Lectures in Economics 6

Lectures following Rüdiger Dornbusch’ works (6)


We illustrate the use of supply and demand analysis with an application that concerns tastes, the Pope, and the price of fish.5 Up to 1966 Catholics were not allowed to eat meat on Fridays, and they tended to eat fish. In 1966 the Pope allowed Catholics to eat meat on Fridays. What happened to the price of fish? This section draws on an interesting article by Frederick W. Bell, “The Pope and the Price of Fish,”American Economic Review; December 1968. You may want to refer to this article for some details.

FIGURE 3-7 EFFECTS OF A REDUCTION IN THE DEMAND FOR FISH. A change in habits reduces the demand for fish. At each price of fish the quantity demanded declines. The demand schedule shifts from DD to DD’. The excess supply of fish at the initial equilibrium price, Po, leads to a fall in price and a reduction in the quantity of fish supplied. The new equilibrium is at point E’, where the price has fallen to P, and Q, fish is consumed.

Figure 3-7 shows the now standard supply and demand curves. As a result of catholics being allowed to eat meat on Fridays the demand for fish falls. The demand shifts down to DD’, the equilibrium to E’, and the equilibrium price and quantity of fish fall. And that is in fact what happened.

Sometimes it is not possible to adjust price to equate the quantity demanded and the quantity supplied. This is the whenever there are price controls in a particular market.
Price controls are government rules or laws that forbid the adjustment of prices to clear markets.
Price controls may take the form of offer prices (minimum prices) or ceiling (maximum prices). We will see controls, for example, or other price measures affect the operation of markets. In p lar, we will see how they create a disequilibrium between quantities supplied and demanded, leaving shortages or excess supplies. Whenever price controls are in and therefore prices cannot be freely adjusted, we say that markets are not free.

Price ceilings are laws or rules introduced by the government in a particular field that make it illegal for sellers to charge more than a specified maximum price. Price ceilings are typically introduced by governments when a shortage in a market tends to raise prices. The higher prices reduce the living standard of those who buy the good. Price controls are frequently established for such goods as food and housing, for increases in the prices of these goods would have especially serious impact on the poor. These people cannot do without these goods, but they cannot pay higher prices for them. Price controls thus seem to be an attractive solution, but how do they work? In Figure 3-8 we look again at the fish market of Figure 3-2 and Table 3-1 and assume that the government has imposed a ceiling price of $2. Sellers are prohibited from selling fish at a price higher than $2.

At the ceiling price, the quantity demanded exceeds the quantity supplied. There is an excess demand for fish equal to the distance AB, or 20 million pounds. In the absence of controls, the price would rise, thereby reducing the quantity demanded and increasing the quantity supplied. In the presence of controls, however, demand is encouraged by the relatively low price, while supply is discouraged. Accordingly, there is an excess demand. The quantity of fish actually sold at the $2 price, shown by point A, is 10 million pounds. Thus the effect of the price control is to create a shortage. The price is held below the level that would clear the market.

Although a higher price would clearly hurt those consumers who can not obtain fish, it is also true that it would increase the quantity of fish supplied. Some of the consumers who now go without fish would be able to buy fish. Further, the existence of excess demand means that some form of rationing has to be used to allocate the available fish. The rationing rules themselves may be arbitrary. For instance, the sellers may make fish available to their old customers and keep new customers out, or perhaps everyone will get the same amount of fish but a reduced amount.
The effect of price controls in creating shortages is common all around the world. Many cities in the United States impose rent controls. These limit the rents landlords can charge. If the rent controls are very tough, not allowing the landlord to raise rents when the costs of maintaining the building go up, the building can be-
FIGURE 3-8 EFFECTS OF PRICE CONTROLS. The government imposes a ceiling price of $2. No seller is allowed to charge more than $2 per pound. At that price the quantity supplied is given by point A (10 million pounds), but the quantity demanded is 30 million pounds, as shown by point B. The distance AB represents the 20-million-pound excess demand for fish. The available fish must somehow be rationed.
come unprofitable. The costs of running it might be larger than the rents that are allowed. In such cases owners often abandon the buildings and let them deteriorate. The South Bronx, in New York City, is the scene of widespread abandonment of buildings. Tough rent controls lead to the disappearance of rental space and start hurting everybody. Milder rent controls-rent controls that allow rents to rise enough so that landlords can look after their property but not to a level that prevents a shortage of housing favor people who already have a low-rent apartment and hurt those who are seeking a place to live. Rent controls also reduce the incentives for building new houses.

Gasoline price controls were in effect in the United States at the time oil prices jumped in 1973. With the price of gasoline controlled and a reduction in the quantity of oil supplied by foreign producers, lines formed at gas stations. The gas stations were not open long hours, since there wasn’t much to sell anyway. Eventually gasoline prices were allowed to increase, and the shortage disappeared.
Another example illustrating the problem of disequilibrium prices – prices that create shortages or surpluses- is given in Figure 3-9. Here we look at the consequences of a floor price. The idea is that the price will be kept above a minimum, or floor, price of $5 so that producers will be guaranteed a certain level of profits on their sales. A floor price is typically introduced by the government or sometimes by an agreement between producers in order to raise the profitability of an industry.
Consider now how a floor price of $5 works. At the $5 price, the quantity demanded is Qo and the quantity supplied is Qs. There is an excess supply equal to Qs

FIGURE 3-9 A MARKET WITH A FLOOR PRICE. The government imposes a floor price of $5. At that price, the quantity supplied is given by point B on the supply curve and is equal to Qs. The quantity demanded at point A on the demand curve is equal to QD. The floor price leads to an excess supply and the need for the government to support the price by buying up the surpus, AB. minus QD, or the distance AB in Fi, Suppliers want to sell more than buyers want to buy. If the price were free the suppliers would cut the price.

Some other mechanisms may be found for allocating supplies and buyers.

One mechanism that is often used by the government is to buy up the excess supply. Thus the government establishes floor price and buys any amount that buyers will not buy. U.S. dairy product ports work this way. The U.S. government guarantees specific prices for those products and buys up excess supply of them. Every now and then the question arises of what to do with the stocks government has bought. At Christmas l U.S. government decided to dispose of million pounds of cheese that it had It disposed of the cheese by giving it to poor people.

The U.S. government is certainly the only government that has built up large stocks of agricultural products, particularly dairy products. The European Common Market countries have for years been buying dairy products at floor prices and then trying to figure out how to get rid of them all.

A key feature of our model of the market and of price determination is the assumption that buyers and sellers respond to prices. The demand and supply schedules that we have drawn show that a decline in price leads to an increase in the quantity demanded and a decrease in the quantity supplied. But is there evidence that buyers and sellers respond to prices2 Here are some striking examples.

Table 3-3 shows the behavior of the market for refined sugar in the period 1972-1979. From 1972-1973 to 1974 -1975 an increase in the world price of sugar doubled the price to U.S. consumers. Accordingly, the quantity demanded of sugar declined from 1972 to 1975.


In everyday talk we refer to an increase in demand; we do not make a distinction between shifts of the demand curve and movements along the demand curve. The accompanying figure shows that from point A on the demand curve DD there are two quite different “increases in demand” that are possible. One is an increase in the quantity demanded, moving along the demand curve from A to B. This increase in the quantity demanded results from consumer adjustment to a reduction in price.
But there is also the possibility of a shift in demand. The entire demand curve shifts to DD`. At the going price, Pa, the consumer initially purchases Qo, but a shift in demand now increases the quantity demanded to Q’ units. Such an adjustment represents the response to an increase in the price of substitute goods (increase in the demand for tea because of higher coffee prices), the response to an increase in income, or a change in tastes and habits.

The distinction between the two kinds of demand change must be kept in mind. The movement along the demand curve represents a consumer adjustment to changes in the market price. A shift in demand, by contrast, represents an adjustment to outside factors (other prices, income, tastes) and leads in turn to an adjustment in the equilibrium price.
The same distinction between movement along a schedule and a shift arises on the supply side. Sellers adjust to an increase in price by a movement along the supply schedule. But changes in factor prices, changes in technology, or other determinants of supply lead to shifts of the supply schedule.
A demand schedule is drawn for given prices of related goods, income, and tastes. Thus a decline in price, with other things being constant, will increase the quantity demanded. The same language applies to the supply side. An increase in price, with other things being constant, will increase the quantity supplied.