Chapter 2 The Basics of Supply and Demand. ©2005 Pearson Education, Inc.Chapter 22 Introduction...
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Chapter 2
The Basics of Supply and Demand
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©2005 Pearson Education, Inc. Chapter 2 2
Introduction
What are supply and demand?What is the market mechanism?What are the effects of changes in
market equilibrium?What are elasticities of supply and
demand?
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©2005 Pearson Education, Inc. Chapter 2 3
Topics to Be Discussed
How do short-run and long-run elasticities differ?
How do we understand and predict the effects of changing market conditions?
What are the effects of government intervention – price controls?
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©2005 Pearson Education, Inc. Chapter 2 4
Supply and Demand
Supply and demand analysis can:1. Help us understand and predict how world
economic conditions affect market price and production
2. Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers
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©2005 Pearson Education, Inc. Chapter 2 5
Supply and Demand
The Supply Curve The relationship between the quantity of a
good that producers are willing to sell and the price of the good.
Measures quantity on the x-axis and price on the y-axis
(P)QQ SS
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©2005 Pearson Education, Inc. Chapter 2 6
The Supply Curve
S
The supply curve slopesupward demonstrating that
at higher prices firmswill increase output
The SupplyCurve Graphically
Quantity
Price($ per unit)
P1
Q1
P2
Q2
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©2005 Pearson Education, Inc. Chapter 2 7
The Supply Curve
Change in Quantity Supplied Movement along the curve caused by a
change in price
Change in Supply Shift of the curve caused by a change in
something other than priceChange in costs of production
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©2005 Pearson Education, Inc. Chapter 2 8
Change in Supply
Other Variables Affecting Supply Costs of Production
LaborCapitalRaw Materials
Lower costs of production allow a firm to produce more at each price and vice versa
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©2005 Pearson Education, Inc. Chapter 2 9
Change in Supply
The cost of raw materials falls Produced Q1 at P1
and Q0 at P2 Now produce Q2 at
P1 and Q1 at P2 Supply curve shifts
right to S’
P S
Q
P1
P2
Q1Q0
S’
Q2
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©2005 Pearson Education, Inc. Chapter 2 10
Supply and Demand
The Demand Curve The relationship between the quantity of a
good that consumers are willing to buy and the price of the good.
Measures quantity on the x-axis and price on the y-axis
(P)QQ DD
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©2005 Pearson Education, Inc. Chapter 2 11
The Demand Curve
D
The demand curve slopesdownward demonstrating that consumers are willing
to buy more at a lower priceas the product becomes
relatively cheaper.
Quantity
Price($ per unit)
P2
Q1
P1
Q2
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©2005 Pearson Education, Inc. Chapter 2 12
The Demand Curve
Changes in quantity demanded Movements along the demand curve caused
by a change in price.
Changes in demand A shift of the entire demand curve caused by
something other than price.IncomePreferences
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©2005 Pearson Education, Inc. Chapter 2 13
Change in Demand
Other Variables Affecting Demand Income
Increases in income allow consumers to purchase more at all prices
Consumer Tastes Price of Related Goods
SubstitutesComplements
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©2005 Pearson Education, Inc. Chapter 2 14
DP
Q
D’
Q1
P2
Q0
P1
Q2
Change in Demand
Income Increases Purchased Q0, at P2
and Q1 at P1 Now purchased Q1 at
P2 and Q2 at P1 Same for all prices Demand Curve shifts
right
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©2005 Pearson Education, Inc. Chapter 2 15
The Market Mechanism
The market mechanism is the tendency in a free market for price to change until the market clears
Markets clear when quantity demanded equals quantity supplied at the prevailing price
Market Clearing price – price at which markets clear
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©2005 Pearson Education, Inc. Chapter 2 16
The Market Mechanism
D
S
The curves intersect atequilibrium, or market-
clearing, price. Quantity demanded
equals quantity supplied at P0
P0
Q0Quantity
Price($ per unit)
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©2005 Pearson Education, Inc. Chapter 2 17
The Market Mechanism
In equilibrium There is no shortage or excess demand There is no surplus or excess supply Quantity supplied equals quantity demanded Anyone who wished to buy at the current
price can and all producers who wish to sell at that price can
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©2005 Pearson Education, Inc. Chapter 2 18
Market Surplus
The market price is above equilibrium There is excess supply - surplus Downward pressure on price Quantity demanded increases and quantity
supplied decreases The market adjusts until new equilibrium is
reached
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©2005 Pearson Education, Inc. Chapter 2 19
The Market Mechanism
D
S
P0
Q0
1. Price is above the market clearing price – P1
2. Qs > QD
3. Price falls to the market-clearing price
4. Market adjusts to equilibrium
P1
Surplus
Quantity
Price($ per unit)
QSQD
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©2005 Pearson Education, Inc. Chapter 2 20
The Market Mechanism
The market price is below equilibrium: There is a excess demand - shortage Upward pressure on prices Quantity demanded decreases and quantity
supplied increases The market adjusts until the new equilibrium
is reached.
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©2005 Pearson Education, Inc. Chapter 2 21
The Market Mechanism
D
S
QS QD
P2
Quantity
Price($ per unit)
1. Price is below the market clearing price – P2
2. QD > QS
3. Price rises to the market-clearing price
4. Market adjusts to equilibrium
Q3
P3
Shortage
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©2005 Pearson Education, Inc. Chapter 2 22
The Market Mechanism
Supply and demand interact to determine the market-clearing price.
When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium.
Markets must be competitive for the mechanism to be efficient.
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©2005 Pearson Education, Inc. Chapter 2 23
Changes In Market Equilibrium
Equilibrium prices are determined by the relative level of supply and demand.
Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market.
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©2005 Pearson Education, Inc. Chapter 2 24
S’
Changes In Market Equilibrium
Raw material prices fall S shifts to S’ Surplus at P1
between Q1, Q2 Price adjusts to
equilibrium at P3, Q3
P
Q
SD
P3
Q3Q1
P1
Q2
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©2005 Pearson Education, Inc. Chapter 2 25
D’S
D
Q3
P3
Changes In Market Equilibrium
Income Increases Demand increases to
D1 Shortage at P1 of Q1,
Q2 Equilibrium at P3, Q3
P
QQ1
P1
Q2
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©2005 Pearson Education, Inc. Chapter 2 26
D’S’
Changes In Market Equilibrium
Income Increases & raw material prices fall Quantity increases If the increase in D is
greater than the increase in S price also increases
P
Q
S
P2
Q2
D
P1
Q1
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©2005 Pearson Education, Inc. Chapter 2 27
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
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©2005 Pearson Education, Inc. Chapter 2 28
The Price of a College Education
The real price of a college education rose 55 percent from 1970 to 2002.
Increases in costs of modern classrooms and wages increased costs of production – decrease in supply
Due to a larger percentage of high school graduates attending college, demand increased
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©2005 Pearson Education, Inc. Chapter 2 29
Market for a College Education
Q (millions enrolled))
P(annual cost
in 1970dollars)
D1970
S1970
S2002
D2002
$3,917
13.2
New equilibriumwas reached at $4,573 and a quantity of 12.3 million students
$2,530
8.6
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©2005 Pearson Education, Inc. Chapter 2 30
The Long-Run Behaviorof Natural Resource Prices
Consumption of copper has increased about a hundred fold from 1880 through 2002.
The long term real price for copper has remained relatively constant.
Increased demand as world economy grew Decreased production costs increased
supply
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©2005 Pearson Education, Inc. Chapter 2 31
S2002
D2002
D1900
S1900 S1950
D1950
Long-Run Path ofPrice and Consumption
Resource Market Equilibrium
Quantity
Price
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©2005 Pearson Education, Inc. Chapter 2 32
Resource Market
Conclusion Decreases in the costs of production have
increased the supply by more than enough to offset the increase in demand.
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©2005 Pearson Education, Inc. Chapter 2 33
Elasticities of Supply and Demand
Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change.
Elasticity gives a way to measure by how much a variable will change with the change in another variable.
Specifically, it gives the percentage change in one variable resulting from a one percent change in another.
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©2005 Pearson Education, Inc. Chapter 2 34
Price Elasticity of Demand
Measures the sensitivity of quantity demanded to price changes. It measures the percentage change in the
quantity demanded of a good that results from a one percent change in price.
P
QE
DDP
%
%
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©2005 Pearson Education, Inc. Chapter 2 35
Price Elasticity of Demand
The percentage change in a variable is the absolute change in the variable divided by the original level of the variable.
Therefore, elasticity can also be written as:
P
Q
Q
P
PP
QQE D
P
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©2005 Pearson Education, Inc. Chapter 2 36
Price Elasticity of Demand
Usually a negative number As price increases, quantity decreases As price decreases, quantity increases
When EP > 1, the good is price elastic %Q > % P
When EP < 1, the good is price inelastic %Q < % P
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©2005 Pearson Education, Inc. Chapter 2 37
Price Elasticity of Demand
The primary determinant of price elasticity of demand is the availability of substitutes. Many substitutes demand is price elastic
Can easily move to another good with price increases
Few substitutes demand is price inelastic
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©2005 Pearson Education, Inc. Chapter 2 38
Price Elasticity of Demand
Looking at a linear demand curve, as we move along the curve Q/P will change
Price elasticity of demand must therefore be measured at a particular point on the demand curve
Elasticity will change along the demand curve in a particular way
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©2005 Pearson Education, Inc. Chapter 2 39
Price Elasticity of Demand
Given a linear demand curve Elasticity depends on slope and on the
values of P and Q The top portion of demand curve is elastic
Price is high and quantity small The bottom portion of demand curve is
inelasticPrice is low and quantity high
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©2005 Pearson Education, Inc. Chapter 2 40
Price Elasticity of Demand
Q
Price
4
8
2
4
Ep = -1
Ep = 0
EP = -
Elastic
Inelastic
Demand Curve
Q = 8 – 2P
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©2005 Pearson Education, Inc. Chapter 2 41
Price Elasticity of Demand
The steeper the demand curve becomes, the more inelastic the good.
The flatter the demand curve becomes, the more elastic the good
Two extreme cases of demand curves Completely inelastic demand – vertical Infinitely elastic demand - horizontal
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©2005 Pearson Education, Inc. Chapter 2 42
Infinitely Elastic Demand
DP*
Quantity
Price
EP =
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©2005 Pearson Education, Inc. Chapter 2 43
Completely Inelastic Demand
Quantity
Price
Q*
D
EP = 0
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©2005 Pearson Education, Inc. Chapter 2 44
Other Demand Elasticities
Income Elasticity of Demand Measures how much quantity demanded
changes with a change in income.
I
Q
Q
I
I/I
Q/Q EI
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©2005 Pearson Education, Inc. Chapter 2 45
Other Demand Elasticities
Cross-Price 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.
m
b
b
m
mm
bbPQ P
Q
Q
P
PP
QQE
mb
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©2005 Pearson Education, Inc. Chapter 2 46
Other Demand Elasticities
Complements: Cars and Tires Cross-price elasticity of demand is negative
Price of cars increases, quantity demanded of tired decreases
Substitutes: Butter and Margarine Cross-price elasticity of demand is positive
Price of butter increases, quantity of margarine demanded increases
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©2005 Pearson Education, Inc. Chapter 2 47
Price Elasticity of Supply
Measures the sensitivity of quantity supplied given a change in price Measures the percentage change in quantity
supplied resulting from a 1 percent change in price.
P
QE
SSP Δ%
Δ%
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©2005 Pearson Education, Inc. Chapter 2 48
Point v. Arc Elasticities
Point elasticity of demand Price elasticity of demand at a particular
point on the demand curve
Arc elasticity of demand Price elasticity of demand calculated over a
range of prices
QP
PQE D
P ΔΔ
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©2005 Pearson Education, Inc. Chapter 2 49
Elasticity: An Application
During 1980’s and 1990’s, market for wheat went through changes that had great implications for American farmers and US agricultural policy
Using the supply and demand curves for wheat, we can analyze what occurred in this market
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©2005 Pearson Education, Inc. Chapter 2 50
Elasticity: An Application
Supply: QS = 1900 + 240P
Demand: QD = 3550 – 266P
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©2005 Pearson Education, Inc. Chapter 2 51
Elasticity: An Application
QD = QS
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million bushels
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©2005 Pearson Education, Inc. Chapter 2 52
Elasticity: An Application
We can find the elasticities of demand and supply at these points
035.)266(630,2
46.3
P
Q
Q
PE DD
P
032.)240(630,2
46.3
P
Q
Q
PE SS
P
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©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 DQ
43.0)266(486,2
00.4D
PE
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©2005 Pearson Education, Inc. Chapter 2 54
Elasticity: An Application
In 2002, the supply and demand for wheat were: Supply: QS = 1439 + 267P
Demand: QD = 2809 – 226P
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©2005 Pearson Education, Inc. Chapter 2 55
Elasticity: An Application
QD = QS
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million bushels
Price of wheat fell in nominal terms.
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©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.
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©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 runConsumers take time to adjust consumption
habitsDemand might be linked to another good that
changes slowlyMore substitutes are usually available in the
long run
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©2005 Pearson Education, Inc. Chapter 2 58
Gasoline: Short-Run and Long-Run Demand Curves
DSR
DLR
•People cannot easily adjust consumption in short run.•In the long run, people tend to drive smaller and more fuel efficient cars.
Quantity of Gas
Price
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©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 so its quantity demanded fall sharply.
But in long run, older durable goods will have to be replaced
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©2005 Pearson Education, Inc. Chapter 2 60
DSR
DLR
•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
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©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
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©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 replaced, purchases will only to
be to replace old cars.Less purchases from income increase in long
run than in short run
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©2005 Pearson Education, Inc. Chapter 2 63
Demand for Gasoline
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©2005 Pearson Education, Inc. Chapter 2 64
Demand for Automobiles
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©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
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©2005 Pearson Education, Inc. Chapter 2 66
SSR
Quantity Primary Copper
Price
Short-Run Versus Long-Run Elasticity
SLR
Due to limitedcapacity, firmsare limited by
output constraintsin the short-run.
In the long-run, theycan expand.
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©2005 Pearson Education, Inc. Chapter 2 67
SSR
Quantity Secondary Copper
Price
Short-Run Versus Long-Run Elasticity
SLR
Price increasesprovide an incentive
to convert scrapcopper into new supply.
In the long-run, thisstock of scrap copper
begins to fall.
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©2005 Pearson Education, Inc. Chapter 2 68
Supply of Copper
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©2005 Pearson Education, Inc. Chapter 2 69
Short-Run v. Long-Run Elasticity – An Application
Why are coffee prices very volatile? Most of the world’s coffee 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
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©2005 Pearson Education, Inc. Chapter 2 70
Price of Brazilian Coffee
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©2005 Pearson Education, Inc. Chapter 2 71
Short-Run v. Long-Run Elasticity – An Application
Demand and supply are more elastic in the long run
In short-run, supply is completely inelastic Weather may destroy part of the fixed supply,
decreasing supply
Demand relatively inelastic as wellPrice increases significantly
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©2005 Pearson Education, Inc. Chapter 2 72
D
P0
S
Q0 Quantity
PriceA freeze or drought
decreases the supplyof coffee
S’
Q1
An Application - Coffee
Price increases significantly due to inelastic supply and
demand
P1
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©2005 Pearson Education, Inc. Chapter 2 73
S’
D
S
P0
Q0
P2
Q2
Intermediate-Run1) Supply and demand are more elastic2) Price falls back to P2.
An Application - Coffee
Quantity
Price
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©2005 Pearson Education, Inc. Chapter 2 74
SP0
Q0
Long-Run1) Supply is extremely elastic.2) Price falls back to P0.3) Quantity back to Q0.
An Application - Coffee
Quantity
Price
D
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©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 dataGiven 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
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©2005 Pearson Education, Inc. Chapter 2 76
Predicting the Effects of Changing Market Conditions
We know Equilibrium Price, P*=$0.75 Equilibrium Quantity, Q*=7.5 Price elasticity of supply, ES=1.6 Price elasticity of demand, ED=-0.8
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©2005 Pearson Education, Inc. Chapter 2 77
Predicting the Effects of Changing Market Conditions
Let’s begin with the equations for supply, demand, elasticity: Demand: Q = a – bP Supply: Q = c + dP Elasticity: (P/Q)(Q/P)
We must calculate numbers for a, b, c, and d.
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©2005 Pearson Education, Inc. Chapter 2 78
Predicting the Effects of Changing Market Conditions
The slope of the demand curve above equals Q/P which equals –b
The slope of the supply curve above equals Q/P which equals d
Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)
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©2005 Pearson Education, Inc. Chapter 2 79
Demand: Q = a - bP
a/bSupply: Q = c + dP
-c/d
P*
Q*
ED = -bP*/Q*ES = dP*/Q*
Predicting the Effects of Changing Market Conditions
Quantity
Price
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©2005 Pearson Education, Inc. Chapter 2 80
Predicting the Effects of Changing Market Conditions
Using P*, Q* and the elasticities, we can solve for d and c from supply
ES = d(P*/Q*)1.6 = d(0.75/7.5) = 0.1d
d = 16Q = c + dP
7.5 = c + (16)(0.75) = c + 12c = -4.5
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©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
ED = –b(P*/Q*)-0.8 = -b(0.75/7.5) = –0.1b
b = 8Q = a – bP
7.5 = a – (8)(0.75) = a – 6a = 13.5
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©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 – 8PSetting them equal will give up
equilibrium price and quantity with which we began
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©2005 Pearson Education, Inc. Chapter 2 83
Supply: QS = -4.5 + 16P
-c/d Demand: QD = 13.5 - 8P
a/b
.75
7.5
Predicting the Effects of Changing Market Conditions
Mmt/yr
Price
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©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 variable such as income
Demand would then be written as:
fIbPaQ
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©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
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©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
EI = (I/Q)(Q/I)
1.3 = (1.0/7.5)(f)
f = 9.75Substituting back into demand equation
gives a = 3.75
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©2005 Pearson Education, Inc. Chapter 2 87
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
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©2005 Pearson Education, Inc. Chapter 2 88
D
Effects of Price Controls
Quantity
Price
P0
Q0
S
Pmax
•Price is regulated to be no higher than Pmax,•Quantity supplied falls and quantity demanded increases•A shortage results
QS
QD
Shortage
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©2005 Pearson Education, Inc. Chapter 2 89
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 ’70’s
Producers typically lose, but some consumers gain. Some consumers lose.
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©2005 Pearson Education, Inc. Chapter 2 90
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.
Price controls created an excess demand of 7 trillion cubic feet.