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.
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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
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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
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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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Quantity
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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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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
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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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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
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
 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
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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
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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
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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
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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
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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.
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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
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Supply of Copper
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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
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Price of Brazilian Coffee
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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
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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
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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
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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
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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
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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
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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%
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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
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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%
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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
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Q0
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QD Quantity
82
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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