Chapter 2

The Basics of Supply & Demand

CHAPTER 2 OUTLINE

2.1 Supply and Demand

2.2 The Market Mechanism

2.3 Changes in Market Equilibrium

2.4 Elasticities of Supply and Demand

2.5 Short-Run versus Long-Run Elasticities

2.7 Effects of Government Intervention—Price Controls

SUPPLY AND DEMAND2.1

● supply curve Relationship between quantity supplied (Qs) and the price of the good, holding constant other factors.

Upward sloping: The higher the price, the more firms are able and willing to produce and sell.

If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve then shifts to the right.

QS = QS(P)

1. Production costs (e.g. wages, interest charges, and the costs of raw materials.)

2. Technology & Productivity

3. Taxes & subsidies

4. Expectation

5. The number of suppliers.

change in supply (S) VS change in the quantity supplied (Qs)

Other Variables That Affect Supply

movements along the same supply curve.

Shift of the entire supply curve

Shifting variables

● Demand curve

Relationship between the quantity of a good that consumers are willing to buy (QD ) and the price of the good (P), holding constant other factors.

QD = QD(P)

The demand curve is downward sloping:

holding other things equal, consumers will want to purchase more of a good as its price goes down (i.e., QD

increases)

If consumers’ incomes increase, we would expect to see an increase in demand—say from D to D’,

1. Income (normal good Vs inferior goods)

2. Price of related goods (substitutes Vs complements)

3. Tastes and preferences.

4. Expectation (future price, income, product availability)

5. The number of consumers.

change in demand (D) VS change in the quantity demanded (QD )

Other Variables That Affect Demand

movements along the same demand curve.

Shift of the entire demand curve

Shifting variables

• Practice Questions

1. What factors are held constant along a demand curve?

2. Consider the market for Canadian beef. What will be the impact on D

and QD?

a) The price of chicken decreases.

b) Household income increases.

c) Price of Canadian beef decreases.

d) A Canadian cow is found to have mad cow disease.

e) The Canadian government raises the price of Canadian beef.

Practice

A highly successful advertising campaign of New Balance makes more and more people want to buy its athletic shoes, as a result:

a. The demand of New Balance athletic shoes increases;b. The quantity demanded of New Balance athletic shoes increases;c. The price of New Balance athletic shoes decrease to encourage people to buy more;d. The demand of New Balance athletic shoes is not affected;e. None of above.

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THE MARKET MECHANISM2.2

The market clears at price P0 and quantity Q0.

At the higher price P1, a surplus develops, so price falls.

At the lower price P2, there is a shortage, so price is bid up.

E

Equilibrium

● equilibrium (or market clearing) price Price that equates the quantity supplied to the quantity demanded.

● market mechanism Tendency in a free market for price to change until the market clears.

● surplus Situation in which the QS > QD

● shortage Situation in which the QD > QS

CHANGES IN MARKET EQUILIBRIUM2.3

Shocks:

A new tech is developed which lowers the production cost.

S shifts to S’

The new equilibrium is E’.

EE’

CHANGES IN MARKET EQUILIBRIUM

E’

E

Shocks:

The impact of oil spill in Mexico gulf on the demand of Nova Scotia oyster.

D shifts to D’

The new equilibrium is E’.

CHANGES IN MARKET EQUILIBRIUM

Shift in both S and D.

• QD increases.

• Change in P depends on the amount by which each curve shifts and the shape of each curve.

• Change in P is uncertain.

EE’

Question 2:

For each of the following scenarios, illustrate graphically how the exogenous event change the price of corn in the U.S. market.

a. The U.S. Department of Agriculture announces that exports of corn to Taiwan and Japan were “surprisingly bullish,” around 30% higher than had been expected.

b. The size of the U.S. corn crop hits a six-year low because of dry weather.

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c. The strengthening of El Nino, the meteorological trend that brings warmer weather to the western coast of South America, reduces corn production outside the United States, thereby increasing foreign countries’ dependence on the U.S. corn crop. (Assume that the U.S. doesn’t import corn).

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Question 3:In each case below, identify the effect on the market for coal and illustrate it with a graph.

a) A new government regulation requiring air purifiers in all work areas.

b) A widespread news report that demand for coal will be much lower next year.

c) The development of a new, lower cost mining technique.

d) A decrease in the population.

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Question 4:

Which of the following would cause an unambiguous increase in the equilibrium price in a market?

a) An increase in supply and an increase in demand.

b) An increase in supply and a decrease in demand

c) A decrease in supply and an increase in demand

d) A decrease in supply and a decrease in demand.

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Question 5:

Assume that steak and potatoes are complements. When the price of steak goes up, the demand curve for potatoes:

A) shifts to the left.

B) shifts to the right.

C) remains constant.

D) shifts to the right initially and then returns to its original position.

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Question 6:

The price of good A goes up. As a result, the demand for good B shifts to the left. From this we can infer that:

A) good A is used to produce good B.

B) good B is used to produce good A.

C) goods A and B are substitutes.

D) goods A and B are complements.

E) none of the above

ELASTICITIES OF SUPPLY AND DEMAND

Price Elasticity of Demand

2.4

● elasticity Percentage change in one variable resulting from a 1-percent increase in another.

● Percentage change in quantity demanded of a good resulting from a 1-percent increase in its price.

(2.1)

D

D

D D D D

D

● linear demand curve Demand curve that is a straight line.

• The price elasticity of demand depends on the slope of the demand curve, the price and quantity.

• The elasticity varies along the curve as price and quantity change. Slope is constant for this linear demand curve.

• The elasticity becomes smaller as we move down the curve.

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• Example– Price of oil increases 10%– Quantity demanded decreases 1%

Ep

-1%10%

.1

E =-0.1 means:1 percent increase in the price would lead to a 0.1

percent decrease in the quantity demanded (QD).

D

D

P

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1. Please note that Ep is always negative– Reason: The law of demand– Exception: a luxury (expensive French wine,

celebrity-endorced perfume etc.)

2. Relative quantities only. The percentage change will be independent of the units chosen.

3. The greater the absolute price elasticity of demand, the greater is the demand responsiveness to relative price changes.

Points To Emphasize

D

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4. Elasticity and slope are not the same thing.

• Elasticity of demand is: • (1) Ep

= (Δ QD/QD) / (Δ P/P) • which can be rewritten as:

• (2) Ep = (Δ QD/QD) x (P/ Δ P) = (Δ QD/ Δ P) x (P/QD)

• Now (Δ QD)/( Δ P) is the inverse of the slope, assuming price is on the vertical axis and quantity on the horizontal axis.

Rewriting (2) gives:

(3) Ep = (1/slope) x (P/QD )

D

D

D

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Elastic Demand: │ EP │>1

Unit Elastic: │ EP │=1

Inelastic Demand: │ EP │<1 D

D

D

● infinitely elastic demand (horizontal)

● consumers will buy as much of a good as they can get at a single price, but for any higher price the quantity demanded drops to zero, while for any lower price the quantity demanded increases without limit.

EP =-∞D

● Principle that consumers will buy a fixed quantity of a good regardless of its price.

● completely inelastic demand EP =0D

ELASTICITIES OF SUPPLY AND DEMAND

Other Demand Elasticities

● income elasticity of demand Percentage change in the quantity demanded resulting from a 1-percent increase in income.

● cross-price elasticity of demand Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another.

● price elasticity of supply Percentage change in quantity supplied resulting from a 1-percent increase in price.

Elasticities of Supply

(2.2)

(2.3)

ELASTICITIES OF SUPPLY AND DEMAND

Point versus Arc Elasticities

● point elasticity of demand Price elasticity at a particular point on the demand curve.

● arc elasticity of demand Price elasticity calculated over a range of prices.

Arc Elasticity of Demand

(2.4)DD D

Let’s examine the supply and demand in the wheat market beginning in 1981.

# 1. What is the market-clearing price of wheat for 1981?

Substituting into the supply curve equation:

#2. Find the price elasticity of demand at equilibrium:

#3. We can likewise calculate the price elasticity of supply:

Thus demand is inelastic.

3.46(240) 0.32

2630S SP

QPE

Q P

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Question:

The demand for books is: Qd = 120 - P

The supply of books is: Qs = 5P

a) Find equilibrium price and quantity.b) If P = $15, which of the following is true? A) There is a surplus equal to 30. B) There is a shortage equal to 30. C) There is a surplus, but it is impossible to determine how large. D) There is a shortage, but it is impossible to determine how large.

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At point A, demand is:

A) completely inelastic.

B) inelastic, but not

completely inelastic.

C) unit elastic.

D) elastic, but not

infinitely elastic.

E) infinitely elastic.

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Question:

The demand for packs of Pokemon cards is given by the equation QD = 500,000 - 45,000P.

A)At a price of $2.50 per pack, what is the quantity demanded?

B)At $5.00 per pack, what is the price elasticity of demand?

C)Is the demand elastic, inelastic, or unit elastic, when P=$5?

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1. The existence, number, and quality of Substitutes

2. Share of Budget

3. The Length of Time Allowed for Adjustment

(Exception: Durable goods)

Determinants of thePrice Elasticity of Demand

2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

(a) Gasoline: Short-Run and Long-Run Demand Curves

Demand of gasoline is less elastic in the short run than in the long run.

Why?

(b) Automobiles: Short-Run and Long-Run Demand Curves

Demand of automobiles is less elastic in the long run than in the short run.

Why?

Demand and Durability

Income Elasticities

Income elasticities also differ from the short run to the long run.

For most goods and services—foods, beverages, fuel, entertainment, etc.— the income elasticity of demand is larger in the long run than in the short run.

For a durable good, the opposite is true. The short-run income elasticity of demand will be much larger than the long-run elasticity.

Consumption of Durables versus Nondurables

Industries that produce consumer durables are “cyclical” (i.e., changes in GDP are magnified). This is not true for producers of nondurables.

● cyclical industries Industries in which sales tend to magnify cyclical changes in gross domestic product and national income.

EXAMPLE 2.6 THE DEMAND FOR GASOLINE AND AUTOMOBILES

TABLE 2.1 DEMAND FOR GASOLINE

NUMBER OF YEARS ALLOWED TO PASSFOLLOWING A PRICE OR INCOME CHANGE

ELASTICITY 1 2 3 5 10

Price -0.2 −0.3 −0.4 −0.5 −0.8

Income 0.2 0.4 0.5 0.6 1.0

TABLE 2.2 DEMAND FOR AUTOMOBILES

NUMBER OF YEARS ALLOWED TO PASSFOLLOWING A PRICE OR INCOME CHANGE

ELASTICITY 1 2 3 5 10

Price −1.2 −0.9 −0.8 −0.6 −0.4

Income 3.0 2.3 1.9 1.4 1.0

Primary Copper (production from the mining and smelting of ore.

Like that of most goods, the supply of primary copper, shown in part (a), is more elastic in the long run.

Why?

Supply and Durability

Secondary Copper: melted own and refabricated.

If the price increases, there is a greater incentive to convert scrap copper into new supply. Initially, therefore, secondary supply (i.e., supply from scrap) increases sharply.But later, as the stock of scrap falls, secondary supply contracts.

Secondary supply is therefore less elastic in the long run than in the short run.

Table 2.3 Supply of Copper

Price Elasticity of: Short-Run Long-RunPrimary supply 0.20 1.60Secondary supply 0.43 0.31Total supply 0.25 1.50

EXAMPLE 2.7 THE WEATHER IN BRAZIL AND THE PRICE OF COFFEE IN NEW YORK

PRICE OF BRAZILIAN COFFEE

FIGURE 2.17

When droughts or freezes damage Brazil’s coffee trees, the price of coffee can soar.

The price usually falls again after a few years, as demand and supply adjust.

SUPPLY AND DEMAND FOR COFFEE

(a) A freeze or drought in Brazil causes the supply curve to shift to the left.

In the short run, supply is completely inelastic; only a fixed number of coffee beans can be harvested.

Demand is also relatively inelastic; consumers change their habits only slowly.

As a result, the initial effect of the freeze is a sharp increase in price, from P0 to P1.

EXAMPLE 2.7 THE WEATHER IN BRAZIL AND THE PRICE OF COFFEE IN NEW YORK

SUPPLY AND DEMAND FOR COFFEE

EXAMPLE 2.7 THE WEATHER IN BRAZIL AND THE PRICE OF COFFEE IN NEW YORK

(b) In the intermediate run, supply and demand are both more elastic; thus price falls part of the way back, to P2.

SUPPLY AND DEMAND FOR COFFEE

EXAMPLE 2.7 THE WEATHER IN BRAZIL AND THE PRICE OF COFFEE IN NEW YORK

(c) In the long run, supply is extremely elastic; because new coffee trees will have had time to mature, the effect of the freeze will have disappeared. Price returns to P0.

EFFECTS OF GOVERNMENT INTERVENTION—PRICE CONTROLS

2.7

Effects of Price Controls

Without price controls, the market clears at the equilibrium price and quantity P0 and Q0.

If price is regulated to be no higher than Pmax, the quantity supplied falls to Q1, the quantity demanded increases to Q2, and a shortage develops.

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Question:

Ice cream can be frozen. In the short run the magnitude of the own price elasticity of demand for ice cream:

A) is higher than in the long run. B) is lower than in the short run. C) is the same as in the long run. D) does not depend on the fact that ice

cream can be frozen.

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Question:

For computers and other business equipment, small changes in business earnings tend to generate relatively large short-run changes in the demand for this equipment. In the long run, the responsiveness of demand for business equipment with respect to income changes tends to be:

A) even more responsive.B) less responsive.C) equally responsive.D) none of the above

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Supply: Q = 15.90 + 0.72PG + 0.05PO

Demand: Q = 0.02 – 1.8PG + 0.69PO

• The following two equations are the supply and demand functions of natural gas. The average price of crude oil PO (which affects the supply and demand for natural gas) was about $50 per barrel.

Practice Question

Find the cross price elasticity of demand for natural gas and oil at the point where the market of natural gas clears out.

Are natural gas and oil complements or substitutes?