the Bachaqueros
(p. 83)
Why do you suppose that the Venezuelan government has begun to provide individuals with
coupons giving them the right to purchase only strictly limited qualities of flour, milk, and toilet
paper?
Dramatic Responses to Cities’ Minimum Wage Hikes: “Zeroing Out”
Employment (pp. 88−89)
When firms respond to minimum wage increases by shutting down entirely, who else is harmed
besides their employees? (Hint: During a West Coast trip, would it now be possible for you to buy
lunch at Z Pizza in Seattle or to purchase dinner at the Abbot’s Cellar in San Francisco?)
The European Union Decides That the Costs of Milk Quotas Outweigh the
Benefits (p. 89)
Other things being equal, is the price of milk in Europe likely to rise or fall in response to the
elimination of milk production quotas? Explain your answer.
◼ You Are There
Price Rationing via Changes in the Number of Items Sold in a Package (p. 90)
1. How do you suppose that when soft drink sellers introduced cans containing 7.5 ounces of soft
drink to sell alongside traditional 12-ounce cans, they managed to offer the soft drinks in the
smaller cans at prices that were several cents higher per ounce of soft drink?
2. Why do you think that most economists seek to study prices measured in terms of dollars per
unit as measured, say, by weight or by volume rather than by prices per package or per
container? Explain your reasoning.
56 Miller • Economics Today, Nineteenth Edition
◼ Issues & Applications
Online Middlemen: Customer Sales Reps Move to the Web (pp. 90–91)
1. Why might transaction costs of locating a replacement clothing item increase with the
number of particular features that characterize that item?
2. It is obvious how finding a provider of cabinet-installation services can reduce a consumer’s
transaction costs, but how can middlemen such as Amazon also reduce transaction costs for
providers of such services?
◼ Research Project
1. Take a look at Amazon’s description of its Home Services offerings in the Web Links in MyEconLab.
◼ Appendix B—Consumer Surplus, Producer Surplus, and Gains
from Trade within a Price System
I. Consumer Surplus: The difference between the total amount that consumers would have been
willing to pay for an item and the total amount that they actually pay. (See Figure B-1.)
A. Willingness to Pay (See Figure B-1.)
1. Graphing Consumer Surplus (See Figure B-1.)
II. Producer Surplus: The difference between the total amount that producers actually receive for an
item and the total amount that they would have been willing to accept. (See Figure B-2.)
A. Willingness to Sell (See Figure B-2.)
1. Graphing Producer Surplus (See Figure B-2.)
III. Gains from Trade within a Price System: The sum of consumer surplus and producer surplus.
(See Figure B-3)
Chapter 4 Extensions of Demand and Supply Analysis 57
◼ Answers to Problems
4-1. In recent years, technological improvements have greatly reduced the costs of producing basic
cell phones, and a number of new firms have entered the cell phone industry. At the same
time, prices of substitutes for cell phones, such as smartphones and some tablet devices, have
declined considerably. Construct a supply and demand diagram of the market for cell phones.
Illustrate the impacts of these developments, and evaluate the effects on the market price and
equilibrium quantity.
The ability to produce basic cellphones at lower cost and the entry of additional producers shift the
4-2. Advances in research and development in the pharmaceutical industry have enabled
manufacturers to identify potential cures more quickly and therefore at lower cost. At the
same time, the aging of our society has increased the demand for new drugs. Construct a
4-3. There are simultaneous changes in the demand for and supply of global-positioning-system
(GPS) devices, with the consequences being an unambiguous increase in the market clearing
price of these devices but no change in the equilibrium quantity. What changes in the demand
for and supply of GPS devices could have generated these outcomes? Explain.
4-4. There are simultaneous changes in the demand for and supply of tablet devices, with the
consequences being an unambiguous decrease in the equilibrium quantity of these devices but
no change in the market clearing price. What changes in the demand for and supply of tablet
devices could have generated these outcomes? Explain.
4-5. The following table depicts the quantity demanded and quantity supplied of studio
apartments in a small college town.
Quantity
Quantity
Monthly Rent
Demanded
Supplied
$600
3,000
1,600
$650
2,500
1,800
$700
2,000
2,000
$750
1,500
2,200
$800
1,000
2,400
What are the market price and equilibrium quantity of apartments in this town? If this town
imposes a rent control of $650 per month, how many studio apartments will be rented?
4-6. Suppose that the government places a ceiling on the price of a medical drug below the
equilibrium price.
a. Show why there is a shortage of the medical drug at the new ceiling price.
b. Suppose that a black market for the medical drug arises, with pharmaceutical firms
secretly selling the drug at higher prices. Illustrate the black market for this medical
drug, including the implicit supply schedule, the ceiling price, the black market supply
and demand, and the highest feasible black market price.
a. At the ceiling price of the medical drug, P1, the quantity of the drug demanded exceeds the
4.7. The table below illustrates the demand and supply schedules for seats on air flights between
two cities:
Quantity
Quantity
Price
Demanded
Supplied
$200
2,000
1,200
60 Miller • Economics Today, Nineteenth Edition
4-8. The consequences of decriminalizing illegal drugs have long been debated. Some claim that
legalization will lower the price of these drugs and reduce related crime and that more people
will use these drugs. Suppose some of these drugs are legalized so that anyone may sell them
and use them. Now consider the two claims—that price will fall and quantity demanded will
increase. Based on positive economic analysis, are these claims sound?
The fact that drug sellers incur legal penalties if caught means that there is an extra cost of
selling drugs over and above those associated with production and distribution of these substances.
4-9. In recent years, the government of Pakistan has established a support price for wheat of
about $0.20 per kilogram of wheat. At this price, consumers are willing to purchase 10 billion
kilograms of wheat per year, while Pakistani farmers are willing to grow and harvest 18 billion
kilograms of wheat per year. The government purchases and stores all surplus wheat.
a. What are annual consumer expenditures on the Pakistani wheat crop?
b. What are annual government expenditures on the Pakistani wheat crop?
c. How much, in total, do Pakistani wheat farmers receive for the wheat they produce?
4-10. Consider the information in Problem 4-9 and your answers to that question. Suppose that
the market-clearing price of Pakistani wheat in the absence of price supports is equal to
$0.10 per kilogram. At this price, the quantity of wheat demanded is 12 billion kilograms.
Under the government wheat price-support program, how much more is spent each year
on wheat harvested in Pakistan than otherwise would have been spent in an unregulated
market for Pakistani wheat?
4-11. Consider the diagram below, which depicts the labor market in a city that has adopted a
“living wage law” requiring employers to pay a minimum wage rate of $11 per hour. Answer
the questions that follow.
a. What condition exists in this city’s labor market at the present minimum wage of
$11 per hour? How many people are unemployed at this wage?
b. A city councilwoman has proposed amending the living wage law. She suggests reducing
the minimum wage to $9 per hour. Assuming that the labor demand and supply curves
were to remain in their present positions, how many people would be unemployed at a
new $9 minimum wage?
c. A councilman has offered a counterproposal. In his view, the current minimum wage is
too low and should be increased to $12 per hour. Assuming that the labor demand and
supply curves remain in their present positions, how many people would be unemployed
at a new $12 minimum wage?
4-12. A city has decided to impose rent controls, and it has established a rent ceiling below the
previous equilibrium rental rate for offices throughout the city. How will the quantity of
offices leased by building owners change?
4-13. In 2013, the government of a nation established a price support for wheat. The government’s
support price has been above the equilibrium price each year since, and the government has
purchased all wheat over and above the amounts that consumers have bought at the support
price. Every year since 2013, there has been an increase in the number of wheat producers in
the market. No other factors affecting the market for wheat have changed. Predict what has
happened every year since 2013, to each of the following:
a. Amount of wheat supplied by wheat producers
b. Amount of wheat demanded by all wheat consumers
c. Amount of wheat purchased by the government
4-14. In advance of the recent increase in the U.S. minimum wage rate, the government of the state
of Arizona decided to boost its own minimum wage by an additional $1.60 per hour. This
pushed the wage rate earned by Arizona teenagers above the equilibrium wage rate in the
teen labor market. What is the predicted effect of this action by Arizona’s government on
each of the following?
a. The quantity of labor supplied by Arizona teenagers
b. The quantity of labor demanded by employers of Arizona teenagers
c. The number of unemployed Arizona teenagers
4-15. Consider Figure 4-1. The current demand and supply curves are D1 and S1, at which the
equilibrium price and quantity are P1 and Q1. If there is a decrease in the price of an item that
consumers regard as a substitute for this good, which curve shifts, and in which direction does
it shift? What happens to the market clearing price and to the equilibrium quantity?
4-16. Consider Figure 4-1. The current demand and supply curves are D1 and S1, at which the
equilibrium price and quantity are P1 and Q1. If firms adopt an improved technique for
producing this goods, which curve shifts, and in which direction does it shift? What happens
to the market clearing price and to the equilibrium quantity?
4-17. Consider Figure 4-3. Suppose that the government reduces the ceiling price to $500 per unit.
Would the shortage at the $500-per-unit ceiling price be greater than at the $600-per-unit
price ceiling?
4-18. Suppose that in Figure 4-4, the government raises the floor price of milk above the displayed
$0.10-per-pound floor price, to $0.12 per pound. Will the excess quantity of milk supplied
increase or decrease as a consequence?
4-19. Suppose that in Figure 4-4, the government reduces the floor price of milk below the
displayed $0.10-per-pound floor price, to $0.08 per pound. Will the excess quantity of milk
supplied increase or decrease as a consequence?
4-20. Suppose that Figure 4-5 applies to the labor market in the state of Ohio, in which Wm is the
minimum wage established by the federal government, and Qs – Qd therefore is Ohio’s excess
quantity of labor supplied as a result of the federal wage minimum. What would happen to
Ohio’s excess quantity of labor supplied if the state were to decide to establish its own
minimum wage at a level above the federal minimum?
◼ Selected References
Barzel, Yoram, “A Theory of Rationing by Waiting,” Journal of Law and Economics, April 1974,
pp. 73–95.