Demand and Supply

This is Unit Two of Principles of Microeconomics, part two of two: what a market gains when it clears, what a control moves and what it destroys, and two chains worked to the end. Carry one idea. A market that reaches equilibrium leaves no wanted trade undone. Hold the price away from it and two things happen at once: some gain moves from one side to the other, and some gain vanishes. Part one built the model; this part measures it. By the end you will be able to say what a floor does in a grain market and in a labor market. To define consumer, producer and social surplus and compute them from straight-line curves. To tell a transfer from a deadweight loss and measure the loss under a ceiling or a floor. To state what a price does for a society, the two conditions under which equilibrium is efficient, and why efficiency is not fairness. And to work a rent ceiling and a drought to the end.

Two entries on the floors governments use most: a crop price support, and the minimum wage.

The most common floor.

MIC 0126 Agricultural Price Supports

A price support holds a crop's price above equilibrium: farmers grow more, buyers take less, and the government buys the surplus or pays farmers to leave land idle. Stored grain, school-lunch donations and acreage limits are all ways to absorb the surplus. Consumers pay twice, a higher price at the store and taxes to fund the purchase.

A floor in a factor market.

MIC 0127 The Minimum Wage as a Floor

A minimum wage is a price floor in the labor market. Above the equilibrium wage the model predicts more workers offered than hired: a labor surplus, which is unemployment. The diagram is the grain market with labor hours along the bottom. The effect's size is contested, and unit three states both sides' evidence; the model gives a direction, not a number.

Four entries on what a market gains: what buyers get, what sellers get, the two together, and measuring both.

What buyers gain from a market.

MIC 0128 Consumer Surplus

Consumer surplus is the gap between what a buyer would have paid and the price paid, summed over every unit: the area below the demand curve and above the price. A buyer willing to pay ninety who pays eighty gains ten dollars. The marginal buyer, willing to pay exactly the price, gains nothing; surplus belongs to buyers who would have paid more.

What sellers gain.

MIC 0129 Producer Surplus

Producer surplus is the gap between the price received and the least the seller would have accepted, summed over every unit: the area above the supply curve and below the price. A seller who would have taken forty-five and gets eighty gains thirty-five. Producer surplus is not profit: it counts price above marginal cost, unit by unit, and ignores fixed costs.

The two surpluses together.

MIC 0130 Social Surplus and Efficiency

Social surplus is consumer surplus plus producer surplus. It is largest at the equilibrium quantity, so a market that reaches it is efficient: every trade both sides wanted has happened. At equilibrium, neither surplus can grow without the other shrinking. Efficient means nothing is left on the table, not that the split is fair, a question this part returns to.

Measuring both areas.

MIC 0131 Computing Surplus from Linear Curves

With straight-line demand and supply, each surplus is a triangle, half of base times height. Consumer surplus runs from the equilibrium price up to the demand intercept over the equilibrium quantity; producer surplus from the supply intercept up to the price over the same quantity. Add the two for social surplus. Demand meets the price axis at fifty dollars and supply at ten, and the market clears at thirty dollars and forty units: consumer surplus is one half times forty times twenty, four hundred dollars; producer surplus is the same, four hundred; social surplus is eight hundred. Height is a price gap; using the whole intercept counts the money buyers paid as if it were surplus.

Five entries on loss: what it is, transfer against loss, measuring it under a ceiling and a floor, and who ends up where.

What is lost when the quantity is wrong.

MIC 0132 Deadweight Loss

Deadweight loss is the social surplus that disappears when a market trades less than the equilibrium quantity, or more: the wanted trades that did not happen. On the diagram it is the triangle between the curves from the restricted quantity to equilibrium. It is not a transfer: money moved from sellers to buyers still exists; the loss is value nobody receives.

Telling the two apart.

MIC 0133 Transfer or Deadweight Loss

A control does two things to surplus: part moves from one side to the other, a transfer, and part vanishes, a deadweight loss, and only the second costs society. Under a ceiling a rectangle passes from sellers to buyers and two triangles vanish. The side that gains the transfer favors the control: buyers back ceilings, sellers back floors, and both overlook the triangles.

Measuring the loss from a ceiling.

MIC 0134 Deadweight Loss from a Ceiling

For a binding ceiling, first read the quantity supplied at the ceiling price. Second, find the price buyers would have paid for that last unit. Third, the deadweight loss is the triangle between the two curves: half the lost quantity times the gap at the restricted quantity. A medicine clears at sixty dollars and twenty thousand doses; a ceiling of forty cuts the quantity supplied to fifteen thousand, where buyers would have paid eighty. The gap is forty dollars, the lost quantity five thousand, and the loss is one half times five thousand times forty, one hundred thousand dollars. Use the quantity supplied, not demanded, since wanting does not create doses, and measure the gap at the restricted quantity, where it is widest.

The same for a floor.

MIC 0135 Deadweight Loss from a Floor

A binding floor mirrors the ceiling. First read the quantity demanded at the floor price. Second, find the lowest price sellers would have accepted for that last unit. Third, the loss is the triangle between the curves: half the lost quantity times the vertical gap at the restricted quantity. Cinema tickets clear at eight dollars and eighteen hundred a night; a floor of twelve cuts the quantity demanded to fourteen hundred, where sellers would have accepted six. The gap is six dollars, the lost quantity four hundred, and the loss is half of four hundred times six, twelve hundred dollars a night. Use the quantity demanded this time; and the transfer runs the other way, a rectangle of consumer surplus moving to sellers.

Who ends up where.

MIC 0136 Who Gains and Who Loses from a Control

Split each side into those still trading and those shut out. Under a ceiling, buyers who still get the good gain the price cut; buyers who no longer get it lose their surplus; sellers lose the price cut and the surplus on lost units. The transfer is a wash for society, and the two lost-surplus triangles are the deadweight loss. In the medicine market fifteen thousand buyers gain twenty dollars each, three hundred thousand transferred from sellers; sellers also lose their surplus on the five thousand doses no longer sold, and shut-out buyers lose theirs, which add to the hundred-thousand loss. A control looks like a pure win only when the shut-out traders are left out; whether the transfer is worth the loss is normative.

Four entries on what a price does, what the curves measure, when equilibrium is efficient, and what efficiency leaves out.

What a price does for a society.

MIC 0137 Prices Carry Information

A price is a signal. When a frost cuts the coffee crop, the higher price tells every buyer to economize and every grower to plant, with no one issuing instructions; seasonal produce prices move diets every year without a committee. Markets answer what, how and for whom through prices, and blocking the price with a control also blocks the information it carried.

What the two curves measure.

MIC 0138 Demand as Marginal Benefit, Supply as Marginal Cost

Demand curve height is marginal benefit, the most a buyer would pay for that unit; supply curve height is marginal cost, the least a seller takes. At equilibrium the last unit's benefit equals its cost, unit one's rule. Hence efficiency: left of equilibrium, units worth more than they cost go unmade; right of it, units worth less than they cost get made.

The conditions the result depends on.

MIC 0139 The Efficiency Condition

Equilibrium is efficient under two conditions: a competitive market, with no one able to set the price, and exclusive, transferable property rights, so every cost and benefit lands on a trader. A grocer who could not stop shoplifters would stock nothing. Units eight through twelve are where a condition fails: one seller, or a cost falling on people outside the trade.

The question efficiency does not answer.

MIC 0140 Efficiency Is Not Equity

Demand reflects ability to pay, so markets serve higher incomes more. Any income distribution yields an efficient allocation, and whether it is fair is normative, which the model cannot settle. Give one household all the income and the market serves it efficiently. The questions are separate: a society can prefer another distribution and still want it allocated efficiently, since waste helps no one.

Two capstones: a rent ceiling followed to the end, and a drought that settles which curve moves.

A control worked to the end.

MIC 0141 Why a Binding Ceiling Can Leave Buyers Worse Off

A ceiling is passed to help buyers, and the diagram shows why it can fail them as a group. Set below equilibrium, it lowers the price for buyers who still get the good, the visible gain. Then the quantity supplied falls, so fewer buyers get anything; the shortage rations by waiting, favoritism or back-door payments; and quality erodes. The buyers who keep the good gain a rectangle transferred from sellers; the buyers who lose it lose a triangle of surplus, and so do the sellers of those units, and that pair of triangles is the deadweight loss. A city's rental market clears at twelve hundred dollars with twenty thousand units let. A ceiling of nine hundred cuts the units offered to sixteen thousand while twenty-four thousand households want one. Sixteen thousand tenants pay three hundred less, four million eight hundred thousand a month transferred from landlords; four thousand households that would have rented find nothing, and a four-thousand-dollar key fee on a one-year lease is more than the old rent. Ten years on, conversions have taken the units to thirteen thousand and the shortage has grown from eight thousand to eleven thousand. The visible gain is real, the invisible losers are the newcomers the policy was meant to help, and none of this says a ceiling is always wrong; it says the loss must be counted.

The error the model catches most.

MIC 0142 The Drought Chain: Which Curve Moves, Which Does Not

One chain settles the distinction the model rests on. A drought strikes the pea crop. Step one: a natural condition is a supply shifter, so supply shifts left. Step two: at the old price there is a shortage, so the price rises. Step three: the higher price moves buyers up along the demand curve; quantity demanded falls, and the demand curve has not moved. The new equilibrium has a higher price and a lower quantity. Three errors follow. Shifting demand left because fewer peas are available, which predicts a lower price for a crop that has halved. Shifting supply right because the higher price attracts sellers, which confuses a movement along the new curve with a shift of it. And shifting supply left again because higher prices cut sales, which runs causation backward. The test is always the same: did the event change what one side would do at each and every price? Before the drought peas clear at two dollars and one hundred thousand pounds a week; the drought halves what growers offer at every price, the price climbs to three dollars, buyers take seventy thousand pounds along their unchanged curve, and growers on the reduced curve manage seventy thousand. Sales fell, and demand did not; those are different sentences, and the second is the one the exam grades.

Look at what you can now do. You can say what a floor does: a grain support makes a surplus the government must absorb, and a minimum wage makes a labor surplus, with the size of that effect contested. You can define consumer, producer and social surplus as areas between the curves and the price, and compute each as half of base times height. You can tell a transfer, a rectangle that moves, from a deadweight loss, the triangles that vanish, and measure the loss under a ceiling from the quantity supplied and under a floor from the quantity demanded. You can say what a price does, carry information, and state the two conditions for efficiency, competition and property rights, while keeping efficiency apart from fairness. And you can follow a rent ceiling to the newcomers it shuts out, and a drought to the curve that never moved. Unit three takes the same model into the markets for labor and for capital.