Transcript Chapter 2
Chapter 2
The Basics of Supply
and Demand
Supply and Demand
Supply and demand analysis can:
1. Help us understand and predict how real
world economic conditions affect market
price and production
2. Analyze the impact of government price
controls, minimum wages, price supports,
and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and
import quotas affect consumers and
producers
©2005 Pearson Education, Inc.
Chapter 2
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Supply and Demand
The Supply Curve
The relationship between the quantity of a
good that producers are willing to sell and the
price of the good
Measures quantity on the x-axis and price on
the y-axis
Q S Q S (P)
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The Supply Curve
S
Price
($ per unit)
The Supply Curve,
Graphically Depicted
P2
The supply curve slopes
upward, demonstrating that
at higher prices firms
will increase output
P1
Q1
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The Supply Curve
Other Variables Affecting Supply
Costs of Production
Labor
Capital
Raw
Materials
Lower costs of production allow a firm to
produce more at each price and vice versa
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Change in Supply
P
The cost of raw
materials falls
Produced Q1 at P1
and Q0 at P2
Now produce Q2 at P1
and Q1 at P2
Supply curve shifts
right to S’
S
P1
P2
Q0
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S’
Chapter 2
Q1
Q2
Q
6
The Supply Curve
Change in Quantity Supplied
Movement along the curve caused by a
change in price
Change in Supply
Shift of the curve caused by a change in
something other than the price of the good
Change
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in costs of production
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Supply and Demand
The Demand Curve
The relationship between the quantity of a
good that consumers are willing to buy and
the price of the good
Measures quantity on the x-axis and price on
the y-axis
QD QD(P)
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The Demand Curve
Price
($ per unit)
The demand curve slopes
downward, demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper.
P2
P1
D
Q1
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The Demand Curve
Other Variables Affecting Demand
Income
Increases
in income allow consumers to
purchase more at all prices
Consumer Tastes
Price of Related Goods
Substitutes
Complements
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Change in Demand
Income Increases
P
D
D’
Purchased Q0, at P2
P2
and Q1 at P1
Now purchased Q1 at
P2 and Q2 at P1
Same for all prices P1
Demand curve shifts
right
Q0
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Chapter 2
Q1
Q2
Q
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The Demand Curve
Changes in quantity demanded
Movements along the demand curve caused
by a change in price
Changes in demand
A shift of the entire demand curve caused by
something other than price
Income
Preferences
©2005 Pearson Education, Inc.
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Friday, April 1, 2005
Homework due Friday, April 8:
Chapter 1: #2
Chapter 2: #4, 7, 11
Course website:
people.ucsc.edu/~jhgonzal/
Nothing on it yet!!!
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The Market Mechanism
The market mechanism is the tendency
in a free market for price to change until
the market clears
Markets clear when quantity demanded
equals quantity supplied at the prevailing
price
Market clearing price – price at which
markets clear
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The Market Mechanism
S
Price
($ per unit)
The curves intersect at
equilibrium, or marketclearing, price.
Quantity demanded
equals quantity
supplied at P0
P0
D
Q0
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The Market Mechanism
In equilibrium
There is no shortage or excess demand
There is no surplus or excess supply
Quantity supplied equals quantity demanded
Anyone who wants to buy at the current price
can and all producers who want to sell at that
price can
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Market Surplus1
The market price is above equilibrium
There is excess supply - surplus
Downward pressure on price
Quantity demanded increases and quantity
supplied decreases
The market adjusts until new equilibrium is
reached
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The Market Mechanism
Price
($ per unit)
S
1.
Surplus
P1
2.
3.
P0
4.
D
Q
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D
Q0
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QS
At P1, price is
above the
market clearing
price
Qs > QD
Price falls to
the marketclearing price
Market adjusts
to equilibrium
Quantity
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The Market Mechanism
The market price is below equilibrium:
There is excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity
supplied increases
The market adjusts until the new equilibrium
is reached
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The Market Mechanism
Price
($ per unit)
1.
2.
3.
P3
4.
P2
D
Shortage
QS
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Q
3
Chapter 2
At P2, price is
below the
market
clearing price
Q D > QS
Price rises to
the marketclearing price
Market adjusts
to equilibrium
QD
Quantity
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Changes in Market Equilibrium
Changes in supply and/or demand will
cause change in the equilibrium price
and/or quantity in a free market
Markets must be competitive for the
mechanism discussed here to be efficient
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Changes in Market Equilibrium
Raw material prices
fall
P
D
S
S’
S shifts to S’
Surplus at P1 between
Q1, Q2
P1
Price adjusts to
equilibrium at P3, Q3 P3
Q1 Q3Q2
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Q
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Changes in Market Equilibrium
P
Income Increases
D
D’
S
Demand increases to
D’
Shortage at P1 of Q1 P3
to Q2
P1
Equilibrium at P3 and
Q3
Q1 Q3 Q
Q
2
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Changes in Market Equilibrium
Income increases
and raw material
prices fall
Quantity increases
If the increase in D is
greater than the
increase in S price
also increases
P
D
D’
S S’
P2
P1
Q1
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Q
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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
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The Price of a College Education
The real price of a college education rose
55 percent from 1970 to 2002
Increases in costs of modern classrooms
and wages increased costs of production
– decrease in supply
Due to a larger percentage of high school
graduates attending college, demand
increased
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Market for a College Education
S2002
P
(annual cost
in 1970
dollars)
$3,917
S1970
New
equilibrium
was reached
at $4,573 and
a quantity of
12.3 million
students
$2,530
D1970
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8.6
13.2
Chapter 2
D2002
Q (millions
enrolled))
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The Long-Run Behavior
of Natural Resource Prices
Consumption of copper has increased about
a hundredfold from 1880 through 2002
The long term real price for copper has
remained relatively constant
Increased demand as world economy grew
Decreased production costs increased
supply
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Resource Market Equilibrium
Price
S1900
S1950
S2002
Long-Run Path of
Price and Consumption
D1900
D1950
D2002
Quantity
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Price Elasticity of Demand
Measures the sensitivity of quantity
demanded to price changes
It measures the percentage change in the
quantity demanded of a good that results
from a one percent change in price
% Q D
E
% P
D
P
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Price Elasticity of Demand
The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable
Therefore, elasticity can also be written
as:
Q Q P Q
E
P P Q P
D
P
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Price Elasticity of Demand
Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
When |EP| > 1, the good is price elastic
|%Q| > |%P|
When |EP| < 1, the good is price inelastic
|%Q| < |% P|
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Price Elasticity of Demand
The primary determinant of price
elasticity of demand is the availability of
substitutes
Many substitutes, demand is price elastic
Can
easily move to another good with price
increases
Few substitutes, demand is price inelastic
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Price Elasticity of Demand
As we move along a linear demand curve
Q/P is constant, but P and Q will
change
Must be measured at a particular point
on the demand curve
Elasticity will change along the demand
curve in a particular way
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Price Elasticity of Demand
Given a linear demand curve
Elasticity depends on slope and on the
values of P and Q
The top portion of demand curve is elastic
Price
is high and quantity small
The bottom portion of demand curve is
inelastic
Price
©2005 Pearson Education, Inc.
is low and quantity high
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Price Elasticity of Demand
Price
4
EP = -
Demand Curve
Q = 8 – 2P
Elastic
Ep = -1
2
Inelastic
4
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Q
Ep = 0
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Price Elasticity of Demand
The steeper the demand curve, the more
inelastic the demand for the good
becomes
The flatter the demand curve, the more
elastic the the demand for the good
becomes
Two extreme cases of demand curves
Completely inelastic demand – vertical
Perfectly elastic demand – horizontal
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Infinitely Elastic Demand
Price
EP =
D
P*
Quantity
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Completely Inelastic Demand
Price
D
EP = 0
Q*
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Quantity
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Other Demand Elasticities
Income Elasticity of Demand
Measures how much quantity demanded
changes with a change in income
Q/Q I Q
EI
I/I Q I
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Other Demand Elasticities
Cross-Price 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
EQb Pm
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Qb Qb Pm Qb
Pm Pm Qb Pm
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Other Demand Elasticities
Complements: Cars and Tires
Cross-price elasticity of demand is negative
Price
of cars increases, quantity demanded of
tires decreases
Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
Price
of butter increases, quantity of margarine
demanded increases
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Price Elasticity of Supply
Measures the sensitivity of quantity
supplied given a change in price
Measures the percentage change in quantity
supplied resulting from a 1 percent change in
price
%QS
E
%P
S
P
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Point vs. Arc Elasticities
Point elasticity of demand
Price elasticity of demand at a particular
point on the demand curve
Arc elasticity of demand
Price elasticity of demand calculated over a
range of prices
D
EP
©2005 Pearson Education, Inc.
ΔQ
P
ΔP Q
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Short-Run Versus Long-Run
Elasticity
Price elasticity varies with the amount of
time consumers have to respond to a
price
Short-run demand and supply curves
often look very different from their longrun counterparts
©2005 Pearson Education, Inc.
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Short-Run Versus Long-Run
Elasticity
Demand
In general, demand is much more price
elastic in the long run
Consumers
take time to adjust consumption
habits
Demand might be linked to another good that
changes slowly
More substitutes are usually available in the
long run
©2005 Pearson Education, Inc.
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Gasoline: Short-Run and Long-Run
Demand Curves
Price
DSR
• People cannot easily
adjust consumption in
the short run.
• In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
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Short-Run Versus Long-Run
Elasticity
Demand and Durability
For some durable goods, demand is more
elastic in the short run
If goods are durable, then when price
increases, consumers choose to hold on to
the good instead of replacing it
But in long run, older durable goods will have
to be replaced
©2005 Pearson Education, Inc.
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Cars: Short-Run and Long-Run
Demand Curves
Price
DLR
• Initially, people may put
off immediate car
purchase
• In long run, older cars
must be replaced
DSR
Quantity of Cars
©2005 Pearson Education, Inc.
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Short-Run Versus Long-Run
Elasticity
Income elasticity also differs from short
run to long run
For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending
©2005 Pearson Education, Inc.
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Short-Run Versus Long-Run
Elasticity
Income elasticity of durable goods
Income elasticity is less in the long run than
in the short run
Increases
in income mean consumers will want
to hold more cars
Once increase in purchases of new cars is
achieved, purchases will only be to replace old
cars
Less purchases from the income increase in
long run than in short run
Cyclical industries
©2005 Pearson Education, Inc.
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Demand for Gasoline
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Demand for Automobiles
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Short-Run Versus Long-Run
Elasticity of Supply
Most goods and services:
Long-run price elasticity of supply is greater
than short-run price elasticity of supply
Sometimes short run perfectly inelastic
Other Goods (durables, recyclables):
Long-run price elasticity of supply is less
than short-run price elasticity of supply
Ex: Recyclables: increase in price leads to
increase in secondary supply
Long
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run – secondary S exhausted
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Short-Run Versus Long-Run
Elasticity
SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.
©2005 Pearson Education, Inc.
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Quantity Primary Copper
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Short-Run Versus Long-Run
Elasticity
SLR
Price
SSR
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long run, this
stock of scrap copper
begins to fall.
Quantity Secondary Copper
©2005 Pearson Education, Inc.
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Supply of Copper
©2005 Pearson Education, Inc.
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Short-Run vs. Long-Run
Elasticity – An Application
Why are coffee prices so volatile?
Most of the world’s coffee is produced in
Brazil
Many changing weather conditions affect the
crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
In long run, prices come back to original
levels, all else equal
©2005 Pearson Education, Inc.
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Price of Brazilian Coffee
©2005 Pearson Education, Inc.
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Short-Run vs. Long-Run
Elasticity – An Application
Demand and supply are more elastic in
the long run
In the short run, supply is completely
inelastic
Weather may destroy part of the fixed supply,
decreasing supply
Demand is relatively inelastic as well
Price increases significantly
©2005 Pearson Education, Inc.
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An Application - Coffee
Price
S’
S
A freeze or drought
decreases the supply
of coffee
Price increases
significantly due to
inelastic supply and
demand
P1
P0
D
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Q1
Q0
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An Application - Coffee
Price
S’
S
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
P2
P0
D
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Q2 Q0
Quantity
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An Application - Coffee
Price
Long-Run
1) Supply is extremely elastic
2) Price falls back to P0.
3) Quantity back to Q0.
S
P0
D
Q0
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Predicting the Effects of
Changing Market Conditions
Supply and demand analysis can be
used to predict the effects of changing
market conditions
Linear demand and supply must be fit to
market data
Given
equilibrium price and quantity along with
elasticities of supply and demand, we can
calculate the curves that fit the information
We can then calculate changes in the market
©2005 Pearson Education, Inc.
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Predicting the Effects of
Changing Market Conditions
We know
Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, ES
Price elasticity of demand, ED
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Predicting the Effects of
Changing Market Conditions
Let’s begin with the equations for supply,
demand, elasticity:
Demand: Q = a – bP
Supply: Q = c + dP
Elasticity: (P/Q)(Q/P)
We must calculate numbers for a, b, c,
and d.
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Predicting the Effects of
Changing Market Conditions
The slope of the demand curve above
equals Q/P which equals -b
The slope of the supply curve above
equals Q/P which equals d
Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)
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Predicting the Effects of
Changing Market Conditions
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
Demand: Q = a - bP
-c/d
Q*
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Predicting the Effects of
Changing Market Conditions
Using P*, Q* and the elasticities, we can
solve for b and c from supply
ES = d(P*/Q*)
1.6 = d(0.75/7.5) = 0.1d
d = 16
Q = c + dP
7.5 = c + (16)(0.75) = c + 12
c = -4.5
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Predicting the Effects of
Changing Market Conditions
Using P*, Q* and the elasticities, we can
solve for a and b from demand
ED = –b(P*/Q*)
-0.8 = -b(0.75/7.5) = –0.1b
b=8
Q = a – bP
7.5 = a – (8)(0.75) = a – 6
a = 13.5
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Predicting the Effects of
Changing Market Conditions
We now have equations for supply and
demand
Supply: Q = –4.5 + 16P
Demand: Q = 13.5 – 8P
Setting them equal will give us
equilibrium price and quantity with which
we began
©2005 Pearson Education, Inc.
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Predicting the Effects of
Changing Market Conditions
Price
Supply: QS = -4.5 + 16P
a/b
.75
Demand: QD = 13.5 - 8P
-c/d
7.5
©2005 Pearson Education, Inc.
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Mmt/yr
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Predicting the Effects of
Changing Market Conditions
We have written supply and demand so
that they only depend upon price
Demand could also depend upon other
variables such as income
Demand would then be written as:
Q a bP fI
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Predicting the Effects of
Changing Market Conditions
We know the following information
regarding the copper industry:
I = 1.0
P* = 0.75
Q* = 7.5
b = 8
Income elasticity: EI= 1.3
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Predicting the Effects of
Changing Market Conditions
Using the elasticity of income formula, we
can solve for f
EI = (I/Q)(Q/I)
1.3 = (1.0/7.5)(f)
f = 9.75
Substituting back into demand equation
gives a = 3.75
©2005 Pearson Education, Inc.
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Declining Demand and the
Behavior of Copper Prices
Copper has gone through difficult market
changes leading the significantly reduced
prices most from decreased demand
from
A decrease in the growth rate of power
generation
The development of substitutes: fiber optics
and aluminum
©2005 Pearson Education, Inc.
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Real versus Nominal
Prices of Copper 1965 - 2002
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Declining Demand and the
Behavior of Copper Prices
Given producers’ concerns about further
declines in demand, we can calculate by
how much prices will fall with future
declines in demand
Assume that demand will fall by 20%
What is the resulting decrease in price?
Demand curve will shift to left by 20%
©2005 Pearson Education, Inc.
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Declining Demand and the Behavior
of Copper Prices
We want to consider 80% of the past
demand
Q = (0.80)(13.5 - 8P)
Q = 10.8 - 6.4P
Recall the equation for supply:
Q = -4.5 + 16P
©2005 Pearson Education, Inc.
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Declining Demand and the Behavior
of Copper Prices
Setting supply equal to demand:
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4
P = 68.3 cents/pound
A decline in demand of 20% will lead to a
drop in price about 7%
©2005 Pearson Education, Inc.
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Effects of Price Controls
Markets are rarely free of government
intervention
Imposed taxes and granted subsidies
Price controls
Price controls usually hold the price
above or below the equilibrium price
Excess demand – shortage
Excess supply – surplus
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Effects of Price Controls
Price
S
• Price is regulated to
be no higher than Pmax
• Quantity supplied
falls and quantity
demanded increases
• A shortage results
P0
Pmax
Shortage
QS
©2005 Pearson Education, Inc.
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QD Quantity
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Effects of Price Controls
Excess demand sometimes takes the
form of queues
Lines at gas stations during 1974 shortage
Sometimes get curtailments and supply
rationing
Natural gas shortage of the mid ’70’s
Producers typically lose, but some
consumers gain. Some consumers lose.
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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
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Price Controls and
Natural Gas Shortages
Price controls created an excess demand
of 7 trillion cubic feet
Price regulation was a major component
of US energy policy in the 1960s and
1970s, and it continued to influence the
natural gas markets in the 1980s
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