Transcript Chapter 2 The Basics of Supply and Demand Topics to Be Discussed  Supply and Demand  The Market Mechanism  Changes in Market Equilibrium  Elasticities of Supply and Demand  Short-Run.

Chapter 2
The Basics of
Supply and
Demand
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 2
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 3
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 4
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 5
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 6
Supply and Demand

The Supply Curve

This price-quantity relationship can be shown
by the equation:
Qs  QS (P )
Chapter 2: The Basics of Supply and Demand
Slide 7
Supply and Demand
The Supply
Curve Graphically
Price
($ per unit)
Vertical axis measures
price (P) received
per unit in dollars
Horizontal axis measures
quantity (Q) supplied in
number of units per
time period
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 8
Supply and Demand
Price
($ per unit)
S
The Supply
Curve Graphically
P2
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output
P1
Q1
Q2
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 9
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 10
Supply and Demand
Change in Supply

The cost of raw
materials falls

At P1, produce Q2

At P2, produce Q1

Supply curve shifts right
to S’

P
S’
S
P1
P2
More produced at any
price on S’ than on S
Q0
Chapter 2: The Basics of Supply and Demand
Q1
Q2
Slide 11
Q
Supply and Demand

Supply - A Review

Supply is determined by non-price supplydetermining 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 12
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 13
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:
QD  QD(P)
Chapter 2: The Basics of Supply and Demand
Slide 14
Supply and Demand
Price
($ per unit)
Vertical axis measures
price (P) paid
per unit in dollars
Horizontal axis measures
quantity (Q) demanded in
number of units per
time period
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 15
Supply and Demand
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 and the
consumer’s real income
increases.
D
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 16
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 17
Supply and Demand
Change in Demand

Income Increases
P
D’
D
P2

At P1, produce Q2

At P2, produce Q1

Demand Curve shifts right P1

More purchased at any
price on D’ than on D
Q0
Chapter 2: The Basics of Supply and Demand
Q1
Q2
Slide 18
Q
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 19
The Market Mechanism
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 20
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 21
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
If price is above equilibrium:
1) Price is above the
market clearing price
2) Qs > Qd
3) Price falls to the
market-clearing price
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 22
The Market Mechanism
A Surplus

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.
Chapter 2: The Basics of Supply and Demand
Slide 23
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Qs : Q2 > Qd : Q1
2) Excess supply is Q1:Q2.
3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
P2
D
Q1
Q3
Q2 Quantity
Chapter 2: The Basics of Supply and Demand
Slide 24
The Market Mechanism
Surplus - Review:

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
Chapter 2: The Basics of Supply and Demand
Slide 25
The Market Mechanism
Shortage

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.
Chapter 2: The Basics of Supply and Demand
Slide 26
The Market Mechanism
Price
($ per unit)
S
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
P3
P2
Shortage
Q1
Q3
D
Q2 Quantity
Chapter 2: The Basics of Supply and Demand
Slide 27
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 28
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 29
Changes In Market Equilibrium

Raw material prices
fall

P
D
S
S’
S shifts to S’

Surplus @ P1 of
Q 1, Q 2

Equilibrium @ P3,
Q3
P1
P3
Q1 Q3 Q2
Chapter 2: The Basics of Supply and Demand
Slide 30
Q
Changes In Market Equilibrium

Income Increases
P

Demand shifts to D1

Shortage @ P1 of Q1, Q2 P3

Equilibrium @ P3, Q3
D
D’
S
P1
Q2 Q1 Q3
Chapter 2: The Basics of Supply and Demand
Slide 31
Q
Changes In Market Equilibrium

Income Increases &
raw material prices fall


The increase in D is
greater than the
increase in S
P
D
D’
S
S’
P2
P1
Equilibrium price and
quantity increase to P2,
Q2
Q1
Chapter 2: The Basics of Supply and Demand
Q2
Slide 32
Q
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 33
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 34
Market for Eggs
P
S1970
(1970
dollars per
dozen)
Prices fell until
a new equilibrium
was reached at $0.26
and a quantity
of 5,300 million dozen
S1998
$0.61
$0.26
D1970
5,300 5,500
Chapter 2: The Basics of Supply and Demand
D1998
Q (million dozens)
Slide 35
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 36
Market for a College Education
P
S1995
(annual cost
in 1970
dollars)
Prices rose until
a new equilibrium
was reached at $4,573
and a quantity
of 12.3 million students
$4,248
S1970
$2,530
D1970
8.6
14.9
Chapter 2: The Basics of Supply and Demand
D1995
Q (millions of students enrolled))
Slide 37
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 38
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 39
Consumption & Price of Copper
1880-1998
Chapter 2: The Basics of Supply and Demand
Slide 40
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 41
Changes In Market Equilibrium
Price
S1900
S1950
S1998
Long-Run Path of
Price and Consumption
D1900
D1950
D1998
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 42
Changes In Market Equilibrium

Conclusion

Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand.
Chapter 2: The Basics of Supply and Demand
Slide 43
Changes In Market Equilibrium

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.
Chapter 2: The Basics of Supply and Demand
Slide 44
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 45
Elasticities of Supply and Demand
Price Elasticity of 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.
Chapter 2: The Basics of Supply and Demand
Slide 46
Elasticities of Supply and Demand

The price elasticity of demand is:
EP  (%Q)/(%P)
Chapter 2: The Basics of Supply and Demand
Slide 47
Elasticities of Supply and Demand
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.
Chapter 2: The Basics of Supply and Demand
Slide 48
Elasticities of Supply and Demand
Price Elasticity of Demand

So the price elasticity of demand is also:
Q/Q P Q
EP 

P/P
Q P
Chapter 2: The Basics of Supply and Demand
Slide 49
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 50
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 51
Elasticities of Supply and Demand
Price Elasticity of 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
Chapter 2: The Basics of Supply and Demand
Slide 52
Price Elasticities of Demand
Price
EP  - 
The lower portion of
a downward sloping
demand curve is less elastic
than the upper portion.
4
Q = 8 - 2P
Ep = -1
2
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Ep = 0
4
Chapter 2: The Basics of Supply and Demand
8
Q
Slide 53
Price Elasticities of Demand
Price
Infinitely Elastic Demand
D
P*
EP  - 
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 54
Price Elasticities of Demand
Completely Inelastic Demand
Price
EP  0
Q*
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 55
Elasticities of Supply and Demand
Other Demand Elasticities

Income elasticity of demand measures
the percentage change in quantity
demanded resulting from a one percent
change in income.
Chapter 2: The Basics of Supply and Demand
Slide 56
Elasticities of Supply and Demand
Other Demand Elasticities

The income elasticity of demand is:
Q/Q
I Q
EI 

I/I
Q I
Chapter 2: The Basics of Supply and Demand
Slide 57
Elasticities of Supply and Demand
Other Demand Elasticities

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.
Chapter 2: The Basics of Supply and Demand
Slide 58
Elasticities of Supply and Demand

The cross elasticity of demand is:
Qb/Qb Pm Qb
EQbPm 

Pm/Pm Qb Pm

The cross elasticity for substitutes is positive,
while that for complements is negative.
Chapter 2: The Basics of Supply and Demand
Slide 59
Elasticities of Supply and Demand
Elasticities of Supply

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.
Chapter 2: The Basics of Supply and Demand
Slide 60
Elasticities of Supply and Demand
Elasticities of Supply

We can refer to elasticity of supply with
respect to interest rates, wage rates, and the
cost of raw materials.
Chapter 2: The Basics of Supply and Demand
Slide 61
Elasticities of Supply and Demand
The Market for Wheat

1981 Supply Curve for Wheat
 QS

= 1,800 + 240P
1981 Demand Curve for Wheat
 QD
= 3,550 - 266P
Chapter 2: The Basics of Supply and Demand
Slide 62
Elasticities of Supply and Demand
The Market for Wheat

Equilibrium: Q S = Q D
1,800 240P  3,550 266P
506P  1,750
P  3.46 / bushel
Q  1,800 (240)(3.46)  2,630million bushels
Chapter 2: The Basics of Supply and Demand
Slide 63
Elasticities of Supply and Demand
The Market for Wheat
P QD
3.46
E 

(2.66)  .035 Inelastic
Q P
2,630
D
P
P QS
3.46
E 

(2.40)  .032 Inelastic
Q P 2,630
S
P
Chapter 2: The Basics of Supply and Demand
Slide 64
Elasticities of Supply and Demand
The Market for Wheat

Assume the price of wheat is $4.00/bushel
QD  3,550 (266)(4.00)  2,486
4.00
Q 
(266)  0.43
2,486
D
P
Chapter 2: The Basics of Supply and Demand
Slide 65
Changes in the Market: 1981-1998
The Market for Wheat
Supply (Qs) Demand (QD)
Equilibrium Price (Qs = QD)
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
Chapter 2: The Basics of Supply and Demand
Slide 66
Short-Run Versus
Long-Run Elasticities
Demand

Price elasticity of demand varies with the
amount of time consumers have to
respond to a price.
Chapter 2: The Basics of Supply and Demand
Slide 67
Short-Run Versus
Long-Run Elasticities
Demand

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)
Chapter 2: The Basics of Supply and Demand
Slide 68
Gasoline: Short-Run and
Long-Run Demand Curves
Price
DSR
People tend to
drive smaller and
more fuel efficient
cars in the long-run
Gasoline
DLR
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 69
Automobiles: Short-Run and
Long-Run Demand Curves
Price
DLR
People may put
off immediate
consumption, but
eventually older cars
must be replaced.
Automobiles
DSR
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 70
Short-Run Versus
Long-Run Elasticities
Income Elasticities

Income elasticity also varies with the
amount of time consumers have to
respond to an income change.
Chapter 2: The Basics of Supply and Demand
Slide 71
Short-Run Versus
Long-Run Elasticities
Income Elasticities

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.
Chapter 2: The Basics of Supply and Demand
Slide 72
Short-Run Versus
Long-Run Elasticities
Income Elasticities

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.
Chapter 2: The Basics of Supply and Demand
Slide 73
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles

Gasoline and automobiles are
complementary goods.
Chapter 2: The Basics of Supply and Demand
Slide 74
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles

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.
Chapter 2: The Basics of Supply and Demand
Slide 75
Short-Run Versus
Long-Run Elasticities
The Demand for Gasoline
Years Following Price or Income Change
Elasticity
Price
Income
1
2
3
4
5
6
-0.11 -0.22 -0.32 -0.49 -0.82 -1.17
0.07 0.13
0.20
Chapter 2: The Basics of Supply and Demand
0.32
0.54
0.78
Slide 76
Short-Run Versus
Long-Run Elasticities
The Demand for Automobiles
Years Following Price or Income Change
Elasticity
Price
Income
1
2
3
4
5
6
-1.20 -0.93 -0.75 -0.55 -0.42 -0.40
3.00 2.33
1.88
Chapter 2: The Basics of Supply and Demand
1.38
1.02
1.00
Slide 77
Short-Run Versus
Long-Run Elasticities
The Demand for
Gasoline and Automobiles

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.
Chapter 2: The Basics of Supply and Demand
Slide 78
Short-Run Versus
Long-Run Elasticities
Supply

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
Chapter 2: The Basics of Supply and Demand
Slide 79
Short-Run Versus
Long-Run Elasticities
Primary Copper: Short-Run and
Long-Run Supply Curves
Price
SSR
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 80
Short-Run Versus
Long-Run Elasticities
Secondary Copper: Short-Run and
Long-Run Supply Curves
SLR
SSR
Price
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
Chapter 2: The Basics of Supply and Demand
Slide 81
Short-Run Versus
Long-Run Elasticities
Supply of Copper
Price Elasticity of:
Short-run
Long-run
Primary supply
0.20
1.60
Secondary supply
0.43
0.31
Total supply
0.25
1.50
Chapter 2: The Basics of Supply and Demand
Slide 82
Short-Run Versus
Long-Run Elasticities
Weather in Brazil and
the price of Coffee
in New York

Elasticity explains why coffee prices are
very volatile.

Due to the differences in supply elasticity in
the long-run and short run.
Chapter 2: The Basics of Supply and Demand
Slide 83
Price of Brazilian Coffee
Chapter 2: The Basics of Supply and Demand
Slide 84
Short-Run Versus
Long-Run Elasticities
Coffee
S’
S
Price
A freeze or drought
decreases the supply
of coffee
P1
P0
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
D
Q1
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 85
Short-Run Versus
Long-Run Elasticities
Coffee
Price
S’
S
P2
P0
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
3) Quantity falls to Q2
D
Q2 Q 0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 86
Short-Run Versus
Long-Run Elasticities
Coffee
Price
Long-Run
1) Supply is extremely elastic.
2) Price falls back to P0.
3) Quantity increase to Q0.
S
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 87
Understanding and Predicting the Effects
of Changing Market Conditions

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.
Chapter 2: The Basics of Supply and Demand
Slide 88
Understanding and Predicting the Effects
of Changing Market Conditions

Available Data

Equilibrium Price, P*

Equilibrium Quantity, Q*

Price elasticity of supply, ES, and
demand, ED.
Chapter 2: The Basics of Supply and Demand
Slide 89
Understanding and Predicting the Effects
of Changing Market Conditions
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
-c/d
Demand: Q = a - bP
Q*
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 90
Understanding and Predicting the Effects
of Changing Market Conditions

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.
Chapter 2: The Basics of Supply and Demand
Slide 91
Understanding and Predicting the Effects
of Changing Market Conditions

Step 1:
Recall:
E  (P/Q)( Q/P)
Chapter 2: The Basics of Supply and Demand
Slide 92
Understanding and Predicting the Effects
of Changing Market Conditions

For linear demand curves, the change in
quantity divided by the change in price is
constant (equal to the slope of the curve).
Chapter 2: The Basics of Supply and Demand
Slide 93
Understanding and Predicting the Effects
of Changing Market Conditions

Substituting the slopes for each into the
formula for elasticity, we get:
ED  - b(P * /Q*)
ES  d(P * /Q*)
Chapter 2: The Basics of Supply and Demand
Slide 94
Understanding and Predicting the Effects
of Changing Market Conditions

Since we will have values for ED, ES, P*,
and Q*, we can solve for b & d, and a & c.
QD  a  bP
*
*
QS  c  dP
*
Chapter 2: The Basics of Supply and Demand
*
Slide 95
Understanding and Predicting the Effects
of Changing Market Conditions

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
Chapter 2: The Basics of Supply and Demand
Slide 96
Understanding and Predicting the Effects
of Changing Market Conditions

Es = d(P*/Q*)

Ed = -b(P*/Q*)

1.6 = d(0.75/7.5)
= 0.1d

-0.8 = -b(0.75/7.5)
= -0.1b

d = 1.6/0.1 = 16

b = 0.8/0.1 = 8
Chapter 2: The Basics of Supply and Demand
Slide 97
Understanding and Predicting the Effects
of Changing Market Conditions

Supply = QS* = c + dP*

Demand = QD* = a -bP*

7.5 = c + 16(0.75)

7.5 = a -(8)(.75)

7.5 = c + 12

7.5 = a - 6

c = 7.5 - 12

a = 7.5 + 6

c = -4.5

a =13.5

Q = -4.5 + 16P

Q = 13.5 - 8P
Chapter 2: The Basics of Supply and Demand
Slide 98
Understanding and Predicting the Effects
of Changing Market Conditions

Setting supply equal to demand gives:
Supply = -4.5 + 16p = 13.5 - 8p = Demand
16p + 8p = 13.5 + 4.5
p = 18/24 = .75
Chapter 2: The Basics of Supply and Demand
Slide 99
Understanding and Predicting the Effects
of Changing Market Conditions
Price
Supply: QS = -4.5 + 16P
a/b
.75
-c/d
Demand: QD = 13.5 - 8P
7.5
Chapter 2: The Basics of Supply and Demand
Mmt/yr
Slide 100
Understanding and 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 income.

Demand would then be written as:
Q  a  bP  fI
Chapter 2: The Basics of Supply and Demand
Slide 101
Understanding and 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: E = 1.3
Chapter 2: The Basics of Supply and Demand
Slide 102
Understanding and Predicting the Effects
of Changing Market Conditions

f can be found by substituting known
values into the income elasticity formula:
E  (I / Q)(Q/ I )
and
f  Q / I
Chapter 2: The Basics of Supply and Demand
Slide 103
Understanding and Predicting the Effects
of Changing Market Conditions

Solving for f gives:
1.3 = (1.0/7.5)f
f = (1.3)(7.5)/1.0 = 9.75
Chapter 2: The Basics of Supply and Demand
Slide 104
Understanding and Predicting the Effects
of Changing Market Conditions

Solving for a gives:
Q  a  bP  fI
*
*
7.5 = a - 8(0.75) + 9.75(1.0)
a = 3.75
Chapter 2: The Basics of Supply and Demand
Slide 105
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 106
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand
Slide 107
Real versus Nominal
Prices of Copper 1965 - 1999

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
Chapter 2: The Basics of Supply and Demand
Slide 108
Real versus Nominal
Prices of Copper 1965 - 1999

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
Chapter 2: The Basics of Supply and Demand
Slide 109
Real versus Nominal
Prices of Copper 1965 - 1999

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
Chapter 2: The Basics of Supply and Demand
Slide 110
Real versus Nominal
Prices of Copper 1965 - 1999

The twenty percent decrease in demand
resulted in a reduction in the equilibrium
price to 68.3 cents from 75 cents, or 10
percent.
Chapter 2: The Basics of Supply and Demand
Slide 111
Price of Crude Oil
Chapter 2: The Basics of Supply and Demand
Slide 112
Upheaval in the World Oil Market

We can predict numerically the impact of
a decrease in the supply of OPEC oil.

In 1995:

P* = $18/barrel

World demand and total supply = 23 bb/yr.

OPEC supply = 10 bb/yr.

Non-OPEC supply = 13 bb/yr
Chapter 2: The Basics of Supply and Demand
Slide 113
Price Elasticity Estimates
Short-Run Long-Run
World Demand:
Competitive Supply
(non-OPEC)
-0.05
-0.40
0.10
0.40
Chapter 2: The Basics of Supply and Demand
Slide 114
Upheaval in the World Oil Market

Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr.

Short-run Demand


D = 24.08 - 0.06P
Short-run Competitive Supply

SC = 11.74 + 0.07P
Chapter 2: The Basics of Supply and Demand
Slide 115
Upheaval in the World Oil Market

Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr.

Short-run Total Supply--before supply
reduction (includes OPEC, 10bb/yr)


ST = 21.74 + 0.07P
Short-run Total Supply--after supply
reduction

ST = 18.74 + 0.07P
Chapter 2: The Basics of Supply and Demand
Slide 116
Upheaval in the World Oil Market

New Price After Reduction
Demand = Supply
24.08 - 0.06P = 18.74 + 0.07P
P = 41.08
Chapter 2: The Basics of Supply and Demand
Slide 117
Impact of Saudi Production Cut
SC
D S’T ST
Price 45
($ per
barrel) 40
Short-Run
Effect
35
30
25
20
18
15
10
5
0
5
10
15
20 23 25
Chapter 2: The Basics of Supply and Demand
30
Quantity
35 (billions barrels/yr)
Slide 118
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 119
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 120
Impact of Saudi Production Cut
SC
Price 45
D
($ per
barrel) 40
S’T ST
Long-run Effect
Due to the elasticity
of the long-run
supply and demand
curves, the long-run
effect of a cut
in production is
much less.
35
30
25
20
18
15
10
5
0
5
10
15
20 23 25
Chapter 2: The Basics of Supply and Demand
30
35
Quantity
(billions barrels/yr)
Slide 121
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 122
Effects of Price Controls
Price
S
If price is regulated to
be no higher than Pmax,
quantity supplied falls
to Q1 and quantity
demanded increases to
Q2. A shortage results
P0
Pmax
D
Excess demand
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 123
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 124
Price Controls and
Natural Gas Shortages

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.
Chapter 2: The Basics of Supply and Demand
Slide 125
Price Controls and
Natural Gas Shortages
The Data: Natural Gas
PES  0.2
Cross elasticity of supply for oil  0.1
D
PE
 0.5
Cross elasticity of demand for oil  1.5
Supply : Q  14  2 PG  .25PO
Demand : Q  5 PG  3.75PO
Supply  Demand @ $2/TcF
Chapter 2: The Basics of Supply and Demand
Slide 126
Price Controls and
Natural Gas Shortages
The Data: Natural Gas
1975 regulated price  $1.00
At $1.00/TcF
QS  18 TcF and Q  25 TcF
Shortage  7 TcF/yr
Chapter 2: The Basics of Supply and Demand
Slide 127
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 128
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 129
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.
Chapter 2: The Basics of Supply and Demand
Slide 130
End of Chapter 2
The Basics of
Supply and
Demand