CHAPTER 02 - PHALL-82241 PINDYCK CHAPTER 02 page 5 of 30...

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Unformatted text preview: PHALL-82241 PINDYCK CHAPTER 02 page 5 of 30 FIGURE 2.1 THE SUPPLY CURVE Price S S′ P1 P2 Q1 Q2 Quantity The supply curve, labeled S in the figure, shows how the quantity of a good offered for sale changes as the price of the good changes. The supply curve is upward sloping: The higher the price, the more firms are able and willing to produce and sell. If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve then shifts to the right (from S to S') Fig 02-01.EPS PHALL-82241 PINDYCK CHAPTER 02 page 6 of 30 FIGURE 2.2 THE DEMAND CURVE Price P2 P1 D Q1 Q2 D′ Quantity The demand curve, labeled D, shows how the quantity of a good demanded by consumers depends on its price. The demand curve is downward sloping; holding other things equal, consumers will want to purchase more of a good as its price goes down. The quantity demanded may also depend on other variables, such as income, the weather, and the prices of other goods. For most products, the quantity demanded increases when income rises. A higher income level shifts the demand curve to the right (from D to D'). Fig 02-02.EPS PHALL-82241 PINDYCK CHAPTER 02 page 7 of 30 FIGURE 2.3 SUPPLY AND DEMAND Price (dollars per unit) S Surplus P1 P0 P2 Shortage D Q0 Quantity The market clears at price P0 and quantity Q0. At the higher price P1, a surplus develops, so price falls. At the lower price P2, there is a shortage, so price is bid up. Fig 02-03.EPS PHALL-82241 PINDYCK CHAPTER 02 page 8 of 30 FIGURE 2.4 NEW EQUILIBRIUM FOLLOWING SHIFT IN SUPPLY Price S S′ P1 P3 D Q1 Q3 Quantity When the supply curve shifts to the right, the market clears at a lower price P3 and a larger quantity Q3. Fig 02-04.EPS PHALL-82241 PINDYCK CHAPTER 02 page 9 of 30 FIGURE 2.5 NEW EQUILIBRIUM FOLLOWING SHIFT IN DEMAND Price S P3 P1 D′ D Q1 Q3 Quantity When the demand curve shifts to the right, the market clears at a higher price P3 and a larger quantity Q3. Fig 02-05.EPS PHALL-82241 PINDYCK CHAPTER 02 page 10 of 30 FIGURE 2.6 NEW EQUILIBRIUM FOLLOWING SHIFTS IN SUPPLY AND DEMAND Price S S′ P2 P1 D′ D Q1 Q2 Quantity Supply and demand curves shift over time as market conditions change. In this example, rightward shifts of the supply and demand curves lead to a slightly higher price and a much larger quantity. In general, changes in price and quantity depend on the amount by which each curve shifts and the shape of each curve. Fig 02-06.EPS PHALL-82241 PINDYCK CHAPTER 02 page 11 of 30 FIGURE 2.7 (a) MARKET FOR EGGS (b) MARKET FOR COLLEGE EDUCATION (1970 dollars per dozen) P S1970 S2007 (annual cost in 1970 dollars) P S2007 $5196 S1970 $0.61 $2530 $0.31 D1970 D2007 5300 7400 (a) Q (million dozens) D1970 6.9 D2007 14.8 Q (millions of students enrolled) (b) (a) The supply curve for eggs shifted downward as production costs fell; the demand curve shifted to the left as consumer preferences changed. As a result, the real price of eggs fell sharply and egg consumption rose. (b) The supply curve for a college education shifted up as the costs of equipment, maintenance, and staffing rose. The demand curve shifted to the right as a growing number of high school graduates desired a college education. As a result, both price and enrollments rose sharply. Fig 02-07.EPS PHALL-82241 PINDYCK CHAPTER 02 page 12 of 30 FIGURE 2.8 CONSUMPTION AND THE PRICE OF COPPER 105 90 Index (1880 � 1) 75 60 Consumption 45 30 15 Price 0 1880 1890 1900 1910 1920 1930 1940 1950 Year 1960 1970 1980 1990 2000 2010 Although annual consumption of copper has increased about a hundredfold, the real (inflation-adjusted) price has not changed much. Fig 02-08.EPS PHALL-82241 PINDYCK CHAPTER 02 page 13 of 30 FIGURE 2.9 LONG-RUN MOVEMENTS OF SUPPLY AND DEMAND FOR MINERAL RESOURCES Price S1900 S1950 S2000 Long-Run Path of Price and Consumption D1900 D1950 D2000 Quantity Although demand for most resources has increased dramatically over the past century, prices have fallen or risen only slightly in real (inflation-adjusted) terms because cost reductions have shifted the supply curve to the right just as dramatically. Fig 02-09.EPS PHALL-82241 PINDYCK CHAPTER 02 page 14 of 30 FIGURE 2.10 SUPPLY AND DEMAND FOR NEW YORK CITY OFFICE SPACE Price ($/psf ) S ′Nov SAug P′ 45.34 41.81 DAug D ′Nov 0 57.2 Q′ 76.4 Quantity (msf ) Following 9/11 the supply curve shifted to the left, but the demand curve also shifted to the left, so that the average rental price fell. Fig 02-10.EPS PHALL-82241 PINDYCK CHAPTER 02 page 15 of 30 FIGURE 2.11 LINEAR DEMAND CURVE Price 4 Ep = – � Q = 8 – 2P E p = –1 2 Ep = 0 4 8 Quantity 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. Fig 02-11.EPS PHALL-82241 PINDYCK CHAPTER 02 page 16 of 30 FIGURE 2.12 (a) INFINITELY ELASTIC DEMAND (b) COMPLETELY INELASTIC DEMAND Price D Price P* D Q* Quantity (a) Quantity (b) (a) For a horizontal demand curve, •Q/•P is infinite. Because a tiny change in price leads to an enormous change in demand, the elasticity of demand is infinite. (b) For a vertical demand curve, •Q/•P is zero. Because the quantity demanded is the same no matter what the price, the 3elasticity of demand is zero. Fig 02-12.EPS PHALL-82241 PINDYCK CHAPTER 02 page 17 of 30 FIGURE 2.13 (a) GASOLINE: SHORT-RUN AND LONG-RUN DEMAND CURVE (b) AUTOMOBILES: SHORT-RUN AND LONG-RUN DEMAND CURVES Price Price DSR DLR DLR DSR Quantity (a) Quantity (b) (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. (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. Fig 02-13.EPS PHALL-82241 PINDYCK CHAPTER 02 page 18 of 30 FIGURE 2.14 GDP AND INVESTMENT IN DURABLE EQUIPMENT 20 Growth rate (annual percentage) 15 10 5 0 GDP �5 Equipment Investment �10 �15 �20 1950 1955 1960 1965 1970 1975 1980 Year 1985 1990 1995 2000 2005 2010 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, changes in investment in equipment magnify changes in GDP. Thus capital goods industries are considered "cyclical." Fig 02-14.EPS PHALL-82241 PINDYCK CHAPTER 02 page 19 of 30 FIGURE 2.15 CONSUMPTION OF DURABLES VERSUS NONDURABLES 20 Durables Growth rate (annual percentage) 15 GDP 10 5 0 Nondurables �5 �10 1950 1955 1960 1965 1970 1975 1980 Year 1985 1990 1995 2000 2005 2010 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. Fig 02-15.EPS PHALL-82241 PINDYCK CHAPTER 02 page 20 of 30 FIGURE 2.16 COPPER: SHORT-RUN AND LONG-RUN SUPPLY CURVES Price Price SSR SLR SSR SLR Quantity (a) Quantity (b) 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. 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. Fig 02-16.EPS PHALL-82241 PINDYCK CHAPTER 02 page 21 of 30 FIGURE 2.17 PRICE OF BRAZILIAN COFFEE $3.50 Nominal price (dollars per pound) $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00 1965 1970 1975 1980 1985 1990 1995 2000 2005 When droughts or freezes damage Brazil's coffee trees, the price of coffee can soar. The price usually falls again after a few years, as demand and supply adjust. Fig 02-17.EPS PHALL-82241 PINDYCK CHAPTER 02 page 22 of 30 FIGURE 2.18 SUPPLY AND DEMAND FOR COFFEE Price S′ Price Price S S′ P1 S P2 P0 P0 S P0 D D D Q1 (a) Q0 Quantity (b) Q 2 Q0 Q 0 Quantity Quantity (c) (a) A freeze or drought in Brazil causes the supply curve to shift to the left. In the short run, supply is completely inelastic; only a fixed number of coffee beans can be harvested. Demand is also relatively inelastic; consumers change their habits only slowly. As a result, the initial effect of the freeze is a sharp increase in price, from P0 to P1. (b) In the intermediate run, supply and demand are both more elastic; thus price falls part of the way back, to P2. (c) In the long run, supply is extremely elastic; because new coffee trees will have had time to mature, the effect of the freeze will have disappeared. Price returns to P0. Fig 02-18.EPS PHALL-82241 PINDYCK CHAPTER 02 page 23 of 30 FIGURE 2.19 FITTING LINEAR SUPPLY AND DEMAND CURVES TO DATA Price a/b Supply: Q = c + dP ED = –b(P*/Q*) ES = d(P*/Q*) P* – c/d Demand: Q = a – bP Q* Linear supply and demand curves provide a convenient tool for analysis. Given data for the equilibrium price and quantity P* and Q*, as well as estimates of the elasticities of demand and supply ED and ES, we can calculate the parameters c and d for the supply curve and a and b for the demand curve. (In the case drawn here, c < 0.) The curves can then be used to analyze the behavior of the market quantitatively. Fig 02-19.EPS a Quantity PHALL-82241 PINDYCK CHAPTER 02 page 24 of 30 Price (cents per pound) FIGURE 2.20 COPPER PRICES, 1965-2007 340 320 300 280 260 240 220 200 180 160 140 120 100 80 60 40 20 0 1965 Nominal Price Real Price (1972$) 1970 1975 1980 1985 1990 1995 2000 2005 2010 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 1988-1990, 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 1996-2002 period but then increased sharply during 2005-2007. Fig 02-20.EPS PHALL-82241 PINDYCK CHAPTER 02 page 25 of 30 FIGURE 2.21 COPPER SUPPLY AND DEMAND 4 D′ D Price (dollars per pound) 3.5 S 3 2.5 P* = 2.00 2 P′ = 1.79 1.5 1 0.5 Q′ = 10 Q* = 12 0 0 5 10 15 Quantity (million metric tons/year) 20 The shift in the demand curve corresponding to a 20-percent decline in demand leads to a 10.5-percent decline in price. Fig 02-21.EPS PHALL-82241 PINDYCK CHAPTER 02 page 26 of 30 FIGURE 2.22 PRICE OF CRUDE OIL 80 Price (dollars per barrel) 70 Real Price (2000$) 60 50 40 30 20 Nominal Price 10 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 The OPEC cartel and political events caused the price of oil to rise sharply at times. It later fell as supply and demand adjusted. Fig 02-22.EPS PHALL-82241 PINDYCK CHAPTER 02 page 27 of 30 FIGURE 2.23 IMPACT OF SAUDI PRODUCTION CUT 100 90 P� = $92.86 Price (dollars per barrel) 80 ST S�T SC D 70 P* = $50 60 50 40 30 20 10 0 (a) Fig 02-23a.EPS 0 5 10 15 20 25 Quantity (billion barrels/yr) 30 35 40 PHALL-82241 PINDYCK CHAPTER 02 page 28 of 30 100 D S�T SC ST 90 Price (dollars per barrel) 80 70 P� = 56.98 60 50 P* = 50.00 40 30 20 10 Q* = 34 0 (b) 0 5 10 15 20 25 30 Quantity (billion barrels/yr) 35 40 45 50 The total supply is the sum of competitive (non-OPEC) supply and the 14 bb/yr of OPEC supply. Part (a) shows the short-run supply and demand curves. If Saudi Arabia stops producing, the supply curve will shift to the left by 3 bb/yr. In the short-run, price will increase sharply. Part (b) shows long-run curves. In the long run, because demand and competitive supply are much more elastic, the impact on price will be much smaller. Fig 02-23b.EPS PHALL-82241 PINDYCK CHAPTER 02 page 29 of 30 FIGURE 2.24 EFFECTS OF PRICE CONTROLS Price S P0 Pmax D Excess Demand Q1 Q0 Q2 Quantity Without price controls, the market clears at the equilibrium price and quantity P0 and Q0. If price is regulated to be no higher than Pmax, the quantity supplied falls to Q1, the quantity demanded increases to Q2, and a shortage develops. Fig 02-24.EPS PHALL-82241 PINDYCK CHAPTER 02 page 30 of 30 FIGURE 2.25 PRICE OF NATURAL GAS 8.00 Dollars per thousand cubic feet 7.00 6.00 5.00 4.00 Real Price (2000$) 3.00 2.00 1.00 Nominal Price 0.00 1950 1960 1970 1980 1990 Natural gas prices rose sharply after 2000, as did the prices of oil and other fuels. Fig 02-25.EPS 2000 2010 ...
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