Chapter 2: The Basics of Supply and Demand

CHAPTER 2 THE BASICS OF SUPPLY AND DEMAND

TEACHING NOTES
This chapter reviews the basics of supply and demand that students should be familiar with from their introductory economics class. The instructor can choose to spend more or less time on this chapter depending on how much of a review the students require. This chapter departs from the standard treatment of supply and demand basics found in most other intermediate microeconomics textbooks by discussing some of the worlds most important markets (wheat gasoline and automobiles! and teaching students how to analy"e these markets with the tools of supply and demand. The real#world applications of this theory can be enlightening for students. $ome problems plague the understanding of supply and demand analysis. %ne of the most common sources of confusion is between movements along the demand curve and shifts in demand . Through a discussion of the ceteris paribus assumption stress that when representing a demand function (either with a graph or an equation! all other variables are held constant. &ovements along the demand curve occur only with changes in price . 's the omitted factors change the entire demand function shifts. (t may also be helpful to present an example of a demand function that depends not only on the price of the good but also on income and the price of other goods directly. This helps students understand that these other variables are actually in the demand function and are merely lumped into the intercept term of the simple linear demand function. )xample 2.* includes an example of a demand and supply function which each depend on the price of a substitute good. $tudents may also find a review of how to solve two equations with two unknowns helpful. (n general it is a good idea at this point to decide on the level of math that you will use in the class. (f you plan to use a lot of algebra and calculus it is a good idea to introduce and review it early on. To stress the quantitative aspects of the demand curve to students make the distinction between quantity demanded as a function of price Q = D(P ! and the inverse demand function where price is a function of the quantity demanded P = D #+(Q!" This may clarify the positioning of price on the #$axis and quantity on the %#axis. $tudents may also question how the market ad,usts to a new equilibrium. %ne simple mechanism is the partial#ad,ustment cobweb model. ' discussion of the cobweb model (based on traditional corn#hog cycle or any other example! adds a certain realism to the discussion and is much appreciated by students. (f you decide to write down the demand function so that income and other prices are visible variables in the demand function you can also do some interesting examples which explore the linkages between markets and how changes in one market affect price and quantity in other markets. 'lthough this chapter introduces demand income and cross#price elasticities you may find it more appropriate to return to income and cross#price elasticity after demand elasticity is reintroduced in -hapter .. $tudents invariably have a difficult time with the concept of elasticity. (t is helpful to explain clearly why a firm may be interested in estimating elasticity. /se concrete examples. 0or example a 1all $treet 2ournal article back in the spring of +**3 discussed how elasticity could be used by the movie industry so that different movies could have different ticket prices. This example tends to go over well as college students watch a lot of movies. This type of discussion can also be postponed until revenue is discussed.

Chapter 2: The Basics of Supply and Demand

QUESTIONS FOR REVIEW

1. Suppose !" u#usu"$$% !o &e" !e' ("uses !e )e*"#) (u'+e ,o' -(e ('e"* o s!-, o !e '-.! . W!% &-$$ !e p'-(e o, -(e ('e"* '-se o " #e& *"'/e 0($e"'-#. $e+e$1 'ssume the supply curve is fixed. The unusually hot weather will cause a rightward shift in the demand curve creating short#run excess demand at the current price. -onsumers will begin to bid against each other for the ice cream putting upward pressure on the price. The price of ice cream will rise until the quantity demanded and the quantity supplied are equal.

5rice
S

P2

P+

D+ Q+ 7 Q2

D2

6uantity of ( ce -ream
0igure 2.+

2. Use supp$% "#) )e*"#) (u'+es o -$$us '" e !o& e"(! o, !e ,o$$o&-#. e+e# s &ou$) ",,e( !e p'-(e o, 2u e' "#) !e 3u"# - % o, 2u e' 2ou.! "#) so$)4 ". A# -#('e"se -# !e p'-(e o, *"'."'-#e. &ost people consider butter and margarine to be substitute goods. 'n increase in the price of margarine will cause people to increase their consumption of butter thereby shifting the demand curve for butter out from D+ to D2 in 0igure 2.2.a. This shift in demand will cause the equilibrium price to rise from P+ to P2 and the equilibrium quantity to increase from Q+ to Q2.

Chapter 2: The Basics of Supply and Demand

5rice
S

P2

P+

D+ Q+ Q2

D2

6uantity of 9utter

0igure 2.2.a 2. A# -#('e"se -# !e p'-(e o, *-$/. &ilk is the main ingredient in butter. 'n increase in the price of milk will increase the cost of producing butter. The supply curve for butter will shift from S+ to S2 in 0igure 2.2.b resulting in a higher equilibrium price P2 covering the higher production costs and a lower equilibrium quantity Q2.

5rice
S2 S+ P2 P+

D Q2 Q+

6uantity of 9utter

0igure 2.2.b :ote: ;iven that butter is in fact made from the fat that is skimmed off of the milk butter and milk are ,oint products. (f you are aware of this relationship then your answer will change. (n this case as the price of milk increases so does the quantity supplied. 's the quantity supplied of milk increases there is a larger supply of fat available to make butter. This will shift the supply of butter curve to the right and the price of butter will fall.

<

(.

Chapter 2: The Basics of Supply and Demand A )e('e"se -# "+e'".e -#(o*e $e+e$s. 'ssume that butter is a normal good. ' decrease in the average income level will cause the demand curve for butter to shift from D+ to D2. This will result in a decline in the equilibrium price from P+ to P2 and a decline in the equilibrium quantity from Q+ to Q2. $ee 0igure 2.2.c.

5rice
S

P+ P2

D2 Q2 Q+

D+

6uantity of 9utter

0igure 2.2.c 5. I, " 50pe'(e# -#('e"se -# !e p'-(e o, (o'# ,$"/es ("uses " 60pe'(e# )e($-#e -# !e 3u"# - % )e*"#)e)7 &!" -s !e e$"s -(- % o, )e*"#)1 The elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in the price. The elasticity of demand for 6 corn flakes is = 2 . This is equivalent to saying that a += increase in price +3 leads to a 2= decrease in quantity demanded. This is in the elastic region of the demand curve where the elasticity of demand exceeds #+.>. 8. E9p$"-# !e )-,,e'e#(e 2e &ee# " s!-, *o+e*e# "$o#. !e supp$% (u'+e. -# !e supp$% (u'+e "#) "

' movement along the supply curve is caused by a change in the price or the quantity of the good since these are the variables on the axes. ' shift of the supply curve is caused by any other relevant variable that causes a change in the quantity supplied at any given price. $ome examples are changes in production costs and an increase in the number of firms supplying the product. :. E9p$"-# &!% ,o' *"#% .oo)s7 !"# !e s!o' 0'u# e$"s -(- %. !e $o#.0'u# p'-(e e$"s -(- % o, supp$% -s $"'.e'

The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in price. 'n increase in price induces an increase in the quantity supplied by firms. $ome firms in some markets may respond quickly and cheaply to price changes. ?owever other firms may be constrained by their production capacity in the short run. The firms with short# run capacity constraints will have a short#run supply elasticity that is less elastic. ?owever in the long run all firms can increase their scale of production and thus have a larger long#run price elasticity.

Chapter 2: The Basics of Supply and Demand 6. W!% )o $o#.0'u# e$"s -(- -es o, )e*"#) )-,,e' ,'o* s!o' 0'u# e$"s -(- -es1 Co#s-)e' &o .oo)s4 p"pe' o&e$s "#) e$e+-s-o#s. W!-(! -s " )u'"2$e .oo)1 Wou$) %ou e9pe( !e p'-(e e$"s -(- % o, )e*"#) ,o' p"pe' o&e$s o 2e $"'.e' -# !e s!o' 0'u# o' -# !e $o#.0'u#1 W!%1 W!" "2ou !e p'-(e e$"s -(- % o, )e*"#) ,o' e$e+-s-o#s1 @ong#run and short#run elasticities differ based on how rapidly consumers respond to price changes and how many substitutes are available. (f the price of paper towels a non#durable good were to increase consumers might react only minimally in the short run. (n the long run however demand for paper towels would be more elastic as new substitutes entered the market (such as sponges or kitchen towels!. (n contrast the quantity demanded of durable goods such as televisions might change dramatically in the short run following a price change. 0or example the initial result of a price increase for televisions would cause consumers to delay purchases because durable goods are built to last longer. )ventually consumers must replace their televisions as they wear out or become obsolete and therefore we expect the demand for durables to be more inelastic in the long run. ;. A'e !e ,o$$o&-#. s " e*e# s 'ue o' ,"$se1 E9p$"-# %ou' "#s&e'. ". T!e e$"s -(- % o, )e*"#) -s (u'+e. !e s"*e "s !e s$ope o, !e )e*"#)

0alse. )lasticity of demand is the percentage change in quantity demanded for a given percentage change in the price of the product. The slope of the demand curve is the change in price for a given change in quantity demanded measured in units of output. Though similar in definition the units for each measure are different. 2. T!e ('oss p'-(e e$"s -(- % &-$$ "$&"%s 2e pos- -+e. 0alse. The cross price elasticity measures the percentage change in the quantity demanded of one product for a given percentage change in the price of another product. This elasticity will be positive for substitutes (an increase in the price of hot dogs is likely to cause an increase in the quantity demanded of hamburgers! and negative for complements (an increase in the price of hot dogs is likely to cause a decrease in the quantity demanded of hot dog buns!. (. T!e supp$% o, "p"' *e# s -s *o'e -#e$"s -( -# !e s!o' 'u# !"# !e $o#. 'u#. True. (n the short run it is difficult to change the supply of apartments in response to a change in price. (ncreasing the supply requires constructing new apartment buildings which can take a year or more. $ince apartments are a durable good in the long run a change in price will induce suppliers to create more apartments (if price increases! or delay construction (if price decreases!. <. Suppose !e .o+e'#*e# 'e.u$" es !e p'-(es o, 2ee, "#) (!-(/e# "#) se s !e* 2e$o& !e-' *"'/e 0($e"'-#. $e+e$s. E9p$"-# &!% s!o' ".es o, !ese .oo)s &-$$ )e+e$op "#) &!" ,"( o's &-$$ )e e'*-#e !e s-=es o, !e s!o' ".es. W!" &-$$ !"ppe# o !e p'-(e o, po'/1 E9p$"-# 2'-e,$%. (f the price of a commodity is set below its market#clearing level the quantity that firms are willing to supply is less than the quantity that consumers wish to purchase. The extent of the excess demand implied by this response will depend on the relative elasticities of demand and supply. 0or instance if both supply and demand are elastic the shortage is larger than if both are inelastic. 0actors such as the willingness of consumers to eat less meat and the ability of farmers to change the si"e of their herds and hence produce less will determine these elasticities and influence the si"e of excess demand. -ustomers whose demands are not met will attempt to purchase substitutes thus increasing the demand for substitutes and raising their prices. (f the

Chapter 2: The Basics of Supply and Demand prices of beef and chicken are set below market#clearing levels the price of pork will rise assuming that pork is a substitute for beef and chicken.

>. T!e (- % (ou#(-$ o, " s*"$$ (o$$e.e o&# )e(-)es o 'e.u$" e 'e# s -# o')e' o 'e)u(e s u)e# $-+-#. e9pe#ses. Suppose !e "+e'".e "##u"$ *"'/e 0($e"'-#. 'e# ,o' " &o02e)'oo* "p"' *e# !") 2ee# ?;@@ pe' *o# !7 "#) 'e# s "'e e9pe( e) o -#('e"se o ?>@@ &- !-# " %e"'. T!e (- % (ou#(-$ $-*- s 'e# s o !e-' (u''e# ?;@@ pe' *o# ! $e+e$. ". D'"& " supp$% "#) )e*"#) .'"p! o -$$us '" e &!" &-$$ !"ppe# o !e 'e# "$ p'-(e o, "# "p"' *e# ", e' !e -*pos- -o# o, 'e# (o# 'o$s. The rental price will stay at the old equilibrium level of A<>> per month. The expected increase to A*>> per month may have been caused by an increase in demand. ;iven this is true the price of A<>> will be below the new equilibrium and there will be a shortage of apartments. 2. Do %ou !-#/ !-s po$-(% &-$$ 2e#e,- "$$ s u)e# s1 W!% o' &!% #o . (t will benefit those students who get an apartment though these students may also find that the costs of searching for an apartment are higher given the shortage of apartments. Those students who do not get an apartment may face higher costs as a result of having to live outside of the college town. Their rent may be higher and the transportation costs will be higher. 1@. I# " )-s(uss-o# o, u- -o# '" es7 " u#-+e's- % o,,-(-"$ "'.ues !" !e )e*"#) ,o' ")*-ss-o# -s (o*p$e e$% p'-(e -#e$"s -(. As e+-)e#(e s!e #o es !" &!-$e !e u#-+e's- % !"s )ou2$e) - s u- -o# A-# 'e"$ e'*sB o+e' !e p"s 1: %e"'s7 #e- !e' !e #u*2e' #o' 3u"$- % o, s u)e# s "pp$%-#. !"s )e('e"se). Wou$) %ou "((ep !-s "'.u*e# 1 E9p$"-# 2'-e,$%. AH-# 4 T!e o,,-(-"$ *"/es "# "sse' -o# "2ou !e )e*"#) ,o' ")*-ss-o#7 2u )oes s!e "( u"$$% o2se'+e " )e*"#) (u'+e1 W!" e$se (ou$) 2e .o-#. o#1B (f demand is fixed the individual firm (a university! may determine the shape of the demand curve it faces by raising the price and observing the change in quantity sold. The university official is not observing the entire demand curve but rather only the equilibrium price and quantity over the last +4 years. (f demand is shifting upward as supply shifts upward demand could have any elasticity. ($ee 0igure 2.< for example.! Bemand could be shifting upward because the value of a college education has increased and students are willing to pay a high price for each opening. &ore market research would be required to support the conclusion that demand is completely price inelastic.

+>

Chapter 2: The Basics of Supply and Demand

5rice
D+**8 S+**8

D+*38

S +*38

D+*<8

S +*<8

6uantity
0igure 2.+>

11. Suppose !e )e*"#) (u'+e ,o' " p'o)u( -s .-+e# 2% QC1@02PDP s7 &!e'e P -s !e p'-(e o, !e p'o)u( "#) P s -s !e p'-(e o, " su2s - u e .oo). T!e p'-(e o, !e su2s - u e .oo) -s ?2.@@. ". Suppose PC?1.@@. W!" -s !e p'-(e e$"s -(- % o, )e*"#)1 W!" -s !e ('oss0p'-(e e$"s -(- % o, )e*"#)1 0irst you need to find the quantity demanded at the price of A+.>>. 67+># 2(+!C27+>. 5rice elasticity of demand 7

P Q 1 2 = ( 2) = = 0.2. Q P 10 10

-ross#price elasticity of demand 7 2.

Ps Q 2 = (1) = 0.2. Q Ps 10

Suppose !e p'-(e o, !e .oo)7 P7 .oes o ?2.@@. No& &!" -s !e p'-(e e$"s -(- % o, )e*"#)1 W!" -s !e ('oss0p'-(e e$"s -(- % o, )e*"#)1 0irst you need to find the quantity demanded at the price of A2.>>. 67+># 2(2!C273. 5rice elasticity of demand 7

P Q 2 4 = ( 2) = = 0.5. Q P 8 8 Ps Q 2 = (1) = 0.25. Q Ps 8

-ross#price elasticity of demand 7

12. Suppose !" '" !e' !"# !e )e($-#-#. )e*"#) "ssu*e) -# E9"*p$e 2.<7 " )e('e"se -# !e (os o, (oppe' p'o)u( -o# ("uses !e supp$% (u'+e o s!-, o !e '-.! 2% 8@ pe'(e# . Ho& &-$$ !e p'-(e o, (oppe' (!"#.e1 (f the supply curve shifts to the right by .>= then the new quantity supplied will be +.> percent of the old quantity supplied at every price. The new supply curve is therefore 6 7 +..D(#..4C+85! 7 #8.EC22..5. To find the new equilibrium price of copper set the new supply equal to demand so that F8.EC22..57+E.4#35.

++

Chapter 2: The Basics of Supply and Demand $olving for price results in 5784 cents per pound for the new equilibrium price. The price decreased by +> cents per pound or +E.E=. 15. Suppose !e )e*"#) ,o' #" u'"$ ."s -s pe',e( $% -#e$"s -(. W!" &ou$) 2e !e e,,e( 7 -, "#%7 o, #" u'"$ ."s p'-(e (o# 'o$s1 (f the demand for natural gas is perfectly inelastic then the demand curve is vertical. -onsumers will demand a certain quantity and will pay any price for this quantity. (n this case a price control will have no effect on the quantity demanded.

EEERCISES
1. Suppose !e )e*"#) (u'+e ,o' " p'o)u( -s .-+e# 2% QC5@@02PD8I7 &!e'e I -s "+e'".e -#(o*e *e"su'e) -# !ous"#)s o, )o$$"'s. T!e supp$% (u'+e -s QC5P0:@. ". I, IC2:7 ,-#) !e *"'/e ($e"'-#. p'-(e "#) 3u"# - % ,o' !e p'o)u( . ;iven (724 the demand curve becomes 67E>>#25C.D24 $etting demand equal to supply we can solve for 5 and then 6: .>>#257E5#4> 57*> 6722>. 2. I, IC:@7 ,-#) !e *"'/e ($e"'-#. p'-(e "#) 3u"# - % ,o' !e p'o)u( . ;iven (74> the demand curve becomes 67E>>#25C.D4> $etting demand equal to supply we can solve for 5 and then 6: 4>>#257E5#4> 57++> 6723>. (. D'"& " .'"p! o -$$us '" e %ou' "#s&e's. )quilibrium price and quantity are found at the intersection of the demand and supply curves. 1hen the income level increases in part b the demand curve will shift up and to the right. The intersection of the new demand curve and the supply curve is the new equilibrium point. 2. Co#s-)e' " (o*pe - -+e *"'/e ,o' &!-(! !e 3u"# - -es )e*"#)e) "#) supp$-e) Ape' %e"'B " +"'-ous p'-(es "'e .-+e# "s ,o$$o&s4
P'-(e A?B 6@ <@ 1@@ 12@ De*"#) A*-$$-o#sB 22 2@ 1< 16 Supp$% A*-$$-o#sB 18 16 1< 2@

or 67.>>#25.

or 674>>#25.

".

C"$(u$" e !e p'-(e e$"s -(- % o, )e*"#) &!e# !e p'-(e -s ?<@ "#) &!e# !e p'-(e -s ?1@@. 1e know that the price elasticity of demand may be calculated using equation 2.+ from the text:

+2

Chapter 2: The Basics of Supply and Demand Q D QD P Q D = = . P Q D P P

&D

1ith each price increase of A2> the quantity demanded decreases by 2. Therefore

QD = 2 = 0.1. P 20
't P 7 3> quantity demanded equals 2> and

80 ED = 20 (0.1) = 0.40.
$imilarly at P 7 +>> quantity demanded equals +3 and

100 ED = 18 (0.1) = 0.56.

2. C"$(u$" e !e p'-(e e$"s -(- % o, supp$% &!e# !e p'-(e -s ?<@ "#) &!e# !e p'-(e -s ?1@@. The elasticity of supply is given by: QS QS P QS = = . P QS P P

&S

1ith each price increase of A2> quantity supplied increases by 2. Therefore

QS = 2 = 0.1. P 20
't P 7 3> quantity supplied equals +8 and

80 ES = 16 (0.1) = 0.5.
$imilarly at P 7 +>> quantity supplied equals +3 and

100 ES = 18 (0.1) = 0.56.

(. W!" "'e !e e3u-$-2'-u* p'-(e "#) 3u"# - %1 The equilibrium price and quantity are found where the quantity supplied equals the quantity demanded at the same price. 's we see from the table the equilibrium price is A+>> and the equilibrium quantity is +3 million. ). Suppose !e .o+e'#*e# se s " p'-(e (e-$-#. o, ?<@. s!o' ".e7 "#) -, so7 !o& $"'.e &-$$ - 2e1 W-$$ !e'e 2e "

1ith a price ceiling of A3> consumers would like to buy 2> million but producers will supply only +8 million. This will result in a shortage of . million. 5. Re,e' o E9"*p$e 2.: o# !e *"'/e ,o' &!e" . A !e e#) o, 1>><7 2o ! B'"=-$ "#) I#)o#es-" ope#e) !e-' &!e" *"'/e s o U.S. ,"'*e's. Suppose !" !ese #e& *"'/e s ")) 2@@ *-$$-o# 2us!e$s o U.S. &!e" )e*"#). W!" &-$$ 2e !e ,'ee *"'/e p'-(e o, &!e" "#) &!" 3u"# - % &-$$ 2e p'o)u(e) "#) so$) 2% U.S. ,"'*e's -# !-s ("se1

+E

Chapter 2: The Basics of Supply and Demand The following equations describe the market for wheat in +**3: QS 7 +*.. C 2><P and QD 7 E2.. # 23EP. (f 9ra"il and (ndonesia add an additional 2>> million bushels of wheat to /.$. wheat demand the new demand curve would be equal to QD C 2>> or QD 7 (E2.. # 23EP! C 2>> 7 E... # 23EP. )quating supply and the new demand we may determine the new equilibrium price +*.. C 2><P 7 E... # 23EP or .*>P = +4>> or P' 7 AE.>8+22 per bushel. To find the equilibrium quantity substitute the price into either the supply or demand equation e.g. QS 7 +*.. C (2><!(E.>8+22! 7 2 4<<.8< and QD 7 E... # (23E!(E.>8+22! 7 2 4<<.8< 8. A +e.e "2$e ,-2e' -s '")e) -# " (o*pe - -+e &o'$) *"'/e 7 "#) !e &o'$) p'-(e -s ?> pe' pou#). U#$-*- e) 3u"# - -es "'e "+"-$"2$e ,o' -*po' -# o !e U#- e) S " es " !-s p'-(e. T!e U.S. )o*es -( supp$% "#) )e*"#) ,o' +"'-ous p'-(e $e+e$s "'e s!o&# 2e$o&. P'-(e 5 6 > 12 1: 1< U.S. Supp$% A*-$$-o# $2s.B 2 8 6 < 1@ 12 U.S. De*"#) A*-$$-o# $2s.B 58 2< 22 16 1@ 8

". W!" -s !e e3u" -o# ,o' )e*"#)1 W!" -s !e e3u" -o# ,o' supp$%1 The equation for demand is of the form 67a#b5. 0irst find the slope which is

increases by E quantity demanded falls by 8 million pounds. Bemand is now 67a#25. To find a plug in any of the price quantity demanded points from the table: 67E.7a#2DE so that a7.> and demand is 67.>#25. The equation for supply is of the form 6 7 c C d5. 0irst find the slope which is

Q 6 = = 2 = b. Gou can figure this out by noticing that every time price P 3

increases by E quantity supplied increases by 2 million pounds. $upply is now

Q2 = = d . P 3

Gou can figure this out by noticing that every time price

2 P. To find c plug in any of the price quantity supplied points from 3 2 2 the table: Q = 2 = c + (3) so that c7> and supply is Q = P. 3 3 Q =c+
2. A " p'-(e o, ?>7 &!" -s !e p'-(e e$"s -(- % o, )e*"#)1 W!" -s - " p'-(e o, ?121

+.

Chapter 2: The Basics of Supply and Demand )lasticity of demand at 57* is

P Q 9 18 = ( 2) = = 0.82. Q P 22 22

)lasticity of demand at 57+2 is

P Q 12 24 = ( 2) = = 1.5. Q P 16 16

(. W!" -s !e p'-(e e$"s -(- % o, supp$% " ?>1 A ?121 )lasticity of supply at 57* is

P Q 9 2 18 = = = 1.0. Q P 6 3 18 P Q 12 2 24 = = = 1.0. Q P 8 3 24

)lasticity of supply at 57+2 is

). I# " ,'ee *"'/e 7 &!" &-$$ 2e !e U.S. p'-(e "#) $e+e$ o, ,-2e' -*po' s1 1ith no restrictions on trade world price will be the price in the /nited $tates so that 57A*. 't this price the domestic supply is 8 million lbs. while the domestic demand is 22 million lbs. (mports make up the difference and are +8 million lbs. :. Mu(! o, !e )e*"#) ,o' U.S. ".'-(u$ u'"$ ou pu !"s (o*e ,'o* o !e' (ou# '-es. I# 1>><7 !e o "$ )e*"#) ,o' &!e" &"s Q C 5288 0 2<5P. O, !-s7 )o*es -( )e*"#) &"s QD C 1;@@ 0 1@;P. Do*es -( supp$% &"s QS C 1>88 D 2@;P. Suppose !e e9po' )e*"#) ,o' &!e" ,"$$s 2% 8@ pe'(e# . ". U.S. ,"'*e's "'e (o#(e'#e) "2ou !-s )'op -# e9po' )e*"#). W!" !"ppe#s o !e ,'ee *"'/e p'-(e o, &!e" -# !e U#- e) S " es1 Do !e ,"'*e's !"+e *u(! 'e"so# o &o''%1 ;iven total demand Q 7 E2.. # 23E P and domestic demand Qd 7 +<>> # +><P we may subtract and determine export demand Qe 7 +4.. # +<8P. The initial market equilibrium price is found by setting total demand equal to supply: E2.. # 23EP 7 +*.. C 2><P or P 7 A2.84. The best way to handle the .> percent drop in export demand is to assume that the export demand curve pivots down and to the left around the vertical intercept so that at all prices demand decreases by .> percent and the reservation price (the maximum price that the foreign country is willing to pay! does not change. (f you instead shifted the demand curve down to the left in a parallel fashion the effect on price and quantity will be qualitatively the same but will differ quantitatively. The new export demand is (")Qe=(")(*+,,$*-)P =./)",$*(+")P. ;raphically export demand has pivoted inwards as illustrated in figure 2.4a below. Total demand becomes QD 7 Qd C >.8Qe 7 +<>> # +><P C *28..#+>4.85 7 2828.. # 2+2.8P.

+4

Chapter 2: The Basics of Supply and Demand

P 8.77

Qe 926.4 1544
F-.u'e 2.:" )quating total supply and total demand +*.. C 2><P 7 2828.. # 2+2.8P or P 7 A+.8E which is a significant drop from the market#clearing price of A2.84 per bushel. 't this price the market#clearing quantity is 223>.84 million bushels. Total revenue has decreased from A88+..8 million to AE<>*.> million. &ost farmers would worry. 2. No& suppose !e U.S. .o+e'#*e# &"# s o 2u% e#ou.! &!e" e"(! %e"' o '"-se !e p'-(e o ?5.:@ pe' 2us!e$. W- ! !-s )'op -# e9po' )e*"#)7 !o& *u(! &!e" &ou$) !e .o+e'#*e# !"+e o 2u%1 Ho& *u(! &ou$) !-s (os !e .o+e'#*e# 1 1ith a price of AE.4> the market is not in equilibrium. 6uantity demanded and supplied are 6B 7 2828..#2+2.8(E.4!7+332.E and 6$ 7 +*.. C 2><(E.4! 7 2883.4. )xcess supply is therefore 2883.4#+332.E7<38.2 million bushels. The government must purchase this amount to support a price of AE.4 and will spend AE.4(<38.2 million! 7 A2<4+.< million per year. 6. T!e 'e# (o# 'o$ ".e#(% o, Ne& Yo'/ C- % !"s ,ou#) !" "..'e." e )e*"#) -s QD C 16@ 0 <P. Qu"# - % -s *e"su'e) -# e#s o, !ous"#)s o, "p"' *e# s. P'-(e7 !e "+e'".e *o# !$% 'e# "$ '" e7 -s *e"su'e) -# !u#)'e)s o, )o$$"'s. T!e ".e#(% "$so #o e) !" !e -#('e"se -# Q " $o&e' P 'esu$ s ,'o* *o'e !'ee0pe'so# ,"*-$-es (o*-#. -# o !e (- % ,'o* Lo#. Is$"#) "#) )e*"#)-#. "p"' *e# s. T!e (- %Fs 2o"') o, 'e"$ o's "(/#o&$e).es !" !-s -s " .oo) )e*"#) es -*" e "#) !"s s!o&# !" supp$% -s QS C ;@ D ;P. ". I, 2o ! !e ".e#(% "#) !e 2o"') "'e '-.! "2ou )e*"#) "#) supp$%7 &!" -s !e ,'ee *"'/e p'-(e1 W!" -s !e (!"#.e -# (- % popu$" -o# -, !e ".e#(% se s " *"9-*u* "+e'".e *o# !$% 'e# "$ o, ?5@@7 "#) "$$ !ose &!o ("##o ,-#) "# "p"' *e# $e"+e !e (- %1 To find the free market price for apartments set supply equal to demand:

+8

Chapter 2: The Basics of Supply and Demand +8> # 3P 7 <> C <P or P 7 A8>> since price is measured in hundreds of dollars. $ubstituting the equilibrium price into either the demand or supply equation to determine the equilibrium quantity: QD 7 +8> # (3!(8! 7 ++2 and QS 7 <> C (<!(8! 7 ++2. 1e find that at the rental rate of A8>> the quantity of apartments rented is + +2> >>>. (f the rent control agency sets the rental rate at AE>> the quantity supplied would then be *+> >>> (QS 7 <> C (<!(E! 7 *+! a decrease of 2+> >>> apartments from the free market equilibrium. ('ssuming three people per family per apartment this would imply a loss of 8E> >>> people.! 't the AE>> rental rate the demand for apartments is + E8> >>> units and the resulting shortage is .4> >>> units (+ E8> >>>#*+> >>>!. ?owever excess demand (supply shortages! and lower quantity demanded are not the same concepts. The supply shortage means that the market cannot accommodate the new people who would have been willing to move into the city at the new lower price. Therefore the city population will only fall by 8E> >>> which is represented by the drop in the number of actual apartments from + +2> >>> (the old equilibrium value! to *+> >>> or 2+> >>> apartments with E people each. 2. Suppose !e ".e#(% 2o&s o !e &-s!es o, !e 2o"') "#) se s " 'e# "$ o, ?>@@ pe' *o# ! o# "$$ "p"' *e# s o "$$o& $"#)$o')s " G,"-'H '" e o, 'e u'#. I, :@ pe'(e# o, "#% $o#.0'u# -#('e"ses -# "p"' *e# o,,e'-#.s (o*e ,'o* #e& (o#s 'u( -o#7 !o& *"#% "p"' *e# s "'e (o#s 'u( e)1 't a rental rate of A*>> the supply of apartments would be <> C <(*! 7 +EE or + EE> >>> units which is an increase of 2+> >>> units over the free market equilibrium. Therefore (>.4!(2+> >>>! 7 +>4 >>> units would be constructed. :ote however that since demand is only 33> >>> units .4> >>> units would go unrented. ;. I# (-."'e s!o&# -s @.:. (-."'e 1>><7 A*e'-("#s s*o/e) 8;@ 2-$$-o# (-."'e es7 o' 25.: 2-$$-o# p"(/s o, es. T!e "+e'".e 'e "-$ p'-(e &"s ?2 pe' p"(/. S " -s -("$ s u)-es !"+e !" !e p'-(e e$"s -(- % o, )e*"#) -s 0@.87 "#) !e p'-(e e$"s -(- % o, supp$% Us-#. !-s -#,o'*" -o#7 )e'-+e $-#e"' )e*"#) "#) supp$% (u'+es ,o' !e e *"'/e .

@et the demand curve be of the general form 67a#b5 and the supply curve be of the general form 67c C d5 where a b c and d are the constants that you have to find from the information given above. To begin recall the formula for the price elasticity of demand
D EP =

P Q . Q P

Gou are given information about the value of the elasticity 5 and 6 which means that you can solve for the slope which is b in the above formula for the demand curve.

2 Q 0 . 4 = 2 3 . 5 P Q 3 . 5 2 = 0 . 4 = 4 . 7 = b . 2 P
+<

Chapter 2: The Basics of Supply and Demand To find the constant a substitute for 6 5 and b into the above formula so that 2E.47a#..<D2 and a7E2.*. The equation for demand is therefore 67E2.*#..<5. To find the supply curve recall the formula for the elasticity of supply and follow the same method as above:

P Q Q P 2 Q 0.5 = 23.5 P Q 23.5 =0.5 =5.875 = d. 2 P

S EP =

To find the constant c substitute for 6 5 and d into the above formula so that 2E.47cC4.3<4D2 and c7++.<4. The equation for supply is therefore 67++.<4C4.3<45. <. I# E9"*p$e 2.< &e e9"*-#e) !e e,,e( o, " 2@ pe'(e# )e($-#e -# (oppe' )e*"#) o# !e p'-(e o, (oppe'7 us-#. !e $-#e"' supp$% "#) )e*"#) (u'+es )e+e$ope) -# Se( -o# 2.8. Suppose !e $o#.0'u# p'-(e e$"s -(- % o, (oppe' )e*"#) &e'e 0@.8 -#s e") o, 0@.<. ". Assu*-#.7 "s 2e,o'e7 !" !e e3u-$-2'-u* p'-(e "#) 3u"# - % "'e P* C ;: (e# s pe' pou#) "#) Q* C ;.: *-$$-o# *e '-( o#s pe' %e"'7 )e'-+e !e $-#e"' )e*"#) (u'+e (o#s-s e# &- ! !e s*"$$e' e$"s -(- %. 0ollowing the method outlined in $ection 2.8 we solve for a and b in the demand equation QD = a # bP. 0irst we know that for a linear demand function

P * ED = b . ?ere &D 7 #>.. (the long#run price elasticity! P' 7 >.<4 (the Q *
0.4 = b 0.75 7.5

equilibrium price! and Q' 7 <.4 (the equilibrium quantity!. $olving for b

or b 7 ..

To find the intercept we substitute for b QD (7 QD! and P (7 PD! in the demand equation: <.4 7 a # (.!(>.<4! or a 7 +>.4. The linear demand equation consistent with a long#run price elasticity of #>.. is therefore QD 7 +>.4 # .P. 2. Us-#. !-s )e*"#) (u'+e7 'e("$(u$" e !e e,,e( o, " 2@ pe'(e# )e($-#e -# (oppe' )e*"#) o# !e p'-(e o, (oppe'. The new demand is 2> percent below the original (using our convention that quantity demanded is reduced by 2>= at every price!:

( )( ) 6 B = 0.8 10.5 4P = 8.4 3.2 P .

)quating this to supply 3.. # E.2P 7 #..4 C +8P or P 7 >.8<2. 1ith the 2> percent decline in the demand the price of copper falls to 8<.2 cents per pound. >. E9"*p$e 2.> "#"$%=es e9"*p$e4 !e &o'$) o-$ *"'/e . Us-#. !e )" " .-+e# -# !"

+3

".

S!o& !" .-+e# 2%

Chapter 2: The Basics of Supply and Demand !e s!o' 0'u# )e*"#) "#) (o*pe - -+e supp$% (u'+es "'e -#)ee) D C 28.@< 0 @.@6P SC C 11.;8 D @.@;P.

0irst considering non#%5)- supply: Sc 7 QD 7 +E. 1ith &S 7 >.+> and PD 7 A+3 &S 7 d(PDHQD! implies d 7 >.><. $ubstituting for d Sc and P in the supply equation c 7 ++.<. and Sc 7 ++.<. C >.><P. $imilarly since QD 7 2E &D 7 #b(PDHQD! 7 #>.>4 and b 7 >.>8. $ubstituting for b QD 7 2E and P 7 +3 in the demand equation gives 2E 7 a # >.>8(+3! so that a 7 2..>3. ?ence QD 7 2..>3 # >.>8P. 2. S!o& !" .-+e# 2% !e $o#.0'u# )e*"#) "#) (o*pe - -+e supp$% (u'+es "'e -#)ee) D C 52.1< 0 @.:1P SC C ;.;< D @.2>P. 's above &S 7 >.. and &D 7 #>..: &S 7 d(PDHQD! and &D = $b(P'0Q' implying >.. 7 d(+3H+E! and #>.. 7 #b(+3H2E!. $o d 7 >.2* and b 7 >.4+. :ext solve for c and a: Sc 7 c C dP and QD 7 a # bP implying +E 7 c C (>.2*!(+3! and 2E 7 a # (>.4+!(+3!. $o c 7 <.<3 and a 7 E2.+3. (. I# 2@@27 S"u)- A'"2-" "((ou# e) ,o' 5 2-$$-o# 2"''e$s pe' %e"' o, OPECFs p'o)u( -o#. Suppose !" &"' o' 'e+o$u -o# ("use) S"u)- A'"2-" o s op p'o)u(-#. o-$. Use !e *o)e$ "2o+e o ("$(u$" e &!" &ou$) !"ppe# o !e p'-(e o, o-$ -# !e s!o' 'u# "#) !e $o#. 'u# -, OPECFs p'o)u( -o# &e'e o )'op 2% 5 2-$$-o# 2"''e$s pe' %e"'. 1ith %5)-s supply reduced from +> bbHyr to < bbHyr add this lower supply of < bbHyr to the short#run and long#run supply equations: Sc 7 < C Sc 7 ++.<. C < C >.><P 7 +3.<. C >.><P and S 7 < C Sc 7 +..<3 C >.2*P. These are equated with short#run and long#run demand so that: +3.<. C >.><P 7 2..>3 # >.>8P implying that P 7 A.+.>3 in the short runI and +..<3 C >.2*P 7 E2.+3 # >.4+P implying that P 7 A2+.<4 in the long run. 1@. Re,e' #" u'"$ ."s. ". o E9"*p$e 2.1@7 &!-(! "#"$%=es !e e,,e( s o, p'-(e (o# 'o$s o#

Us-#. !e )" " -# !e e9"*p$e7 s!o& !" !e ,o$$o&-#. supp$% "#) )e*"#) (u'+es )-) -#)ee) )es('-2e !e *"'/e -# 1>;:4 Supp$%4 Q C 18 D 2PG D @.2:PO De*"#)4 Q C 0:PG D 5.;:PO &!e'e PG "#) PO "'e !e p'-(es o, #" u'"$ ."s "#) o-$7 'espe( -+e$%. A$so7 +e'-,% !" -, !e p'-(e o, o-$ -s ?<.@@7 !ese (u'+es -*p$% " ,'ee *"'/e p'-(e o, ?2.@@ ,o' #" u'"$ ."s.

+*

Chapter 2: The Basics of Supply and Demand To solve this problem we apply the analysis of $ection 2.8 to the definition of cross#price elasticity of demand given in $ection 2... 0or example the cross# price#elasticity of demand for natural gas with respect to the price of oil is:

2>

Chapter 2: The Basics of Supply and Demand

2+

Chapter 2: The Basics of Supply and Demand

22

Chapter 2: The Basics of Supply and Demand is the change in the quantity of natural gas demanded because of a small QG change in the price of oil. 0or linear demand equations is constant. (f PO we represent demand as: Q1 = a # bP1 3 eP2 QG (notice that income is held constant! then 7 e. $ubstituting this into the PO * PO D and Q D are the equilibrium price E = e cross#price elasticity PO * where P2 1

QG

D 7 A3 and Q D 7 2> trillion cubic feet (Tcf!. and quantity. 1e know that P2 1 $olving for e

8 1.5 = e 20 or e 7 E.<4.
Q1 7 c 3 dP1 3 gP2

$imilarly if the general form of the supply equation is represented as: * PO g the cross#price elasticity of supply is * which we know to be >.+. $olving QG for g

8 0.1 = g 20 or g 7 >.24.

The values for d and b may be found with equations 2.4a and 2.4b in $ection 2.8. 1e know that &S 7 >.2 P' 7 2 and Q' 7 2>. Therefore

2 0.2 = d 20 or d 7 2.
'lso &D 7 #>.4 so

2 0.5 = b 20 or b 7 #4.

9y substituting these values for d! g! b and e into our linear supply and demand equations we may solve for c and a: 2> 7 c C (2!(2! C (>.24!(3! or c 7 +. and 2> 7 a # (4!(2! C (E.<4!(3! or a 7 >. (f the price of oil is A3.>> these curves imply a free market price of A2.>> for natural gas. $ubstitute the price of oil in the supply and demand curves to verify these equations. Then set the curves equal to each other and solve for the price of gas. +. C 2P1 C (>.24!(3! 7 #4P1 C (E.<4!(3! <P1 7 +. P1 7 A2.>>. 2. Suppose !e 'e.u$" e) p'-(e o, ."s -# 1>;: !") 2ee# ?1.:@ pe' !ous"#) (u2-( ,ee 7 -#s e") o, ?1.@@. Ho& *u(! e9(ess )e*"#) &ou$) !e'e !"+e 2ee#1 1ith a regulated price of A+.4> for natural gas and a price of oil equal to A3.>> per barrel

2E

Chapter 2: The Basics of Supply and Demand Bemand: QD 7 (#4!(+.4>! C (E.<4!(3! 7 22.4 and $upply: QS 7 +. C (2!(+.4! C (>.24!(3! 7 +*. 1ith a supply of +* Tcf and a demand of 22.4 Tcf there would be an excess demand of E.4 Tcf. (. Suppose !" !e *"'/e ,o' #" u'"$ ."s !") not 2ee# 'e.u$" e). I, !e p'-(e o, o-$ !") -#('e"se) ,'o* ?< o ?167 &!" &ou$) !"+e !"ppe#e) o !e ,'ee *"'/e p'-(e o, #" u'"$ ."s1 (f the price of natural gas had not been regulated and the price of oil had increased from A3 to A+8 then Bemand: QD 7 #4P1 C (E.<4!(+8! 7 8> # 4P1 and $upply: QS 7 +. C 2P1 C (>.24!(+8! 7 +3 C 2P1. )quating supply and demand and solving for the equilibrium price +3 C 2P1 7 8> # 4P1 or P1 7 A8. The price of natural gas would have tripled from A2 to A8. 11. T!e "2$e 2e$o& s!o&s !e 'e "-$ p'-(e "#) s"$es ,o' -#s "# (o,,ee "#) 'o"s e) (o,,ee ,o' 1>>; "#) 1>><. Re "-$ P'-(e o, I#s "# Co,,ee Ye"' 1>>; 1>>< A?I$2B 1@.5: 1@.8< S"$es o, I#s "# Co,,ee A*-$$-o# $2sB ;: ;@ Re "-$ P'-(e o, Ro"s e) Co,,ee A?I$2B 8.11 5.;6 S"$es o, Ro"s e) Co,,ee A*-$$-o# $2sB <2@ <:@

". Us-#. !-s )" " "$o#e7 es -*" e !e s!o' 0'u# p'-(e e$"s -(- % o, )e*"#) ,o' 'o"s e) (o,,ee. De'-+e " $-#e"' )e*"#) (u'+e ,o' 'o"s e) (o,,ee. To find elasticity you must first estimate the slope of the demand curve:

Q 820 850 30 = = = 85.7. P 4.11 3.76 0.35

;iven the slope we can now estimate elasticity using the price and quantity data from the above table. $ince the demand curve is assumed to be linear the elasticity will differ in +**< and +**3 because price and quantity are different. Gou can calculate the elasticity at both points and at the average point between the two years:

P Q 4.11 = ( 85.7) = 0.43 Q P 820 P Q 3.76 98 Ep = = ( 85.7) = 0.38 Q P 850 P97 + P98 Q 3.935 AVE 2 Ep = = ( 85.7) = 0.40. Q97 + Q98 P 835 2
97 Ep =

To derive the demand curve for roasted coffee 67a#b5 note that the slope of the demand curve is #34.<7#b. To find the coefficient a use either of the data points from the table above so that a73E>C34.<D..++7++<2.E or

2.

Chapter 2: The Basics of Supply and Demand a734>C34.<DE.<87++<2.E. The equation for the demand curve is therefore Q=**-/"4$5+"-P. 2. No& es -*" e !e s!o' 0'u# p'-(e e$"s -(- % o, )e*"#) ,o' -#s "# De'-+e " $-#e"' )e*"#) (u'+e ,o' -#s "# (o,,ee. To find elasticity you must first estimate the slope of the demand curve: (o,,ee.

24

Chapter 2: The Basics of Supply and Demand

J
28

Chapter 2: The Basics of Supply and Demand ;iven the slope we can now estimate elasticity using the price and quantity data from the above table. $ince the demand curve 67a#b5 is assumed to be linear the elasticity will differ in +**< and +**3 because price and quantity are different. Gou can calculate the elasticity at both points and at the average point between the two years:

2<

Chapter 2: The Basics of Supply and Demand

23

Chapter 2: The Basics of Supply and Demand

2*

Chapter 2: The Basics of Supply and Demand

P + P 9 7 9 8 Q 1 0 . 4 1 5 A V E 2 E = ( 3 8 . 5 ) = 5 . 5 3 . p = Q + Q P 7 2 . 5 9 7 9 8 2
To derive the demand curve for instant coffee note that the slope of the demand curve is #E3.47#b. To find the coefficient a use either of the data points from the table above so that a7<4CE3.4D+>.E47.<E.4 or a7<>CE3.4D+>..37.<E.4. The equation for the demand curve is therefore Q=,-4"+$45"+P. (. %ou W!-(! (o,,ee !"s !e !-.!e' s!o' 0'u# p'-(e e$"s -(- % o, )e*"#)1 W!% )o !-#/ !-s -s !e ("se1 (nstant coffee is significantly more elastic than roasted coffee. (n fact the demand for roasted coffee is inelastic and the demand for instant coffee is elastic. Roasted coffee may have an inelastic demand in the short#run as many people think of coffee as a necessary good. -hanges in the price of roasted coffee will not drastically affect demand because people must have this good. &any people on the other hand may view instant coffee as a convenient though imperfect substitute for roasted coffee. 0or example if the price rises a little the quantity demanded will fall by a large percentage because people would rather drink roasted coffee instead of paying more for a low quality substitute.

E>