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The Law of Supply and Demand
Restraining the Market Mechanism: Price Ceilings
DEMAND AND QUANTITY DEMANDED Case Study: Rent Controls in New York City
The Demand Schedule Restraining the Market Mechanism: Price Floors
The Demand Curve Case Study: Farm Price Supports and the Case of
Shifts of the Demand Curve Sugar Prices
A Can of Worms
The Supply Schedule and the Supply Curve
Application: Who Really Pays That Tax?
Shifts of the Supply Curve

This chapter, like much of the rest of this book, uses many graphs like those described in the appendix to Chapter 1.

If you have difficulties with these graphs, we suggest that you review that material before proceeding.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 1
56 Getting Acquainted with Economics

Since 1949, the dollars of purchasing power that a buyer had to pay to buy a
barrel of oil had remained remarkably steady, and gasoline had generally
remained a bargain. But
during two exceptional
time periods”one from
about 1975 through 1985
and one beginning in 2003”oil
prices exploded, and filling up
the automobile gas tank became
painful to consumers. Clearly, sup-
ply and demand changes must
have been behind these develop-

SOURCE: © AP Images/Paul Sakuma
ments. But what led them to
change so much and so suddenly?
Later in the chapter, we will pro-
vide excerpts from a newspaper
story about how dramatic and un-
expected events can suddenly
shift supply and will help to bring
the analysis of this chapter to life.

Adam Smith, the father of modern economic analysis, greatly admired the price system.
He marveled at its accomplishments”both as an efficient producer of goods and as a
guarantor that consumers™ preferences are obeyed. Although many people since Smith™s
time have shared his enthusiasm for the concept of the invisible hand, many have not.
Invisible hand is a phrase
used by Adam Smith to Smith™s contemporaries in the American colonies, for example, were often unhappy with
describe how, by pursuing the prices produced by free markets and thought they could do better by legislative
their own self-interests, decree. Such attempts failed, as explained in the accompanying box “Price Controls at
people in a market system
Valley Forge.” In countless other instances, the public was outraged by the prices
are “led by an invisible
charged on the open market, particularly in the case of housing rents, interest rates, and
hand” to promote the well-
insurance rates.
being of the community.
Attempts to control interest rates (which are the price of borrowing money) go back
hundreds of years before the birth of Christ, at least to the code of laws compiled under
the Babylonian king Hammurabi in about 1800 B.C. Our historical legacy also includes
a rather long list of price ceilings on foods and other products imposed in the reign of
Diocletian, emperor of the declining Roman Empire. More recently, Americans have
been offered the “protection” of a variety of price controls. Laws have placed ceilings
on some prices (such as rents) to protect buyers, whereas legislation has placed floors
under other prices (such as farm products) to protect sellers. Yet, somehow, everything
such regulation touches seems to end up in even greater disarray than it was before. De-
spite rent controls, rents in New York City have soared. Despite laws against “scalping,”
tickets for popular shows and sports events sell at tremendous premiums”tickets to
the Super Bowl, for example, often fetch thousands of dollars on the “gray” market. To
understand what goes wrong when we tamper with markets, we must first learn how
they operate unfettered. This chapter takes a first step in that direction by studying the
machinery of supply and demand. Then, at the end of the chapter, we return to the is-
sue of price controls.
Every market has both buyers and sellers. We begin our analysis on the consumers™
side of the market.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 4 57
Supply and Demand: An Initial Look

Price Controls at Valley Forge
George Washington, the history books tell us, was beset by many en-

SOURCE: Engraving “Men Gathering Wood at Valley Forge. “

Munn, 1924 [24.90.1828]. All Rights Reserved, The Met-
emies during the winter of 1777“1778, including the British, their

Metropolitan Museum of Art, bequest of Charles Allen
Hessian mercenaries, and the merciless winter weather. But he had
another enemy that the history books ignore”an enemy that meant
well but almost destroyed his army at Valley Forge. As the following
excerpt explains, that enemy was the Pennsylvania legislature:
In Pennsylvania, where the main force of Washington™s army was
quartered . . . the legislature . . . decided to try a period of price

ropolitan Museum of Art.
control limited to those commodities needed for use by the
army. . . . The result might have been anticipated by those with
some knowledge of the trials and tribulations of other states. The
prices of uncontrolled goods, mostly imported, rose to record
heights. Most farmers kept back their produce, refusing to sell at
what they regarded as an unfair price. Some who had large fam-
ilies to take care of even secretly sold their food to the British,
the purposes proposed, but likewise productive of very evil con-
who paid in gold.
sequences . . . resolved, that it be recommended to the several
After the disastrous winter at Valley Forge when Washing-
states to repeal or suspend all laws or resolutions within the
ton™s army nearly starved to death (thanks largely to these well-
said states respectively limiting, regulating or restraining the
intentioned but misdirected laws), the ill-fated experiment in
Price of any Article, Manufacture or Commodity.”
price controls was finally ended. The Continental Congress on
June 4, 1778, adopted the following resolution:
SOURCE: Robert L. Schuettinger and Eamonn F. Butler, Forty Centuries of Wage and
“Whereas . . . it hath been found by experience that limita- Price Controls (Washington, DC: Heritage Foundation, 1979), p. 41. Reprinted by
tions upon the prices of commodities are not only ineffectual for permission.

People commonly think of consumer demands as fixed amounts. For example, when
product designers propose a new computer model, management asks: “What is its mar-
ket potential?” That is, just how many are likely to be sold? Similarly, government bureaus
conduct studies to determine how many engineers or doctors the United States will re-
quire (demand) in subsequent years.
Economists respond that such questions are not well posed”that there is no single an-
swer to such a question. Rather, they say, the “market potential” for computers or the
number of engineers that will be “required” depends on a great number of influences, in-
cluding the price charged for each.
The quantity demanded of any product normally depends on its price. Quantity de- The quantity demanded
is the number of units of a
manded also depends on a number of other determinants, including population size,
good that consumers are
consumer incomes, tastes, and the prices of other products.
willing and can afford to
Because prices play a central role in a market economy, we begin our study of demand buy over a specified period
by focusing on how quantity demanded depends on price. A little later, we will bring the of time.
other determinants of quantity demanded back into the picture. For now, we will consider
all influences other than price to be fixed. This assumption, often expressed as “other
things being equal,” is used in much of economic analysis. As an example of the relation-
ship between price and demand, let™s think about the quantity of beef demanded. If the
price of beef is very high, its “market potential” may be very small. People will find ways
to get along with less beef, perhaps by switching to pork or fish. If the price of beef de-
clines, people will tend to eat more beef. They may serve it more frequently or eat larger
portions or switch away from fish. Thus:
There is no one demand figure for beef, or for computers, or for engineers. Rather, there is a
different quantity demanded at each possible price, all other influences being held constant.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 1
58 Getting Acquainted with Economics

The Demand Schedule
Table 1 shows how such information for beef can be recorded TA BL E 1
in a demand schedule. It indicates how much beef con-
A demand schedule is a
Demand Schedule for Beef
table showing how the sumers in a particular area are willing and able to buy at dif-
Price Quantity Label in
quantity demanded of some ferent possible prices during a specified period of time, other
per Pound Demanded Figure 1
product during a specified
things held equal. Specifically, the table shows the quantity
period of time changes as
of beef that will be demanded in a year at each possible price A
$7.50 45
the price of that product
7.40 50
ranging from $6.90 to $7.50 per pound. At a relatively low
changes, holding all other
7.30 55
price, such as $7.00 per pound, customers wish to purchase
determinants of quantity
7.20 60
70 (million) pounds per year. But if the price were to rise
demanded constant. F
7.10 65
to, say, $7.40 per pound, quantity demanded would fall to G
7.00 70
A demand curve is a
50 million pounds. H
6.90 75
graphical depiction of a
Common sense tells us why this happens. First, as prices NOTE: Quantity is in pounds per year.
demand schedule. It
rise, some customers will reduce the quantity of beef they
shows how the quantity
consume. Second, higher prices will induce some customers to drop out of the market
demanded of some product
will change as the price of entirely”for example, by switching to pork or fish. On both counts, quantity demanded
that product changes will decline as the price rises.
during a specified period of
As the price of an item rises, the quantity demanded normally falls. As the price falls,
time, holding all other
the quantity demanded normally rises, all other things held constant.
determinants of quantity
demanded constant.

The Demand Curve
F I GU R E 1
The information contained in Table 1 can be sum-
Demand Curve for Beef
marized in a graph like Figure 1, which is called
a demand curve. Each point in the graph corre-
sponds to a line in the table. This curve shows
the relationship between price and quantity de-


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