Chapter 2
The Basics of
Supply and
Demand
Chapter 2,The Basics of Supply and Demand Slide 2
Topics to Be Discussed
? Supply and Demand
? The Market Mechanism
? Changes in Market Equilibrium
? Elasticities of Supply and Demand
? Short-Run Versus Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 3
Topics to Be Discussed
? Understanding and Predicting the Effects
of Changing Market Conditions
? Effects of Government Intervention--Price
Controls
Chapter 2,The Basics of Supply and Demand Slide 4
Introduction
? Applications of Supply and Demand
Analysis
? Understanding and predicting how world
economic conditions affect market price and
production
? Analyzing the impact of government price
controls,minimum wages,price supports,
and production incentives
Chapter 2,The Basics of Supply and Demand Slide 5
Introduction
? Applications of Supply and Demand
Analysis
? Analyzing how taxes,subsidies,and import
restrictions affect consumers and producers
Chapter 2,The Basics of Supply and Demand Slide 6
Supply and Demand
? The Supply Curve
? The supply curve shows how much of a good
producers are willing to sell at a given price,
holding constant other factors that might
affect quantity supplied
Chapter 2,The Basics of Supply and Demand Slide 7
Supply and Demand
? The Supply Curve
? This price-quantity relationship can be shown
by the equation,
)( PQQ Ss ?
Chapter 2,The Basics of Supply and Demand Slide 8
Horizontal axis measures
quantity (Q) supplied in
number of units per
time period
Vertical axis measures
price (P) received
per unit in dollars
Supply and Demand
The Supply
Curve Graphically
Quantity
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 9
Supply and Demand
S
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output
The Supply
Curve Graphically
Quantity
Price
($ per unit)
P1
Q1
P2
Q2
Chapter 2,The Basics of Supply and Demand Slide 10
Supply and Demand
? Non-price Determining Variables of
Supply
? Costs of Production
?Labor
?Capital
?Raw Materials
Chapter 2,The Basics of Supply and Demand Slide 11
Supply and Demand
? The cost of raw
materials falls
? At P1,produce Q2
? At P2,produce Q1
? Supply curve shifts right
to S’
? More produced at any
price on S’ than on S
P S
Change in Supply
Q
P1
P2
Q1 Q0
S’
Q2
Chapter 2,The Basics of Supply and Demand Slide 12
Supply and Demand
? Supply - A Review
? Supply is determined by non-price supply-
determining variables as such as the cost of
labor,capital,and raw materials,
? Changes in supply are shown by shifting the
entire supply curve,
Chapter 2,The Basics of Supply and Demand Slide 13
Supply and Demand
? Supply - A Review
? Changes in quantity supplied are shown by
movements along the supply curve and are
caused by a change in the price of the
product,
Chapter 2,The Basics of Supply and Demand Slide 14
Supply and Demand
? The Demand Curve
? The demand curve shows how much of a
good consumers are willing to buy as the
price per unit changes holding non-price
factors constant,
? This price-quantity relationship can be shown
by the equation,
( P )QQ DD ?
Chapter 2,The Basics of Supply and Demand Slide 15
Supply and Demand
Quantity
Horizontal axis measures
quantity (Q) demanded in
number of units per
time period
Vertical axis measures
price (P) paid
per unit in dollars
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 16
Supply and Demand
D
The demand curve slopes
downward demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper and the
consumer’s real income
increases,
Quantity
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 17
Supply and Demand
? Non-price Determining Variables of
Demand
? Income
? Consumer Tastes
? Price of Related Goods
?Substitutes
?Complements
Chapter 2,The Basics of Supply and Demand Slide 18
D P
Q Q1
P2
Q0
P1
D’
Q2
Change in Demand
Supply and Demand
? Income Increases
? At P1,produce Q2
? At P2,produce Q1
? Demand Curve shifts right
? More purchased at any
price on D’ than on D
Chapter 2,The Basics of Supply and Demand Slide 19
Shifts in Supply and Demand
? Demand - A Review
? Demand is determined by non-price
demand-determining variables,such as,
income,price of related goods,and tastes,
? Changes in demand are shown by shifting
the entire demand curve,
? Changes in quantity demanded are shown by
movements along the demand curve,
Chapter 2,The Basics of Supply and Demand Slide 20
The Market Mechanism
Quantity
D
S
The curves intersect at
equilibrium,or market-
clearing,price,At P0 the
quantity supplied is equal
to the quantity demanded
at Q0,
P0
Q0
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 21
The Market Mechanism
? Characteristics of the equilibrium or
market clearing price,
?QD = QS
?No shortage
?No excess supply
?No pressure on the price to change
Chapter 2,The Basics of Supply and Demand Slide 22
The Market Mechanism
Quantity
D
S
P0
Q0
If price is above equilibrium,
1) Price is above the
market clearing price
2) Qs > Qd
3) Price falls to the
market-clearing price
P1
Surplus
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 23
The Market Mechanism
? The market price is above equilibrium
? There is excess supply
? Producers lower prices
? Quantity demanded increases and quantity
supplied decreases
? The market continues to adjust until the
equilibrium price is reached,
A Surplus
Chapter 2,The Basics of Supply and Demand Slide 24
The Market Mechanism
D
S
Q1
Assume the price is P1,then,
1) Qs, Q1 > Qd, Q2
2) Excess supply is Q1:Q2,
3) Producers lower price,
4) Quantity supplied decreases
and quantity demanded
increases,
5) Equilibrium at P2Q3
P1
Surplus
Q2 Quantity
Price
($ per unit)
P2
Q3
Chapter 2,The Basics of Supply and Demand Slide 25
The Market Mechanism
? The market price is above equilibrium,
? There is excess supply
? Producers lower prices
? Quantity demanded increases and quantity
supplied decreases
? The market continues to adjust until the
equilibrium price is reached
Surplus - Review,
Chapter 2,The Basics of Supply and Demand Slide 26
The Market Mechanism
D
S
Q1 Q2
P2
Shortage
Quantity
Price
($ per unit)
Assume the price is P2,then,
1) Qd, Q2 > Qs, Q1
2) Shortage is Q1:Q2,
3) Producers raise price,
4) Quantity supplied increases
and quantity demanded
decreases,
5) Equilibrium at P3,Q3
Q3
P3
Chapter 2,The Basics of Supply and Demand Slide 27
The Market Mechanism
? The market price is below equilibrium,
? There is a shortage
? Producers raise prices
? Quantity demanded decreases and quantity
supplied increases
? The market continues to adjust until the new
equilibrium price is reached,
Shortage
Chapter 2,The Basics of Supply and Demand Slide 28
The Market Mechanism
? Market Mechanism Summary
1) Supply and demand interact to
determine the market-clearing price,
2) When not in equilibrium,the market will
adjust to alleviate a shortage or surplus
and return the market to equilibrium,
3) Markets must be competitive for the
mechanism to be efficient,
Chapter 2,The Basics of Supply and Demand Slide 29
Changes In Market Equilibrium
? Equilibrium prices are determined by the
relative level of supply and demand,
? Supply and demand are determined by
particular values of supply and demand
determining variables,
? Changes in any one or combination of
these variables can cause a change in
the equilibrium price and/or quantity,
Chapter 2,The Basics of Supply and Demand Slide 30
S’
Q2
? Raw material prices
fall
? S shifts to S’
? Surplus @ P1 of
Q1,Q2
? Equilibrium @ P3,
Q3
P
Q
S D
P3
Q3 Q1
P1
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 31
D’ S D
Q3
P3
Q2
? Income Increases
? Demand shifts to D1
? Shortage @ P1 of Q1,Q2
? Equilibrium @ P3,Q3
P
Q Q1
P1
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 32
D’ S’ ? Income Increases &
raw material prices fall
? The increase in D is
greater than the
increase in S
? Equilibrium price and
quantity increase to P2,
Q2
P
Q
S
P2
Q2
D
P1
Q1
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 33
Shifts in Supply and Demand
? When supply and demand change
simultaneously,the impact on the
equilibrium price and quantity is
determined by,
1) The relative size and direction of the
change
2) The shape of the supply and demand
models
Chapter 2,The Basics of Supply and Demand Slide 34
The Price of Eggs and the Price
of a College Education Revisited
? The real price of eggs fell 59% from 1970
to 1998,
? Supply increased due to the increased
mechanization of poultry farming and the
reduced cost of production,
? Demand decreased due to the increasing
consumer concern over the health and
cholesterol consequences of eating eggs,
Chapter 2,The Basics of Supply and Demand Slide 35
Market for Eggs
Q (million dozens)
P
(1970
dollars per
dozen)
D1970
S1970
$0.61
5,500
D1998
S1998
Prices fell until
a new equilibrium
was reached at $0.26
and a quantity
of 5,300 million dozen
$0.26
5,300
Chapter 2,The Basics of Supply and Demand Slide 36
The Price of a College Education
? The real price of a college education rose
68 percent from 1970 to 1995,
? Supply decreased due to higher costs of
equipping and maintaining modern
classrooms,laboratories and libraries,
and higher faculty salaries,
? Demand increased due a larger
percentage of a larger number of high
school graduates attending college,
Chapter 2,The Basics of Supply and Demand Slide 37
Market for a College Education
Q (millions of students enrolled))
P
(annual cost
in 1970
dollars)
D1970
S1970
S1995
D1995
$4,248
14.9
Prices rose until
a new equilibrium
was reached at $4,573
and a quantity
of 12.3 million students
$2,530
8.6
Chapter 2,The Basics of Supply and Demand Slide 38
Changes In Market Equilibrium
? Wage Inequality in the United States
?Real after-tax income from 1977 to 1999,
?Rose 40+% for the top 20% of the income
distribution
?Fell 10+% for the bottom 20%
Chapter 2,The Basics of Supply and Demand Slide 39
Changes In Market Equilibrium
? Question
?Why did the income distribution become
more unequal for 1977 to 1999?
Chapter 2,The Basics of Supply and Demand Slide 40
Consumption & Price of Copper
1880-1998
Chapter 2,The Basics of Supply and Demand Slide 41
The Long-Run Behavior
of Natural Resource Prices
? Observations
? Consumption of copper has increased about
a hundred fold from 1880 through 1998
indicating a large increase in demand,
? The real price for copper has remained
relatively constant,
Chapter 2,The Basics of Supply and Demand Slide 42
S1998
D1998 D1900
S1900 S1950
D1950
Long-Run Path of
Price and Consumption
Changes In Market Equilibrium
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 43
? Conclusion
? Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand,
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 44
? Observation
? To accurately predict the future price of a
product or service,it is necessary to consider
the potential change in supply and demand,
? 1970 predictions for oil and other minerals
proved incorrect because they only
considered the demand side of the market,
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 45
Elasticities of Supply and Demand
? Generally,elasticity is a measure of the
sensitivity of one variable to another,
? It tells us the percentage change in one
variable in response to a one percent
change in another variable,
Chapter 2,The Basics of Supply and Demand Slide 46
Elasticities of Supply and Demand
? Measures the sensitivity of quantity
demanded to price changes,
? It measures the percentage change in the
quantity demanded for a good or service that
results from a one percent change in the
price,
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 47
Elasticities of Supply and Demand
? The price elasticity of demand is,
P)Q ) / ( %(% E P ???
Chapter 2,The Basics of Supply and Demand Slide 48
Elasticities of Supply and Demand
? The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable,
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 49
Elasticities of Supply and Demand
? So the price elasticity of demand is also,
P
Q
Q
P
P / P
Q / Q
E P
?
?
?
?
?
?
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 50
Elasticities of Supply and Demand
? Interpreting Price Elasticity of Demand
Values
1) Because of the inverse relationship
between P and Q; EP is negative,
2) If EP > 1,the percent change in quantity is
greater than the percent change in
price,We say the demand is price
elastic,
Chapter 2,The Basics of Supply and Demand Slide 51
Elasticities of Supply and Demand
? Interpreting Price Elasticity of Demand
Values
3) If EP < 1,the percent change in
quantity is less than the percent
change in price,We say the demand
is price inelastic,
Chapter 2,The Basics of Supply and Demand Slide 52
Elasticities of Supply and Demand
? The primary determinant of price elasticity
of demand is the availability of
substitutes,
? Many substitutes demand is price elastic
? Few substitutes demand is price inelastic
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 53
Price Elasticities of Demand
Q
Price
Q = 8 - 2P
Ep = -1
Ep = 0
?? - E P The lower portion of
a downward sloping
demand curve is less elastic
than the upper portion,
4
8
2
4
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Chapter 2,The Basics of Supply and Demand Slide 54
Price Elasticities of Demand
D P*
?? - E P
Quantity
Price Infinitely Elastic Demand
Chapter 2,The Basics of Supply and Demand Slide 55
Price Elasticities of Demand
Q*
0 E P ?
Quantity
Price
Completely Inelastic Demand
Chapter 2,The Basics of Supply and Demand Slide 56
Elasticities of Supply and Demand
? Income elasticity of demand measures
the percentage change in quantity
demanded resulting from a one percent
change in income,
Other Demand Elasticities
Chapter 2,The Basics of Supply and Demand Slide 57
Elasticities of Supply and Demand
? The income elasticity of demand is,
I
Q
Q
I
I / I
Q / Q
E I
?
?
?
?
?
?
Other Demand Elasticities
Chapter 2,The Basics of Supply and Demand Slide 58
Elasticities of Supply and Demand
? Cross elasticity of demand measures the
percentage change in the quantity
demanded of one good that results from a
one percent change in the price of
another good,
? For example consider the substitute
goods,butter and margarine,
Other Demand Elasticities
Chapter 2,The Basics of Supply and Demand Slide 59
Elasticities of Supply and Demand
? The cross elasticity of demand is,
m
b
b
m
mm
bb
PQ
P
Q
Q
P
/PP
/QQ
E mb
?
?
?
?
?
?
? The cross elasticity for substitutes is positive,
while that for complements is negative,
Chapter 2,The Basics of Supply and Demand Slide 60
Elasticities of Supply and Demand
? Price elasticity of supply measures the
percentage change in quantity supplied
resulting from a 1 percent change in price,
? The elasticity is usually positive because
price and quantity supplied are directly
related,
Elasticities of Supply
Chapter 2,The Basics of Supply and Demand Slide 61
Elasticities of Supply and Demand
? We can refer to elasticity of supply with
respect to interest rates,wage rates,and the
cost of raw materials,
Elasticities of Supply
Chapter 2,The Basics of Supply and Demand Slide 62
Elasticities of Supply and Demand
? 1981 Supply Curve for Wheat
?QS = 1,800 + 240P
? 1981 Demand Curve for Wheat
?QD = 3,550 - 266P
The Market for Wheat
Elasticities of Supply and Demand
? Equilibrium,Q S = Q D
PP 266550,3240800,1 ???
7 5 0,15 0 6 ?P
b u s h e lP /46.3?
b u s h e l s m i l l i o n 630,2)46.3)(240(800,1 ???Q
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 63
Elasticities of Supply and Demand
I ne l as ti c 035.)66.2(
630,2
46.3 ????
?
??
P
Q
Q
PE DD
P
I n el as ti c 032.)40.2(
630,2
46.3 ??
?
??
P
Q
Q
PE SS
P
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 64
Chapter 2,The Basics of Supply and Demand Slide 65
Elasticities of Supply and Demand
? Assume the price of wheat is $4.00/bushel
486,2)00.4)(266(550,3 ???DQ
43.0)266(
486,2
00.4 ????D
PQ
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 66
1981 1800 + 240P 3550 - 266P 1800+240P = 3550-266P
506P = 1750
P1981 = $3.46/bushel
1998 1,944 + 207P 3,244 - 283P 1,944+207P = 3,244-283P
P1998 = $2.65/bushel
Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD)
Changes in the Market,1981-1998
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 67
Short-Run Versus
Long-Run Elasticities
? Price elasticity of demand varies with the
amount of time consumers have to
respond to a price,
Demand
Chapter 2,The Basics of Supply and Demand Slide 68
? Most goods and services,
? Short-run elasticity is less than long-run
elasticity,(e.g,gasoline,Drs.)
? Other Goods (durables),
? Short-run elasticity is greater than long-run
elasticity (e.g,automobiles)
Short-Run Versus
Long-Run Elasticities
Demand
Chapter 2,The Basics of Supply and Demand Slide 69
Gasoline,Short-Run and
Long-Run Demand Curves
DSR
DLR
People tend to
drive smaller and
more fuel efficient
cars in the long-run
Gasoline
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 70
DSR
DLR
People may put
off immediate
consumption,but
eventually older cars
must be replaced,
Automobiles
Automobiles,Short-Run and
Long-Run Demand Curves
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 71
? Income elasticity also varies with the
amount of time consumers have to
respond to an income change,
Short-Run Versus
Long-Run Elasticities
Income Elasticities
Chapter 2,The Basics of Supply and Demand Slide 72
? Most goods and services,
? Income elasticity is greater in the long-run
than in the short run,
?Higher incomes may be converted into
bigger cars so the income elasticity of
demand for gasoline increases with time,
Short-Run Versus
Long-Run Elasticities
Income Elasticities
Chapter 2,The Basics of Supply and Demand Slide 73
? Other Goods (durables),
? Income elasticity is less in the long-run than
in the short-run,
?Originally,consumers will want to hold
more cars,
?Later,purchases will only to be to replace
old cars,
Short-Run Versus
Long-Run Elasticities
Income Elasticities
Chapter 2,The Basics of Supply and Demand Slide 74
? Gasoline and automobiles are
complementary goods,
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Chapter 2,The Basics of Supply and Demand Slide 75
? Gasoline
? The long-run price and income elasticities
are larger than the short-run elasticities,
? Automobiles
? The long-run price and income elasticities
are smaller than the short-run elasticities,
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Chapter 2,The Basics of Supply and Demand Slide 76
Price -0.11 -0.22 -0.32 -0.49 -0.82 -1.17
Income 0.07 0.13 0.20 0.32 0.54 0.78
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
The Demand for Gasoline
Short-Run Versus
Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 77
Price -1.20 -0.93 -0.75 -0.55 -0.42 -0.40
Income 3.00 2.33 1.88 1.38 1.02 1.00
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
The Demand for Automobiles
Short-Run Versus
Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 78
? Data Explains,
1) Why the price of oil did not continue to
rise above $30/barrel even though it
rose very rapidly in the early 1970s,
2) Why automobile sales are so sensitive
to the business cycle,
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Chapter 2,The Basics of Supply and Demand Slide 79
? Most goods and services,
? Long-run price elasticity of supply is greater
than short-run price elasticity of supply,
? Other Goods (durables,recyclables),
? Long-run price elasticity of supply is less
than short-run price elasticity of supply
Short-Run Versus
Long-Run Elasticities
Supply
Chapter 2,The Basics of Supply and Demand Slide 80
SSR
Primary Copper,Short-Run and
Long-Run Supply Curves
Quantity
Price
Short-Run Versus
Long-Run Elasticities
SLR
Due to limited
capacity,firms
are limited by
output constraints
in the short-run,
In the long-run,they
can expand,
Chapter 2,The Basics of Supply and Demand Slide 81
SSR
Secondary Copper,Short-Run and
Long-Run Supply Curves
Quantity
Price
Short-Run Versus
Long-Run Elasticities
SLR
Price increases
provide an incentive
to convert scrap
copper into new supply,
In the long-run,this
stock of scrap copper
begins to fall,
Chapter 2,The Basics of Supply and Demand Slide 82
Primary supply 0.20 1.60
Secondary supply 0.43 0.31
Total supply 0.25 1.50
Price Elasticity of,Short-run Long-run
Supply of Copper
Short-Run Versus
Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 83
? Elasticity explains why coffee prices are
very volatile,
? Due to the differences in supply elasticity in
the long-run and short run,
Short-Run Versus
Long-Run Elasticities
Weather in Brazil and
the price of Coffee
in New York
Chapter 2,The Basics of Supply and Demand Slide 84
Price of Brazilian Coffee
Chapter 2,The Basics of Supply and Demand Slide 85
D
S
P0
Q0 Quantity
Price
P1
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
A freeze or drought
decreases the supply
of coffee
S’
Q1
Short-Run Versus
Long-Run Elasticities
Coffee
Chapter 2,The Basics of Supply and Demand Slide 86
S’
D
S
P0
Q0
P2
Q2
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2,
3) Quantity falls to Q2
Short-Run Versus
Long-Run Elasticities
Quantity
Price
Coffee
Chapter 2,The Basics of Supply and Demand Slide 87
D
S P0
Q0
Long-Run
1) Supply is extremely elastic,
2) Price falls back to P0,
3) Quantity increase to Q0,
Short-Run Versus
Long-Run Elasticities
Coffee
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 88
? First,we must learn how to,fit” linear
demand and supply curves to market
data,
? Then we can determine numerically how
a change in a variable will cause supply
or demand to shift and thereby affect the
market price and quantity,
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 89
? Available Data
? Equilibrium Price,P*
? Equilibrium Quantity,Q*
? Price elasticity of supply,ES,and
demand,ED,
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 90
Demand,Q = a - bP
a/b Supply,Q = c + dP
-c/d
P*
Q*
ED = -bP*/Q*
ES = dP*/Q*
Understanding and Predicting the Effects
of Changing Market Conditions
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 91
? Let’s begin with the equations for supply
and demand,
Demand,QD = a - bP
Supply,QS = c + dP
? We must choose numbers for a,b,c,
and d,
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 92
? Step 1,
Recall,
P)Q/( P / Q ) ( E ???
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 93
? For linear demand curves,the change in
quantity divided by the change in price is
constant (equal to the slope of the curve),
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 94
? Substituting the slopes for each into the
formula for elasticity,we get,
/ Q * )*b (P- E D ?
/ Q * )*d ( P E S ?
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 95
? Since we will have values for ED,ES,P*,
and Q*,we can solve for b & d,and a & c,
Understanding and Predicting the Effects
of Changing Market Conditions
** bPaQ D ??
** dPcQ S ??
Chapter 2,The Basics of Supply and Demand Slide 96
? Deriving the long-run supply and demand
for copper,
? The relevant data are,
?Q* = 7.5 mmt/yr,
?P* = 75 cents/pound
?ES = 1.6
?ED = -0.8
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 97
? Es = d(P*/Q*)
? 1.6 = d(75/7.5)
= 0.1d
? d = 1.6/0.1 = 16
? Ed = -b(P*/Q*)
? -0.8 = -b(.75/7.5)
= -0.1b
? b = 0.8/0.1 = 8
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 98
? Supply = QS* = c + dP*
? 7.5 = c + 16(0.75)
? 7.5 = c + 12
? c = 7.5 - 12
? c = -4.5
? Q = -4.5 + 16P
? Demand = QD* = a -bP*
? 7.5 = a -(8)(.75)
? 7.5 = a - 6
? a = 7.5 + 6
? a =13.5
? Q = 13.5 - 8P
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 99
? Setting supply equal to demand gives,
Supply = -4.5 + 16p = 13.5 - 8p = Demand
16p + 8p = 13.5 + 4.5
p = 18/24 =,75
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 100
Supply,QS = -4.5 + 16P
-c/d Demand,QD = 13.5 - 8P
a/b
.75
7.5
Understanding and Predicting the Effects
of Changing Market Conditions
Mmt/yr
Price
Chapter 2,The Basics of Supply and Demand Slide 101
? We have written supply and demand so
that they only depend upon price,
? Demand could also depend upon income,
? Demand would then be written as,
Understanding and Predicting the Effects
of Changing Market Conditions
fIbPaQ ???
Chapter 2,The Basics of Supply and Demand Slide 102
? We know the following information
regarding the copper industry,
? I = 1.0
? P* = 0.75
? Q* = 7.5
? b = 8
? Income elasticity,E = 1.3
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 103
? f can be found by substituting known
values into the income elasticity formula,
IQf ??? /
)/)(/( IQQIE ???
and
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 104
? Solving for f gives,
1.3 = (1.0/7.5)f
f = (1.3)(7.5)/1.0 = 9.75
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 105
? Solving for a gives,
7.5 = a - 8(0.75) + 9.75(1.0)
a = 3.75
Understanding and Predicting the Effects
of Changing Market Conditions
fIbPaQ ??? **
Chapter 2,The Basics of Supply and Demand Slide 106
Declining Demand and the
Behavior of Copper Prices
? The relevant factors leading to a
decrease in the demand for copper are,
1) A decrease in the growth rate of power
generation
2) The development of substitutes,fiber
optics and aluminum
Chapter 2,The Basics of Supply and Demand Slide 107
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 108
? We will try to estimate the impact of a 20
percent decrease in the demand for
copper,
? Recall the equation for the demand curve,
Q = 13.5 - 8P
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 109
? Multiply this equation by 0.80 to get the
new equation,This gives,
Q = (0.80)(13.5 - 8P)
Q = 10.8 - 6.4P
? Recall the equation for supply,
Q = -4.5 + 16P
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 110
? The new equilibrium price is,
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4
P = 68.3 cents/pound
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 111
? The twenty percent decrease in demand
resulted in a reduction in the equilibrium
price to 68.3 cents from 75 cents,or 10
percent,
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 112
Price of Crude Oil
Chapter 2,The Basics of Supply and Demand Slide 113
Upheaval in the World Oil Market
? We can predict numerically the impact of
a decrease in the supply of OPEC oil,
? In 1995,
? P* = $18/barrel
? World demand and total supply = 23 bb/yr,
? OPEC supply = 10 bb/yr,
? Non-OPEC supply = 13 bb/yr
Chapter 2,The Basics of Supply and Demand Slide 114
Price Elasticity Estimates
World Demand,-0.05 -0.40
Competitive Supply 0.10 0.40
(non-OPEC)
Short-Run Long-Run
Chapter 2,The Basics of Supply and Demand Slide 115
Upheaval in the World Oil Market
? Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr,
? Short-run Demand
?D = 24.08 - 0.06P
? Short-run Competitive Supply
?SC = 11.74 + 0.07P
Chapter 2,The Basics of Supply and Demand Slide 116
Upheaval in the World Oil Market
? Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr,
? Short-run Total Supply--before supply
reduction (includes OPEC,10bb/yr)
?ST = 21.74 + 0.07P
? Short-run Total Supply--after supply
reduction
?ST = 18.74 + 0.07P
Chapter 2,The Basics of Supply and Demand Slide 117
Upheaval in the World Oil Market
? New Price After Reduction
Demand = Supply
24.08 - 0.06P = 18.74 + 0.07P
P = 41.08
Chapter 2,The Basics of Supply and Demand Slide 118
D
Quantity
(billions barrels/yr)
Price
($ per
barrel)
5
18
ST
0 5 15 20 25 30 35 10
10
15
20
25
30
35
40
45
23
Impact of Saudi Production Cut
SC
Short-Run
Effect
S’T
Chapter 2,The Basics of Supply and Demand Slide 119
Upheaval in the World Oil Market
? Long-Run Impact of a stoppage Saudi
Production equal to 3 bb/yr.,
? Long-run Demand
?D = 32.18 - 0.51P
? Long-run Total Supply
?S = 17.78 + 0.29P
Chapter 2,The Basics of Supply and Demand Slide 120
Upheaval in the World Oil Market
? New Price is found setting long-run
supply equal to long-run demand,
32.18 - 0.51P = 14.78 + 0.29P
P = 21.75
Chapter 2,The Basics of Supply and Demand Slide 121
D
Quantity
(billions barrels/yr)
Price
($ per
barrel)
5
ST
0 5 15 20 25 30 35 10
10
15
20
25
30
35
40
45
23
18
Impact of Saudi Production Cut
SC
Due to the elasticity
of the long-run
supply and demand
curves,the long-run
effect of a cut
in production is
much less,
S’T Long-run Effect
Chapter 2,The Basics of Supply and Demand Slide 122
Effects of Government Intervention --
Price Controls
? If the government decides that the
equilibrium price is too high,they may
establish a maximum allowable ceiling
price,
Chapter 2,The Basics of Supply and Demand Slide 123
D
Effects of Price Controls
Quantity
Price
P0
Q0
S
Pmax
Excess demand
If price is regulated to
be no higher than Pmax,
quantity supplied falls
to Q1 and quantity
demanded increases to
Q2,A shortage results
Chapter 2,The Basics of Supply and Demand Slide 124
Price Controls and
Natural Gas Shortages
? In 1954,the federal government began
regulating the wellhead price of natural
gas,
? In 1962,the ceiling prices that were
imposed became binding and shortages
resulted,
Chapter 2,The Basics of Supply and Demand Slide 125
? Price controls created an excess demand
of 7 trillion cubic feet,
? Price regulation was a major component
of U.S,energy policy in the 1960s and
1970s,and it continued to influence the
natural gas markets in the 1980s,
Price Controls and
Natural Gas Shortages
Chapter 2,The Basics of Supply and Demand Slide 126
$ 2 / T c F @
1, 5 o i l f o r d e m a n d of e l a s t i c i t y C r o s s
0, 1 o i l f o rs u p p l y of e l a s t i c i t y C r o s s
D e m a n dS u p p l y
PPQD e m a n d
PPQS u p p l y
P
P
OG
OG
D
E
S
E
?
???
???
?
??
?
?
75.35:
25.214:
5.0
2.0
Price Controls and
Natural Gas Shortages
The Data,Natural Gas
Chapter 2,The Basics of Supply and Demand Slide 127
Price Controls and
Natural Gas Shortages
The Data,Natural Gas
T c F /y r 7 S ho r ta ge
T c F 25 and T c F
$1,00 /T c F At
$1,00 pr i c e r eg ul at ed 19 75
?
??
?
QQ
S
18
Chapter 2,The Basics of Supply and Demand Slide 128
Summary
? Supply-demand analysis is a basic tool of
microeconomics,
? The market mechanism is the tendency
for supply and demand to equilibrate,so
that there is neither excess demand nor
excess supply
Chapter 2,The Basics of Supply and Demand Slide 129
Summary
? Elasticities describe the responsiveness
of supply and demand to changes in
price,income,and other variables,
? Elasticities pertain to a time frame,
? If we can estimate the supply and
demand curves for a particular market,
we can calculate the market clearing
price,
Chapter 2,The Basics of Supply and Demand Slide 130
Summary
? Simple numerical analysis can often be
done by fitting linear supply and demand
curves to data on price and quantity and
to estimates of elasticities,
End of Chapter 2
The Basics of
Supply and
Demand
The Basics of
Supply and
Demand
Chapter 2,The Basics of Supply and Demand Slide 2
Topics to Be Discussed
? Supply and Demand
? The Market Mechanism
? Changes in Market Equilibrium
? Elasticities of Supply and Demand
? Short-Run Versus Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 3
Topics to Be Discussed
? Understanding and Predicting the Effects
of Changing Market Conditions
? Effects of Government Intervention--Price
Controls
Chapter 2,The Basics of Supply and Demand Slide 4
Introduction
? Applications of Supply and Demand
Analysis
? Understanding and predicting how world
economic conditions affect market price and
production
? Analyzing the impact of government price
controls,minimum wages,price supports,
and production incentives
Chapter 2,The Basics of Supply and Demand Slide 5
Introduction
? Applications of Supply and Demand
Analysis
? Analyzing how taxes,subsidies,and import
restrictions affect consumers and producers
Chapter 2,The Basics of Supply and Demand Slide 6
Supply and Demand
? The Supply Curve
? The supply curve shows how much of a good
producers are willing to sell at a given price,
holding constant other factors that might
affect quantity supplied
Chapter 2,The Basics of Supply and Demand Slide 7
Supply and Demand
? The Supply Curve
? This price-quantity relationship can be shown
by the equation,
)( PQQ Ss ?
Chapter 2,The Basics of Supply and Demand Slide 8
Horizontal axis measures
quantity (Q) supplied in
number of units per
time period
Vertical axis measures
price (P) received
per unit in dollars
Supply and Demand
The Supply
Curve Graphically
Quantity
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 9
Supply and Demand
S
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output
The Supply
Curve Graphically
Quantity
Price
($ per unit)
P1
Q1
P2
Q2
Chapter 2,The Basics of Supply and Demand Slide 10
Supply and Demand
? Non-price Determining Variables of
Supply
? Costs of Production
?Labor
?Capital
?Raw Materials
Chapter 2,The Basics of Supply and Demand Slide 11
Supply and Demand
? The cost of raw
materials falls
? At P1,produce Q2
? At P2,produce Q1
? Supply curve shifts right
to S’
? More produced at any
price on S’ than on S
P S
Change in Supply
Q
P1
P2
Q1 Q0
S’
Q2
Chapter 2,The Basics of Supply and Demand Slide 12
Supply and Demand
? Supply - A Review
? Supply is determined by non-price supply-
determining variables as such as the cost of
labor,capital,and raw materials,
? Changes in supply are shown by shifting the
entire supply curve,
Chapter 2,The Basics of Supply and Demand Slide 13
Supply and Demand
? Supply - A Review
? Changes in quantity supplied are shown by
movements along the supply curve and are
caused by a change in the price of the
product,
Chapter 2,The Basics of Supply and Demand Slide 14
Supply and Demand
? The Demand Curve
? The demand curve shows how much of a
good consumers are willing to buy as the
price per unit changes holding non-price
factors constant,
? This price-quantity relationship can be shown
by the equation,
( P )QQ DD ?
Chapter 2,The Basics of Supply and Demand Slide 15
Supply and Demand
Quantity
Horizontal axis measures
quantity (Q) demanded in
number of units per
time period
Vertical axis measures
price (P) paid
per unit in dollars
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 16
Supply and Demand
D
The demand curve slopes
downward demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper and the
consumer’s real income
increases,
Quantity
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 17
Supply and Demand
? Non-price Determining Variables of
Demand
? Income
? Consumer Tastes
? Price of Related Goods
?Substitutes
?Complements
Chapter 2,The Basics of Supply and Demand Slide 18
D P
Q Q1
P2
Q0
P1
D’
Q2
Change in Demand
Supply and Demand
? Income Increases
? At P1,produce Q2
? At P2,produce Q1
? Demand Curve shifts right
? More purchased at any
price on D’ than on D
Chapter 2,The Basics of Supply and Demand Slide 19
Shifts in Supply and Demand
? Demand - A Review
? Demand is determined by non-price
demand-determining variables,such as,
income,price of related goods,and tastes,
? Changes in demand are shown by shifting
the entire demand curve,
? Changes in quantity demanded are shown by
movements along the demand curve,
Chapter 2,The Basics of Supply and Demand Slide 20
The Market Mechanism
Quantity
D
S
The curves intersect at
equilibrium,or market-
clearing,price,At P0 the
quantity supplied is equal
to the quantity demanded
at Q0,
P0
Q0
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 21
The Market Mechanism
? Characteristics of the equilibrium or
market clearing price,
?QD = QS
?No shortage
?No excess supply
?No pressure on the price to change
Chapter 2,The Basics of Supply and Demand Slide 22
The Market Mechanism
Quantity
D
S
P0
Q0
If price is above equilibrium,
1) Price is above the
market clearing price
2) Qs > Qd
3) Price falls to the
market-clearing price
P1
Surplus
Price
($ per unit)
Chapter 2,The Basics of Supply and Demand Slide 23
The Market Mechanism
? The market price is above equilibrium
? There is excess supply
? Producers lower prices
? Quantity demanded increases and quantity
supplied decreases
? The market continues to adjust until the
equilibrium price is reached,
A Surplus
Chapter 2,The Basics of Supply and Demand Slide 24
The Market Mechanism
D
S
Q1
Assume the price is P1,then,
1) Qs, Q1 > Qd, Q2
2) Excess supply is Q1:Q2,
3) Producers lower price,
4) Quantity supplied decreases
and quantity demanded
increases,
5) Equilibrium at P2Q3
P1
Surplus
Q2 Quantity
Price
($ per unit)
P2
Q3
Chapter 2,The Basics of Supply and Demand Slide 25
The Market Mechanism
? The market price is above equilibrium,
? There is excess supply
? Producers lower prices
? Quantity demanded increases and quantity
supplied decreases
? The market continues to adjust until the
equilibrium price is reached
Surplus - Review,
Chapter 2,The Basics of Supply and Demand Slide 26
The Market Mechanism
D
S
Q1 Q2
P2
Shortage
Quantity
Price
($ per unit)
Assume the price is P2,then,
1) Qd, Q2 > Qs, Q1
2) Shortage is Q1:Q2,
3) Producers raise price,
4) Quantity supplied increases
and quantity demanded
decreases,
5) Equilibrium at P3,Q3
Q3
P3
Chapter 2,The Basics of Supply and Demand Slide 27
The Market Mechanism
? The market price is below equilibrium,
? There is a shortage
? Producers raise prices
? Quantity demanded decreases and quantity
supplied increases
? The market continues to adjust until the new
equilibrium price is reached,
Shortage
Chapter 2,The Basics of Supply and Demand Slide 28
The Market Mechanism
? Market Mechanism Summary
1) Supply and demand interact to
determine the market-clearing price,
2) When not in equilibrium,the market will
adjust to alleviate a shortage or surplus
and return the market to equilibrium,
3) Markets must be competitive for the
mechanism to be efficient,
Chapter 2,The Basics of Supply and Demand Slide 29
Changes In Market Equilibrium
? Equilibrium prices are determined by the
relative level of supply and demand,
? Supply and demand are determined by
particular values of supply and demand
determining variables,
? Changes in any one or combination of
these variables can cause a change in
the equilibrium price and/or quantity,
Chapter 2,The Basics of Supply and Demand Slide 30
S’
Q2
? Raw material prices
fall
? S shifts to S’
? Surplus @ P1 of
Q1,Q2
? Equilibrium @ P3,
Q3
P
Q
S D
P3
Q3 Q1
P1
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 31
D’ S D
Q3
P3
Q2
? Income Increases
? Demand shifts to D1
? Shortage @ P1 of Q1,Q2
? Equilibrium @ P3,Q3
P
Q Q1
P1
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 32
D’ S’ ? Income Increases &
raw material prices fall
? The increase in D is
greater than the
increase in S
? Equilibrium price and
quantity increase to P2,
Q2
P
Q
S
P2
Q2
D
P1
Q1
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 33
Shifts in Supply and Demand
? When supply and demand change
simultaneously,the impact on the
equilibrium price and quantity is
determined by,
1) The relative size and direction of the
change
2) The shape of the supply and demand
models
Chapter 2,The Basics of Supply and Demand Slide 34
The Price of Eggs and the Price
of a College Education Revisited
? The real price of eggs fell 59% from 1970
to 1998,
? Supply increased due to the increased
mechanization of poultry farming and the
reduced cost of production,
? Demand decreased due to the increasing
consumer concern over the health and
cholesterol consequences of eating eggs,
Chapter 2,The Basics of Supply and Demand Slide 35
Market for Eggs
Q (million dozens)
P
(1970
dollars per
dozen)
D1970
S1970
$0.61
5,500
D1998
S1998
Prices fell until
a new equilibrium
was reached at $0.26
and a quantity
of 5,300 million dozen
$0.26
5,300
Chapter 2,The Basics of Supply and Demand Slide 36
The Price of a College Education
? The real price of a college education rose
68 percent from 1970 to 1995,
? Supply decreased due to higher costs of
equipping and maintaining modern
classrooms,laboratories and libraries,
and higher faculty salaries,
? Demand increased due a larger
percentage of a larger number of high
school graduates attending college,
Chapter 2,The Basics of Supply and Demand Slide 37
Market for a College Education
Q (millions of students enrolled))
P
(annual cost
in 1970
dollars)
D1970
S1970
S1995
D1995
$4,248
14.9
Prices rose until
a new equilibrium
was reached at $4,573
and a quantity
of 12.3 million students
$2,530
8.6
Chapter 2,The Basics of Supply and Demand Slide 38
Changes In Market Equilibrium
? Wage Inequality in the United States
?Real after-tax income from 1977 to 1999,
?Rose 40+% for the top 20% of the income
distribution
?Fell 10+% for the bottom 20%
Chapter 2,The Basics of Supply and Demand Slide 39
Changes In Market Equilibrium
? Question
?Why did the income distribution become
more unequal for 1977 to 1999?
Chapter 2,The Basics of Supply and Demand Slide 40
Consumption & Price of Copper
1880-1998
Chapter 2,The Basics of Supply and Demand Slide 41
The Long-Run Behavior
of Natural Resource Prices
? Observations
? Consumption of copper has increased about
a hundred fold from 1880 through 1998
indicating a large increase in demand,
? The real price for copper has remained
relatively constant,
Chapter 2,The Basics of Supply and Demand Slide 42
S1998
D1998 D1900
S1900 S1950
D1950
Long-Run Path of
Price and Consumption
Changes In Market Equilibrium
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 43
? Conclusion
? Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand,
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 44
? Observation
? To accurately predict the future price of a
product or service,it is necessary to consider
the potential change in supply and demand,
? 1970 predictions for oil and other minerals
proved incorrect because they only
considered the demand side of the market,
Changes In Market Equilibrium
Chapter 2,The Basics of Supply and Demand Slide 45
Elasticities of Supply and Demand
? Generally,elasticity is a measure of the
sensitivity of one variable to another,
? It tells us the percentage change in one
variable in response to a one percent
change in another variable,
Chapter 2,The Basics of Supply and Demand Slide 46
Elasticities of Supply and Demand
? Measures the sensitivity of quantity
demanded to price changes,
? It measures the percentage change in the
quantity demanded for a good or service that
results from a one percent change in the
price,
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 47
Elasticities of Supply and Demand
? The price elasticity of demand is,
P)Q ) / ( %(% E P ???
Chapter 2,The Basics of Supply and Demand Slide 48
Elasticities of Supply and Demand
? The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable,
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 49
Elasticities of Supply and Demand
? So the price elasticity of demand is also,
P
Q
Q
P
P / P
Q / Q
E P
?
?
?
?
?
?
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 50
Elasticities of Supply and Demand
? Interpreting Price Elasticity of Demand
Values
1) Because of the inverse relationship
between P and Q; EP is negative,
2) If EP > 1,the percent change in quantity is
greater than the percent change in
price,We say the demand is price
elastic,
Chapter 2,The Basics of Supply and Demand Slide 51
Elasticities of Supply and Demand
? Interpreting Price Elasticity of Demand
Values
3) If EP < 1,the percent change in
quantity is less than the percent
change in price,We say the demand
is price inelastic,
Chapter 2,The Basics of Supply and Demand Slide 52
Elasticities of Supply and Demand
? The primary determinant of price elasticity
of demand is the availability of
substitutes,
? Many substitutes demand is price elastic
? Few substitutes demand is price inelastic
Price Elasticity of Demand
Chapter 2,The Basics of Supply and Demand Slide 53
Price Elasticities of Demand
Q
Price
Q = 8 - 2P
Ep = -1
Ep = 0
?? - E P The lower portion of
a downward sloping
demand curve is less elastic
than the upper portion,
4
8
2
4
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Chapter 2,The Basics of Supply and Demand Slide 54
Price Elasticities of Demand
D P*
?? - E P
Quantity
Price Infinitely Elastic Demand
Chapter 2,The Basics of Supply and Demand Slide 55
Price Elasticities of Demand
Q*
0 E P ?
Quantity
Price
Completely Inelastic Demand
Chapter 2,The Basics of Supply and Demand Slide 56
Elasticities of Supply and Demand
? Income elasticity of demand measures
the percentage change in quantity
demanded resulting from a one percent
change in income,
Other Demand Elasticities
Chapter 2,The Basics of Supply and Demand Slide 57
Elasticities of Supply and Demand
? The income elasticity of demand is,
I
Q
Q
I
I / I
Q / Q
E I
?
?
?
?
?
?
Other Demand Elasticities
Chapter 2,The Basics of Supply and Demand Slide 58
Elasticities of Supply and Demand
? Cross elasticity of demand measures the
percentage change in the quantity
demanded of one good that results from a
one percent change in the price of
another good,
? For example consider the substitute
goods,butter and margarine,
Other Demand Elasticities
Chapter 2,The Basics of Supply and Demand Slide 59
Elasticities of Supply and Demand
? The cross elasticity of demand is,
m
b
b
m
mm
bb
PQ
P
Q
Q
P
/PP
E mb
?
?
?
?
?
?
? The cross elasticity for substitutes is positive,
while that for complements is negative,
Chapter 2,The Basics of Supply and Demand Slide 60
Elasticities of Supply and Demand
? Price elasticity of supply measures the
percentage change in quantity supplied
resulting from a 1 percent change in price,
? The elasticity is usually positive because
price and quantity supplied are directly
related,
Elasticities of Supply
Chapter 2,The Basics of Supply and Demand Slide 61
Elasticities of Supply and Demand
? We can refer to elasticity of supply with
respect to interest rates,wage rates,and the
cost of raw materials,
Elasticities of Supply
Chapter 2,The Basics of Supply and Demand Slide 62
Elasticities of Supply and Demand
? 1981 Supply Curve for Wheat
?QS = 1,800 + 240P
? 1981 Demand Curve for Wheat
?QD = 3,550 - 266P
The Market for Wheat
Elasticities of Supply and Demand
? Equilibrium,Q S = Q D
PP 266550,3240800,1 ???
7 5 0,15 0 6 ?P
b u s h e lP /46.3?
b u s h e l s m i l l i o n 630,2)46.3)(240(800,1 ???Q
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 63
Elasticities of Supply and Demand
I ne l as ti c 035.)66.2(
630,2
46.3 ????
?
??
P
Q
Q
PE DD
P
I n el as ti c 032.)40.2(
630,2
46.3 ??
?
??
P
Q
Q
PE SS
P
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 64
Chapter 2,The Basics of Supply and Demand Slide 65
Elasticities of Supply and Demand
? Assume the price of wheat is $4.00/bushel
486,2)00.4)(266(550,3 ???DQ
43.0)266(
486,2
00.4 ????D
PQ
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 66
1981 1800 + 240P 3550 - 266P 1800+240P = 3550-266P
506P = 1750
P1981 = $3.46/bushel
1998 1,944 + 207P 3,244 - 283P 1,944+207P = 3,244-283P
P1998 = $2.65/bushel
Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD)
Changes in the Market,1981-1998
The Market for Wheat
Chapter 2,The Basics of Supply and Demand Slide 67
Short-Run Versus
Long-Run Elasticities
? Price elasticity of demand varies with the
amount of time consumers have to
respond to a price,
Demand
Chapter 2,The Basics of Supply and Demand Slide 68
? Most goods and services,
? Short-run elasticity is less than long-run
elasticity,(e.g,gasoline,Drs.)
? Other Goods (durables),
? Short-run elasticity is greater than long-run
elasticity (e.g,automobiles)
Short-Run Versus
Long-Run Elasticities
Demand
Chapter 2,The Basics of Supply and Demand Slide 69
Gasoline,Short-Run and
Long-Run Demand Curves
DSR
DLR
People tend to
drive smaller and
more fuel efficient
cars in the long-run
Gasoline
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 70
DSR
DLR
People may put
off immediate
consumption,but
eventually older cars
must be replaced,
Automobiles
Automobiles,Short-Run and
Long-Run Demand Curves
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 71
? Income elasticity also varies with the
amount of time consumers have to
respond to an income change,
Short-Run Versus
Long-Run Elasticities
Income Elasticities
Chapter 2,The Basics of Supply and Demand Slide 72
? Most goods and services,
? Income elasticity is greater in the long-run
than in the short run,
?Higher incomes may be converted into
bigger cars so the income elasticity of
demand for gasoline increases with time,
Short-Run Versus
Long-Run Elasticities
Income Elasticities
Chapter 2,The Basics of Supply and Demand Slide 73
? Other Goods (durables),
? Income elasticity is less in the long-run than
in the short-run,
?Originally,consumers will want to hold
more cars,
?Later,purchases will only to be to replace
old cars,
Short-Run Versus
Long-Run Elasticities
Income Elasticities
Chapter 2,The Basics of Supply and Demand Slide 74
? Gasoline and automobiles are
complementary goods,
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Chapter 2,The Basics of Supply and Demand Slide 75
? Gasoline
? The long-run price and income elasticities
are larger than the short-run elasticities,
? Automobiles
? The long-run price and income elasticities
are smaller than the short-run elasticities,
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Chapter 2,The Basics of Supply and Demand Slide 76
Price -0.11 -0.22 -0.32 -0.49 -0.82 -1.17
Income 0.07 0.13 0.20 0.32 0.54 0.78
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
The Demand for Gasoline
Short-Run Versus
Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 77
Price -1.20 -0.93 -0.75 -0.55 -0.42 -0.40
Income 3.00 2.33 1.88 1.38 1.02 1.00
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
The Demand for Automobiles
Short-Run Versus
Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 78
? Data Explains,
1) Why the price of oil did not continue to
rise above $30/barrel even though it
rose very rapidly in the early 1970s,
2) Why automobile sales are so sensitive
to the business cycle,
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles
Chapter 2,The Basics of Supply and Demand Slide 79
? Most goods and services,
? Long-run price elasticity of supply is greater
than short-run price elasticity of supply,
? Other Goods (durables,recyclables),
? Long-run price elasticity of supply is less
than short-run price elasticity of supply
Short-Run Versus
Long-Run Elasticities
Supply
Chapter 2,The Basics of Supply and Demand Slide 80
SSR
Primary Copper,Short-Run and
Long-Run Supply Curves
Quantity
Price
Short-Run Versus
Long-Run Elasticities
SLR
Due to limited
capacity,firms
are limited by
output constraints
in the short-run,
In the long-run,they
can expand,
Chapter 2,The Basics of Supply and Demand Slide 81
SSR
Secondary Copper,Short-Run and
Long-Run Supply Curves
Quantity
Price
Short-Run Versus
Long-Run Elasticities
SLR
Price increases
provide an incentive
to convert scrap
copper into new supply,
In the long-run,this
stock of scrap copper
begins to fall,
Chapter 2,The Basics of Supply and Demand Slide 82
Primary supply 0.20 1.60
Secondary supply 0.43 0.31
Total supply 0.25 1.50
Price Elasticity of,Short-run Long-run
Supply of Copper
Short-Run Versus
Long-Run Elasticities
Chapter 2,The Basics of Supply and Demand Slide 83
? Elasticity explains why coffee prices are
very volatile,
? Due to the differences in supply elasticity in
the long-run and short run,
Short-Run Versus
Long-Run Elasticities
Weather in Brazil and
the price of Coffee
in New York
Chapter 2,The Basics of Supply and Demand Slide 84
Price of Brazilian Coffee
Chapter 2,The Basics of Supply and Demand Slide 85
D
S
P0
Q0 Quantity
Price
P1
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
A freeze or drought
decreases the supply
of coffee
S’
Q1
Short-Run Versus
Long-Run Elasticities
Coffee
Chapter 2,The Basics of Supply and Demand Slide 86
S’
D
S
P0
Q0
P2
Q2
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2,
3) Quantity falls to Q2
Short-Run Versus
Long-Run Elasticities
Quantity
Price
Coffee
Chapter 2,The Basics of Supply and Demand Slide 87
D
S P0
Q0
Long-Run
1) Supply is extremely elastic,
2) Price falls back to P0,
3) Quantity increase to Q0,
Short-Run Versus
Long-Run Elasticities
Coffee
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 88
? First,we must learn how to,fit” linear
demand and supply curves to market
data,
? Then we can determine numerically how
a change in a variable will cause supply
or demand to shift and thereby affect the
market price and quantity,
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 89
? Available Data
? Equilibrium Price,P*
? Equilibrium Quantity,Q*
? Price elasticity of supply,ES,and
demand,ED,
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 90
Demand,Q = a - bP
a/b Supply,Q = c + dP
-c/d
P*
Q*
ED = -bP*/Q*
ES = dP*/Q*
Understanding and Predicting the Effects
of Changing Market Conditions
Quantity
Price
Chapter 2,The Basics of Supply and Demand Slide 91
? Let’s begin with the equations for supply
and demand,
Demand,QD = a - bP
Supply,QS = c + dP
? We must choose numbers for a,b,c,
and d,
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 92
? Step 1,
Recall,
P)Q/( P / Q ) ( E ???
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 93
? For linear demand curves,the change in
quantity divided by the change in price is
constant (equal to the slope of the curve),
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 94
? Substituting the slopes for each into the
formula for elasticity,we get,
/ Q * )*b (P- E D ?
/ Q * )*d ( P E S ?
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 95
? Since we will have values for ED,ES,P*,
and Q*,we can solve for b & d,and a & c,
Understanding and Predicting the Effects
of Changing Market Conditions
** bPaQ D ??
** dPcQ S ??
Chapter 2,The Basics of Supply and Demand Slide 96
? Deriving the long-run supply and demand
for copper,
? The relevant data are,
?Q* = 7.5 mmt/yr,
?P* = 75 cents/pound
?ES = 1.6
?ED = -0.8
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 97
? Es = d(P*/Q*)
? 1.6 = d(75/7.5)
= 0.1d
? d = 1.6/0.1 = 16
? Ed = -b(P*/Q*)
? -0.8 = -b(.75/7.5)
= -0.1b
? b = 0.8/0.1 = 8
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 98
? Supply = QS* = c + dP*
? 7.5 = c + 16(0.75)
? 7.5 = c + 12
? c = 7.5 - 12
? c = -4.5
? Q = -4.5 + 16P
? Demand = QD* = a -bP*
? 7.5 = a -(8)(.75)
? 7.5 = a - 6
? a = 7.5 + 6
? a =13.5
? Q = 13.5 - 8P
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 99
? Setting supply equal to demand gives,
Supply = -4.5 + 16p = 13.5 - 8p = Demand
16p + 8p = 13.5 + 4.5
p = 18/24 =,75
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 100
Supply,QS = -4.5 + 16P
-c/d Demand,QD = 13.5 - 8P
a/b
.75
7.5
Understanding and Predicting the Effects
of Changing Market Conditions
Mmt/yr
Price
Chapter 2,The Basics of Supply and Demand Slide 101
? We have written supply and demand so
that they only depend upon price,
? Demand could also depend upon income,
? Demand would then be written as,
Understanding and Predicting the Effects
of Changing Market Conditions
fIbPaQ ???
Chapter 2,The Basics of Supply and Demand Slide 102
? We know the following information
regarding the copper industry,
? I = 1.0
? P* = 0.75
? Q* = 7.5
? b = 8
? Income elasticity,E = 1.3
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 103
? f can be found by substituting known
values into the income elasticity formula,
IQf ??? /
)/)(/( IQQIE ???
and
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 104
? Solving for f gives,
1.3 = (1.0/7.5)f
f = (1.3)(7.5)/1.0 = 9.75
Understanding and Predicting the Effects
of Changing Market Conditions
Chapter 2,The Basics of Supply and Demand Slide 105
? Solving for a gives,
7.5 = a - 8(0.75) + 9.75(1.0)
a = 3.75
Understanding and Predicting the Effects
of Changing Market Conditions
fIbPaQ ??? **
Chapter 2,The Basics of Supply and Demand Slide 106
Declining Demand and the
Behavior of Copper Prices
? The relevant factors leading to a
decrease in the demand for copper are,
1) A decrease in the growth rate of power
generation
2) The development of substitutes,fiber
optics and aluminum
Chapter 2,The Basics of Supply and Demand Slide 107
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 108
? We will try to estimate the impact of a 20
percent decrease in the demand for
copper,
? Recall the equation for the demand curve,
Q = 13.5 - 8P
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 109
? Multiply this equation by 0.80 to get the
new equation,This gives,
Q = (0.80)(13.5 - 8P)
Q = 10.8 - 6.4P
? Recall the equation for supply,
Q = -4.5 + 16P
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 110
? The new equilibrium price is,
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4
P = 68.3 cents/pound
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 111
? The twenty percent decrease in demand
resulted in a reduction in the equilibrium
price to 68.3 cents from 75 cents,or 10
percent,
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2,The Basics of Supply and Demand Slide 112
Price of Crude Oil
Chapter 2,The Basics of Supply and Demand Slide 113
Upheaval in the World Oil Market
? We can predict numerically the impact of
a decrease in the supply of OPEC oil,
? In 1995,
? P* = $18/barrel
? World demand and total supply = 23 bb/yr,
? OPEC supply = 10 bb/yr,
? Non-OPEC supply = 13 bb/yr
Chapter 2,The Basics of Supply and Demand Slide 114
Price Elasticity Estimates
World Demand,-0.05 -0.40
Competitive Supply 0.10 0.40
(non-OPEC)
Short-Run Long-Run
Chapter 2,The Basics of Supply and Demand Slide 115
Upheaval in the World Oil Market
? Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr,
? Short-run Demand
?D = 24.08 - 0.06P
? Short-run Competitive Supply
?SC = 11.74 + 0.07P
Chapter 2,The Basics of Supply and Demand Slide 116
Upheaval in the World Oil Market
? Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr,
? Short-run Total Supply--before supply
reduction (includes OPEC,10bb/yr)
?ST = 21.74 + 0.07P
? Short-run Total Supply--after supply
reduction
?ST = 18.74 + 0.07P
Chapter 2,The Basics of Supply and Demand Slide 117
Upheaval in the World Oil Market
? New Price After Reduction
Demand = Supply
24.08 - 0.06P = 18.74 + 0.07P
P = 41.08
Chapter 2,The Basics of Supply and Demand Slide 118
D
Quantity
(billions barrels/yr)
Price
($ per
barrel)
5
18
ST
0 5 15 20 25 30 35 10
10
15
20
25
30
35
40
45
23
Impact of Saudi Production Cut
SC
Short-Run
Effect
S’T
Chapter 2,The Basics of Supply and Demand Slide 119
Upheaval in the World Oil Market
? Long-Run Impact of a stoppage Saudi
Production equal to 3 bb/yr.,
? Long-run Demand
?D = 32.18 - 0.51P
? Long-run Total Supply
?S = 17.78 + 0.29P
Chapter 2,The Basics of Supply and Demand Slide 120
Upheaval in the World Oil Market
? New Price is found setting long-run
supply equal to long-run demand,
32.18 - 0.51P = 14.78 + 0.29P
P = 21.75
Chapter 2,The Basics of Supply and Demand Slide 121
D
Quantity
(billions barrels/yr)
Price
($ per
barrel)
5
ST
0 5 15 20 25 30 35 10
10
15
20
25
30
35
40
45
23
18
Impact of Saudi Production Cut
SC
Due to the elasticity
of the long-run
supply and demand
curves,the long-run
effect of a cut
in production is
much less,
S’T Long-run Effect
Chapter 2,The Basics of Supply and Demand Slide 122
Effects of Government Intervention --
Price Controls
? If the government decides that the
equilibrium price is too high,they may
establish a maximum allowable ceiling
price,
Chapter 2,The Basics of Supply and Demand Slide 123
D
Effects of Price Controls
Quantity
Price
P0
Q0
S
Pmax
Excess demand
If price is regulated to
be no higher than Pmax,
quantity supplied falls
to Q1 and quantity
demanded increases to
Q2,A shortage results
Chapter 2,The Basics of Supply and Demand Slide 124
Price Controls and
Natural Gas Shortages
? In 1954,the federal government began
regulating the wellhead price of natural
gas,
? In 1962,the ceiling prices that were
imposed became binding and shortages
resulted,
Chapter 2,The Basics of Supply and Demand Slide 125
? Price controls created an excess demand
of 7 trillion cubic feet,
? Price regulation was a major component
of U.S,energy policy in the 1960s and
1970s,and it continued to influence the
natural gas markets in the 1980s,
Price Controls and
Natural Gas Shortages
Chapter 2,The Basics of Supply and Demand Slide 126
$ 2 / T c F @
1, 5 o i l f o r d e m a n d of e l a s t i c i t y C r o s s
0, 1 o i l f o rs u p p l y of e l a s t i c i t y C r o s s
D e m a n dS u p p l y
PPQD e m a n d
PPQS u p p l y
P
P
OG
OG
D
E
S
E
?
???
???
?
??
?
?
75.35:
25.214:
5.0
2.0
Price Controls and
Natural Gas Shortages
The Data,Natural Gas
Chapter 2,The Basics of Supply and Demand Slide 127
Price Controls and
Natural Gas Shortages
The Data,Natural Gas
T c F /y r 7 S ho r ta ge
T c F 25 and T c F
$1,00 /T c F At
$1,00 pr i c e r eg ul at ed 19 75
?
??
?
S
18
Chapter 2,The Basics of Supply and Demand Slide 128
Summary
? Supply-demand analysis is a basic tool of
microeconomics,
? The market mechanism is the tendency
for supply and demand to equilibrate,so
that there is neither excess demand nor
excess supply
Chapter 2,The Basics of Supply and Demand Slide 129
Summary
? Elasticities describe the responsiveness
of supply and demand to changes in
price,income,and other variables,
? Elasticities pertain to a time frame,
? If we can estimate the supply and
demand curves for a particular market,
we can calculate the market clearing
price,
Chapter 2,The Basics of Supply and Demand Slide 130
Summary
? Simple numerical analysis can often be
done by fitting linear supply and demand
curves to data on price and quantity and
to estimates of elasticities,
End of Chapter 2
The Basics of
Supply and
Demand
