Demand, Supply, and Markets

This is Unit Two of Principles of Macroeconomics, part two of two. Part one closed on telling a binding price control from a harmless one. This part asks what a binding one actually does, and then finds the same diagram in two more markets. Carry the unit's idea to its payoff. One diagram serves every market in this course, and a control never removes the pressure in a market, it relocates it. The last entry of the unit names that outright, and the capstone before it shows where the pressure goes when a rent is capped. By the end you will be able to say who gains, who loses and what is destroyed when a control binds. To explain why a binding ceiling can leave the buyers it was written for worse off. To tell a transfer from a deadweight loss. To work out which curve moved in the market for loanable funds. And to compute a bond's interest rate from its price.

Three entries on controls at work: a ceiling on rents, a floor under wages, and a floor under farm prices.

A ceiling in the housing market.

MAC 0123 Rent Control

Rent control caps rents to keep housing affordable. Where it binds, fewer units are offered than at the market rent, some leave the rental market, and maintenance is cut, so quality falls. Long-standing tenants gain, while people looking for a first apartment queue. Studies of long-running programs find reduced mobility and a widening gap between controlled and uncontrolled rents.

A floor in the labor market.

MAC 0124 The Minimum Wage

The minimum wage is a price floor in the labor market, and a binding floor produces a surplus of labor, meaning unemployment among the workers it covers. At the floor, more people want work at that wage than employers want to hire. The size of that effect is contested: some studies find a small reduction in hiring, others none.

A floor in farming.

MAC 0125 Agricultural Price Supports

Governments have long set floors under farm prices. Because the floor creates a surplus, the government has often bought the surplus itself, stored it, or paid farmers to plant less. Farmers gain a higher and steadier price, while taxpayers and food buyers pay for it. Support paid in proportion to output goes mostly to the largest producers, whatever the stated purpose.

One entry, the unit's first capstone: what a binding ceiling does to the people it was written to help.

Who a price ceiling really helps.

MAC 0126 Why a Binding Ceiling Can Leave Buyers Worse Off

A price ceiling is meant to help buyers, and it does help some of them: everyone who gets the good at the capped price pays less than they would have. But the cap changes neither how much sellers will offer at that price nor how much buyers want. It forbids the price from moving, so the shortage it creates is permanent rather than temporary. The good must still be rationed among more willing buyers than there are units, and when price cannot do the rationing, something else does: queues, waiting lists, luck, personal connection, or how long someone has already held the good. None of those favours the buyers who need it most, and none of them is free, because time spent queueing buys nothing. And since willing buyers remain who would gladly pay more, payments reappear in forms the law does not reach. Cap rents below the market level in a city: the tenants already in place pay less and stay longer, so fewer apartments come free each year, and owners facing more applicants than units can demand a large deposit, a payment for furniture the tenant does not want, or a fee for the key. A newcomer paying the capped rent plus a three thousand dollar key payment may pay more in total than the uncapped rent would have been, while maintenance is cut because the units let regardless. Three cautions. This is an argument about a binding ceiling, not about whether housing should be affordable: subsidising renters' incomes pursues the same goal and leaves the price signal working. The losers are not only sellers, because the buyers who never find a unit lose outright, and they are usually the newcomers and the poor rather than the sitting tenants the policy names. And a control suppresses the signal without changing the underlying demand and supply, so the pressure does not disappear, it reappears somewhere the law is not looking.

Four entries on measuring what a market creates, what a control destroys, and what a price does when it is left alone.

Measuring what each side gains.

MAC 0127 Consumer and Producer Surplus

Consumer surplus is what a buyer would have paid minus what they did pay, and producer surplus is the price received minus the least the seller would accept. Someone willing to pay thirty dollars who pays twenty gains ten. Their sum is social surplus, and it is largest at the equilibrium quantity.

What a control destroys.

MAC 0128 Deadweight Loss

Deadweight loss is the social surplus destroyed when a market trades a quantity other than the equilibrium one, because trades both sides wanted are blocked. A binding control moves some surplus from one side to the other and destroys the rest. The transfer and the loss are different things: the transfer changes who gains, while the loss belongs to nobody.

Sorting winners from losers.

MAC 0129 Who Gains and Who Loses from a Control

A binding control has three effects, and keeping them apart is the whole skill. First a transfer: a ceiling moves surplus from sellers to the buyers who still get the good, and a floor moves it from buyers to the sellers who still sell. Second an exclusion: the quantity traded falls, so some buyers and some sellers who would have traded do not, and they lose entirely. Third a deadweight loss: the surplus those blocked trades would have created is destroyed and goes to no one. Under a binding ceiling, buyers who obtain the good at the capped price gain, sellers who still sell receive less and lose, buyers who wanted it and cannot find it gain nothing at all, and the sellers of units no longer produced also lose. Total surplus falls, so the gains to the first group are smaller than the losses to everyone else. The trap is to treat a control as costless because someone visibly gains. Ask each time who is excluded, since those people are absent from the market and easy to overlook, and they are usually the ones the policy was written for.

What prices do when left alone.

MAC 0130 Prices Carry Information

A price gathers and transmits information about scarcity, and buyers and sellers respond to it correctly without needing to know why it moved. A price rise tells every buyer to economise and every seller to produce more, with no announcement. A control suppresses that message without changing what caused it, which is why economists describe it as killing the messenger.

Four entries taking the same diagram to two more markets: the market for work, and the market for borrowing.

The same model applied to work.

MAC 0131 The Labor Market

In the labor market households supply and employers demand, and the wage is the price. Above the equilibrium wage there is a surplus of labor; below it, a shortage. Labor demand is derived demand: it depends on demand for what the labor produces, so cooks are hired because meals are bought.

The same model applied to borrowing.

MAC 0132 The Loanable Funds Market

In the loanable funds market, savers supply and borrowers demand, and the interest rate is the price. A higher rate raises the quantity supplied and lowers the quantity demanded. Households, firms, governments and foreigners appear on both sides. The exam calls this the loanable funds market and the anchor calls it the market for financial capital, and they are the same diagram.

What moves each side.

MAC 0133 What Shifts Saving and Borrowing

Supply shifts with saving decisions, income and the return available elsewhere. Demand shifts with confidence about future returns and the ability to repay. A collapse in business confidence shifts the demand for funds left. Foreign savers are part of domestic supply, so a loss of their confidence shifts supply left and raises the rate.

Working a change through it.

MAC 0134 Loanable Funds: Which Curve Shifts

Use the same routine as any market, with saving as supply and borrowing as demand. Ask whether the event changes how much people wish to save at each rate, which moves supply, or how much they wish to borrow at each rate, which moves demand. Then read the result: supply right lowers the rate and raises the quantity of funds, supply left raises the rate and lowers the quantity, demand right raises both, and demand left lowers both. Households deciding to save more of their income at every rate is supply shifting right, so the real interest rate falls and the quantity rises. Firms turning pessimistic and cutting planned investment is demand shifting left, so the rate falls again, but this time the quantity falls too. Both cases lower the rate, so the rate alone does not identify which curve moved. The quantity does: it rises when supply moves right and falls when demand moves left. Check both every time.

Three entries on bonds and on a ceiling in the credit market: how price and rate move against each other, how to compute one, and what a cap on lending does.

Borrowing seen from the other side.

MAC 0135 Bond Prices and Interest Rates

A bond promises to repay a fixed amount at a set date, and its interest rate is the gap between face value and price, so a lower price means a higher rate. Selling more bonds pushes their price down and the rate up. The bond diagram plots price where the loanable funds diagram plots the rate, so the two move opposite ways.

Computing the rate.

MAC 0136 Computing a Bond's Interest Rate

For a bond making a single payment at maturity, the interest rate is the face value minus the price, divided by the price, times one hundred. Take the face value, which is what the issuer must repay. Subtract the price actually paid, which gives the amount earned for lending. Divide by the price, because the price is what was lent. Multiply by a hundred to express it as a percentage. The face value stays fixed, so every fall in the price raises the rate, and not in a straight line: the rate climbs faster as the price falls further. A bond repaying one thousand dollars in a year, bought for nine hundred and fifty, earns fifty on nine hundred and fifty, about five and three tenths percent. Bought for nine hundred, it earns a hundred on nine hundred, about eleven and one tenth percent. Bought for eight hundred, two hundred on eight hundred, which is twenty-five percent. Divide by the price and not by the face value: dividing the fifty by one thousand gives five percent rather than five and three tenths, and the error grows as the discount grows.

A ceiling in the credit market.

MAC 0137 Usury Laws as a Price Ceiling

A usury law caps the interest rate a lender may charge, which is a price ceiling in the credit market, and where it binds it creates a shortage of credit. Lenders ration by refusing the riskiest applicants rather than by charging them more. Most caps sit above market rates and do nothing, which is the non-binding case again.

One entry to close the unit: what the three markets have in common, and the two things this model cannot do.

What the three markets share.

MAC 0138 One Model, Three Markets

Here the unit's governing idea is at work. This unit has drawn the same diagram three times. In the market for goods the price is a price, in the labor market it is a wage, and in the loanable funds market it is an interest rate, but the structure never changes: demand sloping down, supply sloping up, an equilibrium where the two quantities are equal, a surplus above it and a shortage below it, and shifters that move whole curves while the good's own price only moves you along one. The price controls behave identically too. A binding ceiling sits below equilibrium and makes a shortage, whether it caps a rent, a wage that employers may pay, or an interest rate a lender may charge. A binding floor sits above equilibrium and makes a surplus, whether it props up a crop price or a wage. And in every case the control leaves the underlying demand and supply untouched, which is why the pressure reappears in queues, in waiting lists, in side payments, or in unsold stock the government must buy. Three events, one routine: savers deciding to save more shifts the supply of funds right, so the rate falls and the quantity rises; a drought shifts a crop's supply left, so its price rises and the quantity falls; a minimum wage set above the equilibrium wage is a binding floor, so a surplus of labor appears. Two cautions carry into the rest of the course. The model tells you the direction of a change and not its size, and when two shifts pull a variable opposite ways it tells you nothing at all about that variable. And it is a model of one market at a time, holding everything else unchanged: the macroeconomics that begins in unit three asks what happens when every market moves at once, and the answer is not this diagram repeated.

Look at what you can now do. You can say who gains, who loses and what is destroyed when a control binds: a transfer, an exclusion, and a deadweight loss that goes to no one. You can explain why a binding ceiling can leave the buyers it names worse off, because rationing moves from price to queues and to payments the law does not reach. You can tell a transfer from a deadweight loss, since one changes who gains while the other belongs to nobody. You can work out which curve moved in the market for loanable funds by reading the quantity, because the rate alone cannot tell you. And you can compute a bond's interest rate by dividing what is earned by the price paid, never by the face value. Unit three turns to measuring the whole economy's output.