Chapter 4 Applications of Demand and Supply

The Personal Computer Market

In the 1960s, to speak of computers was to speak of IBM, the dominant maker of large mainframe computers used by business and government agencies. Then between 1976, when Apple Computer introduced its first desktop computer, and 1981, when IBM produced its first personal computers (PCs), the old world was turned upside down. In 1984, just 8.2% of U.S. households owned a personal computer. By 2007, Google estimates that 78% did. The tools of demand and supply tell the story from an economic perspective.

Technological change has been breathtakingly swift in the computer industry. Because personal computers have changed so dramatically in performance and in the range of the functions they perform, we shall speak of “quality-adjusted” personal computers. The price per unit of quality-adjusted desktop computers fell by about half every 50 months during the period 1976–1989. In the first half of the 1990s, those prices fell by half every 28 months. In the second half of the 1990s, the “halving time” fell to every 24 months.Ilkka Tuomi, “The Lives and Death of Moore’s Law.” http://www.firstmonday.org/issues/issue7_11/tuomi/index. First Monday (http://www.firstmonday.org) is a peer-reviewed journal on the Internet.

Consider another indicator of the phenomenal change in computers. Between 1993 and 1998, the Bureau of Labor Statistics estimates that central processing unit (CPU) speed rose 1,263%, system memory increased 1,500%, hard drive capacity soared by 3,700%, and monitor size went up 13%. It seems safe to say that the dizzying pace of change recorded in the 1990s has increased in this century. A “computer” today is not the same good as a “computer” even five years ago. To make them comparable, we must adjust for these changes in quality.

Initially, most personal computers were manufactured by Apple or Compaq; both companies were very profitable. The potential for profits attracted IBM and other firms to the industry. Unlike large mainframe computers, personal computer clones turned out to be fairly easy things to manufacture. As shown in Table 4.1 "Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States", the top five personal computer manufacturers produced only 48% of the personal computers sold in the world in 2005, and the largest manufacturer, Dell, sold only about 19% of the total in that year. This is a far cry from the more than 90% of the mainframe computer market that IBM once held. The market has become far more competitive.

Figure 4.1 "The Personal Computer Market" illustrates the changes that have occurred in the computer market. The horizontal axis shows the quantity of quality-adjusted personal computers. Thus, the quantity axis can be thought of as a unit of computing power. Similarly, the price axis shows the price per unit of computing power. The rapid increase in the number of firms, together with dramatic technological improvements, led to an increase in supply, shifting the supply curve in Figure 4.1 "The Personal Computer Market" to the right from S₁ to S₂.

Demand also shifted to the right from D₁ to D₂, as incomes rose and new uses for computers, from e-mail and social networking to Voice over Internet Protocol (VoIP) and Radio Frequency ID (RFID) tags (which allow wireless tracking of commercial shipments via desktop computers), altered the preferences of consumer and business users. Because we observe a fall in equilibrium price and an increase in equilibrium quantity, we conclude that the rightward shift in supply has outweighed the rightward shift in demand. The power of market forces has profoundly affected the way we live and work.

The Markets for Crude Oil and for Gasoline

The market for crude oil took a radical turn in 1973. The price per barrel of crude oil quadrupled in 1973 and 1974. Price remained high until the early 1980s but then fell back drastically and remained low for about two decades. In 2004, the price of oil began to move upward and by 2008 had reached $147 per barrel.

What caused the dramatic increase in gasoline and oil prices in 2008? It appeared to be increasing worldwide demand outpacing producers’ ability—or willingness—to increase production much. This increase in demand is illustrated in Figure 4.2 "The Increasing Demand for Crude Oil".

Higher oil prices also increase the cost of producing virtually every good or service, as at a minimum, the production of most goods requires transportation. These costs inevitably translate into higher prices for nearly all goods and services. Supply curves of the goods and services thus affected shift to the left, putting downward pressure on output and upward pressure on prices.

Graphically, the impact of higher gasoline prices on businesses that use gasoline is illustrated in Figure 4.3 "The Impact of Higher Gasoline Prices". Because higher gasoline prices increase the cost of doing business, they shift the supply curves for nearly all businesses to the left, putting upward pressure on prices and downward pressure on output. In the case shown here, the supply curve in a typical industry shifts from S₁ to S₂. This increases the equilibrium price from P₁ to P₂ and reduces the equilibrium quantity from Q₁ to Q₂.

Then, as the world economy slowed dramatically in the second half of 2008, the demand curve for oil shifted back to the left. By November 2008, the price per barrel had dropped back to below $60 per barrel. As gas prices also subsided, so did the threat of higher prices in other industries.

The Stock Market

The circular flow model suggests that capital, like other factors of production, is supplied by households to firms. Firms, in turn, pay income to those households for the use of their capital. Generally speaking, however, capital is actually owned by firms themselves. General Motors owns its assembly plants, and Wal-Mart owns its stores; these firms therefore own their capital. But firms, in turn, are owned by people—and those people, of course, live in households. It is through their ownership of firms that households own capital.

A firm may be owned by one individual (a sole proprietorshipA firm owned by one individual.), by several individuals (a partnershipA firm owned by several individuals.), or by shareholders who own stock in the firm (a corporationA firm owned by shareholders who own stock in the firm.). Although most firms in the United States are sole proprietorships or partnerships, the bulk of the nation’s total output (about 90%) is produced by corporations. Corporations also own most of the capital (machines, plants, buildings, and the like).

This section describes how the prices of shares of corporate stockShares in the ownership of a corporation., shares in the ownership of a corporation, are determined by the interaction of demand and supply. Ultimately, the same forces that determine the value of a firm’s stock determine the value of a sole proprietorship or partnership.

When a corporation needs funds to increase its capital or for other reasons, one means at its disposal is to issue new stock in the corporation. (Other means include borrowing funds or using past profits.) Once the new shares have been sold in what is called an initial public offering (IPO), the corporation receives no further funding as shares of its stock are bought and sold on the secondary market. The secondary market is the market for stocks that have been issued in the past, and the daily news reports about stock prices almost always refer to activity in the secondary market. Generally, the corporations whose shares are traded are not involved in these transactions.

The stock marketThe set of institutions in which shares of stock are bought and sold. is the set of institutions in which shares of stock are bought and sold. The New York Stock Exchange (NYSE) is one such institution. There are many others all over the world, such as the DAX in Germany and the Bolsa in Mexico. To buy or sell a share of stock, one places an order with a stockbroker who relays the order to one of the traders at the NYSE or at some other exchange.

The process through which shares of stock are bought and sold can seem chaotic. At many exchanges, traders with orders from customers who want to buy stock shout out the prices those customers are willing to pay. Traders with orders from customers who want to sell shout out offers of prices at which their customers are willing to sell. Some exchanges use electronic trading, but the principle is the same: if the price someone is willing to pay matches the price at which someone else is willing to sell, the trade is made. The most recent price at which a stock has traded is reported almost instantaneously throughout the world.

Figure 4.4 "Demand and Supply in the Stock Market" applies the model of demand and supply to the determination of stock prices. Suppose the demand curve for shares in Intel Corporation is given by D₁ and the supply by S₁. (Even though the total number of shares outstanding is fixed at any point in time, the supply curve is not vertical. Rather, the supply curve is upward sloping because it represents how many shares current owners are prepared to sell at each price, and that number will be greater at higher prices.) Suppose that these curves intersect at a price of $25, at which Q₁ shares are traded each day. If the price were higher, more shares would be offered for sale than would be demanded, and the price would quickly fall. If the price were lower, more shares would be demanded than would be supplied, and the price would quickly rise. In general, we can expect the prices of shares of stock to move quickly to their equilibrium levels.

The intersection of the demand and supply curves for shares of stock in a particular company determines the equilibrium price for a share of stock. But what determines the demand and supply for shares of a company’s stock?

The owner of a share of a company’s stock owns a share of the company, and, hence, a share of its profits; typically, a corporation will retain and reinvest some of its profits to increase its future profitability. The profits kept by a company are called retained earningsProfits kept by a company.. Profits distributed to shareholders are called dividendsProfits distributed to shareholders.. Because a share of stock gives its owner a claim on part of a company’s future profits, it follows that the expected level of future profits plays a role in determining the value of its stock.

Of course, those future profits cannot be known with certainty; investors can only predict what they might be, based on information about future demand for the company’s products, future costs of production, information about the soundness of a company’s management, and so on. Stock prices in the real world thus reflect estimates of a company’s profits projected into the future.

The downward slope of the demand curve suggests that at lower prices for the stock, more people calculate that the firm’s future earnings will justify the stock’s purchase. The upward slope of the supply curve tells us that as the price of the stock rises, more people conclude that the firm’s future earnings do not justify holding the stock and therefore offer to sell it. At the equilibrium price, the number of shares supplied by people who think holding the stock no longer makes sense just balances the number of shares demanded by people who think it does.

What factors, then, cause the demand or supply curves for shares of stocks to shift? The most important factor is a change in the expectations of a company’s future profits. Suppose Intel announces a new generation of computer chips that will lead to faster computers with larger memories. Current owners of Intel stock would adjust upward their estimates of what the value of a share of Intel stock should be. At the old equilibrium price of $25 fewer owners of Intel stock would be willing to sell. Since this would be true at every possible share price, the supply curve for Intel stock would shift to the left, as shown in Figure 4.5 "A Change in Expectations Affects the Price of Corporate Stock". Just as the expectation that a company will be more profitable shifts the supply curve for its stock to the left, that same change in expectations will cause more people to want to purchase the stock, shifting the demand curve to the right. In Figure 4.5 "A Change in Expectations Affects the Price of Corporate Stock", we see the supply curve shifting to the left, from S₁ to S₂, while the demand curve shifts to the right, from D₁ to D₂.

Other factors may alter the price of an individual corporation’s share of stock or the level of stock prices in general. For example, demographic change and rising incomes have affected the demand for stocks in recent years. For example, with a large proportion of the U.S. population nearing retirement age and beginning to think about and plan for their lives during retirement, the demand for stocks has risen.

Information on the economy as a whole is also likely to affect stock prices. If the economy overall is doing well and people expect that to continue, they may become more optimistic about how profitable companies will be in general, and thus the prices of stocks will rise. Conversely, expectations of a sluggish economy, as happened in the fall of 2008, could cause stock prices in general to fall.

The stock market is bombarded with new information every minute of every day. Firms announce their profits of the previous quarter. They announce that they plan to move into a new product line or sell their goods in another country. We learn that the price of Company A’s good, which is a substitute for one sold by Company B, has risen. We learn that countries sign trade agreements, launch wars, or make peace. All of this information may affect stock prices because any information can affect how buyers and sellers value companies.

Agricultural Price Floors

Governments often seek to assist farmers by setting price floors in agricultural markets. A minimum allowable price set above the equilibrium price is a price floorA minimum allowable price set above the equilibrium price.. With a price floor, the government forbids a price below the minimum. (Notice that, if the price floor were for whatever reason set below the equilibrium price, it would be irrelevant to the determination of the price in the market since nothing would prohibit the price from rising to equilibrium.) A price floor that is set above the equilibrium price creates a surplus.

Figure 4.8 "Price Floors in Wheat Markets" shows the market for wheat. Suppose the government sets the price of wheat at P_F. Notice that P_F is above the equilibrium price of P_E. At P_F, we read over to the demand curve to find that the quantity of wheat that buyers will be willing and able to purchase is W₁ bushels. Reading over to the supply curve, we find that sellers will offer W₂ bushels of wheat at the price floor of P_F. Because P_F is above the equilibrium price, there is a surplus of wheat equal to (W₂ − W₁) bushels. The surplus persists because the government does not allow the price to fall.

Why have many governments around the world set price floors in agricultural markets? Farming has changed dramatically over the past two centuries. Technological improvements in the form of new equipment, fertilizers, pesticides, and new varieties of crops have led to dramatic increases in crop output per acre. Worldwide production capacity has expanded markedly. As we have learned, technological improvements cause the supply curve to shift to the right, reducing the price of food. While such price reductions have been celebrated in computer markets, farmers have successfully lobbied for government programs aimed at keeping their prices from falling.

While the supply curve for agricultural goods has shifted to the right, the demand has increased with rising population and with rising income. But as incomes rise, people spend a smaller and smaller fraction of their incomes on food. While the demand for food has increased, that increase has not been nearly as great as the increase in supply. Figure 4.9 "Supply and Demand Shifts for Agricultural Products" shows that the supply curve has shifted much farther to the right, from S₁ to S₂, than the demand curve has, from D₁ to D₂. As a result, equilibrium quantity has risen dramatically, from Q₁ to Q₂, and equilibrium price has fallen, from P₁ to P₂.

On top of this long-term historical trend in agriculture, agricultural prices are subject to wide swings over shorter periods. Droughts or freezes can sharply reduce supplies of particular crops, causing sudden increases in prices. Demand for agricultural goods of one country can suddenly dry up if the government of another country imposes trade restrictions against its products, and prices can fall. Such dramatic shifts in prices and quantities make incomes of farmers unstable.

The Great Depression of the 1930s led to a major federal role in agriculture. The Depression affected the entire economy, but it hit farmers particularly hard. Prices received by farmers plunged nearly two-thirds from 1930 to 1933. Many farmers had a tough time keeping up mortgage payments. By 1932, more than half of all farm loans were in default.

Farm legislation passed during the Great Depression has been modified many times, but the federal government has continued its direct involvement in agricultural markets. This has meant a variety of government programs that guarantee a minimum price for some types of agricultural products. These programs have been accompanied by government purchases of any surplus, by requirements to restrict acreage in order to limit those surpluses, by crop or production restrictions, and the like.

To see how such policies work, look back at Figure 4.8 "Price Floors in Wheat Markets". At P_F, W₂ bushels of wheat will be supplied. With that much wheat on the market, there is market pressure on the price of wheat to fall. To prevent price from falling, the government buys the surplus of (W₂ - W₁) bushels of wheat, so that only W₁ bushels are actually available to private consumers for purchase on the market. The government can store the surpluses or find special uses for them. For example, surpluses generated in the United States have been shipped to developing countries as grants-in-aid or distributed to local school lunch programs. As a variation on this program, the government can require farmers who want to participate in the price support program to reduce acreage in order to limit the size of the surpluses.

After 1973, the government stopped buying the surpluses (with some exceptions) and simply guaranteed farmers a “target price.” If the average market price for a crop fell below the crop’s target price, the government paid the difference. If, for example, a crop had a market price of $3 per unit and a target price of $4 per unit, the government would give farmers a payment of $1 for each unit sold. Farmers would thus receive the market price of $3 plus a government payment of $1 per unit. For farmers to receive these payments, they had to agree to remove acres from production and to comply with certain conservation provisions. These restrictions sought to reduce the size of the surplus generated by the target price, which acted as a kind of price floor.

What are the effects of such farm support programs? The intention is to boost and stabilize farm incomes. But, with price floors, consumers pay more for food than they would otherwise, and governments spend heavily to finance the programs. With the target price approach, consumers pay less, but government financing of the program continues. U.S. federal spending for agriculture averaged well over $22 billion per year between 2003 and 2007, roughly $70 per person.

Help to farmers has sometimes been justified on the grounds that it boosts incomes of “small” farmers. However, since farm aid has generally been allotted on the basis of how much farms produce rather than on a per-farm basis, most federal farm support has gone to the largest farms. If the goal is to eliminate poverty among farmers, farm aid could be redesigned to supplement the incomes of small or poor farmers rather than to undermine the functioning of agricultural markets.

In 1996, the U.S. Congress passed the Federal Agriculture Improvement and Reform Act of 1996, or FAIR. The thrust of the new legislation was to do away with the various programs of price support for most crops and hence provide incentives for farmers to respond to market price signals. To protect farmers through a transition period, the act provided for continued payments that were scheduled to decline over a seven-year period. However, with prices for many crops falling in 1998, the U.S. Congress passed an emergency aid package that increased payments to farmers. In 2008, as farm prices reached record highs, Congress passed a farm bill that increased subsidy payments to $40 billion. It did, however, for the first time limit payments to the wealthiest farmers. Individual farmers whose farm incomes exceed $750,000 (or $1.5 million for couples) would be ineligible for some subsidy programs.

Rental Price Ceilings

The purpose of rent control is to make rental units cheaper for tenants than they would otherwise be. Unlike agricultural price controls, rent control in the United States has been largely a local phenomenon, although there were national rent controls in effect during World War II. Currently, about 200 cities and counties have some type of rent control provisions, and about 10% of rental units in the United States are now subject to price controls. New York City’s rent control program, which began in 1943, is among the oldest in the country. Many other cities in the United States adopted some form of rent control in the 1970s. Rent controls have been pervasive in Europe since World War I, and many large cities in poorer countries have also adopted rent controls.

Rent controls in different cities differ in terms of their flexibility. Some cities allow rent increases for specified reasons, such as to make improvements in apartments or to allow rents to keep pace with price increases elsewhere in the economy. Often, rental housing constructed after the imposition of the rent control ordinances is exempted. Apartments that are vacated may also be decontrolled. For simplicity, the model presented here assumes that apartment rents are controlled at a price that does not change.

Figure 4.10 "Effect of a Price Ceiling on the Market for Apartments" shows the market for rental apartments. Notice that the demand and supply curves are drawn to look like all the other demand and supply curves you have encountered so far in this text: the demand curve is downward-sloping and the supply curve is upward-sloping.

The demand curve shows that a higher price (rent) reduces the quantity of apartments demanded. For example, with higher rents, more young people will choose to live at home with their parents. With lower rents, more will choose to live in apartments. Higher rents may encourage more apartment sharing; lower rents would induce more people to live alone.

The supply curve is drawn to show that as rent increases, property owners will be encouraged to offer more apartments to rent. Even though an aerial photograph of a city would show apartments to be fixed at a point in time, owners of those properties will decide how many to rent depending on the amount of rent they anticipate. Higher rents may also induce some homeowners to rent out apartment space. In addition, renting out apartments implies a certain level of service to renters, so that low rents may lead some property owners to keep some apartments vacant.

Rent control is an example of a price ceilingA maximum allowable price., a maximum allowable price. With a price ceiling, the government forbids a price above the maximum. A price ceiling that is set below the equilibrium price creates a shortage that will persist.

Suppose the government sets the price of an apartment at P_C in Figure 4.10 "Effect of a Price Ceiling on the Market for Apartments". Notice that P_C is below the equilibrium price of P_E. At P_C, we read over to the supply curve to find that sellers are willing to offer A₁ apartments. Reading over to the demand curve, we find that consumers would like to rent A₂ apartments at the price ceiling of P_C. Because P_C is below the equilibrium price, there is a shortage of apartments equal to (A₂ - A₁). (Notice that if the price ceiling were set above the equilibrium price it would have no effect on the market since the law would not prohibit the price from settling at an equilibrium price that is lower than the price ceiling.)

If rent control creates a shortage of apartments, why do some citizens nonetheless clamor for rent control and why do governments often give in to the demands? The reason generally given for rent control is to keep apartments affordable for low- and middle-income tenants.

But the reduced quantity of apartments supplied must be rationed in some way, since, at the price ceiling, the quantity demanded would exceed the quantity supplied. Current occupants may be reluctant to leave their dwellings because finding other apartments will be difficult. As apartments do become available, there will be a line of potential renters waiting to fill them, any of whom is willing to pay the controlled price of P_C or more. In fact, reading up to the demand curve in Figure 4.11 "The Unintended Consequences of Rent Control" from A₁ apartments, the quantity available at P_C, you can see that for A₁ apartments, there are potential renters willing and able to pay P_B. This often leads to various “backdoor” payments to apartment owners, such as large security deposits, payments for things renters may not want (such as furniture), so-called “key” payments (“The monthly rent is $500 and the key price is $3,000”), or simple bribes.

In the end, rent controls and other price ceilings often end up hurting some of the people they are intended to help. Many people will have trouble finding apartments to rent. Ironically, some of those who do find apartments may actually end up paying more than they would have paid in the absence of rent control. And many of the people that the rent controls do help (primarily current occupants, regardless of their income, and those lucky enough to find apartments) are not those they are intended to help (the poor). There are also costs in government administration and enforcement.

Because New York City has the longest history of rent controls of any city in the United States, its program has been widely studied. There is general agreement that the rent control program has reduced tenant mobility, led to a substantial gap between rents on controlled and uncontrolled units, and favored long-term residents at the expense of newcomers to the city.Richard Arnott, “Time for Revisionism on Rent Control,” Journal of Economic Perspectives 9(1) (Winter, 1995): 99–120. These distortions have grown over time, another frequent consequence of price controls.

A more direct means of helping poor tenants, one that would avoid interfering with the functioning of the market, would be to subsidize their incomes. As with price floors, interfering with the market mechanism may solve one problem, but it creates many others at the same time.

The Demand and Supply for Health Care

When we speak of “health care,” we are speaking of the entire health-care industry. This industry produces services ranging from heart transplant operations to therapeutic massages; it produces goods ranging from X-ray machines to aspirin tablets. Clearly each of these goods and services is exchanged in a particular market. To assess the market forces affecting health care, we will focus first on just one of these markets: the market for physician office visits. When you go to the doctor, you are part of the demand for these visits. Your doctor, by seeing you, is part of the supply.

Figure 4.15 "Total Spending for Physician Office Visits" shows the market, assuming that it operates in a fashion similar to other markets. The demand curve D₁ and the supply curve S₁ intersect at point E, with an equilibrium price of $30 per office visit. The equilibrium quantity of office visits per week is 1,000,000.

We can use the demand and supply graph to show total spending, which equals the price per unit (in this case, $30 per visit) times the quantity consumed (in this case, 1,000,000 visits per week). Total spending for physician office visits thus equals $30,000,000 per week ($30 times 1,000,000 visits). We show total spending as the area of a rectangle bounded by the price and the quantity. It is the shaded region in Figure 4.15 "Total Spending for Physician Office Visits".

The picture in Figure 4.15 "Total Spending for Physician Office Visits" misses a crucial feature of the market. Most people in the United States have health insurance, provided either by private firms, by private purchases, or by the government. With health insurance, people agree to pay a fixed amount to the insurer in exchange for the insurer’s agreement to pay for most of the health-care expenses they incur. While insurance plans differ in their specific provisions, let us suppose that all individuals have plans that require them to pay $10 for an office visit; the insurance company will pay the rest.

How will this insurance affect the market for physician office visits? If it costs only $10 for a visit instead of $30, people will visit their doctors more often. The quantity of office visits demanded will increase. In Figure 4.16 "Total Spending for Physician Office Visits Covered by Insurance", this is shown as a movement along the demand curve. Think about your own choices. When you get a cold, do you go to the doctor? Probably not, if it is a minor cold. But if you feel like you are dying, or wish you were, you probably head for the doctor. Clearly, there are lots of colds in between these two extremes. Whether you drag yourself to the doctor will depend on the severity of your cold and what you will pay for a visit. At a lower price, you are more likely to go to the doctor; at a higher price, you are less likely to go.

In the case shown, the quantity of office visits rises to 1,500,000 per week. But that suggests a potential problem. The quantity of visits supplied at a price of $30 per visit was 1,000,000. According to supply curve S₁, it will take a price of $50 per visit to increase the quantity supplied to 1,500,000 visits (Point F on S₁). But consumers—patients—pay only $10.

Insurers make up the difference between the fees doctors receive and the price patients pay. In our example, insurers pay $40 per visit of insured patients to supplement the $10 that patients pay. When an agent other than the seller or the buyer pays part of the price of a good or service, we say that the agent is a third-party payerAn agent other than the seller or the buyer who pays part of the price of a good or service..

Notice how the presence of a third-party payer affects total spending on office visits. When people paid for their own visits, and the price equaled $30 per visit, total spending equaled $30 million per week. Now doctors receive $50 per visit and provide 1,500,000 visits per week. Total spending has risen to $75 million per week ($50 times 1,500,000 visits, shown by the darkly shaded region plus the lightly shaded region).

The response described in Figure 4.16 "Total Spending for Physician Office Visits Covered by Insurance" holds for many different types of goods and services covered by insurance or otherwise paid for by third-party payers. For example, the availability of scholarships and subsidized tuition at public and private universities increases the quantity of education demanded and the total expenditures on higher education. In markets with third-party payers, an equilibrium is achieved, but it is not at the intersection of the demand and supply curves. The effect of third-party payers is to decrease the price that consumers directly pay for the goods and services they consume and to increase the price that suppliers receive. Consumers use more than they would in the absence of third-party payers, and providers are encouraged to supply more than they otherwise would. The result is increased total spending.