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Q
P
P
Q
E
D
P
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P
Q
Q
P
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P
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S S
P
2005 Pearson Education, Inc. Chapter 2 53
Elasticity: An Application
Assume the price of wheat is
$4.00/bushel due to decrease in supply
486 , 2 ) 00 . 4 )( 266 ( 550 , 3 =
D
Q
43 . 0 ) 266 (
486 , 2
00 . 4
= =
D
P
Q
2005 Pearson Education, Inc. Chapter 2 54
Elasticity: An Application
In 2002, the supply and demand for
wheat were:
Supply: Q
S
= 1439 + 267P
Demand: Q
D
= 2809 226P
2005 Pearson Education, Inc. Chapter 2 55
Elasticity: An Application
Q
D
= Q
S
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million
bushels
Price of wheat fell in nominal terms.
2005 Pearson Education, Inc. Chapter 2 56
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 long-
run counterparts
2005 Pearson Education, Inc. Chapter 2 57
Short-Run Versus Long-Run
Elasticity
Demand
In general, demand is much more price
elastic in the long run
Consumers take time to adjust consumption
habits
Demand might be linked to another good that
changes slowly
More substitutes are usually available in the
long run
2005 Pearson Education, Inc. Chapter 2 58
Gasoline: Short-Run and Long-Run
Demand Curves
D
SR
D
LR
People cannot easily
adjust consumption in
the short run.
In the long run, people
tend to drive smaller and
more fuel efficient cars.
Quantity of Gas
Price
2005 Pearson Education, Inc. Chapter 2 59
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. Chapter 2 60
D
SR
D
LR
Initially, people may put
off immediate car
purchase
In long run, older cars
must be replaced
Cars: Short-Run and Long-Run
Demand Curves
Quantity of Cars
Price
2005 Pearson Education, Inc. Chapter 2 61
Short-Run Versus Long-Run
Elasticity
Income elasticity also varies with the
amount of time consumers have to
respond to an income change
For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending
2005 Pearson Education, Inc. Chapter 2 62
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 older cars are replaced, purchases will
only be to replace old cars
Less purchases from income increase in long
run than in short run
2005 Pearson Education, Inc. Chapter 2 63
Demand for Gasoline
2005 Pearson Education, Inc. Chapter 2 64
Demand for Automobiles
2005 Pearson Education, Inc. Chapter 2 65
Short-Run Versus Long-Run
Elasticity
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
2005 Pearson Education, Inc. Chapter 2 66
S
SR
Quantity Primary Copper
Price
Short-Run Versus Long-Run
Elasticity
S
LR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.
2005 Pearson Education, Inc. Chapter 2 67
S
SR
Quantity Secondary Copper
Price
Short-Run Versus Long-Run
Elasticity
S
LR
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long run, this
stock of scrap copper
begins to fall.
2005 Pearson Education, Inc. Chapter 2 68
Supply of Copper
2005 Pearson Education, Inc. Chapter 2 69
Short-Run vs. Long-Run
Elasticity An Application
Why are coffee prices very volatile?
Most of the worlds coffee is produced in
Brazil
Many changing weather conditions affect the
crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
In long run, prices come back to original
levels, all else equal
2005 Pearson Education, Inc. Chapter 2 70
Price of Brazilian Coffee
2005 Pearson Education, Inc. Chapter 2 71
Short-Run vs. Long-Run
Elasticity An Application
Demand and supply are more elastic in
the long run
In the short run, supply is completely
inelastic
Weather may destroy part of the fixed
supply, decreasing supply
Demand is relatively inelastic as well
Price increases significantly
2005 Pearson Education, Inc. Chapter 2 72
D
P
0
S
Q
0
Quantity
Price
A freeze or drought
decreases the supply
of coffee
S
Q
1
An Application - Coffee
Price increases
significantly due to
inelastic supply and
demand
P
1
2005 Pearson Education, Inc. Chapter 2 73
S
D
S
P
0
Q
0
P
2
Q
2
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P
2
.
An Application - Coffee
Quantity
Price
2005 Pearson Education, Inc. Chapter 2 74
S
P
0
Q
0
Long-Run
1) Supply is extremely elastic
2) Price falls back to P
0
.
3) Quantity back to Q
0.
An Application - Coffee
Quantity
Price
D
2005 Pearson Education, Inc. Chapter 2 75
Predicting the Effects of
Changing Market Conditions
Supply and demand analysis can be
used to predict the effects of changing
market conditions
Linear demand and supply must be fit to
market data
Given equilibrium price and quantity along with
elasticities of supply and demand, we can
calculate the curves that fit the information
We can then calculate changes in the market
2005 Pearson Education, Inc. Chapter 2 76
Predicting the Effects of
Changing Market Conditions
We know
Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, E
S
Price elasticity of demand, E
D
2005 Pearson Education, Inc. Chapter 2 77
Predicting the Effects of
Changing Market Conditions
Lets begin with the equations for supply,
demand, elasticity:
Demand: Q = a bP
Supply: Q = c + dP
Elasticity: (P/Q)(AQ/AP)
We must calculate numbers for a, b, c,
and d.
2005 Pearson Education, Inc. Chapter 2 78
Predicting the Effects of
Changing Market Conditions
The slope of the demand curve above
equals AQ/AP which equals -b
The slope of the supply curve above
equals AQ/AP which equals d
Demand: E
D
= -b(P*/Q*)
Supply: E
S
= d(P*/Q*)
2005 Pearson Education, Inc. Chapter 2 79
Demand: Q = a - bP
a/b
Supply: Q = c + dP
-c/d
P*
Q*
E
D
= -bP*/Q*
E
S
= dP*/Q*
Predicting the Effects of
Changing Market Conditions
Quantity
Price
2005 Pearson Education, Inc. Chapter 2 80
Predicting the Effects of
Changing Market Conditions
Using P*, Q* and the elasticities, we can
solve for b and c from supply
E
S
= 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
2005 Pearson Education, Inc. Chapter 2 81
Predicting the Effects of
Changing Market Conditions
Using P*, Q* and the elasticities, we can
solve for a and b from demand
E
D
= 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
2005 Pearson Education, Inc. Chapter 2 82
Predicting the Effects of
Changing Market Conditions
We now have equations for supply and
demand
Supply: Q = 4.5 + 16P
Demand: Q = 13.5 8P
Setting them equal will give us
equilibrium price and quantity with which
we began
2005 Pearson Education, Inc. Chapter 2 83
Supply: Q
S
= -4.5 + 16P
-c/d
Demand: Q
D
= 13.5 - 8P
a/b
.75
7.5
Predicting the Effects of
Changing Market Conditions
Mmt/yr
Price
2005 Pearson Education, Inc. Chapter 2 84
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:
fI bP a Q + =
2005 Pearson Education, Inc. Chapter 2 85
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
I
= 1.3
2005 Pearson Education, Inc. Chapter 2 86
Predicting the Effects of
Changing Market Conditions
Using the elasticity of income formula, we
can solve for f
E
I
= (I/Q)(AQ/AI)
1.3 = (1.0/7.5)(f)
f = 9.75
Substituting back into demand equation
gives a = 3.75
2005 Pearson Education, Inc. Chapter 2 87
Declining Demand and the
Behavior of Copper Prices
Copper has gone through difficult market
changes leading the significantly reduced
prices most from decreased demand
from
A decrease in the growth rate of power
generation
The development of substitutes: fiber optics
and aluminum
2005 Pearson Education, Inc. Chapter 2 88
Real versus Nominal
Prices of Copper 1965 - 2002
2005 Pearson Education, Inc. Chapter 2 89
Declining Demand and the
Behavior of Copper Prices
Given producers concerns about further
declines in demand, we can calculate by
how much prices will fall with future
declines in demand
Assume that demand will fall by 20%
What is the resulting decrease in price?
Demand curve will shift to left by 20%
2005 Pearson Education, Inc. Chapter 2 90
Declining Demand and the Behavior
of Copper Prices
We want to consider 80% of the past
demand
Q = (0.80)(13.5 - 8P)
Q = 10.8 - 6.4P
Recall the equation for supply:
Q = -4.5 + 16P
2005 Pearson Education, Inc. Chapter 2 91
Declining Demand and the Behavior
of Copper Prices
Setting supply equal to demand:
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4
P = 68.3 cents/pound
A decline in demand of 20% will lead to a
drop in price about 7%
2005 Pearson Education, Inc. Chapter 2 92
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
2005 Pearson Education, Inc. Chapter 2 93
D
Effects of Price Controls
Quantity
Price
P
0
Q
0
S
P
max
Price is regulated to
be no higher than P
max
Quantity supplied
falls and quantity
demanded increases
A shortage results
Q
S
Q
D
Shortage
2005 Pearson Education, Inc. Chapter 2 94
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 70s
Producers typically lose, but some
consumers gain. Some consumers lose.
2005 Pearson Education, Inc. Chapter 2 95
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
2005 Pearson Education, Inc. Chapter 2 96
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