SM - Ch02Microeconomics 8th Edition by Robert Pindyck

8Pindyck/Rubinfeld,Microeconomics,EighthEdition
Chapter2
TheBasicsofSupplyandDemand
Teaching Notes
Copyright2013PearsonEducation.Inc.PublishingasPrenticeHall.
Thischapterreviewsthebasicsofsupplyanddemandthatstudentsshouldbefamiliarwithfromtheir
introductoryeconomicscourses.Youmaychoosetospendmoreorlesstimeonthischapterdepending
onhowmuchreviewyourstudentsrequire.Chapter2departsfromthestandardtreatmentofsupplyand
demandbasicsfoundinmostotherintermediatemicroeconomicstextbooksbydiscussingmanyrealworld
markets(copper,officespaceinNewYorkCity,wheat,gasoline,naturalgas,coffee,andothers)and
teachingstudentshowtoanalyzethesemarketswiththetoolsofsupplyanddemand.Therealworld
applicationsareintendedtoshowstudentstherelevanceofsupplyanddemandanalysis,andyoumay
findithelpfultorefertotheseexamplesduringclass.
Oneofthemostcommonproblemsstudentshaveinsupply/demandanalysisisconfusionbetweena
movementalongasupplyordemandcurveandashiftinthecurve.Youshouldstresstheceterisparibus
assumption,andexplainthatallvariablesexceptpriceareheldconstantalongasupplyordemandcurve.
Somovementsalongthedemandcurveoccuronlywithchangesinprice.Whenoneoftheomittedfactors
changes,theentiresupplyordemandcurveshifts.Youmightfinditusefultomakeupasimplelinear
demandfunctionwithquantitydemandedontheleftandthegoodsprice,acompetinggoodspriceand
incomeontheright.Thisgivesyouachancetodiscusssubstitutesandcomplementsandalsonormaland
inferiorgoods.Pluginvaluesforthecompetinggoodspriceandincomeandplotthedemandcurve.Then
change,say,theothergoodspriceandplotthedemandcurveagaintoshowthatitshifts.Thisdemonstration
helpsstudentsunderstandthattheothervariablesareactuallyinthedemandfunctionandaremerely
lumpedintotheintercepttermwhenwedrawademandcurve.Thesame,ofcourse,appliestosupply
curvesaswell.
Itisimportanttomakethedistinctionbetweenquantitydemandedasafunctionofprice,QDD(P),and
theinversedemandfunction,PD1(QD),wherepriceisafunctionofthequantitydemanded.Sincewe
plotpriceontheverticalaxis,theinversedemandfunctionisveryuseful.Youcandemonstratethisifyou
useanexampleassuggestedaboveandplottheresultingdemandcurves.And,ofcourse,thereare
regularandinversesupplycurvesaswell.
Studentsalsocanhavedifficultiesunderstandinghowamarketadjuststoanewequilibrium.Theyoften
thinkthatthesupplyand/ordemandcurvesshiftaspartoftheequilibriumprocess.Forexample,suppose
demandincreases.Studentstypicallyrecognizethatpricemustincrease,butsomegoontosaythatsupply
willalsohavetoincreasetosatisfytheincreasedlevelofdemand.Thismaybeacaseofconfusingan
increaseinquantitysuppliedwithanincreaseinsupply,butIhaveseenmanystudentsdrawashiftin
supply,soItrytogetthisclearedupassoonaspossible.
Theconceptofelasticity,introducedinSection2.4,isanothersourceofproblems.Itisimportanttostress
thefactthatanyelasticityistheratiooftwopercentages.So,forexample,ifafirmsproducthasaprice
elasticityofdemandof2,thefirmcandeterminethata5%increaseinpricewillresultina10%dropin
sales.Uselotsofconcreteexamplestoconvincestudentsthatfirmsandgovernmentscanmakeimportant
useofelasticityinformation.Acommonsourceofconfusionisthenegativevalueforthepriceelasticity
ofdemand.Weoftentalkaboutitasifitwereapositivenumber.Thebookiscarefulinreferringtothe
magnitudeofthepriceelasticity,bywhichitmeanstheabsolutevalueofthepriceelasticity,butstudents
maynotpickthisupontheirown.IwarnstudentsthatIwillspeakofpriceelasticitiesasiftheywere
positivenumbersandwillsaythatagoodwhoseelasticityis2ismoreelastic(orgreater)thanonewhose
elasticityis1,eventhoughthemathematicallyinclinedmaycringe.
Chapter2TheBasicsofSupplyandDemand 10
Section2.6bringsalotofthismaterialtogetherbecauseelasticitiesareusedtoderivedemandandsupply
curves,marketequilibriaarecomputed,curvesareshifted,andnewequilibriaaredetermined.Thisshows
studentshowwecanestimatethequantitative(notjustthequalitative)effectsof,say,adisruptioninoil
supplyasinExample2.9.Unfortunately,thissectiontakessometimetocover,especiallyifyourstudents
algebraisrusty.Youllhavetodecidewhetherthebenefitsoutweighthecosts.
PricecontrolsareintroducedinSection2.7.Studentsusuallydontrealizethefulleffectsofpricecontrols.
Theythinkonlyoftheinitialeffectonpriceswithoutrealizingthatshortagesorsurplusesarecreated,so
thisisanimportanttopic.However,thecoveragehereisquitebrief.Chapter9examinestheeffectsof
pricecontrolsandotherformsofgovernmentinterventioninmuchgreaterdetail,soyoumaywantto
deferthistopicuntilthen.
Questions for Review

1. Supposethatunusuallyhotweathercausesthedemandcurveforicecreamtoshifttotheright.
Whywillthepriceoficecreamrisetoanewmarketclearinglevel?
Supposethesupplyoficecreamiscompletelyinelasticintheshortrun,sothesupplycurveis
verticalasshownbelow.TheinitialequilibriumisatpriceP1.Theunusuallyhotweathercausesthe
demandcurveforicecreamtoshiftfromD1toD2,creatingshortrunexcessdemand(i.e.,atemporary
shortage)atthecurrentprice.Consumerswillbidagainsteachotherfortheicecream,putting
upwardpressureontheprice,andicecreamsellerswillreactbyraisingprice.Thepriceoficecream
willriseuntilthequantitydemandedandthequantitysuppliedareequal,whichoccursatpriceP2.
2. Usesupplyanddemandcurvestoillustratehoweachofthefollowingeventswouldaffectthe
priceofbutterandthequantityofbutterboughtandsold:
a. Anincreaseinthepriceofmargarine.
Butterandmargarinearesubstitutegoodsformostpeople.Therefore,anincreaseinthepriceof
margarinewillcausepeopletoincreasetheirconsumptionofbutter,therebyshiftingthedemand
curveforbutteroutfromD1toD2inFigure2.2.a.Thisshiftindemandcausestheequilibrium
priceofbuttertorisefromP1toP2andtheequilibriumquantitytoincreasefromQ1toQ2.
Figure2.2.a
b. Anincreaseinthepriceofmilk.
Milkisthemainingredientinbutter.Anincreaseinthepriceofmilkincreasesthecostof
producingbutter,whichreducesthesupplyofbutter.Thesupplycurveforbuttershiftsfrom
S1toS2inFigure2.2.b,resultinginahigherequilibriumprice,P2andalowerequilibrium
quantity,Q2,forbutter.
Figure2.2.b
Note:Butterisinfactmadefromthefatthatisskimmedfrommilk;thusbutterandmilkarejoint
products,andthiscomplicatesthings.Ifyoutakeaccountofthisrelationship,youranswermight
change,butitdependsonwhythepriceofmilkincreased.Iftheincreasewerecausedbyan
increaseinthedemandformilk,theequilibriumquantityofmilksuppliedwouldincrease.With
moremilkbeingproduced,therewouldbemoremilkfatavailabletomakebutter,andtheprice
ofmilkfatwouldfall.Thiswouldshiftthesupplycurveforbuttertotheright,resultinginadrop
inthepriceofbutterandanincreaseinthequantityofbuttersupplied.
c. Adecreaseinaverageincomelevels.
Assumingthatbutterisanormalgood,adecreaseinaverageincomewillcausethedemand
curveforbuttertodecrease(i.e.,shiftfromD1toD2).Thiswillresultinadeclineinthe
equilibriumpricefromP1toP2,andadeclineintheequilibriumquantityfromQ1toQ2.See
Figure2.2.c.
Figure2.2.c
3. Ifa3%increaseinthepriceofcornflakescausesa6%declineinthequantitydemanded,what
istheelasticityofdemand?
Theelasticityofdemandisthepercentagechangeinthequantitydemandeddividedbythe
percentagechangeintheprice.Theelasticityofdemandforcornflakesistherefore
EPD
%Q 6
2.
%P 3
4. Explainthedifferencebetweenashiftinthesupplycurveandamovementalongthesupply
curve.
Amovementalongthesupplycurveoccurswhenthepriceofthegoodchanges.Ashiftofthesupply
curveiscausedbyachangeinsomethingotherthanthegoodspricethatresultsinachangeinthe
quantitysuppliedatthecurrentprice.Someexamplesareachangeinthepriceofaninput,achange
intechnologythatreducesthecostofproduction,andanincreaseinthenumberoffirmssupplying
theproduct.
5. Explainwhyformanygoods,thelongrunpriceelasticityofsupplyislargerthantheshortrun
elasticity.
Thepriceelasticityofsupplyisthepercentagechangeinthequantitysupplieddividedbythe
percentagechangeinprice.Intheshortrun,anincreaseinpriceinducesfirmstoproducemoreby
usingtheirfacilitiesmorehoursperweek,payingworkerstoworkovertimeandhiringnewworkers.
Nevertheless,thereisalimittohowmuchfirmscanproducebecausetheyfacecapacityconstraints
intheshortrun.Inthelongrun,however,firmscanexpandcapacitybybuildingnewplantsand
hiringnewpermanentworkers.Also,newfirmscanenterthemarketandaddtheiroutputtototal
supply.Henceagreaterchangeinquantitysuppliedispossibleinthelongrun,andthustheprice
elasticityofsupplyislargerinthelongrunthanintheshortrun.
6. Whydolongrunelasticitiesofdemanddifferfromshortrunelasticities?Considertwogoods:
papertowelsandtelevisions.Whichisadurablegood?Wouldyouexpectthepriceelasticityof
demandforpapertowelstobelargerintheshortrunorinthelongrun?Why?Whataboutthe
priceelasticityofdemandfortelevisions?
Longrunandshortrunelasticitiesdifferbasedonhowrapidlyconsumersrespondtopricechanges
andhowmanysubstitutesareavailable.Ifthepriceofpapertowels,anondurablegood,wereto
increase,consumersmightreactonlyminimallyintheshortrunbecauseittakestimeforpeopleto
changetheirconsumptionhabits.Inthelongrun,however,consumersmightlearntouseother
productssuchasspongesorkitchentowelsinsteadofpapertowels.Thus,thepriceelasticitywould
belargerinthelongrunthanintheshortrun.Incontrast,thequantitydemandedofdurablegoods,
suchastelevisions,mightchangedramaticallyintheshortrun.Forexample,theinitialresultofa
priceincreasefortelevisionswouldcauseconsumerstodelaypurchasesbecausetheycouldkeep
onusingtheircurrentTVslonger.Eventuallyconsumerswouldreplacetheirtelevisionsastheywore
outorbecameobsolete.Therefore,weexpectthedemandfordurablestobemoreelasticintheshort
runthaninthelongrun.
7. Arethefollowingstatementstrueorfalse?Explainyouranswers.
a. Theelasticityofdemandisthesameastheslopeofthedemandcurve.
False.Elasticityofdemandisthepercentagechangeinquantitydemandeddividedbythe
percentagechangeinthepriceoftheproduct.Incontrast,theslopeofthedemandcurveisthe
changeinquantitydemanded(inunits)dividedbythechangeinprice(typicallyindollars).
Thedifferenceisthatelasticityusespercentagechangeswhiletheslopeisbasedonchanges
inthenumberofunitsandnumberofdollars.
b. Thecrosspriceelasticitywillalwaysbepositive.
False.Thecrosspriceelasticitymeasuresthepercentagechangeinthequantitydemandedof
onegoodduetoa1%changeinthepriceofanothergood.Thiselasticitywillbepositivefor
substitutes(anincreaseinthepriceofhotdogsislikelytocauseanincreaseinthequantity
demandedofhamburgers)andnegativeforcomplements(anincreaseinthepriceofhotdogsis
likelytocauseadecreaseinthequantitydemandedofhotdogbuns).
c. Thesupplyofapartmentsismoreinelasticintheshortrunthanthelongrun.
True.Intheshortrunitisdifficulttochangethesupplyofapartmentsinresponsetoachangein
price.Increasingthesupplyrequiresconstructingnewapartmentbuildings,whichcantakeayear
ormore.Therefore,theelasticityofsupplyismoreinelasticintheshortrunthaninthelongrun.
8. Supposethegovernmentregulatesthepricesofbeefandchickenandsetsthembelowtheir
marketclearinglevels.Explainwhyshortagesofthesegoodswilldevelopandwhatfactorswill
determinethesizesoftheshortages.Whatwillhappentothepriceofpork?Explainbriefly.
Ifthepriceofacommodityissetbelowitsmarketclearinglevel,thequantitythatfirmsarewilling
tosupplyislessthanthequantitythatconsumerswishtopurchase.Theextentoftheresultingshortage
dependsontheelasticitiesofdemandandsupplyaswellastheamountbywhichtheregulatedprice
issetbelowthemarketclearingprice.Forinstance,ifbothsupplyanddemandareelastic,theshortage
islargerthanifbothareinelastic,andiftheregulatedpriceissubstantiallybelowthemarketclearing
price,theshortageislargerthaniftheregulatedpriceisonlyslightlybelowthemarketclearingprice.
Factorssuchasthewillingnessofconsumerstoeatlessmeatandtheabilityoffarmerstoreducethe
sizeoftheirherds/flockswilldeterminetherelevantelasticities.Customerswhosedemandsfor
beefandchickenarenotmetbecauseoftheshortageswillwanttopurchasesubstituteslikepork.
Thisincreasesthedemandforpork(i.e.,shiftsdemandtotheright),whichresultsinahigherprice
forpork.
9. Thecitycouncilofasmallcollegetowndecidestoregulaterentsinordertoreducestudent
livingexpenses.Supposetheaverageannualmarketclearingrentforatwobedroomapartment
hadbeen$700permonthandthatrentswereexpectedtoincreaseto$900withinayear.The
citycouncillimitsrentstotheircurrent$700permonthlevel.
a. Drawasupplyanddemandgraphtoillustratewhatwillhappentotherentalpriceofan
apartmentaftertheimpositionofrentcontrols.
InitiallydemandisD1andsupplyisS,sotheequilibriumrentis$700andQ1apartmentsare
rented.Withoutregulation,demandwasexpectedtoincreasetoD2,whichwouldhaveraised
rentto$900andresultedinQ2apartmentrentals.Underthecitycouncilregulation,however,
therentalpricestaysattheoldequilibriumlevelof$700permonth.Afterdemandincreasesto
D2,onlyQ1apartmentswillbesuppliedwhileQ3willbedemanded.Therewillbeashortageof
Q3Q1apartments.
a. Doyouthinkthispolicywillbenefitallstudents?Whyorwhynot?
No.Itwillbenefitthosestudentswhogetanapartment,althoughthesestudentsmayfindthatthe
costofsearchingforanapartmentishighergiventheshortageofapartments.Thosestudentswho
donotgetanapartmentmayfacehighercostsasaresultofhavingtoliveoutsidethecollege
town.Theirrentmaybehigherandtheirtransportationcostswillbehigher,sotheywillbeworse
offasaresultofthepolicy.
10. Inadiscussionoftuitionrates,auniversityofficialarguesthatthedemandforadmissionis
completelypriceinelastic.Asevidence,shenotesthatwhiletheuniversityhasdoubledits
tuition(inrealterms)overthepast15years,neitherthenumbernorqualityofstudents
applyinghasdecreased.Wouldyouacceptthisargument?Explainbriefly.(Hint:Theofficial
makesanassertionaboutthedemandforadmission,butdoessheactuallyobserveademand
curve?Whatelsecouldbegoingon?)
Iwouldnotacceptthisargument.Theuniversityofficialassumesthatdemandhasremainedstable
(i.e.,thedemandcurvehasnotshifted)overthe15yearperiod.Thisseemsveryunlikely.Demand
forcollegeeducationshasincreasedovertheyearsformanyreasonsrealincomeshaveincreased,
populationhasincreased,theperceivedvalueofacollegedegreehasincreased,etc.Whathas
probablyhappenedisthattuitiondoubledfromT1toT2,butdemandalsoincreasedfromD1toD2
overthe15years,andthetwoeffectshaveoffseteachother.Theresultisthatthequantity(and
quality)ofapplicationshasremainedsteadyatA.Thedemandcurveisnotperfectlyinelasticas
theofficialasserts.
11. SupposethedemandcurveforaproductisgivenbyQ102PPS,wherePisthepriceof
theproductandPSisthepriceofasubstitutegood.Thepriceofthesubstitutegoodis$2.00.
a. SupposeP$1.00.Whatisthepriceelasticityofdemand?Whatisthecrosspriceelasticity
ofdemand?
FindquantitydemandedwhenP$1.00andPS$2.00.Q102(1)210.
Priceelasticityofdemand
P Q 1
2
(2) 0.2.
Q P 10
10
Crosspriceelasticityofdemand
Ps Q 2
(1) 0.2.
Q Ps 10
b. Supposethepriceofthegood,P,goesto$2.00.Nowwhatisthepriceelasticityofdemand?
Whatisthecrosspriceelasticityofdemand?
WhenP$2.00,Q102(2)28.
Priceelasticityofdemand
P Q 2
4
(2) 0.5.
Q P 8
8
Crosspriceelasticityofdemand
Ps Q 2
(1) 0.25.
Q Ps 8
12. SupposethatratherthanthedecliningdemandassumedinExample2.8,adecreaseinthecost
ofcopperproductioncausesthesupplycurvetoshifttotherightby40%.Howwillthepriceof
copperchange?
Ifthesupplycurveshiftstotherightby40%thenthenewquantitysuppliedwillbe140%oftheold
quantitysuppliedateveryprice.Thenewsupplycurveisthereforetheoldsupplycurvemultiplied
by1.4.
QS1.4(99P)12.612.6P.Tofindthenewequilibriumpriceofcopper,setthenewsupply
equaltodemand.Thus,12.612.6P273P.SolvingforpriceresultsinP$2.54perpoundfor
thenewequilibriumprice.Thepricedecreasedby46centsperpound,from$3.00to$2.54,adropof
about15.3%.
13. Supposethedemandfornaturalgasisperfectlyinelastic.Whatwouldbetheeffect,ifany,of
naturalgaspricecontrols?
Ifthedemandfornaturalgasisperfectlyinelastic,thedemandcurveisvertical.Consumerswill
demandthesamequantityregardlessofprice.Inthiscase,pricecontrolswillhavenoeffectonthe
quantitydemanded,buttheywillstillcauseashortageifthesupplycurveisupwardslopingandthe
regulatedpriceissetbelowthemarketclearingprice,becausesupplierswillproducelessnaturalgas
thanconsumerswishtopurchase.
Exercises
1. SupposethedemandcurveforaproductisgivenbyQ3002P4I,whereIisaverage
incomemeasuredinthousandsofdollars.ThesupplycurveisQ3P50.
a. IfI25,findthemarketclearingpriceandquantityfortheproduct.
GivenI25,thedemandcurvebecomesQ3002P4(25),orQ4002P.Setdemand
equaltosupplyandsolveforPandthenQ:
4002P3P50
P90
Q4002(90)220.
b. IfI50,findthemarketclearingpriceandquantityfortheproduct.
GivenI50,thedemandcurvebecomesQ3002P4(50),orQ5002P.Settingdemand
equaltosupply,solveforPandthenQ:
5002P3P50
P110
Q5002(110)280.
c. Drawagraphtoillustrateyouranswers.
Itiseasiertodrawthedemandandsupplycurvesifyoufirstsolvefortheinversedemandand
supplyfunctions,i.e.,solvethefunctionsforP.DemandinpartaisP2000.5Qandsupply
isP16.670.333Q.TheseareshownonthegraphasDaandS.Equilibriumpriceandquantity
arefoundattheintersectionofthesedemandandsupplycurves.Whentheincomelevelincreases
inpartb,thedemandcurveshiftsupandtotheright.InversedemandisP2500.5Qandis
labeledDb.Theintersectionofthenewdemandcurveandoriginalsupplycurveisthenew
equilibriumpoint.
2. Consideracompetitivemarketforwhichthequantitiesdemandedandsupplied(peryear)at
variouspricesaregivenasfollows:
Price(Dollars)
Demand(Millions)
Supply(Millions)
60
22
14
80
20
16
100
18
18
120
16
20
a. Calculatethepriceelasticityofdemandwhenthepriceis$80andwhenthepriceis$100.
QD
Q
P QD
ED D
.
P
QD P
P
Witheachpriceincreaseof$20,thequantitydemandeddecreasesby2million.Therefore,
2
QD
P 20 0.1.
AtP80,quantitydemandedis20millionandthus
80
(0.1) 0.40.
20
ED
Similarly,atP100,quantitydemandedequals18millionand
100
(0.1) 0.56.
18
ED
b. Calculatethepriceelasticityofsupplywhenthepriceis$80andwhenthepriceis$100.
QS
Q
P QS
ES S
.
P QS P
P
Witheachpriceincreaseof$20,quantitysuppliedincreasesby2million.Therefore,
2
QS
P 20 0.1.
AtP80,quantitysuppliedis16millionand
80
(0.1) 0.5.
16
ES
Similarly,atP100,quantitysuppliedequals18millionand
100
(0.1) 0.56.
18
ES
c. Whataretheequilibriumpriceandquantity?
Theequilibriumpriceisthepriceatwhichthequantitysuppliedequalsthequantitydemanded.
Usingthetable,theequilibriumpriceisP*$100andtheequilibriumquantityisQ*18million.
d. Supposethegovernmentsetsapriceceilingof$80.Willtherebeashortage,andifso,how
largewillitbe?
Withapriceceilingof$80,pricecannotbeabove$80,sothemarketcannotreachitsequilibrium
priceof$100.At$80,consumerswouldliketobuy20million,butproducerswillsupplyonly
16million.Thiswillresultinashortageof4millionunits.
3. RefertoExample2.5(page37)onthemarketforwheat.In1998,thetotaldemandforU.S.
wheatwasQ3244283PandthedomesticsupplywasQS1944207P.Attheendof1998,
bothBrazilandIndonesiaopenedtheirwheatmarketstoU.S.farmers.Supposethatthesenew
marketsadd200millionbushelstoU.S.wheatdemand.Whatwillbethefreemarketpriceof
wheatandwhatquantitywillbeproducedandsoldbyU.S.farmers?
IfBrazilandIndonesiaadd200millionbushelsofwheattoU.S.wheatdemand,thenewdemand
curvewillbeQ200,or
QD(3244283P)2003444283P.
Equatesupplyandthenewdemandtofindthenewequilibriumprice.
1944207P3444283P,or
490P1500,andthusP$3.06perbushel.
Tofindtheequilibriumquantity,substitutethepriceintoeitherthesupplyordemandequation.
Usingdemand,
QD3444283(3.06)2578millionbushels.
4. Avegetablefiberistradedinacompetitiveworldmarket,andtheworldpriceis$9perpound.
UnlimitedquantitiesareavailableforimportintotheUnitedStatesatthisprice.TheU.S.
domesticsupplyanddemandforvariouspricelevelsareshownasfollows:
U.S.Supply
(MillionLbs.)
U.S.Demand
(MillionLbs.)
34
28
22
12
16
15
10
10
18
12
Price
a. Whatistheequationfordemand?Whatistheequationforsupply?
TheequationfordemandisoftheformQabP.Firstfindtheslope,whichis
Q 6
2 b.Youcanfigurethisoutbynoticingthateverytimepriceincreasesby3,
P
3
quantitydemandedfallsby6millionpounds.DemandisnowQa2P.Tofinda,pluginany
ofthepriceandquantitydemandedpointsfromthetable.Forexample:Q34a2(3)sothat
a40anddemandisthereforeQ402P.
Q 2
d.
P 3
Youcanfigurethisoutbynoticingthateverytimepriceincreasesby3,quantitysupplied
2
increasesby2millionpounds.SupplyisnowQ c P.Tofindc,pluginanyoftheprice
3
2
andquantitysuppliedpointsfromthetable.Forexample:Q 2 c (3) sothatc0and
3
2
supplyisQ P.
3
TheequationforsupplyisoftheformQcdP.Firstfindtheslope,whichis
b. Atapriceof$9,whatisthepriceelasticityofdemand?Whatisitatapriceof$12?
ElasticityofdemandatP9is
P Q 9
18
(2)
0.82.
Q P 22
22
ElasticityofdemandatP12is
P Q 12
24
(2)
1.5.
Q P 16
16
c. Whatisthepriceelasticityofsupplyat$9?At$12?
ElasticityofsupplyatP9is
P Q 9 2
18
1.0.
Q P 6 3
18
ElasticityofsupplyatP12is
P Q 12

Q P 8
2
24
1.0.

3
24
d. Inafreemarket,whatwillbetheU.S.priceandleveloffiberimports?
Withnorestrictionsontrade,thepriceintheUnitedStateswillbethesameastheworldprice,
soP$9.Atthisprice,thedomesticsupplyis6millionlbs.,whilethedomesticdemandis
22millionlbs.Importsmakeupthedifferenceandare16millionlbs.
5. MuchofthedemandforU.S.agriculturaloutputhascomefromothercountries.In1998,the
totaldemandforwheatwasQ3244283P.Ofthis,totaldomesticdemandwasQD1700
107P,anddomesticsupplywasQS1944207P.Supposetheexportdemandforwheatfalls
by40%.
a. U.S.farmersareconcernedaboutthisdropinexportdemand.Whathappenstothefree
marketpriceofwheatintheUnitedStates?Dofarmershavemuchreasontoworry?
Beforethedropinexportdemand,themarketequilibriumpriceisfoundbysettingtotaldemand
equaltodomesticsupply:
3244283P1944207P,or
P$2.65.
Exportdemandisthedifferencebetweentotaldemandanddomesticdemand:Q3244283P
minusQD1700107P.SoexportdemandisoriginallyQe1544176P.Afterthe40%drop,
exportdemandisonly60%oftheoriginalexportdemand.Thenewexportdemandistherefore,
Qe0.6Qe0.6(1544176P)926.4105.6P.Graphically,exportdemandhaspivoted
inwardasillustratedinthefigurebelow.
Thenewtotaldemandbecomes
QQDQe(1700107P)(926.4105.6P)2626.4212.6P.
Equatingtotalsupplyandthenewtotaldemand,
1944207P2626.4212.6P,or
P$1.63,
whichisasignificantdropfromtheoriginalmarketclearingpriceof$2.65perbushel.Atthis
price,themarketclearingquantityisaboutQ2281millionbushels.Totalrevenuehas
decreasedfromabout$6609millionto$3718million,sofarmershavealottoworryabout.
b. NowsupposetheU.S.governmentwantstobuyenoughwheattoraisethepriceto$3.50per
bushel.Withthedropinexportdemand,howmuchwheatwouldthegovernmenthaveto
buy?Howmuchwouldthiscostthegovernment?
Withapriceof$3.50,themarketisnotinequilibrium.Quantitydemandedandsuppliedare
Q2626.4212.6(3.50)1882.3,and
QS1944207(3.50)2668.5.
Excesssupplyistherefore2668.51882.3786.2millionbushels.Thegovernmentmust
purchasethisamounttosupportapriceof$3.50,andwillhavetospend$3.50(786.2million)
$2751.7million.
6. TherentcontrolagencyofNewYorkCityhasfoundthataggregatedemandisQD1608P.
Quantityismeasuredintensofthousandsofapartments.Price,theaveragemonthlyrental
rate,ismeasuredinhundredsofdollars.TheagencyalsonotedthattheincreaseinQatlower
PresultsfrommorethreepersonfamiliescomingintothecityfromLongIslandand
demandingapartments.Thecitysboardofrealtorsacknowledgesthatthisisagooddemand
estimateandhasshownthatsupplyisQS707P.
a. Ifboththeagencyandtheboardarerightaboutdemandandsupply,whatisthefree
marketprice?Whatisthechangeincitypopulationiftheagencysetsamaximumaverage
monthlyrentof$300andallthosewhocannotfindanapartmentleavethecity?
Setsupplyequaltodemandtofindthefreemarketpriceforapartments:
1608P707P,orP6,
whichmeanstherentalpriceis$600sincepriceismeasuredinhundredsofdollars.Substituting
theequilibriumpriceintoeitherthedemandorsupplyequationtodeterminetheequilibrium
quantity:
QD1608(6)112
and
QS707(6)112.
Thequantityofapartmentsrentedis1,120,000sinceQismeasuredintensofthousandsof
apartments.Iftherentcontrolagencysetstherentalrateat$300,thequantitysuppliedwould
be910,000(QS707(3)91),adecreaseof210,000apartmentsfromthefreemarket
equilibrium.Assumingthreepeopleperfamilyperapartment,thiswouldimplyalossincity
populationof630,000people.Note:Atthe$300rentalrate,thedemandforapartmentsis
1,360,000units,andtheresultingshortageis450,000units(1,360,000910,000).However,
excessdemand(theshortage)andlowerquantitydemandedarenotthesameconcept.The
shortageof450,000unitsisthedifferencebetweenthenumberofapartmentsdemandedatthe
newlowerprice(includingthenumberdemandedbynewpeoplewhowouldhavemovedinto
thecity),andthenumbersuppliedatthelowerprice.Butthesenewpeoplewillnotactually
moveintothecitybecausetheapartmentsarenotavailable.Therefore,thecitypopulationwill
fallby630,000,whichisduetothedropinthenumberofapartmentsavailablefrom1,120,000
(theoldequilibriumvalue)to910,000.
b. Supposetheagencybowstothewishesoftheboardandsetsarentalof$900permonthon
allapartmentstoallowlandlordsafairrateofreturn.If50%ofanylongrunincreases
inapartmentofferingscomefromnewconstruction,howmanyapartmentsareconstructed?
Atarentalrateof$900,thedemandforapartmentswouldbe1608(9)88,or880,000units,
whichis240,000fewerapartmentsthantheoriginalfreemarketequilibriumnumberof
1,120,000.Therefore,nonewapartmentswouldbeconstructed.
7. In2010,Americanssmoked315billioncigarettes,or15.75billionpacksofcigarettes.The
averageretailprice(includingtaxes)wasabout$5.00perpack.Statisticalstudieshaveshown
thatthepriceelasticityofdemandis0.4,andthepriceelasticityofsupplyis0.5.
a. Usingthisinformation,derivelineardemandandsupplycurvesforthecigarettemarket.
LetthedemandcurvebeoftheformQabPandthesupplycurvebeoftheformQcdP,
wherea,b,c,anddarepositiveconstants.Tobegin,recalltheformulaforthepriceelasticityof
demand
EPD
P Q
.
Q P
Weknowthedemandelasticityis0.4,P5,andQ15.75,whichmeanswecansolveforthe
slope,b,whichisQ/Pintheaboveformula.
5 Q
15.75 P
Q
15.75
0.4
1.26 b.
P
5
0.4
Tofindtheconstanta,substituteforQ,P,andbinthedemandfunctiontoget15.75a
1.26(5),soa22.05.TheequationfordemandisthereforeQ22.051.26P.Tofindthe
supplycurve,recalltheformulafortheelasticityofsupplyandfollowthesamemethodasabove:
P Q
Q P
5 Q
0.5
15.75 P
Q
15.75
0.5
1.575 d.
P
5
EPS
Tofindtheconstantc,substituteforQ,P,anddinthesupplyfunctiontoget15.75c1.575(5)
andc7.875.TheequationforsupplyisthereforeQ7.8751.575P.
b. In1998,Americanssmoked23.5billionpackscigarettes,andtheretailpricewasabout
$2.00perpack.Thedeclineincigaretteconsumptionfrom1998to2010wasdueinpartto
greaterpublicawarenessofthehealthhazardsfromsmoking,butwasalsodueinpartto
theincreaseinprice.Supposethattheentiredeclinewasduetotheincreaseinprice.What
couldyoudeducefromthataboutthepriceelasticityofdemand?
Calculatethearcelasticityofdemandsincewehavearangeofpricesratherthanasingleprice.
Thearcelasticityformulais
Q P
EP
P Q
wherePandQ areaveragepriceandquantity,respectively.Thechangeinquantitywas
15.7523.57.75,andthechangeinpricewas523.Theaveragepricewas(25)/2
3.50,andtheaveragequantitywas(23.515.75)/219.625.Therefore,thepriceelasticityof
demand,assumingthattheentiredeclineinquantitywasduesolelytothepriceincrease,was
EP
Q P 7.75 3.50
0.46.
P Q
3 19.625
8. InExample2.8weexaminedtheeffectofa20%declineincopperdemandonthepriceof
copper,usingthelinearsupplyanddemandcurvesdevelopedinSection2.6.Supposethelong
runpriceelasticityofcopperdemandwere0.75insteadof0.5.
a. Assuming,asbefore,thattheequilibriumpriceandquantityareP*$3perpoundand
Q*18millionmetrictonsperyear,derivethelineardemandcurveconsistentwiththe
smallerelasticity.
FollowingthemethodoutlinedinSection2.6,solveforaandbinthedemandequation
QDabP.Becausebistheslope,wecanusebratherthanQ/Pintheelasticity
P *
formula.Therefore,ED b
.HereED0.75(thelongrunpriceelasticity),P*3
Q *
andQ*18.Solvingforb,
3
, orb0.75(6)4.5.
18
0.75 b
Tofindtheintercept,wesubstituteforb,QD(Q*),andP(P*)inthedemandequation:
18a4.5(3),ora31.5.
Thelineardemandequationistherefore
QD31.54.5P.
b. Usingthisdemandcurve,recalculatetheeffectofa20%declineincopperdemandonthe
priceofcopper.
Thenewdemandis20%belowtheoriginal(usingourconventionthatquantitydemandedis
reducedby20%ateveryprice);therefore,multiplydemandby0.8becausethenewdemandis
80%oftheoriginaldemand:
QD (0.8)(31.5 4.5P ) 25.2 3.6 P.
Equatingthistosupply,
25.23.6P99P,so
P$2.71.
Withthe20%declineindemand,thepriceofcopperfallsfrom$3.00to$2.71perpound.The
decreaseindemandthereforeleadstoadropinpriceof29centsperpound,a9.7%decline.
9. InExample2.8(page52),wediscussedtherecentincreaseinworlddemandforcopper,duein
parttoChinasrisingconsumption.
a. Usingtheoriginalelasticitiesofdemandandsupply(i.e.,ES1.5andED0.5),calculate
theeffectofa20%increaseincopperdemandonthepriceofcopper.
TheoriginaldemandisQ273PandsupplyisQ99Passhownonpage51.The
20%increaseindemandmeansthatthenewdemandis120%oftheoriginaldemand,sothe
newdemandisQD1.2Q.QD(1.2)(273P)32.43.6P.Thenewequilibriumiswhere
QDequalstheoriginalsupply:
32.43.6P99P.
ThenewequilibriumpriceisP*$3.29perpound.Anincreaseindemandof20%,therefore,
entailsanincreaseinpriceof29centsperpound,or9.7%.
b. Nowcalculatetheeffectofthisincreaseindemandontheequilibriumquantity,Q*.
Usingthenewpriceof$3.29inthesupplycurve,thenewequilibriumquantityisQ*9
9(3.29)20.61millionmetrictonsperyear,anincreaseof2.61millionmetrictons(mmt)
peryear.Exceptforrounding,yougetthesameresultbypluggingthenewpriceof$3.29into
thenewdemandcurve.Soanincreaseindemandof20%entailsanincreaseinquantity
of2.61mmtperyear,or14.5%.
c. AswediscussedinExample2.8,theU.S.productionofcopperdeclinedbetween2000and
2003.Calculatetheeffectontheequilibriumpriceandquantityofbotha20%increasein
copperdemand(asyoujustdidinparta)andofa20%declineincoppersupply.
Thenewsupplyofcopperfalls(shiftstotheleft)to80%oftheoriginal,soQS0.8Q
(0.8)(99P)7.27.2P.ThenewequilibriumiswhereQDQS.
32.43.6P7.27.2P
ThenewequilibriumpriceisP*$3.67perpound.Pluggingthispriceintothenewsupply
equation,thenewequilibriumquantityisQ*7.27.2(3.67)19.22millionmetrictons
peryear.Exceptforrounding,yougetthesameresultifyousubstitutethenewpriceintothe
newdemandequation.Thecombinedeffectofa20%increaseindemandanda20%decrease
insupplyisthatpriceincreasesby67centsperpound,or22%,andquantityincreasesby1.22
mmtperyear,or6.8%,comparedtotheoriginalequilibrium.
10. Example2.9(page54)analyzestheworldoilmarket.Usingthedatagiveninthatexample:
a. Showthattheshortrundemandandcompetitivesupplycurvesareindeedgivenby
D33.60.020P
SC18.050.012P.
Thecompetitive(nonOPEC)quantitysuppliedisScQ*19.Thegeneralformforthelinear
competitivesupplyequationisSCcdP.Wecanwritetheshortrunsupplyelasticityas
ESd(P*/Q*).SinceES0.05,P*$80,andQ*19,0.05d(80/19).Henced0.011875.
Substitutingford,Sc,andPinthesupplyequation,c18.05,andtheshortruncompetitive
supplyequationisSc18.050.012P.
Similarly,worlddemandisDabP,andtheshortrundemandelasticityisEDb(P*/Q*),
whereQ*istotalworlddemandof32.Therefore,0.05b(80/32),andb0.020.Substituting
b0.02,D32,andP80inthedemandequationgives32a0.02(80),sothata33.6.
HencetheshortrunworlddemandequationisD33.60.020P.
b. Showthatthelongrundemandandcompetitivesupplycurvesareindeedgivenby
D41.60.120P
SC13.30.071P.
Dothesamecalculationsasabovebutnowusingthelongrunelasticities,ES0.30andED
0.30:ESd(P*/Q*)andEDb(P*/Q*),implying0.30d(80/19)and0.30b(80/32).
Sod0.07125andb0.12.
Nextsolveforcanda:SccdPandDabP,implying19c0.07125(80)and32
a0.12(80).Soc13.3anda41.6.
c. InExample2.9weexaminedtheimpactonpriceofadisruptionofoilfromSaudiArabia.
Supposethatinsteadofadeclineinsupply,OPECproductionincreasesby2billionbarrels
peryear(bb/yr)becausetheSaudisopenlargenewoilfields.Calculatetheeffectofthis
increaseinproductiononthesupplyofoilinboththeshortrunandthelongrun.
OPECssupplyincreasesfrom13bb/yrto15bb/yrasaresult.Add15bb/yrtotheshortrun
andlongruncompetitivesupplyequations.Thenewtotalsupplyequationsare:
Shortrun:ST15Sc1518.050.012P33.050.012P,and
Longrun:ST15Sc1513.30.071P28.30.071P.
Theseareequatedwithshortrunandlongrundemand,sothat:
33.050.012P33.60.020P,implyingthatP$17.19intheshortrun,and
28.30.071P41.60.120P,implyingthatP$69.63inthelongrun.
Intheshortrun,totalsupplyis33.050.012(17.19)33.26bb/yr.Inthelongrun,totalsupply
remainsvirtuallythesameat28.30.071(69.63)33.24bb/yr.Comparedtocurrenttotal
supplyof32bb/yr,supplyincreasesbyabout1.25bb/yr.
11. RefertoExample2.10(page59),whichanalyzestheeffectsofpricecontrolsonnaturalgas.
a. Usingthedataintheexample,showthatthefollowingsupplyanddemandcurvesdescribe
themarketfornaturalgasin20052007:
Supply:Q15.900.72PG0.05PO
Demand:Q0.021.8PG0.69PO
Also,verifythatifthepriceofoilis$50,thesecurvesimplyafreemarketpriceof$6.40for
naturalgas.
Tosolvethisproblem,applytheanalysisofSection2.6usingthedefinitionofcrossprice
elasticityofdemandgiveninSection2.4.Forexample,thecrosspriceelasticityofdemand
fornaturalgaswithrespecttothepriceofoilis:
QG P O
.
PO Q G
EGO
QG
isthechangeinthequantityofnaturalgasdemandedbecauseofasmallchangein
PO
thepriceofoil,andforlineardemandequations,itisconstant.Ifwerepresentdemandas
QG
QG a bPG ePO (noticethatincomeisheldconstant),then
e.Substitutingthisinto
PO
P *
thecrosspriceelasticity,EGO e O* , wherePO*andQG* aretheequilibriumpriceandquantity.
QG
*
*
WeknowthatPo $50andQG 23trillioncubicfeet(Tcf).Solvingfore,
50
,ore0.69.
23
1.5 e
Similarly,representingthesupplyequationasQG c dPG gPO , thecrosspriceelasticityof

P *
50
,org0.5roundedto
supplyisg O* ,whichweknowtobe0.1.Solvingforg, 0.1 g
23
QG
onedecimalplace.
6.40
,ord0.72.Also,
23
WeknowthatES0.2,PG*6.40,andQ*23.Therefore, 0.2 d
6.40
,andthusb1.8.
23
ED0.5,so 0.5 b
Bysubstitutingthesevaluesford,g,b,andeintoourlinearsupplyanddemandequations,we
maysolveforcanda:
23c0.72(6.40)0.05(50),soc15.9,and
23a1.8(6.40)0.69(50),sothata0.02.
Therefore,thesupplyanddemandcurvesfornaturalgasareasgiven.Ifthepriceofoilis$50,
thesecurvesimplyafreemarketpriceof$6.40fornaturalgasasshownbelow.Substitutethe
priceofoilinthesupplyanddemandequations.Thensetsupplyequaltodemandandsolvefor
thepriceofgas.
15.90.72PG0.05(50)0.021.8PG0.69(50)
18.40.72PG34.521.8PG
PG$6.40.
b. Supposetheregulatedpriceofgaswere$4.50perthousandcubicfeetinsteadof$3.00.How
muchexcessdemandwouldtherehavebeen?
Witharegulatedpriceof$4.50fornaturalgasandthepriceofoilequalto$50perbarrel,
Demand:QD0.021.8(4.50)0.69(50)26.4,and
Supply:QS15.90.72(4.50)0.05(50)21.6
Withademandof26.4Tcfandasupplyof21.6Tcf,therewouldbeanexcessdemand(i.e.,a
shortage)of4.8Tcf.
c. Supposethatthemarketfornaturalgasremainedunregulated.Ifthepriceofoilhad
increasedfrom$50to$100,whatwouldhavehappenedtothefreemarketpriceof
naturalgas?
Inthiscase
Demand:QD0.021.8PG0.69(100)69.021.8PG,and
Supply:QS15.90.72PG0.05(100)20.90.72PG.
Equatingsupplyanddemandandsolvingfortheequilibriumprice,
20.90.72PG69.021.8PG,orPG$19.10.
Thefreemarketpriceofnaturalgaswouldhavealmosttripledfrom$6.40to$19.10.
12. Thetablebelowshowstheretailpriceandsalesforinstantcoffeeandroastedcoffeefortwo
years.
Year
RetailPriceof
InstantCoffee
($/Lb)
SalesofInstant
Coffee
(MillionLbs)
RetailPriceof
RoastedCoffee
($/Lb)
Salesof
RoastedCoffee
(MillionLbs)
Year1
10.35
75
4.11
820
Year2
10.48
70
3.76
850
a. Usingthesedataalone,estimatetheshortrunpriceelasticityofdemandforroastedcoffee.
Derivealineardemandcurveforroastedcoffee.
Tofindelasticity,firstestimatetheslopeofthedemandcurve:
Q 820 850 30
85.7
P 4.11 3.76 0.35
Giventheslope,wecannowestimateelasticityusingthepriceandquantitydatafromtheabove
table.Assumingthedemandcurveislinear,theelasticitywilldifferthetwoyearsbecauseprice
andquantityaredifferent.Wecancalculatetheelasticitiesatbothpointsandalsofindthearc
elasticityattheaveragepointbetweenthetwoyears:
P Q 4.11
(85.7) 0.043
Q P 820
P Q 3.76
EP2
(85.7) 0.038
Q P 850
E1P
EPARC
P Q 3.935
(85.7) 0.040.
Q P
835
Toderivethedemandcurveforroastedcoffee,QabP,notethattheslopeofthedemand
curveis85.7b.Tofindthecoefficienta,useeitherofthedatapointsfromthetableabove
sothat820a85.7(4.11)or850a85.7(3.76).Ineithercase,a1172.2.Theequationfor
thedemandcurveistherefore
Q1172.285.7P.
b. Nowestimatetheshortrunpriceelasticityofdemandforinstantcoffee.Derivealinear
demandcurveforinstantcoffee.
Tofindelasticity,firstestimatetheslopeofthedemandcurve:
Q
75 70
5
38.5
P 10.35 10.48 0.13
Giventheslope,wecannowestimateelasticityusingthepriceandquantitydatafromtheabove
table.AssumingdemandisoftheformQabP,theelasticitywilldifferinthetwoyears
becausepriceandquantityaredifferent.Theelasticitiesatbothpointsandattheaveragepoint
betweenthetwoyearsare:
P Q 10.35
(38.5) 5.31
Q P
75
P Q 10.48
EP2
(38.5) 5.76
Q P
70
E1P
EPARC
P Q 10.415
(38.5) 5.53.
Q P
72.5
Toderivethedemandcurveforinstantcoffee,notethattheslopeofthedemandcurve
is38.5b.Tofindthecoefficienta,useeitherofthedatapointsfromthetableabove
sothata7538.5(10.35)473.5ora7038.5(10.48)473.5.Theequationforthe
demandcurveistherefore
Q473.538.5P.
c. Whichcoffeehasthehighershortrunpriceelasticityofdemand?Whydoyouthinkthisis
thecase?
Instantcoffeeissignificantlymoreelasticthanroastedcoffee.Infact,thedemandforroasted
coffeeisinelasticandthedemandforinstantcoffeeishighlyelastic.Roastedcoffeemayhave
aninelasticdemandintheshortrunbecausemanypeoplethinkofcoffeeasanecessarygood.
Changesinthepriceofroastedcoffeewillnotdrasticallyaffectthequantitydemandedbecause
peoplewanttheirroastedcoffee.Manypeople,ontheotherhand,mayviewinstantcoffeeasa
convenient,thoughimperfectandsomewhatinferior,substituteforroastedcoffee.Soiftheprice
ofinstantcoffeerises,thequantitydemandedwillfallbyalargepercentagebecausemany
peoplewilldecidetoswitchtoroastedcoffeeinsteadofpayingmoreforalowerquality
substitute.

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Questions for Review

Similarly,representingthesupplyequationasQG c dPG gPO , thecrosspriceelasticityof

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