CHAPTER

Working with Supply

and Demand

PowerPoint Slides
Slides prepared
prepared by:
by:
PowerPoint
Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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Government Intervention in Markets

Governments
Sometimes intervene to change the
market outcome
Fight the market
Prevent the price from reaching equilibrium

value
Price ceilings
Price floors

Manipulate markets
Changing the equilibrium itself
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Fighting the Market: Price Ceilings

Price ceiling
Government-imposed maximum price in a
market

Short side of the market

The smaller of quantity supplied and
quantity demanded at a particular price

When QD and QS differ

The short side of the market will prevail

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Fighting the Market: Price Ceilings

Shortage
Excess demand not eliminated by a rise in
price
Q D > QS

Price ceiling: creates a shortage

Increases the time and trouble required to
buy the good
Price decreases
Opportunity cost may rise
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Figure 1
A Price Ceiling in the Market for Maple Syrup
Price per
Bottle

3. and increases quantity

demanded, creating a
shortage equal to the
distance between R and V.

$4.00
E

3.00
R

2.00
D
40,000 50,000 60,000
1. A price ceiling lower than
the equilibrium price

Number of Bottles
of Maple Syrup

2. decreases
quantity supplied

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Fighting the Market: Price Ceilings

Black market
A market in which goods are sold illegally
at a price above the legal ceiling
Price: above equilibrium price

Unintended consequences of price

ceilings
Long lines
Black markets
Often higher prices
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Figure 2
A Price Ceiling with a Black Market
Price per
Bottle

S
3. will sell for a price
even higher than the
equilibrium price.

T
$4.00
E

3.00

V
2.00

R
D
40,000 50,000

1. With a price ceiling lower

than the equilibrium price and a
black market...

Number of Bottles
of Maple Syrup

2. the lower quantity

supplied...

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Fighting the Market: Price Ceilings

Rent control
Price ceiling imposed in a rental housing
market
Government-imposed maximum rents on
apartments and homes
Purpose: to keep housing affordable
Especially for those with low incomes

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Fighting the Market: Price Ceilings

Problems with rent control
It doesnt target those with low incomes
Luck

Persistent excess demand

Wasted time

Black market
Rent: higher than rent-controlled price

Decrease in the quantity of apartments

supplied
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Fighting the Market: Price Floors

Price floor
Government-imposed minimum price in a
market
Purpose: to help sellers

Price floors for agricultural goods

Price support programs
United States Department of Agriculture
Programs to maintain high prices for cotton,

wheat, rice, corn, tobacco, honey, milk,

cheese, butter, peanuts, sugar, dairy products
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10

Fighting the Market: Price Floors

Surplus
Excess supply not eliminated by a fall in
price
QS > QD

Price floor
Surplus of a good
Temptation: to sell the surplus below the
price floor
Government: purchases the surplus
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11

Figure 3
A Price Floor in the Market for Nonfat Dry Milk
Price per
Pound

1. A price floor higher than

the equilibrium price

3. and increases
quantity supplied.
S

$0.80
E

0.65

4. The result is a surplus

the distance between
K and J.

180
2. Decreases quantity
demanded

200 220

Millions of
Pounds

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12

Fighting the Market: Price Floors

Government: limit any excess supplies
Dairy market: control the production and
sale
Government: ordered or paid farmers not
to grow crops on portions of their land
Imposed strict limits on imports of food
from abroad

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13

Fighting the Market: Price Floors

Critics
Government spends too much money
buying surplus agricultural products
Higher prices distort the publics buying
and eating habits
Assistance: support all farmers
Many farmers are wealthy individuals or

powerful corporations
More cost-effective if given directly to those
truly in need
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14

Manipulating the Market: Taxes

Excise tax
A tax on a specific good or service
Can be collected from either sellers or
buyers

Tax incidence
The division of a tax payment between
buyers and sellers
Determined by comparing the new (after
tax) and old (pretax) market equilibriums
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15

Manipulating the Market: Taxes

Tax shifting
Some/all of a tax imposed on one side of a
market
Ends up being paid by the other side of the
market

Excise tax on sellers

Shifts the supply curve upward by the
amount of the tax
Incidence: both sides of the market
Buyers pay more and sellers receive less
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16

Figure 4
A Tax on Sellers Shifts the Supply Curve Upward
Price per
Gallon

S After Tax
A

$3.60

3.00

S1

400

Millions of
Gallons per Day

After a $0.60 per gallon tax is imposed on sellers, the price at which any given quantity
would be supplied is $0.60 greater than before, so the supply curve shifts upward. For
example, before the tax, 400 million gallons would be supplied at $3 per gallon (point A);
after the tax, to get that same quantity supplied requires a price of $3.60 (point A).
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17

Figure 5
The Effect of an Excise Tax Imposed on Sellers
Price per
Gallon
Buyers pay
this price to
sellers.

S After Tax
B

S1

$3.40
A

3.00
Sellers get this
price (after
paying tax).

2.80
D
300

400

Millions of
Gallons per Day

After a $0.60 excise tax is imposed on sellers, the market equilibrium moves from point A
to point B, with buyers paying sellers $3.40 per gallon. But sellers get only $3.40 $0.60
= $2.80 after paying the tax. Thus, the tax causes buyers to pay $0.40 more per gallon,
and sellers to get $0.20 less than before.
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18

Manipulating the Market: Taxes

Excise tax on buyers
Shifts the demand curve downward by the
amount of the tax
Tax incidence both sides of the market
Buyers pay more

Sellers receive less

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19

Figure 6
A Tax on Buyers Shifts the Demand Curve Downward
Price per
Gallon
A
$3.00

2.40

D1
D After Tax
400

Millions of
Gallons per Day

After a $0.60 per gallon tax is imposed on buyers, the price at which any given quantity
would be demanded is $0.60 less than before, so the demand curve shifts downward. For
example, before the tax, 400 million gallons would be demanded at $3 per gallon (point
A); after the tax, that same quantity would be demanded at a price of $2.40 (point A).
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20

Figure 7
The Effect of an Excise Tax Imposed on Buyers
Price per
Gallon

Buyers pay
this price
(including tax).
Sellers get
this price
from buyers.

$3.40
A
3.00
C

2.80

D1
D After Tax
300

400

Millions of
Gallons per Day

After a $0.60 excise tax is imposed on buyers, the market equilibrium moves from point A
to point C, with buyers paying sellers $2.80 per gallon. But buyers pay a total of $2.80 +
$0.60 = $3.40 per gallon when the tax is included. Thus, the tax causes buyers to pay
$0.40 more, and sellers to get $0.20 less, just as when the tax is imposed on sellers.
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21

Manipulating the Market: Taxes

Tax incidence
Distribution of tax burden between buyers
and sellers

Tax incidence vs. tax collection

The tax incidence is the same whether the
tax is collected from buyers or sellers

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22

Manipulating the Market: Subsidies

Subsidy
A government payment to buyers or
sellers on each unit purchased or sold
Medical care for the poor and elderly
Energy-saving equipment

Smoking-cessation programs
College education

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23

Manipulating the Market: Subsidies

Subsidy to buyers
Shifts the demand curve upward by the
amount of the subsidy
Benefits both sides of a market
Buyers pay less

Sellers receive more for each unit sold

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24

Figure 8
A Subsidy for Students Attending College
Price per
Year
Colleges get
this price

S
B

$31,000
A

25,000
D After Subsidy

21,000
Students pay this
price (after
deducting subsidy)

D1
4 million 4.8 million

Number of Students
Attending College

After a $10,000 subsidy is given to college students, the market equilibrium moves from point
A to point B, with students paying colleges $31,000 per year. But students pay a total of
$31,000 $10,000 = $21,000 when their subsidy is deducted. Thus, the subsidy causes
students to pay $4,000 less per year, and it causes colleges to get $6,000 more per year.
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25

Manipulating the Market: Subsidies

Subsidy to sellers
Shifts the supply curve downward by the
amount of the subsidy
Benefits both sides of a market
Buyers pay less

Sellers receive more for each unit sold

Distribution of benefits from a subsidy

Are the same, regardless of whether the
subsidy is paid to buyers or sellers
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26

Supply and Demand in Housing Markets

Stock variable
Measures a quantity in existence at a
moment in time
Housing stock: number of homes that people

own at a given time

Flow variable
Measures a process that takes place over
a period of time
New home construction
New home purchases
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27

Supply and Demand in Housing Markets

Housing markets
Newly constructed homes and previously
owned homes are very close substitutes

The stock approach: demand and supply

Supply of housing: housing stock
Demand for housing stock

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28

Supply and Demand in Housing Markets

Supply curve for housing
Total number of homes in a market that
are available for ownership
Vertical line
Housing stock at any point in time is fixed

Number of homes that were built in the past

and still suitable for ownership

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29

Figure 9
The Supply Curve in a Housing Market
Price per
Home

Supply

Price per
Home

$200,000

$200,000

$150,000

$150,000

$100,000

$100,000

600,000

Number
of Homes

S1

600,000

S2

800,000

Number
of Homes

In panel (a), the supply curve tells us the number of homes (600,000) that exist at a
particular time. It is a vertical line because the housing stock at any time does not depend
on the price. Panel (b) shows the impact of building 200,000 new homes over the year.
The housing stock rises to 800,000 so the supply curve shifts rightward, from S1 to S2 .
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30

Supply and Demand in Housing Markets

Shifts vs. movements along the supply
curve
Movement along: when the price of homes
changes
Shift: changes in the housing stock

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31

Supply and Demand in Housing Markets

Demand curve for housing
Total number of homes that everyone in
the market would like to own
At each price
Given the constraints that they face
Slopes downward

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32

Supply and Demand in Housing Markets

Home ownership
An alternative to renting

Monthly cost of owning a home

Maintenance, property taxes, interest

Monthly costs for prospective owners

Foregone monthly interest
Mortgage and interest
Higher home prices
Higher cost of ownership
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33

Supply and Demand in Housing Markets

Mortgage
Loan given to a homebuyer
Part of the purchase price of the home

Monthly costs for current owners

Foregone interest
Higher home prices
Higher cost of ownership

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34

Supply and Demand in Housing Markets

Ownership Costs
Interest cost of ownership
Both current and prospective homeowners

This cost rises when current home prices

rise, and falls when current home prices
fall

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35

Figure 10
The Demand Curve in a Housing Market (a)
Price per
Home
A

$200,000
B
$150,000

Demand
C

$100,000

D1
300,000 600,000 900,000 Number of Homes
In panel (a), the demand curve tells usat each pricethe number of people who would
like to own homes. It slopes downward because a decrease in the average selling price of
a home lowers the ongoing interest cost of home ownership, increasing the number of
people who want to own.
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36

Figure 10
The Demand Curve in a Housing Market (b)
Price per
Home

$150,000

D1
600,000

D2

800,000

Number of Homes
In panel (b), tastes change in favor of home ownership. More people would like to own at
each price, so the demand curve shifts rightward from D1 to D2.
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37

Supply and Demand in Housing Markets

Shift vs. movement along the demand
curve
Movement along: change in price, other
things constant
Shift: changes in
Monthly cost of renting a home
Interest rates in the economy
Tastes for homeownership
Average income
Population
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38

Housing Market Equilibrium

Equilibrium
Intersection of demand and supply

The equilibrium price in a housing market

The price at which the quantity of homes
demanded and quantity supplied are equal

Quantity of homes demanded

Number of homes that people want to own

Quantity of homes supplied

Housing stock
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39

Figure 11
Equilibrium in a Housing Market
Supply

Price per
Home
A
$200,000
$150,000

B
C

$100,000
Demand

The equilibrium in this

market is at point B, where
the price of homes is
$150,000. If the price were
highersay $200,000 the
number of homes people
want to own (300,000 at
point A) would be less than
the number in existence and
currently owned (600,000).
Owners would try to sell,
and the price would fall until
all 600,000 homes were
demanded.

300,000 600,000 900,000

Number of Homes
If the price were lower than the equilibrium pricesay $100,000the number of homes
people want to own (900,000 at point C) would be greater than the number in existence and
currently owned (600,000). People would try to buy homes, and the price would rise until only
600,000 were demanded.
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40

What Happens when Things Change

Over time
Supply curve shifts rightward
As the housing stock rises (new homes are

built)

Demand curve shifts rightward

Population growth, rising incomes

Market equilibrium will move rightward

Home prices: relative shifts in the supply and

demand curves

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41

What Happens when Things Change

Equal changes in supply and demand
Housing stock grows at the same rate as
housing demand
Housing prices: unchanged
A stable housing market

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42

Figure 12
A Stable Housing Market
Price
per
Home

$150,000

S1

S2

D2

D1
600,000

610,000

Number of Homes

When the supply of homes increases at the same rate as demand for them, the equilibrium
price remains unchanged. In the figure, the rightward shift in the supply curve (from S1 to S2) is
equal to the rightward shift in the demand curve (from D1 to D2). Equilibrium moves from point B
to point E, but the price remains at $150,000.
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43

What Happens when Things Change

Restrictions on new building
Slow increase in supply
Housing stock grows slower than the
demand
Rapidly rising prices

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44

Figure 13
A Housing Market with Restricted Supply Growth
Price
per
Home
$200,000

$150,000

S1

S2

G
F

D2

D1
600,000

603,000

610,000

Number of Homes

When supply is restricted, and cannot increase as fast as demand, housing prices rise. In
the figure, the rightward shift in the supply curve (from S1 to S2) is less than the rightward
shift in the demand curve (from D1 to D2). Equilibrium moves from point B to point G, and
the price rises from $150,000 to $200,000.
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45

What Happens when Things Change

Faster demand growth
Due to
Population shifts
Sudden influx of new residents
Rapid income growth
Booming industry in the area
Change in expectations about future prices

Rapidly rising prices

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46

What Happens when Things Change

House: an asset
One of the most leveraged financial
investments

Leverage
Magnifies the impact of a price change on
the rate of return you will get from an asset

Capital gain
Gain to the owner of an asset
When it is sold for a price higher than its

original purchase price

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47

What Happens when Things Change

Capital loss
Loss to the owner of an asset
When it is sold for a price lower than its

original purchase price

Faster demand growth

The housing stock typically lags behind,
and housing prices rise

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48

Figure 14
Accelerating Demand Growth
Price per
Home

S2

S1

$185,000

$150,000

D2

D1
600,000 610,000

Number of Homes

When demand begins to increase faster than previously, increases in supply usually lag
behind. In the figure, the rightward shift in the supply curve (from S1 to S2) is less than the
rightward shift in the demand curve (from D1 to D2'). Equilibrium moves from point B to
point J, with the price rising from $150,000 to $185,000.
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49

The Housing Boom and Bust

19972011
Housing price index
Index measure of inflation-adjusted U.S.
housing prices

1997 2006
Housing price index almost doubled
Bubble

Mid-2006
Falling housing prices
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50

Figure 15
Index of Home Prices, Adjusted for Inflation

After adjusting for price changes from general inflation, the housing boom began in 1997, and
home prices increased ever more rapidly until 2006. That marked the beginning of the housing
bust, with prices dropping dramatically for several years.
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51

The Housing Boom

1997-2006: accelerated demand growth
Supply increased, but it lagged behind
Result: a surge in housing prices

Causes for rapidly rising demand

Economic growth
Low interest rates
The Fed
Global financial forces

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52

The Housing Boom

Causes for rapidly rising demand
Government policy: encouraged home
ownership
Mortgage interest payments: deducted from

taxable income
Increased funding available for mortgage
lending
Higher capital gains exclusions on home sales

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53

The Housing Boom

Causes for rapidly rising demand
Financial innovations
More-attractive terms for borrowers (ARM)
Securitization: made mortgage-lending more

attractive
Mortgage-backed securities

Deteriorating lending standards

Subprime loans
Declining down-payments

Speculation
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54

Figure 16
The Housing Boom in Las Vegas
Median
Home Price

S2003

$324,000
$179,000

S2006

A
D2006

D2003
Q1

Q2

Number of
Homes

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

55

The Housing Bust

Mid-2006: a sudden drop in demand
Oil and gasoline prices spiked
Many new homeowners were struggling to

make ends meet

Interest rates on a large group of

adjustable rate mortgages reset to higher
levels
Disturbing rise in defaults
Subprime mortgages with no down payments

Prospect of higher default rates

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56

The Housing Bust

Mid-2006: a sudden drop in demand
Interest rates on new mortgages rose
Demand curve for housing shifted leftward
Housing prices fell

Speculation
Demand curve shifted further leftward
Housing prices fell even more rapidly

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57

Figure 17
The Housing Bust in Las Vegas
Median
Home
Price

S2006

S2008

$324,000

$178,000

D2006
D2008
Q2

Q3

Number of
Homes

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58

The Long Housing Slump

End of 2008 through 2011
The U.S. economy suffered the aftermath
of an unusually severe recession
High unemployment and declining
incomes
Millions of homeowners struggling to pay their

monthly mortgage bills

More mortgage defaults

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59

The Long Housing Slump

End of 2008 through 2011
Financial institutions foreclosed on close to
3 million homes
Several million additional homes had received

legal notices
Shifted the demand curve for housing further
to the left

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60

The Long Housing Slump

U.S. home prices stabilized a bit in 2009
and early 2010
Making Home Affordable Program
Incentives for banks and homeowners to

renegotiate mortgage agreements and

prevent foreclosures

Additional tax benefits to new home

buyers
Temporary effect at best
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61

The Long Housing Slump

2010
Home prices resumed their downward
trajectory

By mid-2011
Average U.S. home price (adjusted for
inflation) had fallen to 40% of its peak five
years earlier

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62

Understanding Leverage

Without leverage
10% higher housing prices
10% capital gains

10% lower housing prices

10% capital loses

Leverage
Magnification of gains and losses through
borrowing

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63

Understanding Leverage

Leveraged financial investment

Using borrowed money to buy a home
10% higher housing prices
More than 10% capital gains

10% lower housing prices

More than 10% capital loses

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64

Understanding Leverage

An owners equity in an asset

Difference between the assets value and
any unpaid debts on the asset
Equity in Asset = Value of asset - Debt
associated with asset

Simple leverage ratio

Ratio of an assets value to the owners
equity in the asset

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65

Figure A.1
Leveraged Buying and Selling

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66

Understanding Leverage

Simple leverage ratio = Rate-of-return

multiplier
Rate of return on the (leveraged)
investment
Rate of change in a homes price
Times the leverage ratio

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67

Understanding Leverage

When asset prices rise

Leverage increases your rate of return
dramatically

When asset prices fall

Leverage increases the chance of wiping
out your entire investment

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68