2 CHAPTER OUTLINE
2.1 Supply and Demand
2.2 The Market Mechanism
2.3 Changes in Market Equilibrium
Chapter 2 Supply and Demand
2.4 Elasticities of Supply and Demand
2.5 Short-Run versus Long-Run Elasticities
2.6 Understanding and Predicting the Effects of
Changing Market Conditions
2.7 Effects of Government InterventionPrice Controls
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N.B
SUPPLY AND DEMAND
14.30
Chapter 2 Supply and Demand
p, $ per kg
The Demand Curve
Demand curve for pork, D1
Law of Demand
consumers demand more
of a good the lower its
price, holding constant all
other factors that
influence consumption
3.30
2.30
4.30
0
200 220 240
286
Q, Million kg of pork per year
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A Shift of the
Demand Curve
N.B
Chapter 2 Supply and Demand
p, $ per kg
The Demand Curve
Effect of a 60 increase in the price of beef
3.30
D2
D1
0
176
220
232
Q, Million kg of pork per year
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N.B
SUPPLY AND DEMAND
The Demand function
The processed pork demand function is:
Chapter 2 Supply and Demand
Q = D(p, pb, pc, I)
where Q is the quantity of pork demanded
p is the price of pork (dollars per kg)
pb is the price of beef (dollars per kg)
pc is the price of chicken (dollars per kg)
I is the income of consumers (thousand
dollars)
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N.B
SUPPLY AND DEMAND
From the demand function to the demand curve
Estimated demand function for pork:
Chapter 2 Supply and Demand
Q = 17120p + 20pb + 3pc + 2I
Using the values pb = 4, pc = 3.33 and I =
12.5, we have
Q = 28620p
which is the linear demand function for pork.
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N.B
SUPPLY AND DEMAND
Q = 28620p
14.30
Chapter 2 Supply and Demand
p, $ per kg
From the demand function to the demand curve
Demand cur ve for pork, D1
If p =ecreases by!$1
In pgeneral, thenby
IfIfIf p3.30 then,
d $ ncreases
p i = 0, !
Q = 220!$2.30) then,!
(to1 (to $4.30)
Q = -20 p !
Q $ 286
=
Q = 240
then,!
Q = 200
4.30
3.30
2.30
0
200 220 240
286
Q, Million kg of pork per year
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N.B
SUPPLY AND DEMAND
PROBLEM
Chapter 2 Supply and Demand
How much would the price have to fall for
consumers to be willing to buy 1 million
more kg of pork per year?
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N.B
SUPPLY AND DEMAND
1. Express the price that consumers are
willing to pay as a function of quantity.
Chapter 2 Supply and Demand
Q = 28620p
20p = 286 - Q
p = 14.30 0.05Q
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N.B
SUPPLY AND DEMAND
Chapter 2 Supply and Demand
2. Use the inverse demand curve to determine
how much the price must change for
consumers to buy 1 million more kg of pork
per year.
p = p2 p1
= (14.30 0.05Q2) (14.30 0.05Q1)
= 0.05(Q2 Q1)
= 0.05Q.
The change in quantity is Q = Q2 Q1 = (Q1 +
1)Q1 = 1, so the change in price is p = 0.05.
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N.B
SUPPLY AND DEMAND
Chapter 2 Supply and Demand
The slope of the demand curve is p/Q, the
rise (the change along the vertical axis) divided
by the run (change along the horizontal axis)
slope =p/Q = $1 per Kg / -20 million kg per year =
= - $0.05 per million kg per year
The negative sign of the slope is consistent with the
Law of Demand. The slope says that the price rises
by $1 per kg as the quantity demanded falls by 20
million kg per year. Turning that statement around:
the quantity demanded falls by 20 million kg per
year as the price rises by $1 per kg.
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N.B
SUPPLY AND DEMAND
p, $ per kg
The supply curve
An increase in the price
5.30
rv
, S
Supply cu
e
1
Chapter 2 Supply and Demand
3.30
causes a movement
along the curve.
0
176
220
and an increase in the
quantity supplied.
300
Q, Million kg of por
per
year
k
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N.B
SUPPLY AND DEMAND
p, $ per kg
Shift of the supply curve
A $0.25 increase in
the price of hogs..
shifts the supply
curve to the left
Chapter 2 Supply and Demand
S2
1
S
3.30
reducing the
quantity supplied at
the previous price.
0
176
205
220
Q
Million kg of po
per
y
,
rk
ear
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N.B
SUPPLY AND DEMAND
The supply function
The processed pork supply function is:
Chapter 2 Supply and Demand
Q = S(p, ph)
where Q is the quantity of pork supplied
p is the price of pork (dollars per kg)
ph is the price of a hog (dollars per kg)
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N.B
SUPPLY AND DEMAND
From the supply function to the supply curve
Estimated supply function for pork:
Chapter 2 Supply and Demand
Q = 178 + 40p60ph
Using the values ph = $1.50 per kg
Q = 88 + 40p.
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THE MARKET MECHANISM
Above the
equilibrium price.
p, $ per kg
N.B
Market equilibrium point!!
Excess supply = 39
S
3.95
e
3.30
Chapter 2 Supply and Demand
2.65
Excess demand = 39
Below the
equilibrium
price.
is below the
quantity
demanded
0
176
the quantity supplied.
194
207
220
the quantity demanded.
D
is below the
quantity supplied
233
246
Q, Million kg of por
per
year
k
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N.B
THE MARKET MECHANISM
Chapter 2 Supply and Demand
Using math to determine equilibrium
Demand: Qd = 286 20p
Supply: Qs = 88 + 40p
Equilibrium:
Qd = Qs
286 20p = 88 + 40p
60p = 198
P = $3.30
Q = 286 20(3.3) = 220
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Chapter 2 Supply and Demand
N.B
THE MARKET MECHANISM
The equilibrium changes only if a shock
occurs that shifts the demand curve or the
supply curve. These curves shift if one of
the variables we were holding constant
changes.
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N.B
THE MARKET MECHANISM
Chapter 2 Supply and Demand
,
p
$ per kg
Equilibrium Effects of a Shift of a Demand Curve
A $0.60 increase in the price
of beef shifts demand outward
Which puts an upward
pressure on the price to
a new equilibrium.
e2
3.50
3.30
e
1
S
D2
1
D
At the original price
there is now excess
demand.
Excess demand = 12
0
176
220
228
232
Q, Million kg of pork per year
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N.B
THE MARKET MECHANISM
Equilibrium Effects of a Shift of a Supply Curve
p , $ per kg
A $0.25 increase in the price of hogs
shifts the supply curve to the left
Chapter 2 Supply and Demand
Which puts an upward
pressure on the price to a
new equilibrium.
S2
S1
e2
3.55
3.30
e1
D
At the original
price there is now
excess demand.
Excess demand = 15
0
176
205
215 220
Q, Million kg of pork per year
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N.B
THE MARKET MECHANISM
Chapter 2 Supply and Demand
Equilibrium Effects of a Shift of a Supply Curve
Mathematically, how does the equilibrium
price of pork vary as the price of hogs
changes if the variables that affect
demand are held constant at their typical
values?
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N.B
THE MARKET MECHANISM
Equilibrium Effects of a Shift of a Supply Curve
Chapter 2 Supply and Demand
1. Solve for the equilibrium price of pork in terms
of the price of hogs.
Qd = 28620p
Qs = 178 + 40p60ph
28620p = 178 + 40p60ph
-60p = 108 60ph
-p = 1.8 ph
2. Show how the equilibrium price of pork varies
with the price of hogs.
Since p = ph, any increase in the price of hogs
causes an equal increase in the price of
processed pork.
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Chapter 2 Supply and Demand
The shapes of the demand and supply
curves determine by how much a shock
affects the equilibrium price and quantity.
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How the Effect of a Supply Shock Depends on the Shape
of the Demand Curve
Chapter 2 Supply and Demand
(a)!
p, $ per kg !
This shift of the supply curve causes a
movement along the demand curve
3.55!
3.30!
D1!
A $0.25 increase in the price of hogs causes
the supply of pork to shift to the left
A $0.25 increase
in the price of
hogs causes the
supply of pork to
shift to the left.
e2!
0! 176!
3.675!
3.30!
e1!
S2!
S1!
215! 220!
D2!
e2!
e1!
S2!
S1!
0! 176!
Q, Million kg of pork per year!
and a reduction in quantity.
(b)!
p, $ per kg !
2.4
220!
Q, Million kg of pork per year!
But equilibrium quantity does not change since
consumption is not sensitive to price
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How the Effect of a Supply Shock Depends on the Shape
of the Demand Curve
Chapter 2 Supply and Demand
When demand is very
sensitive to price!
a shift in the supply
curve to S2!
has no effect on the
equilibrium price!
and a substantial effect
on the quantity!
(c)!
p, $ per kg !
2.4
3.30!
D3!
e2!
e1!
S2!
S1!
0!
176!
205!
220!
Q, Million kg of pork per year!
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Chapter 2 Supply and Demand
2.4
How the Effect of a Supply Shock Depends on the Shape
of the Demand Curve
How the shapes of demand and
supply curves matter?!
Sensitivity of quantity demanded
to price.!
Sensitivity of quantity supplied to
price.!
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
elasticity Percentage change in one variable resulting from
a 1-percent increase in another variable.
Price Elasticity of Demand: measures the sensitivity of quantity
demanded to price changes
Chapter 2 Supply and Demand
price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1-percent increase in its
price.
The percentage change in a variable is just the
absolute change in the variable divided by the
original level of the variable, e.g. %Q= Q/Q
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
elasticity Percentage change in one variable resulting from
a 1-percent increase in another.
Price Elasticity of Demand: measures the sensitivity of quantity
demanded to price changes
Chapter 2 Supply and Demand
price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1-percent increase in its
price.
(2.1)
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Price Elasticity of Demand
Chapter 2 Supply and Demand
price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1-percent increase in its
price.
Is usually negative
(when P increases Q
falls) Ep is neg.!
(2.1)
Magnitude of price elasticity, e.g. Ep =-2, is 2 in magnitude!
If Ep > 1 in magnitude demand is price elastic!
If Ep < 1 in magnitude demand is price inelastic!
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Linear Demand Curve
linear demand curve
Demand curve that is a straight line.
Figure 2.11
Linear Demand Curve
Chapter 2 Supply and Demand
The price elasticity of demand
depends not only on the slope
of the demand curve but also
on the price and quantity.
The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear demand
curve.
Near the top, because price is
high and quantity is small, the
elasticity is large in magnitude.
The elasticity becomes smaller
as we move down the curve.
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Linear Demand Curve
linear demand curve
Demand curve that is a straight line.
Figure 2.11
Linear Demand Curve
Chapter 2 Supply and Demand
Q = 8 2P
Q/P is constant = -2
But not constant elasticity
At Q=0 Ep = -2 (P/Q) = -
At P=2, Q=4 Ep = -1
At P=0 Ep = -2 (P/Q) = 0
Because we draw P in the
vertical axis and Q in the
horizontal:
Q/P = 1/slope of curve
As a result for any P and Q the
steeper the slope of the curve
the less elastic is the Ep
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Linear Demand Curve
Figure 2.12
(a) Infinitely Elastic Demand
Chapter 2 Supply and Demand
(a) For a horizontal demand
curve, Q/P is infinite (= 1/0)
=). Because a tiny change in
price leads to an enormous
change in demand, the
elasticity of demand is infinite.
infinitely elastic demand Principle that consumers will buy as much
of a good as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price the quantity
demanded increases without limit.
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Linear Demand Curve
Figure 2.12
(b) Completely Inelastic Demand
Chapter 2 Supply and Demand
(b) For a vertical demand curve,
Q/P is zero (=1/). Because
the quantity demanded is the
same no matter what the price,
the elasticity of demand is zero.
completely inelastic demand Principle that consumers will buy a
fixed quantity of a good regardless of its price.
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Elasticity of demand
Along linear demand curve with a function of:
Chapter 2 Supply and Demand
Where -b is the slope or
the elasticity of demand is
Q p
p
E p = p Q = b Q
d
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p, $ per kg
Elasticity Along the Pork Demand Curve
Q = 286 -20p
Perfectly elastic
p
a/b
= 14.30
Ep= -b
= -20 x 3.30 = -0.3
11.44
220 = -4
Q
57.2
Elastic
Ep < 1
11.44
Ep = 4
Chapter 2 Supply and Demand
D
a/(2b) = 7.15
Unitary:Ep= -1"
3.30
0
Inelastic 0 > Ep > 1
Ep= 0.3
a/5 = 57.2
a/2 = 143
Perfectly"
inelastic
220
a = 286
Q, Million kg of pork per year
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Other Demand Elasticities
income elasticity of demand Percentage change in the quantity
demanded resulting from a 1-percent increase in income.
Chapter 2 Supply and Demand
(2.2)
cross-price elasticity of demand Percentage change in the
quantity demanded of one good (e.g. Qb= quantity of butter) resulting
from a 1-percent increase in the price of another (e.g. Pm = price of
margarine).
(2.3)
EQbPm>0 if substitutes
EQbPm<0 if complements
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Point versus Arc Elasticities
point elasticity of demand
the demand curve.
Price elasticity at a particular point on
Chapter 2 Supply and Demand
Arc Elasticity of Demand
arc elasticity of demand Price elasticity calculated over a range of
prices. (we use an average of the initial and final prices and quantities)
(2.4)
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Elasticities of Supply
price elasticity of supply Percentage change in quantity supplied
resulting from a 1-percent increase in price.
Along linear supply curve with a function of:
Chapter 2 Supply and Demand
Q = c + dp
Where d is the slope or
Q
d=
p
the elasticity of supply is
Q p
p
E p = p Q = d Q
s
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Elasticities of Supply
price elasticity of supply Percentage change in quantity supplied
resulting from a 1-percent increase in price.
Ep=0.71!
Chapter 2 Supply and Demand
Ep=0.66!
Ep=0.6!
Ep=0.5!
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
During recent decades, changes in the wheat market had
major implications for both American farmers and U.S.
agricultural policy.
Chapter 2 Supply and Demand
To understand what happened, lets examine the behavior of supply
and demand beginning in 1981.
By setting the quantity supplied equal to the quantity demanded, determine we
can the market-clearing price of wheat for 1981:!
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Substituting into the supply curve equation, we get
Chapter 2 Supply and Demand
We use the demand curve to find the price elasticity of demand:
Thus demand is inelastic.
We can likewise calculate the price elasticity of supply:
Because these supply and demand curves are linear, the price
elasticities will vary as we move along the curves.
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2.4
ELASTICITIES OF SUPPLY AND DEMAND
Suppose that a drought caused the supply curve to shift to the left to push
the price up to $4.00 per bushel
Then: the quantity demanded 3550-(266)($4.00)=2486 million bushels
Chapter 2 Supply and Demand
At this price and quantity, Elasticity of demand,
Ep = 4.00/2486 (-2.66) =-.43
The wheat market evolved:
In 2007 raise in price:
Demand
Qd = 2900 125P
Supply
Qs = 1460 +115P
Then Qd=Qs 1460+115P = 2900-125P
P = $6.00
Q = 1460 + (115) *(6) = 2150 million bushels
Ed = -0.35, Es=0.32 price rose sharply
The causes? Dry weather in 2005 and heavy rains in 2007 + increased
export demand
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Figure 2.13
(a) Gasoline: Short-Run and Long-Run
Demand Curves
Chapter 2 Supply and Demand
(a) In the short run, an increase in
price has only a small effect on the
quantity of gasoline demanded.
Motorists may drive less, but they will
not change the kinds of cars they are
driving overnight.
In the longer run, however, because
they will shift to smaller and more
fuel-efficient cars, the effect of the
price increase will be larger.
Demand, therefore, is more elastic in
the long run than in the short run.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Demand and Durability
Figure 2.13
Chapter 2 Supply and Demand
(b) Automobiles: Short-Run and Long-Run
Demand Curves
(b) The opposite is true for
automobile demand. If price
increases, consumers initially defer
buying new cars; thus annual
quantity demanded falls sharply.
In the longer run, however, old cars
wear out and must be replaced; thus
annual quantity demanded picks up.
Demand, therefore, is less elastic in
the long run than in the short run.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Income Elasticities
Income elasticities also differ from the short run to the long run.
Chapter 2 Supply and Demand
For most goods and servicesfoods, beverages, fuel, entertainment,
etc. the income elasticity of demand is larger in the long run than in
the short run.
For a durable good, the opposite is true. The short-run income elasticity
of demand will be much larger than the long-run elasticity.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Cyclical Industries
cyclical industries Industries in which sales tend to magnify cyclical
changes in gross domestic product and national income.
Figure 2.14
Chapter 2 Supply and Demand
GDP and Investment in Durable
Equipment
Annual growth rates are
compared for GDP and
investment in durable
equipment.
Because the short-run GDP
elasticity of demand is larger
than the long-run elasticity for
long-lived capital equipment
(machinery purchased by
firms), changes in investment
in equipment magnify changes
in GDP. Thus capital goods
industries are considered
cyclical.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Cyclical Industries
Figure 2.15
Chapter 2 Supply and Demand
Consumption of Durables versus
Nondurables
Annual growth rates are compared
for GDP, consumer expenditures
on durable goods (automobiles,
appliances, furniture, etc.), and
consumer expenditures on
nondurable goods (food, clothing,
services, etc.).
Because the stock of durables is
large compared with annual
demand, short-run demand
elasticities are larger than long-run
elasticities. Like capital
equipment, industries that produce
consumer durables are
cyclical (i.e., changes in GDP are
magnified). This is not true for
producers of nondurables.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
TABLE 2.1
Chapter 2 Supply and Demand
Elasticity
Price
Income
TABLE 2.2
Elasticity
Price
Income
Demand for Gasoline
Number of Years Allowed to Pass Following
a Price or Income Change
1
2
3
5
10
0.2
0.3
0.4
0.5
0.8
0.2
0.4
0.5
0.6
1.0
Demand for Automobiles
Number of Years Allowed to Pass Following
a Price or Income Change
1
2
3
5
10
1.2
0.9
0.8
0.6
0.4
3.0
2.3
1.9
1.4
1.0
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Supply
Chapter 2 Supply and Demand
Supply elasticities may differ in the shortrun and the long-run
The difference depends on the ability to
convert fixed inputs into variable inputs
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Supply
Supply and Durability
Figure 2.16
Copper: Short-Run and Long-Run
Supply Curves
Chapter 2 Supply and Demand
Like that of most goods, the
supply of primary copper,
shown in part (a), is more
elastic in the long run.
If price increases, firms would
like to produce more but are
limited by capacity
constraints in the short run.
In the longer run, they can add
to capacity and produce more.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Supply
Supply and Durability
Figure 2.16
Copper: Short-Run and Long-Run
Supply Curves
Chapter 2 Supply and Demand
Part (b) shows supply curves
for secondary copper.
If the price increases, there is a
greater incentive to convert
scrap copper into new supply.
Initially, therefore, secondary
supply (i.e., supply from scrap)
increases sharply.
But later, as the stock of scrap
falls, secondary supply
contracts.
Secondary supply is therefore
less elastic in the long run than
in the short run.
Table 2.3
Supply of Copper
Price Elasticity of:
Primary supply
Secondary supply
Total supply
Short-Run
0.20
0.43
0.25
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Long-Run!
1.60!
0.31!
1.50!
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Figure 2.17
Chapter 2 Supply and Demand
Price of Brazilian Coffee
When droughts or
freezes damage
Brazils coffee trees,
the price of coffee can
soar.
The price usually falls
again after a few
years, as demand
and supply adjust.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Figure 2.18
Supply and Demand for Coffee
Chapter 2 Supply and Demand
(a) A freeze or drought in
Brazil causes the supply
curve to shift to the left.
In the short run, supply is
completely inelastic; only a
fixed number of coffee
beans can be harvested.
Demand is also relatively
inelastic; consumers
change their habits only
slowly.
As a result, the initial effect
of the freeze is a sharp
increase in price, from P0 to
P1.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Figure 2.18
Supply and Demand for Coffee
Chapter 2 Supply and Demand
(b) In the intermediate run,
supply and demand are
both more elastic; thus
price falls part of the way
back, to P2.
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2.5
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Figure 2.18
Chapter 2 Supply and Demand
Supply and Demand for Coffee
(c) In the long run, supply
is extremely elastic;
because new coffee trees
will have had time to
mature, the effect of the
freeze will have
disappeared. Price returns
to P0.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Figure 2.19
Fitting Linear Supply and Demand
Curves to Data
Chapter 2 Supply and Demand
Linear supply and demand
curves provide a convenient
tool for analysis.
Given data for the equilibrium
price and quantity P* and Q*,
as well as estimates of the
elasticities of demand and
supply ED and ES, we can
calculate the parameters c and
d for the supply curve and a
and b for the demand curve. (In
the case drawn here, c < 0.)
The curves can then be used
to analyze the behavior of the
market quantitatively.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Demand: Q = a bP
(2.5a)
Supply: Q = c + dP
(2.5b)
Step 1:
Chapter 2 Supply and Demand
E = (P/Q)(Q/P)
Demand: ED = b(P*/Q*)
(2.6a)
Supply: ES = d(P*/Q*)
(2.6b)
We can solve for b and d, then (step 2) we substitute b
and d in 2.5a and 2.5b to obtaint a and c respectively!
Step 2:
a = Q* + bP*
c = Q*-+ dP*
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
EXAMPLE:!
Quantity Q* = 12 million metric tons!
Price P*= $2.00!
Elasticity supply = 1.5, Elasticity demand = -0.5!
Chapter 2 Supply and Demand
Step 1:
Step 2:
Elasticity Supply: 1.5 = d(2/12) = d/6
d = (1.5) (6) = 9
12 = c + (9)(2.00) = c +18 c = -6
Supply: Q = -6 +9P
Step 1:
Step 2:
Elasticity demand: -0.5 = -b(2/12) = -b/6
b = (0.5) (6) = 3
12 = a (3)(2.00) = a - 6 a = 12+6=18
demand: Q = 18 -3P
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
We check: supply = demand!
Supply = -6+9P = 18-3P = Demand!
P = 24/12 = $2!
Chapter 2 Supply and Demand
Q = a bP + fI
I = index of aggregate income or GDP!
Income elasticity of demand = (I/Q) (Q/I)= (I/Q) (f)!
Step 1 we compute f then we substitute and compute a (Step 2)!
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Demand: Q = a bP
(2.5a)
Supply: Q = c + dP
(2.5b)
Step 1:
Chapter 2 Supply and Demand
E = (P/Q)(Q/P)
Demand: ED = b(P*/Q*)
(2.6a)
Supply: ES = d(P*/Q*)
(2.6b)
Step 2:
a = Q* + bP*
Q = a bP + fI
(2.7)
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
After reaching a level of about $1.00 per pound in 1980, the price
of copper fell sharply to about 60 cents per pound in 1986.
Chapter 2 Supply and Demand
Worldwide recessions in 1980 and 1982 contributed to the decline
of copper prices.
Why did the price increase sharply in 20052007? First, the
demand for copper from China and other Asian countries began
increasing dramatically. Second, because prices had dropped so
much from 1996 through 2003, producers closed unprofitable
mines and cut production.
What would a decline in demand do to the price of copper? To find
out, we can use linear supply and demand curves.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Figure 2.20
Chapter 2 Supply and Demand
Copper Prices, 19652007
Copper prices are shown in
both nominal (no adjustment
for inflation) and real
(inflation-adjusted) terms. In
real terms, copper prices
declined steeply from the
early 1970s through the
mid-1980s as demand fell. In
19881990, copper prices
rose in response to supply
disruptions caused by strikes
in Peru and Canada but later
fell after the strikes ended.
Prices declined during the
19962002 period but then
increased sharply during
20052007.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
What would a decline in demand do to price of the
copper?!
Figure 2.21
Chapter 2 Supply and Demand
Copper Supply and Demand
The shift in the demand
curve corresponding to a
20-percent decline in
demand leads to a 10.5percent decline in price.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Since the early 1970s, the world oil market
has been buffeted by the OPEC cartel and
by political turmoil in the Persian Gulf.
Figure 2.22
Chapter 2 Supply and Demand
Price of Crude Oil
The OPEC cartel and
political events caused
the price of oil to rise
sharply at times. It later
fell as supply and
demand adjusted.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Because this example is set in 20052007, all prices are measured in
2005 dollars. Here are some rough figures:
Chapter 2 Supply and Demand
20057 world price = $50 per barrel
World demand and total supply = 34 billion barrels per year (bb/yr)
OPEC supply = 14 bb/yr
Competitive (non-OPEC) supply = 20 bb/yr
The following table gives price elasticity estimates for oil supply and
demand:
Short Run
Long Run
World demand:
-0.05
-0.40
Competitive supply:
0.10
0.40
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Figure 2.23
Chapter 2 Supply and Demand
Impact of Saudi Production Cut
The total supply (ST) is the sum of competitive (nonOPEC) supply (SC) and the 14 bb/yr of OPEC supply. Part
(a) shows the short-run supply and demand curves.
If Saudi Arabia stops producing, the supply curve will shift
to the left by 3 bb/yr. In the short-run, price will increase
sharply.
Part (b) shows long-run curves.
In the long run, because demand and
competitive supply are much more elastic,
the impact on price will be much smaller.
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2.6
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS
Short-run demand: D = 35.5 0.03 P
Short-run competitive supply: Sc = 18.0 + 0.04 P
Chapter 2 Supply and Demand
Total supply = Sc + OPEC
OPEC is constant = 14 bb/y
Short-run total supply = (18+14) + 0.04 P
Equilibrium price = $50 per barrel
If Saudi Arabia stops producing oil (-10% world production = 3 bb/ y)
Short-run demand: D = 35.5 0.03 P
Short-run total supply: St = 29 + 0.04 P
Price = $92.86 per barrel
Short Run
Long Run
World demand:
-0.05
-0.40
Competitive supply:
0.10
0.40
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2.7
EFFECTS OF GOVERNMENT INTERVENTION
PRICE CONTROLS
Figure 2.24
Effects of Price Controls
Chapter 2 Supply and Demand
Without price controls, the
market clears at the equilibrium
price and quantity P0 and Q0.
If price is regulated to be no
higher than Pmax, the quantity
supplied falls to Q1, the
quantity demanded increases
to Q2, and a shortage
develops.
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2.7
EFFECTS OF GOVERNMENT INTERVENTION
PRICE CONTROLS
Figure 2.25
Price of Natural Gas
Chapter 2 Supply and Demand
Natural gas prices rose sharply after 2000,
as did the prices of oil and other fuels.
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2.7
EFFECTS OF GOVERNMENT INTERVENTION
PRICE CONTROLS
The (free-market) wholesale price of natural gas was $6.40 per mcf
(thousand cubic feet);
Production and consumption of gas were 23 Tcf (trillion cubic feet);
The average price of crude oil (which affects the supply and demand
for natural gas) was about $50 per barrel.!
Chapter 2 Supply and Demand
Supply:
Demand:
Q = 15.90 + 0.72PG + 0.05PO
Q = 0.02 0.18PG + 0.69PO
Substitute $3.00 for PG in both the supply and demand equations
(keeping the price of oil, PO, fixed at $50).
You should find that the supply equation gives a quantity supplied of
20.6 Tcf and the demand equation a quantity demanded of 29.1 Tcf.
Therefore, these price controls would create an excess demand of
29.1 20.6 = 8.5 Tcf.!
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Chapter 2 Supply and Demand
Minimum wage
Suppose that there is a single labor market in
which everyone is paid the same wage. If a
binding minimum wage, w, is imposed, what
happens to the equilibrium in this market?
Answer:
Show the initial equilibrium before the minimum wage
is imposed.
Draw a horizontal line at the minimum wage, and
show how the market equilibrium changes.
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Chapter 2 Supply and Demand
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