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Chapter 2
The Basics of Supply and
Demand
The Basics of Supply and
Demand
Chapter 2: The Basics of Supply and Demand Slide 2
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 3
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 4
Introduction
Applications of Supply and Demand AnalysisUnderstanding 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 5
Introduction
Applications of Supply and Demand AnalysisAnalyzing how taxes, subsidies, and import
restrictions affect consumers and producers
Chapter 2: The Basics of Supply and Demand Slide 6
Supply and Demand
The Supply CurveThe 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 7
Supply and Demand
The Supply CurveThis price-quantity relationship can be shown
by the equation:
)(PQQ Ss
Chapter 2: The Basics of Supply and Demand Slide 8
Horizontal axis measures quantity (Q) supplied innumber of units per time period
Vertical axis measures price (P) receivedper unit in dollars
Supply and Demand
The SupplyCurve Graphically
The SupplyCurve Graphically
Quantity
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 9
Supply and Demand
S
The supply curve slopesupward demonstrating that
at higher prices firmswill increase output
The SupplyCurve Graphically
The SupplyCurve Graphically
Quantity
Price($ per unit)
P1
Q1
P2
Q2
Chapter 2: The Basics of Supply and Demand Slide 10
Supply and Demand
Non-price Determining Variables of SupplyCosts of Production
LaborCapitalRaw Materials
Chapter 2: The Basics of Supply and Demand Slide 11
Supply and Demand
The cost of raw materials falls
At P1, produce Q2
At P2, produce Q1
Supply curve shifts right to S’
More produced at any price on S’ than on S
P S
Change in SupplyChange in Supply
Q
P1
P2
Q1Q0
S’
Q2
Chapter 2: The Basics of Supply and Demand Slide 12
Supply and Demand
Supply - A ReviewSupply is determined by non-price supply-
determining 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 13
Supply and Demand
Supply - A ReviewChanges 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 14
Supply and Demand
The Demand CurveThe 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:
(P)QQ DD
Chapter 2: The Basics of Supply and Demand Slide 15
Supply and Demand
Quantity
Horizontal axis measures quantity (Q) demanded innumber of units per time period
Vertical axis measures price (P) paidper unit in dollars
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 16
Supply and Demand
D
The demand curve slopesdownward demonstrating that consumers are willing
to buy more at a lower priceas the product becomes
relatively cheaper and the consumer’s real income
increases.
Quantity
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 17
Supply and Demand
Non-price Determining Variables of DemandIncome
Consumer Tastes
Price of Related GoodsSubstitutesComplements
Chapter 2: The Basics of Supply and Demand Slide 18
DP
QQ1
P2
Q0
P1
D’
Q2
Change in DemandChange in Demand
Supply and Demand
Income Increases At P1, produce Q2
At P2, produce Q1
Demand Curve shifts right
More purchased at any price on D’ than on D
Chapter 2: The Basics of Supply and Demand Slide 19
Shifts in Supply and Demand
Demand - A ReviewDemand 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 20
The Market Mechanism
Quantity
D
S
The curves intersect atequilibrium, or market-
clearing, price. At P0 thequantity supplied is equalto the quantity demanded
at Q0 .
P0
Q0
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 21
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 22
The Market Mechanism
Quantity
D
S
P0
Q0
If price is above equilibrium:
1) Price is above the market clearing price2) Qs > Qd
3) Price falls to the market-clearing price
P1
Surplus
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 23
The Market Mechanism
The market price is above equilibriumThere is excess supplyProducers lower pricesQuantity demanded increases and quantity
supplied decreasesThe market continues to adjust until the
equilibrium price is reached.
A SurplusA Surplus
Chapter 2: The Basics of Supply and Demand Slide 24
The Market Mechanism
D
S
Q1
Assume the price is P1 , then:1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2.3) Producers lower price.4) Quantity supplied decreases
and quantity demanded increases.
5) Equilibrium at P2Q3
P1
Surplus
Q2 Quantity
Price($ per unit)
P2
Q3
Chapter 2: The Basics of Supply and Demand Slide 25
The Market Mechanism
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
Surplus - Review:Surplus - Review:
Chapter 2: The Basics of Supply and Demand Slide 26
The Market Mechanism
D
S
Q1 Q2
P2
Shortage
Quantity
Price($ per unit)
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
Q3
P3
Chapter 2: The Basics of Supply and Demand Slide 27
The Market Mechanism
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.
ShortageShortage
Chapter 2: The Basics of Supply and Demand Slide 28
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 29
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 30
S’
Q2
Raw material prices fall
S shifts to S’
Surplus @ P1 of Q1, Q2
Equilibrium @ P3, Q3
P
Q
SD
P3
Q3Q1
P1
Changes In Market Equilibrium
Chapter 2: The Basics of Supply and Demand Slide 31
D’ SD
Q3
P3
Q2
Income Increases
Demand shifts to D1
Shortage @ P1 of Q1, Q2
Equilibrium @ P3, Q3
P
QQ1
P1
Changes In Market Equilibrium
Chapter 2: The Basics of Supply and Demand Slide 32
D’ S’ Income Increases & raw material prices fall
The increase in D is greater than the increase in S
Equilibrium price and quantity increase to P2, Q2
P
Q
S
P2
Q2
D
P1
Q1
Changes In Market Equilibrium
Chapter 2: The Basics of Supply and Demand Slide 33
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 34
The Price of Eggs and the Priceof 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 35
Market for Eggs
Q (million dozens)
P(1970
dollars perdozen)
D1970
S1970
$0.61
5,500
D1998
S1998
Prices fell untila new equilibrium
was reached at $0.26and a quantity
of 5,300 million dozen
$0.26
5,300
Chapter 2: The Basics of Supply and Demand Slide 36
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 37
Market for a College Education
Q (millions of students enrolled))
P(annual cost
in 1970dollars)
D1970
S1970
S1995
D1995
$4,248
14.9
Prices rose untila new equilibrium
was reached at $4,573and a quantity
of 12.3 million students
$2,530
8.6
Chapter 2: The Basics of Supply and Demand Slide 38
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 39
Consumption & Price of Copper 1880-1998
Chapter 2: The Basics of Supply and Demand Slide 40
The Long-Run Behaviorof Natural Resource Prices
ObservationsConsumption 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
S1998
D1998D1900
S1900 S1950
D1950
Long-Run Path ofPrice and Consumption
Changes In Market Equilibrium
Quantity
Price
Chapter 2: The Basics of Supply and Demand Slide 42
ConclusionDecreases in the costs of production have
increased the supply by more than enough to offset the increase in demand.
Changes In Market Equilibrium
Chapter 2: The Basics of Supply and Demand Slide 43
ObservationTo 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.
Changes In Market Equilibrium
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
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.
Price Elasticity of DemandPrice Elasticity of Demand
Chapter 2: The Basics of Supply and Demand Slide 46
Elasticities of Supply and Demand
The price elasticity of demand is:
P)Q)/(%(% EP
Chapter 2: The Basics of Supply and Demand Slide 47
Elasticities of Supply and Demand
The percentage change in a variable is the absolute change in the variable divided by the original level of the variable.
Price Elasticity of DemandPrice Elasticity of Demand
Chapter 2: The Basics of Supply and Demand Slide 48
Elasticities of Supply and Demand
So the price elasticity of demand is also:
P
Q
Q
P
P/P
Q/Q EP
Price Elasticity of DemandPrice Elasticity of Demand
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
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
Price Elasticity of DemandPrice Elasticity of Demand
Chapter 2: The Basics of Supply and Demand Slide 52
Price Elasticities of Demand
Q
Price
Q = 8 - 2P
Ep = -1
Ep = 0
- EP The lower portion of a downward sloping
demand curve is less elasticthan the upper portion.
4
8
2
4
Linear Demand CurveQ = a - bPQ = 8 - 2P
Chapter 2: The Basics of Supply and Demand Slide 53
Price Elasticities of Demand
DP*
- EP
Quantity
Price Infinitely Elastic Demand
Chapter 2: The Basics of Supply and Demand Slide 54
Price Elasticities of Demand
Q*
0 EP
Quantity
PriceCompletely Inelastic Demand
Chapter 2: The Basics of Supply and Demand Slide 55
Elasticities of Supply and Demand
Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percent change in income.
Other Demand ElasticitiesOther Demand Elasticities
Chapter 2: The Basics of Supply and Demand Slide 56
Elasticities of Supply and Demand
The income elasticity of demand is:
I
Q
Q
I
I/I
Q/Q EI
Other Demand ElasticitiesOther Demand Elasticities
Chapter 2: The Basics of Supply and Demand Slide 57
Elasticities of Supply and Demand
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.
Other Demand ElasticitiesOther Demand Elasticities
Chapter 2: The Basics of Supply and Demand Slide 58
Elasticities of Supply and Demand
The cross elasticity of demand is:
m
b
b
m
mm
bbPQ
P
Q
Q
P
/PP
/QQ E mb
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
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.
Elasticities of SupplyElasticities of Supply
Chapter 2: The Basics of Supply and Demand Slide 60
Elasticities of Supply and Demand
We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials.
Elasticities of SupplyElasticities of Supply
Chapter 2: The Basics of Supply and Demand Slide 61
Elasticities of Supply and Demand
1981 Supply Curve for Wheat
QS = 1,800 + 240P
1981 Demand Curve for Wheat
QD = 3,550 - 266P
The Market for WheatThe Market for Wheat
Elasticities of Supply and Demand
Equilibrium: Q S = Q D
PP 266550,3240800,1
750,1506 P
bushelP /46.3
bushels million 630,2)46.3)(240(800,1 Q
The Market for WheatThe Market for Wheat
Chapter 2: The Basics of Supply and Demand Slide 62
Elasticities of Supply and Demand
Inelastic 035.)66.2(630,2
46.3
P
Q
Q
PE DD
P
Inelastic 032.)40.2(630,2
46.3
P
Q
Q
PE SS
P
The Market for WheatThe Market for Wheat
Chapter 2: The Basics of Supply and Demand Slide 63
Chapter 2: The Basics of Supply and Demand Slide 64
Elasticities of Supply and Demand
Assume the price of wheat is $4.00/bushel
486,2)00.4)(266(550,3 DQ
43.0)266(486,2
00.4D
PQ
The Market for WheatThe Market for Wheat
Chapter 2: The Basics of Supply and Demand Slide 65
1981 1800 + 240P 3550 - 266P 1800+240P = 3550-266P506P = 1750
P1981 = $3.46/bushel
1998 1,944 + 207P 3,244 - 283P 1,944+207P = 3,244-283P P1998 = $2.65/bushel
Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD)
Changes in the Market: 1981-1998
The Market for WheatThe Market for Wheat
Chapter 2: The Basics of Supply and Demand Slide 66
Short-Run Versus Long-Run Elasticities
Price elasticity of demand varies with the amount of time consumers have to respond to a price.
DemandDemand
Chapter 2: The Basics of Supply and Demand Slide 67
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)
Short-Run Versus Long-Run Elasticities
DemandDemand
Chapter 2: The Basics of Supply and Demand Slide 68
Gasoline: Short-Run andLong-Run Demand Curves
DSR
DLR
People tend to drive smaller and more fuel efficient
cars in the long-run
Gasoline
Quantity
Price
Chapter 2: The Basics of Supply and Demand Slide 69
DSR
DLR
People may putoff immediate
consumption, buteventually older cars
must be replaced.
Automobiles
Automobiles: Short-Run andLong-Run Demand Curves
Quantity
Price
Chapter 2: The Basics of Supply and Demand Slide 70
Income elasticity also varies with the amount of time consumers have to respond to an income change.
Short-Run Versus Long-Run Elasticities
Income ElasticitiesIncome Elasticities
Chapter 2: The Basics of Supply and Demand Slide 71
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.
Short-Run Versus Long-Run Elasticities
Income ElasticitiesIncome Elasticities
Chapter 2: The Basics of Supply and Demand Slide 72
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.
Short-Run Versus Long-Run Elasticities
Income ElasticitiesIncome Elasticities
Chapter 2: The Basics of Supply and Demand Slide 73
Gasoline and automobiles are complementary goods.
Short-Run Versus Long-Run Elasticities
The Demand forGasoline and Automobiles
The Demand forGasoline and Automobiles
Chapter 2: The Basics of Supply and Demand Slide 74
GasolineThe long-run price and income elasticities
are larger than the short-run elasticities.
AutomobilesThe long-run price and income elasticities
are smaller than the short-run elasticities.
Short-Run Versus Long-Run Elasticities
The Demand forGasoline and Automobiles
The Demand forGasoline and Automobiles
Chapter 2: The Basics of Supply and Demand Slide 75
Price -0.11 -0.22 -0.32 -0.49 -0.82 -1.17
Income 0.07 0.13 0.20 0.32 0.54 0.78
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
The Demand for GasolineThe Demand for Gasoline
Short-Run Versus Long-Run Elasticities
Chapter 2: The Basics of Supply and Demand Slide 76
Price -1.20 -0.93 -0.75 -0.55 -0.42 -0.40
Income 3.00 2.33 1.88 1.38 1.02 1.00
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
The Demand for AutomobilesThe Demand for Automobiles
Short-Run Versus Long-Run Elasticities
Chapter 2: The Basics of Supply and Demand Slide 77
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.
Short-Run Versus Long-Run Elasticities
The Demand forGasoline and Automobiles
The Demand forGasoline and Automobiles
Chapter 2: The Basics of Supply and Demand Slide 78
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
Short-Run Versus Long-Run Elasticities
SupplySupply
Chapter 2: The Basics of Supply and Demand Slide 79
SSR
Primary Copper: Short-Run and Long-Run Supply Curves
Primary Copper: Short-Run and Long-Run Supply Curves
Quantity
Price
Short-Run Versus Long-Run Elasticities
SLR
Due to limitedcapacity, firmsare limited by
output constraintsin the short-run.
In the long-run, theycan expand.
Chapter 2: The Basics of Supply and Demand Slide 80
SSR
Secondary Copper: Short-Run and Long-Run Supply Curves
Secondary Copper: Short-Run and Long-Run Supply Curves
Quantity
Price
Short-Run Versus Long-Run Elasticities
SLR
Price increasesprovide an incentive
to convert scrapcopper into new supply.
In the long-run, thisstock of scrap copper
begins to fall.
Chapter 2: The Basics of Supply and Demand Slide 81
Primary supply 0.20 1.60
Secondary supply 0.43 0.31
Total supply 0.25 1.50
Price Elasticity of: Short-run Long-run
Supply of CopperSupply of Copper
Short-Run Versus Long-Run Elasticities
Chapter 2: The Basics of Supply and Demand Slide 82
Elasticity explains why coffee prices are very volatile.Due to the differences in supply elasticity in
the long-run and short run.
Short-Run Versus Long-Run Elasticities
Weather in Brazil andthe price of Coffee
in New York
Weather in Brazil andthe price of Coffee
in New York
Chapter 2: The Basics of Supply and Demand Slide 83
Price of Brazilian Coffee
Chapter 2: The Basics of Supply and Demand Slide 84
D
S
P0
Q0 Quantity
Price
P1
Short-Run1) Supply is completely inelastic2) Demand is relatively inelastic3) Very large change in price
A freeze or drought decreases the supply
of coffee
S’
Q1
Short-Run Versus Long-Run ElasticitiesCoffeeCoffee
Chapter 2: The Basics of Supply and Demand Slide 85
S’
D
S
P0
Q0
P2
Q2
Intermediate-Run1) Supply and demand are more elastic2) Price falls back to P2.3) Quantity falls to Q2
Short-Run Versus Long-Run Elasticities
Quantity
Price
CoffeeCoffee
Chapter 2: The Basics of Supply and Demand Slide 86
D
SP0
Q0
Long-Run1) Supply is extremely elastic.2) Price falls back to P0.3) Quantity increase to Q0.
Short-Run Versus Long-Run ElasticitiesCoffeeCoffee
Quantity
Price
Chapter 2: The Basics of Supply and Demand Slide 87
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.
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 88
Available DataEquilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, ES, and demand, ED.
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 89
Demand: Q = a - bP
a/bSupply: Q = c + dP
-c/d
P*
Q*
ED = -bP*/Q*ES = dP*/Q*
Understanding and Predicting the Effects of Changing Market Conditions
Quantity
Price
Chapter 2: The Basics of Supply and Demand Slide 90
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.
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 91
Step 1:
Recall:
P)Q/(P/Q)( E
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 92
For linear demand curves, the change in quantity divided by the change in price is constant (equal to the slope of the curve).
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 93
Substituting the slopes for each into the formula for elasticity, we get:
/Q*)*b(P- ED
/Q*)*d(P ES
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 94
Since we will have values for ED, ES, P*, and Q*, we can solve for b & d, and a & c.
Understanding and Predicting the Effects of Changing Market Conditions
** bPaQD ** dPcQS
Chapter 2: The Basics of Supply and Demand Slide 95
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
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 96
Es = d(P*/Q*)
1.6 = d(75/7.5) = 0.1d
d = 1.6/0.1 = 16
Ed = -b(P*/Q*)
-0.8 = -b(.75/7.5) = -0.1b
b = 0.8/0.1 = 8
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 97
Supply = QS* = c + dP*
7.5 = c + 16(0.75)
7.5 = c + 12
c = 7.5 - 12
c = -4.5
Q = -4.5 + 16P
Demand = QD* = a -bP*
7.5 = a -(8)(.75)
7.5 = a - 6
a = 7.5 + 6
a =13.5
Q = 13.5 - 8P
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 98
Setting supply equal to demand gives:
Supply = -4.5 + 16p = 13.5 - 8p = Demand
16p + 8p = 13.5 + 4.5
p = 18/24 = .75
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 99
Supply: QS = -4.5 + 16P
-c/d Demand: QD = 13.5 - 8P
a/b
.75
7.5
Understanding and Predicting the Effects of Changing Market Conditions
Mmt/yr
Price
Chapter 2: The Basics of Supply and Demand Slide 100
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:
Understanding and Predicting the Effects of Changing Market Conditions
fIbPaQ
Chapter 2: The Basics of Supply and Demand Slide 101
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
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 102
f can be found by substituting known values into the income elasticity formula:
IQf /
)/)(/( IQQIE and
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 103
Solving for f gives:
1.3 = (1.0/7.5)f
f = (1.3)(7.5)/1.0 = 9.75
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 104
Solving for a gives:
7.5 = a - 8(0.75) + 9.75(1.0)
a = 3.75
Understanding and Predicting the Effects of Changing Market Conditions
fIbPaQ **
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 NominalPrices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand Slide 107
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
Real versus NominalPrices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand Slide 108
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
Real versus NominalPrices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand Slide 109
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
Real versus NominalPrices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand Slide 110
The twenty percent decrease in demand resulted in a reduction in the equilibrium price to 68.3 cents from 75 cents, or 10 percent.
Real versus NominalPrices of Copper 1965 - 1999
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* = $18/barrel
World demand and total supply = 23 bb/yr.
OPEC supply = 10 bb/yr.
Non-OPEC supply = 13 bb/yr
Chapter 2: The Basics of Supply and Demand Slide 113
Price Elasticity Estimates
World Demand: -0.05 -0.40
Competitive Supply 0.10 0.40(non-OPEC)
Short-Run Long-Run
Chapter 2: The Basics of Supply and Demand Slide 114
Upheaval in the World Oil Market
Short-Run Impact of a stoppage of Saudi Production equal to 3 bb/yr.
Short-run Demand
D = 24.08 - 0.06P
Short-run Competitive Supply
SC = 11.74 + 0.07P
Chapter 2: The Basics of Supply and Demand Slide 115
Upheaval in the World Oil Market
Short-Run Impact of a stoppage of Saudi Production equal to 3 bb/yr.Short-run Total Supply--before supply
reduction (includes OPEC, 10bb/yr)
ST = 21.74 + 0.07P
Short-run Total Supply--after supply reduction
ST = 18.74 + 0.07P
Chapter 2: The Basics of Supply and Demand Slide 116
Upheaval in the World Oil Market
New Price After Reduction
Demand = Supply
24.08 - 0.06P = 18.74 + 0.07P
P = 41.08
Chapter 2: The Basics of Supply and Demand Slide 117
D
Quantity(billions barrels/yr)
Price($ per barrel)
5
18
ST
0 5 15 20 25 30 3510
10
15
20
25
30
35
40
45
23
Impact of Saudi Production CutSC
Short-RunEffect
S’T
Chapter 2: The Basics of Supply and Demand 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
D
Quantity(billions barrels/yr)
Price($ per barrel)
5
ST
0 5 15 20 25 30 3510
10
15
20
25
30
35
40
45
23
18
Impact of Saudi Production Cut
SC
Due to the elasticityof the long-run
supply and demand curves, the long-run
effect of a cutin production is
much less.
S’T Long-run Effect
Chapter 2: The Basics of Supply and Demand 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
D
Effects of Price Controls
Quantity
Price
P0
Q0
S
Pmax
Excess demand
If price is regulated tobe no higher than Pmax,quantity supplied falls
to Q1 and quantitydemanded increases toQ2. A shortage results
Chapter 2: The Basics of Supply and Demand Slide 123
Price Controls andNatural 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 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.
Price Controls andNatural Gas Shortages
Chapter 2: The Basics of Supply and Demand Slide 125
$2/TcF @
1.5 oil for demand of elasticity Cross
0.1 oil forsupply of elasticity Cross
DemandSupply
PPQDemand
PPQSupply
P
P
OG
OG
DE
SE
75.35:
25.214:
5.0
2.0
Price Controls andNatural Gas Shortages
The Data: Natural GasThe Data: Natural Gas
Chapter 2: The Basics of Supply and Demand Slide 126
Price Controls andNatural Gas Shortages
The Data: Natural GasThe Data: Natural Gas
TcF/yr 7 Shortage
TcF 25 and TcF
$1.00/TcF At
$1.00 price regulated 1975
QQS 18