Ch02 Pindyck

Chapter 2
The Basics of Supply

and Demand
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?
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?
Supply and Demand
Supply and demand analysis can:
1. Help us understand and predict how real
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
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) Q Q
S S
=
The Supply Curve
S
The supply curve slopes
upward, demonstrating that
at higher prices firms
will increase output
The Supply Curve,
Graphically Depicted
Quantity
Price
($ per unit)
P
1

Q
1

P
2

Q
2

The Supply Curve
Other Variables Affecting Supply
Costs of Production
Labor
Capital
Raw Materials
Lower costs of production allow a firm to
produce more at each price and vice versa
Change in Supply
The cost of raw
materials falls
Produced Q
1
at P
1

and Q
0
at P
2
Now produce Q
2
at P
1

and Q
1
at P
2
Supply curve shifts
right to S
P
S
Q
P
1
P
2
Q
1
Q
0
S
Q
2
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 the price of the good
Change in costs of production
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) Q Q
D D
=
The Demand Curve
D
The demand curve slopes
downward, demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper.
Quantity
Price
($ per unit)
P
2

Q
1

P
1

Q
2

The Demand Curve
Other Variables Affecting Demand
Income
Increases in income allow consumers to
purchase more at all prices
Consumer Tastes
Price of Related Goods
Substitutes
Complements
D
P
Q
D
Q
1
P
2
Q
0
P
1
Q
2
Change in Demand
Income Increases
Purchased Q
0
, at P
2

and Q
1
at P
1
Now purchased Q
1
at
P
2
and Q
2
at P
1
Same for all prices
Demand curve shifts
right
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
Income
Preferences
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
D
S
The curves intersect at
equilibrium, or market-
clearing, price.
Quantity demanded
equals quantity
supplied at P
0

P
0
Q
0
Quantity
Price
($ per unit)
In equilibrium
There is no shortage or excess demand
There is no surplus or excess supply
Quantity supplied equals quantity demanded
Anyone who wants to buy at the current price
can and all producers who want to sell at that
price can
Market Surplus1
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
D
S
P
0
Q
0
1. At P
1
, price is
above the
market clearing
price

2. Q
s
> Q
D
3. Price falls to
the market-
clearing price
4. Market adjusts
to equilibrium
P
1
Surplus
Quantity
Price
($ per unit)
Q
S
Q
D
The market price is below equilibrium:
There is excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity
supplied increases
The market adjusts until the new equilibrium
is reached
D
Q
S
Q
D
P
2
Quantity
Price
($ per unit)
1. At P
2
, price is
below the
market
clearing price

2. Q
D
> Q
S
3. Price rises to
the market-
clearing price
4. Market adjusts
to equilibrium
Q
3
P
3
Shortage
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
Changes in Market Equilibrium
Equilibrium prices are determined by the
relative level of supply and demand
Changes in supply and/or demand will
cause change in the equilibrium price
and/or quantity in a free market
S
Raw material prices
fall
S shifts to S
Surplus at P
1
between
Q
1
, Q
2
Price adjusts to
equilibrium at P
3
, Q
3

P
Q
S
D
P
3
Q
3
Q
1
P
1
Q
2

D
S
D
Q
3

P
3
Income Increases
Demand increases to
D
Shortage at P
1
of Q
1

to Q
2
Equilibrium at P
3
and
Q
3

P
Q
Q
1
P
1
Q
2
D
S
Income increases
and raw material
prices fall
Quantity increases
If the increase in D is
greater than the
increase in S price
also increases
P
Q
S
P
2
Q
2
D
P
1
Q
1
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
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
Market for a College Education
Q (millions enrolled))

P
(annual cost
in 1970
dollars)
D
1970
S
1970
S
2002
D
2002
$3,917
13.2
New
equilibrium
was reached
at $4,573 and
a quantity of
12.3 million
students
$2,530
8.6
The Long-Run Behavior
of Natural Resource Prices
Consumption of copper has increased about
a hundredfold 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
S
2002
D
2002
D
1900
S
1900
S
1950
D
1950
Long-Run Path of
Price and Consumption
Resource Market Equilibrium
Quantity
Price
Resource Market
Conclusion
Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand
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
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
Q
E
D
D
P
A
A
=
%
%
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
P P
Q Q
E
D
P
A
A
=
A
A
=
Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
When |E
P
| > 1, the good is price elastic
|%AQ| > |%AP|
When |E
P
| < 1, the good is price inelastic
|%AQ| < |% AP|
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
Looking at a linear demand curve, as we
move along the curve AQ/AP is constant,
but P and Q 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
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
inelastic
Price is low and quantity high
Q
Price
4
8
2
4
E
p
= -1
E
p
= 0
E
P
= -
Elastic
Inelastic
Demand Curve
Q = 8 2P
The steeper the demand curve, the more
inelastic the demand for the good
becomes
The flatter the demand curve, the more
elastic the the demand for the good
becomes
Two extreme cases of demand curves
Completely inelastic demand vertical
Infinitely elastic demand horizontal
Infinitely Elastic Demand
D P
*
Quantity
Price
E
P
=
Completely Inelastic Demand
Quantity
Price
Q
*
D
E
P
= 0
Other Demand Elasticities
Income Elasticity of Demand
Measures how much quantity demanded
changes with a change in income
I A
A
=
A
A
=
Q
Q
I
I/I
Q/Q
E
I

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
m m
b b
P Q
P
Q
Q
P
P P
Q Q
E
m b
A
A
=
A
A
=
Complements: Cars and Tires
Cross-price elasticity of demand is negative
Price of cars increases, quantity demanded of
tires decreases
Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
Price of butter increases, quantity of margarine
demanded increases
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
Q
E
S
S
P
A
A
=
%
%

Point vs. 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
( )
|
.
|
\
|
=
Q
P
P
Q
E
D
P

Elasticity: An Application
During the 1980s and 1990s, the 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
Supply: Q
S
= 1900 + 24P
Demand: Q
D
= 3550 266P
Q
D
= Q
S
1800 + 240P = 3550 266P
506P = 1750
P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million
bushels
We can find the elasticities of demand
and supply at these points
035 . ) 66 . 2 (
630 , 2
46 . 3
= = =
P
Q
Q
P
E
D D
P
032 . ) 40 . 2 (
630 , 2
46 . 3
= = =
P
Q
Q
P
E
S S
P
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
In 2002, the supply and demand for
wheat were:
Supply: Q
S
= 1439 + 267P
Demand: Q
D
= 2809 226P
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.
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
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
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
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
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
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
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
Demand for Gasoline
Demand for Automobiles
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
S
SR
Quantity Primary Copper
Price
Elasticity
S
LR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.
S
SR
Quantity Secondary Copper
Price
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.
Supply of Copper
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
Price of Brazilian Coffee
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
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
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
.
Quantity
Price
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.
Quantity
Price
D
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
We know
Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, E
S
Price elasticity of demand, E
D
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.
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*)
Demand: Q = a - bP
a/b
Supply: Q = c + dP
-c/d
P*
Q*
E
D
= -bP*/Q*
E
S
= dP*/Q*
Quantity
Price
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
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
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
Supply: Q
S
= -4.5 + 16P
-c/d
Demand: Q
D
= 13.5 - 8P
a/b
.75
7.5
Mmt/yr
Price
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 + =
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
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
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
Real versus Nominal
Prices of Copper 1965 - 2002
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%
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
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%
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
D
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
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.
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
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

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Chapter 2

The Basics of Supply

2005 Pearson Education, Inc. Chapter 2 49

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