1. Chapter 2 The Basics of Supply and Demand

2. Chapter 2: The Basics of Supply and DemandSlide 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

3. Chapter 2: The Basics of Supply and DemandSlide 3 Topics to Be Discussed Understanding and Predicting the Effects of Changing Market Conditions Effects of Government Intervention--Price Controls

4. Chapter 2: The Basics of Supply and DemandSlide 4 Introduction Applications of Supply and Demand Analysis Understanding 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

5. Chapter 2: The Basics of Supply and DemandSlide 5 Introduction Applications of Supply and Demand Analysis Analyzing how taxes, subsidies, and import restrictions affect consumers and producers

6. Chapter 2: The Basics of Supply and DemandSlide 6 Supply and Demand The Supply Curve The 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

7. Chapter 2: The Basics of Supply and DemandSlide 7 Supply and Demand The Supply Curve This price-quantity relationship can be shown by the equation:

8. Chapter 2: The Basics of Supply and DemandSlide 8 Horizontal axis measures quantity (Q) supplied in number of units per time period Vertical axis measures price (P) received per unit in dollars Supply and Demand The Supply Curve Graphically The Supply Curve Graphically Quantity Price ($ per unit)

9. Chapter 2: The Basics of Supply and DemandSlide 9 Supply and Demand S The supply curve slopes upward demonstrating that at higher prices firms will increase output The Supply Curve Graphically The Supply Curve Graphically Quantity Price ($ per unit) P1P1 Q1Q1 P2P2 Q2Q2

10. Chapter 2: The Basics of Supply and DemandSlide 10 Supply and Demand Non-price Determining Variables of Supply Costs of Production  Labor  Capital  Raw Materials

11. Chapter 2: The Basics of Supply and DemandSlide 11 Supply and Demand The cost of raw materials falls At P 1, produce Q 2 At P 2, produce Q 1 Supply curve shifts right to S ’ More produced at any price on S ’ than on S P S Change in Supply Q P1P1 P2P2 Q1Q1 Q0Q0 S’S’ Q2Q2

12. Chapter 2: The Basics of Supply and DemandSlide 12 Supply and Demand Supply - A Review Supply 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.

13. Chapter 2: The Basics of Supply and DemandSlide 13 Supply and Demand Supply - A Review Changes in quantity supplied are shown by movements along the supply curve and are caused by a change in the price of the product.

14. Chapter 2: The Basics of Supply and DemandSlide 14 Supply and Demand The Demand Curve The 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:

15. Chapter 2: The Basics of Supply and DemandSlide 15 Supply and Demand Quantity Horizontal axis measures quantity (Q) demanded in number of units per time period Vertical axis measures price (P) paid per unit in dollars Price ($ per unit)

16. Chapter 2: The Basics of Supply and DemandSlide 16 Supply and Demand D The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper and the consumer ’ s real income increases. Quantity Price ($ per unit)

17. Chapter 2: The Basics of Supply and DemandSlide 17 Supply and Demand Non-price Determining Variables of Demand Income Consumer Tastes Price of Related Goods  Substitutes  Complements

18. Chapter 2: The Basics of Supply and DemandSlide 18 D P Q Q1Q1 P2P2 Q0Q0 P1P1 D’D’ Q2Q2 Change in Demand Supply and Demand Income Increases At P 1, produce Q 2 At P 2, produce Q 1 Demand Curve shifts right More purchased at any price on D ’ than on D

19. Chapter 2: The Basics of Supply and DemandSlide 19 Shifts in Supply and Demand Demand - A Review Demand 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.

20. Chapter 2: The Basics of Supply and DemandSlide 20 The Market Mechanism Quantity D S The curves intersect at equilibrium, or market- clearing, price. At P 0 the quantity supplied is equal to the quantity demanded at Q 0. P0P0 Q0Q0 Price ($ per unit)

21. Chapter 2: The Basics of Supply and DemandSlide 21 The Market Mechanism Characteristics of the equilibrium or market clearing price: Q D = Q S No shortage No excess supply No pressure on the price to change

22. Chapter 2: The Basics of Supply and DemandSlide 22 The Market Mechanism Quantity D S P0P0 Q0Q0 If price is above equilibrium: 1) Price is above the market clearing price 2) Q s > Q d 3) Price falls to the market-clearing price P1P1 Surplus Price ($ per unit)

23. Chapter 2: The Basics of Supply and DemandSlide 23 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. A Surplus

24. Chapter 2: The Basics of Supply and DemandSlide 24 The Market Mechanism D S Q1Q1 Assume the price is P 1, then: 1) Q s : Q 1 > Q d : Q 2 2) Excess supply is Q 1 :Q 2. 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P 2 Q 3 P1P1 Surplus Q2Q2 Quantity Price ($ per unit) P2P2 Q3Q3

25. Chapter 2: The Basics of Supply and DemandSlide 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:

26. Chapter 2: The Basics of Supply and DemandSlide 26 The Market Mechanism D S Q1Q1 Q2Q2 P2P2 Shortage Quantity Price ($ per unit) Assume the price is P 2, then: 1) Q d : Q 2 > Q s : Q 1 2) Shortage is Q 1 :Q 2. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P 3, Q 3 Q3Q3 P3P3

27. Chapter 2: The Basics of Supply and DemandSlide 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. Shortage

28. Chapter 2: The Basics of Supply and DemandSlide 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.

29. Chapter 2: The Basics of Supply and DemandSlide 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.

30. Chapter 2: The Basics of Supply and DemandSlide 30 S’S’ Q2Q2 Raw material prices fall S shifts to S ’ Surplus @ P 1 of Q 1, Q 2 Equilibrium @ P 3, Q 3 P Q SD P3P3 Q3Q3 Q1Q1 P1P1 Changes In Market Equilibrium

31. Chapter 2: The Basics of Supply and DemandSlide 31 D’D’ SD Q3Q3 P3P3 Q2Q2 Income Increases Demand shifts to D 1 Shortage @ P 1 of Q 1, Q 2 Equilibrium @ P 3, Q 3 P Q Q1Q1 P1P1 Changes In Market Equilibrium

32. Chapter 2: The Basics of Supply and DemandSlide 32 D’D’ S’S’ Income Increases & raw material prices fall The increase in D is greater than the increase in S Equilibrium price and quantity increase to P 2, Q 2 P Q S P2P2 Q2Q2 D P1P1 Q1Q1 Changes In Market Equilibrium

33. Chapter 2: The Basics of Supply and DemandSlide 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

34. Chapter 2: The Basics of Supply and DemandSlide 34 The Price of Eggs and the Price of 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.

35. Chapter 2: The Basics of Supply and DemandSlide 35 Market for Eggs Q (million dozens) P ( 1970 dollars per dozen) D 1970 S 1970 $0.61 5,500 D 1998 S 1998 Prices fell until a new equilibrium was reached at $0.26 and a quantity of 5,300 million dozen $0.26 5,300

36. Chapter 2: The Basics of Supply and DemandSlide 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.

37. Chapter 2: The Basics of Supply and DemandSlide 37 Market for a College Education Q ( millions of students enrolled)) P ( annual cost in 1970 dollars) D 1970 S 1970 S 1995 D 1995 $4,248 14.9 Prices rose until a new equilibrium was reached at $4,573 and a quantity of 12.3 million students $2,530 8.6

38. Chapter 2: The Basics of Supply and DemandSlide 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%

39. Chapter 2: The Basics of Supply and DemandSlide 39 Changes In Market Equilibrium Question Why did the income distribution become more unequal for 1977 to 1999?

40. Chapter 2: The Basics of Supply and DemandSlide 40 Consumption & Price of Copper 1880-1998

41. Chapter 2: The Basics of Supply and DemandSlide 41 The Long-Run Behavior of Natural Resource Prices Observations Consumption 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.

42. Chapter 2: The Basics of Supply and DemandSlide 42 S 1998 D 1998 D 1900 S 1900 S 1950 D 1950 Long-Run Path of Price and Consumption Changes In Market Equilibrium Quantity Price

43. Chapter 2: The Basics of Supply and DemandSlide 43 Conclusion Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand. Changes In Market Equilibrium

44. Chapter 2: The Basics of Supply and DemandSlide 44 Observation To 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

45. Chapter 2: The Basics of Supply and DemandSlide 45 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.

46. Chapter 2: The Basics of Supply and DemandSlide 46 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 Demand

47. Chapter 2: The Basics of Supply and DemandSlide 47 Elasticities of Supply and Demand The price elasticity of demand is:

48. Chapter 2: The Basics of Supply and DemandSlide 48 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 Demand

49. Chapter 2: The Basics of Supply and DemandSlide 49 Elasticities of Supply and Demand So the price elasticity of demand is also: Price Elasticity of Demand

50. Chapter 2: The Basics of Supply and DemandSlide 50 Elasticities of Supply and Demand Interpreting Price Elasticity of Demand Values 1)Because of the inverse relationship between P and Q; E P is negative. 2)If E P > 1, the percent change in quantity is greater than the percent change in price. We say the demand is price elastic.

51. Chapter 2: The Basics of Supply and DemandSlide 51 Elasticities of Supply and Demand Interpreting Price Elasticity of Demand Values 3)If E P < 1, the percent change in quantity is less than the percent change inprice. We say the demand is price inelastic.

52. Chapter 2: The Basics of Supply and DemandSlide 52 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 Demand

53. Chapter 2: The Basics of Supply and DemandSlide 53 Price Elasticities of Demand Q P rice Q = 8 - 2P E p = -1 E p = 0 The lower portion of a downward sloping demand curve is less elastic than the upper portion. 4 8 2 4 Linear Demand Curve Q = a - bP Q = 8 - 2P

54. Chapter 2: The Basics of Supply and DemandSlide 54 Price Elasticities of Demand D P*P* Quantity Price Infinitely Elastic Demand

55. Chapter 2: The Basics of Supply and DemandSlide 55 Price Elasticities of Demand Q*Q* Quantity Price Completely Inelastic Demand

56. Chapter 2: The Basics of Supply and DemandSlide 56 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 Elasticities

57. Chapter 2: The Basics of Supply and DemandSlide 57 Elasticities of Supply and Demand The income elasticity of demand is: Other Demand Elasticities

58. Chapter 2: The Basics of Supply and DemandSlide 58 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 Elasticities

59. Chapter 2: The Basics of Supply and DemandSlide 59 Elasticities of Supply and Demand The cross elasticity of demand is: The cross elasticity for substitutes is positive, while that for complements is negative.

60. Chapter 2: The Basics of Supply and DemandSlide 60 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 Supply

61. Chapter 2: The Basics of Supply and DemandSlide 61 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 Supply

62. Chapter 2: The Basics of Supply and DemandSlide 62 Elasticities of Supply and Demand 1981 Supply Curve for Wheat Q S = 1,800 + 240P 1981 Demand Curve for Wheat Q D = 3,550 - 266P The Market for Wheat

63. Elasticities of Supply and Demand Equilibrium: Q S = Q D The Market for Wheat Chapter 2: The Basics of Supply and DemandSlide 63

64. Elasticities of Supply and Demand The Market for Wheat Chapter 2: The Basics of Supply and DemandSlide 64

65. Chapter 2: The Basics of Supply and DemandSlide 65 Elasticities of Supply and Demand Assume the price of wheat is $4.00/bushel The Market for Wheat

66. Chapter 2: The Basics of Supply and DemandSlide 66 19811800 + 240P3550 - 266P1800+240P = 3550-266P 506P = 1750 P 1981 = $3.46/bushel 19981,944 + 207P3,244 - 283P 1,944+207P = 3,244-283P P 1998 = $2.65/bushel Supply (Q s )Demand (Q D )Equilibrium Price (Q s = Q D ) Changes in the Market: 1981-1998 The Market for Wheat

67. Chapter 2: The Basics of Supply and DemandSlide 67 Short-Run Versus Long-Run Elasticities Price elasticity of demand varies with the amount of time consumers have to respond to a price. Demand

68. Chapter 2: The Basics of Supply and DemandSlide 68 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 Demand

69. Chapter 2: The Basics of Supply and DemandSlide 69 Gasoline: Short-Run and Long-Run Demand Curves D SR D LR People tend to drive smaller and more fuel efficient cars in the long-run Gasoline Quantity Price

70. Chapter 2: The Basics of Supply and DemandSlide 70 D SR D LR People may put off immediate consumption, but eventually older cars must be replaced. Automobiles Automobiles: Short-Run and Long-Run Demand Curves Quantity Price

71. Chapter 2: The Basics of Supply and DemandSlide 71 Income elasticity also varies with the amount of time consumers have to respond to an income change. Short-Run Versus Long-Run Elasticities Income Elasticities

72. Chapter 2: The Basics of Supply and DemandSlide 72 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 Elasticities

73. Chapter 2: The Basics of Supply and DemandSlide 73 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 Elasticities

74. Chapter 2: The Basics of Supply and DemandSlide 74 Gasoline and automobiles are complementary goods. Short-Run Versus Long-Run Elasticities The Demand for Gasoline and Automobiles The Demand for Gasoline and Automobiles

75. Chapter 2: The Basics of Supply and DemandSlide 75 Gasoline The long-run price and income elasticities are larger than the short-run elasticities. Automobiles The long-run price and income elasticities are smaller than the short-run elasticities. Short-Run Versus Long-Run Elasticities The Demand for Gasoline and Automobiles The Demand for Gasoline and Automobiles

76. Chapter 2: The Basics of Supply and DemandSlide 76 Price-0.11-0.22-0.32-0.49-0.82-1.17 Income0.070.130.200.320.540.78 Years Following Price or Income Change Elasticity 123456 The Demand for Gasoline Short-Run Versus Long-Run Elasticities

77. Chapter 2: The Basics of Supply and DemandSlide 77 Price-1.20-0.93-0.75-0.55-0.42-0.40 Income3.002.331.881.381.021.00 Years Following Price or Income Change Elasticity 123456 The Demand for Automobiles Short-Run Versus Long-Run Elasticities

78. Chapter 2: The Basics of Supply and DemandSlide 78 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 for Gasoline and Automobiles The Demand for Gasoline and Automobiles

79. Chapter 2: The Basics of Supply and DemandSlide 79 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 Supply

80. Chapter 2: The Basics of Supply and DemandSlide 80 S SR 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 S LR Due to limited capacity, firms are limited by output constraints in the short-run. In the long-run, they can expand.

81. Chapter 2: The Basics of Supply and DemandSlide 81 S SR 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 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.

82. Chapter 2: The Basics of Supply and DemandSlide 82 Primary supply0.201.60 Secondary supply0.430.31 Total supply0.251.50 Price Elasticity of:Short-runLong-run Supply of Copper Short-Run Versus Long-Run Elasticities

83. Chapter 2: The Basics of Supply and DemandSlide 83 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 and the price of Coffee in New York Weather in Brazil and the price of Coffee in New York

84. Chapter 2: The Basics of Supply and DemandSlide 84 Price of Brazilian Coffee

85. Chapter 2: The Basics of Supply and DemandSlide 85 D S P0P0 Q0Q0 Quantity Price P1P1 Short-Run 1) Supply is completely inelastic 2) Demand is relatively inelastic 3) Very large change in price A freeze or drought decreases the supply of coffee S’S’ Q1Q1 Short-Run Versus Long-Run Elasticities Coffee

86. Chapter 2: The Basics of Supply and DemandSlide 86 S’S’ D S P0P0 Q0Q0 P2P2 Q2Q2 Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P 2. 3) Quantity falls to Q 2 Short-Run Versus Long-Run Elasticities Quantity Price Coffee

87. Chapter 2: The Basics of Supply and DemandSlide 87 D S P0P0 Q0Q0 Long-Run 1) Supply is extremely elastic. 2) Price falls back to P 0. 3) Quantity increase to Q 0. Short-Run Versus Long-Run Elasticities Coffee Quantity Price

88. Chapter 2: The Basics of Supply and DemandSlide 88 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

89. Chapter 2: The Basics of Supply and DemandSlide 89 Available Data Equilibrium Price, P* Equilibrium Quantity, Q* Price elasticity of supply, E S, and demand, E D. Understanding and Predicting the Effects of Changing Market Conditions

90. Chapter 2: The Basics of Supply and DemandSlide 90 Demand: Q = a - bP a/b Supply: Q = c + dP -c/d P* Q* E D = -bP*/Q* E S = dP*/Q* Understanding and Predicting the Effects of Changing Market Conditions Quantity Price

91. Chapter 2: The Basics of Supply and DemandSlide 91 Let ’ s begin with the equations for supply and demand: Demand:Q D = a - bP Supply:Q S = c + dP We must choose numbers for a, b, c, and d. Understanding and Predicting the Effects of Changing Market Conditions

92. Chapter 2: The Basics of Supply and DemandSlide 92 Step 1: Recall: Understanding and Predicting the Effects of Changing Market Conditions

93. Chapter 2: The Basics of Supply and DemandSlide 93 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

94. Chapter 2: The Basics of Supply and DemandSlide 94 Substituting the slopes for each into the formula for elasticity, we get: Understanding and Predicting the Effects of Changing Market Conditions

95. Chapter 2: The Basics of Supply and DemandSlide 95 Since we will have values for E D, E S, P*, and Q*, we can solve for b & d, and a & c. Understanding and Predicting the Effects of Changing Market Conditions

96. Chapter 2: The Basics of Supply and DemandSlide 96 Deriving the long-run supply and demand for copper: The relevant data are:  Q* = 7.5 mmt/yr.  P* = 75 cents/pound  E S = 1.6  E D = -0.8 Understanding and Predicting the Effects of Changing Market Conditions

97. Chapter 2: The Basics of Supply and DemandSlide 97 E s = d(P*/Q*) 1.6 = d(75/7.5) = 0.1d d = 1.6/0.1 = 16 E d = -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

98. Chapter 2: The Basics of Supply and DemandSlide 98 Supply = Q S * = c + dP* 7.5 = c + 16(0.75) 7.5 = c + 12 c = 7.5 - 12 c = -4.5 Q = -4.5 + 16P Demand = Q D * = 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

99. Chapter 2: The Basics of Supply and DemandSlide 99 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

100. Chapter 2: The Basics of Supply and DemandSlide 100 Supply: Q S = -4.5 + 16P -c/d Demand: Q D = 13.5 - 8P a/b.75 7.5 Understanding and Predicting the Effects of Changing Market Conditions Mmt/yr Price

101. Chapter 2: The Basics of Supply and DemandSlide 101 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

102. Chapter 2: The Basics of Supply and DemandSlide 102 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

103. Chapter 2: The Basics of Supply and DemandSlide 103 f can be found by substituting known values into the income elasticity formula: and Understanding and Predicting the Effects of Changing Market Conditions

104. Chapter 2: The Basics of Supply and DemandSlide 104 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

105. Chapter 2: The Basics of Supply and DemandSlide 105 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

106. Chapter 2: The Basics of Supply and DemandSlide 106 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

107. Chapter 2: The Basics of Supply and DemandSlide 107 Real versus Nominal Prices of Copper 1965 - 1999

108. Chapter 2: The Basics of Supply and DemandSlide 108 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 Nominal Prices of Copper 1965 - 1999

109. Chapter 2: The Basics of Supply and DemandSlide 109 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 Nominal Prices of Copper 1965 - 1999

110. Chapter 2: The Basics of Supply and DemandSlide 110 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 Nominal Prices of Copper 1965 - 1999

111. Chapter 2: The Basics of Supply and DemandSlide 111 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 Nominal Prices of Copper 1965 - 1999

112. Chapter 2: The Basics of Supply and DemandSlide 112 Price of Crude Oil

113. Chapter 2: The Basics of Supply and DemandSlide 113 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

114. Chapter 2: The Basics of Supply and DemandSlide 114 Price Elasticity Estimates World Demand:-0.05-0.40 Competitive Supply 0.10 0.40 (non-OPEC) Short-Run Long-Run

115. Chapter 2: The Basics of Supply and DemandSlide 115 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  S C = 11.74 + 0.07P

116. Chapter 2: The Basics of Supply and DemandSlide 116 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)  S T = 21.74 + 0.07P Short-run Total Supply--after supply reduction  S T = 18.74 + 0.07P

117. Chapter 2: The Basics of Supply and DemandSlide 117 Upheaval in the World Oil Market New Price After Reduction Demand = Supply 24.08 - 0.06P = 18.74 + 0.07P P = 41.08

118. Chapter 2: The Basics of Supply and DemandSlide 118 D Quantity (billions barrels/yr) P rice ($ per barrel) 5 18 STST 05152025303510 15 20 25 30 35 40 45 23 Impact of Saudi Production Cut SCSC Short-Run Effect S’TS’T

119. Chapter 2: The Basics of Supply and DemandSlide 119 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

120. Chapter 2: The Basics of Supply and DemandSlide 120 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

121. Chapter 2: The Basics of Supply and DemandSlide 121 D Quantity (billions barrels/yr) P rice ($ per barrel) 5 STST 05152025303510 15 20 25 30 35 40 45 23 18 Impact of Saudi Production Cut SCSC Due to the elasticity of the long-run supply and demand curves, the long-run effect of a cut in production is much less. S’TS’T Long-run Effect

122. Chapter 2: The Basics of Supply and DemandSlide 122 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.

123. Chapter 2: The Basics of Supply and DemandSlide 123 D Effects of Price Controls Quantity P rice P0P0 Q0Q0 S P max Excess demand If price is regulated to be no higher than P max, quantity supplied falls to Q 1 and quantity demanded increases to Q 2. A shortage results

124. Chapter 2: The Basics of Supply and DemandSlide 124 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.

125. Chapter 2: The Basics of Supply and DemandSlide 125 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 and Natural Gas Shortages

126. Chapter 2: The Basics of Supply and DemandSlide 126 Price Controls and Natural Gas Shortages The Data: Natural Gas

127. Chapter 2: The Basics of Supply and DemandSlide 127 Price Controls and Natural Gas Shortages The Data: Natural Gas

128. Chapter 2: The Basics of Supply and DemandSlide 128 Summary Supply-demand analysis is a basic tool of microeconomics. The market mechanism is the tendency for supply and demand to equilibrate, so that there is neither excess demand nor excess supply

129. Chapter 2: The Basics of Supply and DemandSlide 129 Summary Elasticities describe the responsiveness of supply and demand to changes in price, income, and other variables. Elasticities pertain to a time frame. If we can estimate the supply and demand curves for a particular market, we can calculate the market clearing price.

130. Chapter 2: The Basics of Supply and DemandSlide 130 Summary Simple numerical analysis can often be done by fitting linear supply and demand curves to data on price and quantity and to estimates of elasticities.

131. End of Chapter 2 The Basics of Supply and Demand