The Basics of Supply and Demand

Chapter 2
The Basics of
Supply and
Demand
Topics to Be Discussed
• Supply and Demand
• The Market Mechanism
• Changes in Market Equilibrium
• Elasticities of Supply and Demand
• Short-Run Versus Long-Run
Elasticities
Chapter 1 2
Topics to Be Discussed
• Understanding and Predicting the
Effects of Changing Market
Conditions
• Effects of Government Intervention--

Price Controls
Chapter 1 3
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
Chapter 1 4
Introduction
• Applications of Supply and Demand
Analysis
– Analyzing how taxes, subsidies, and
import restrictions affect consumers and
producers
Chapter 1 5
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
Chapter 1 6
Supply and Demand
• The Supply Curve
– This price-quantity relationship can be
shown by the equation:
Qs = QS (P)
Chapter 1 7
Supply and Demand
The Supply
Price
Curve Graphically
($ per unit)
Vertical axis measures

price (P) received
per unit in dollars
Horizontal axis measures

quantity (Q) supplied in
number of units per
time period
Quantity
Chapter 1 8
Supply and Demand The Supply
Price
Curve Graphically
($ per unit) S
P2
The supply curve slopes
P1 upward demonstrating that
at higher prices firms
will increase output
Q1 Q2 Quantity
Chapter 1 9
Supply and Demand
• Non-price Determining Variables of
Supply
– Costs of Production
• Labor
• Capital
• Raw Materials
Chapter 1 10
Supply and Demand
Change in Supply
• The cost of raw P

S S’
materials falls
– At P1, produce Q2
– At P2, produce Q1 P1
– Supply curve shifts
right to S’ P2
– More produced at any

price on S’ than on S
Q0 Q1 Q2 Q
Chapter 1 11
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.
Chapter 1 12
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.
Chapter 1 13
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:
QD = QD(P)
Chapter 1 14
Supply and Demand
Price
($ per unit)
Vertical axis measures

price (P) paid
per unit in dollars
Horizontal axis measures

quantity (Q) demanded in
number of units per
time period
Quantity
Chapter 1 15
Supply and Demand
Price
($ per unit) 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
Chapter 1 16
Supply and Demand
• Non-price Determining Variables of
Demand
– Income
– Consumer Tastes
– Price of Related Goods
• Substitutes
• Complements
Chapter 1 17
Supply and Demand
Change in Demand
P D D’
• Income P2
Increases
P1
– Demand Curve shifts

right
– More purchased at any

price on D’ than on D
Q0 Q1 Q2 Q
Chapter 1 18
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. Chapter 1 19
The Market Mechanism
Price
($ per unit) S
The curves intersect at

equilibrium, or market-
clearing, price. At P0 the
P0 quantity supplied is equal
to the quantity demanded
at Q0 .
Q0 Quantity
Chapter 1 20
• Characteristics of the equilibrium or

market clearing price:
– QD = QS
– No shortage
– No excess supply
– No pressure on the price to change
Chapter 1 21
Price
S
($ per unit)
Surplus
P1
If price is above equilibrium:
1) Price is above the
P0 market clearing price
2) Qs > Qd
3) Price falls to the
market-clearing price
Q0 Quantity
Chapter 1 22
A Surplus
• 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.
Chapter 1 23
Price
S
($ per unit)
Surplus
P1
Assume the price is P1 , then:
1) Qs : Q1 > Qd : Q2
2) Excess supply is Q1:Q2.
P2 3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
Q1 Q3 Q2 Quantity
Chapter 1 24
Surplus - Review:
• The market price is above

equilibrium:
– There is excess supply
– Producers lower prices
– Quantity demanded increases and
quantity supplied decreases
equilibrium price is reached
Chapter 1 25
Price
($ per unit) S
Assume the price is P2 , then:

1) Qd : Q2 > Qs : Q1
2) Shortage is Q1:Q2.
P3 3) Producers raise price.
4) Quantity supplied increases
and quantity demanded
decreases.
P2 5) Equilibrium at P3, Q3
Shortage
D
Q1 Q3 Q2 Quantity
Chapter 1 26
Shortage
• The market price is below

equilibrium:
– There is a shortage
– Producers raise prices
– Quantity demanded decreases and
quantity supplied increases
new equilibrium price is reached.
Chapter 1 27
• 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.
Chapter 1 28
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
Chapter 1 29
Changes In Market
Equilibrium
• Raw material P
D S S’
prices fall
– S shifts to S’
– Surplus @ P1 of
P1
Q1, Q2
P3
– Equilibrium @ P3,
Q3
Q1 Q3 Q2 Q
Chapter 1 30
Changes In Market
Equilibrium
• Income Increases P D D’ S
– Demand shifts to D1
– Shortage @ P1 of Q1, P3
Q2 P1
– Equilibrium @ P3, Q3
Q2 Q1 Q3 Q
Chapter 1 31
Changes In Market
Equilibrium
• Income Increases & P D D’ S S’

raw material prices
fall
– The increase in D is P2
P1
greater than the
increase in S
– Equilibrium price
and quantity
increase to P2, Q2
Q1 Q2 Q
Chapter 1 32
Shifts in Supply and
Demand
• When supply and demand change
simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1) The relative size and direction of the
change
2) The shape of the supply and demand
models
Chapter 1 33
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
Chapter 1 34
Market for Eggs Prices fell until
P S1970 a new equilibrium
(1970 was reached at $0.26
dollars per and a quantity
dozen) of 5,300 million dozen
S1998
$0.61
$0.26
D1970
D1998
5,300 5,500 Q (million dozens)
Chapter 1 35
The Price of a College Education
• The real price of a college education

rose 68 percent from 1970 to 1995.
• Supply decreased due to higher costs
of equipping and maintaining modern
classrooms, laboratories and
libraries, and higher faculty salaries.
• Demand increased due a larger
percentage of a larger number of
high school graduates attending
college. Chapter 1 36
Market
P for a CollegeS Education Prices rose until
1995
(annual cost a new equilibrium
in 1970
was reached at $4,573
dollars)
and a quantity
of 12.3 million students
$4,248
S1970
$2,530
D1995
D1970
8.6 14.9 Q (millions of students enrolled))

Chapter 1 37
Changes In Market
Equilibrium
• Wage Inequality in the United States

– Real after-tax income from 1977 to
1999:
• Rose 40+% for the top 20% of the income
distribution
• Fell 10+% for the bottom 20%
Chapter 1 38
Changes In Market
Equilibrium
• Question
– Why did the income distribution become
more unequal for 1977 to 1999?
Chapter 1 39
Consumption & Price of
Copper 1880-
1998
Chapter 1 40
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.
Chapter 1 41
Changes In Market
Equilibrium
Price S1900 S1950
S1998
Long-Run Path of
Price and Consumption
D1900 D1950 D1998

Quantity
Chapter 1 42
Changes In Market
Equilibrium
• Conclusion
– Decreases in the costs of production
have increased the supply by more than
enough to offset the increase in
demand.
Chapter 1 43
Changes In Market
Equilibrium
• 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.
Chapter 1 44
Elasticities of Supply and Demand
• Generally, elasticity is a measure of

the sensitivity of one variable to
another.
• It tells us the percentage change in

one variable in response to a one
percent change in another variable.
Chapter 1 45
Price Elasticity of 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.
Chapter 1 46
• The price elasticity of demand is:
EP = (%∆Q)/(%∆P)
Chapter 1 47
• The percentage change in a variable

is the absolute change in the variable
divided by the original level of the
variable.
Chapter 1 48
• So the price elasticity of demand is

also:
∆Q/Q P ∆Q
EP = =
∆P/P Q ∆P
Chapter 1 49
• Interpreting Price Elasticity of
Demand Values
1) Because of the inverse relationship
between P and Q; EP is negative.
2) If EP > 1, the percent change in

quantity is greater than the
percent change in price. We say
the demand is price elastic.
Chapter 1 50
• Interpreting Price Elasticity of
Demand Values
3) If EP < 1, the percent change in

quantity is less than the percent
change in price. We say the
demand is price inelastic.
Chapter 1 51
• 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
Chapter 1 52
Price Elasticities of Demand
Price
EP = - ∞ The lower portion of
4 a downward sloping
demand curve is less elastic
Q = 8 - 2P than the upper portion.
Ep = -1
2
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Ep = 0
4 8 Q
Chapter 1 53
Price Elasticities of Demand
Price
Infinitely Elastic Demand
P* D
EP = - ∞
Quantity
Chapter 1 54
Price Elasticities
CompletelyofInelastic
Demand Demand
Price
EP = 0
Q* Quantity
Chapter 1 55
Other Demand Elasticities
• Income elasticity of demand

measures the percentage change in
quantity demanded resulting from a
one percent change in income.
Chapter 1 56
• The income elasticity of demand is:
∆Q/Q I ∆Q
EI = =
∆I/I Q ∆I
Chapter 1 57
• 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.
Chapter 1 58
• The cross elasticity of demand is:
∆Qb/Qb Pm ∆Qb
EQbPm = =
∆Pm/Pm Qb ∆Pm
• The cross elasticity for substitutes is

positive, while that for complements is
negative.
Chapter 1 59
Elasticities
Elasticities of Supply
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.
Chapter 1 60
Elasticities
Elasticities of Supply
of Supply and Demand
• We can refer to elasticity of supply with

respect to interest rates, wage rates,
and the cost of raw materials.
Chapter 1 61
The Market for Wheat
• 1981 Supply Curve for Wheat

– QS = 1,800 + 240P
• 1981 Demand Curve for Wheat
– QD = 3,550 - 266P
Chapter 1 62
• Equilibrium: Q S = Q D
1,800 + 240 P = 3,550 − 266 P
506 P = 1,750
P = 3.46 / bushel
Q = 1,800 + (240)(3.46) = 2,630 million bushels
Chapter 2: The Basics of Supply and Demand Slide 63

P ∆QD 3.46
E =
D
P = (−2.66) = −.035 Inelastic
Q ∆P 2,630
P ∆QS 3.46
E = S
P = (2.40) = .032 Inelastic
Q ∆P 2,630
Chapter 2: The Basics of Supply and Demand Slide 64

• Assume the price of wheat is

$4.00/bushel
QD = 3,550 − (266)(4.00) − 2,486
4.00
Q =D
P ( −266) = −0.43
2,486
Chapter 1 65
Changes in the Market:
The Market for Wheat 1981-1998
Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD)
1981 1800 + 240P 3550 - 266P 1800+240P = 3550-

266P 506P =
1750 P1981 =
$3.46/bushel
1998 1,944 + 207P 3,244 - 283P

1,944+207P = 3,244-283P
P1998 = $2.65/bushel
Chapter 1 66
Short-Run Versus
Long-Run Elasticities
Demand
• Price elasticity of demand varies with

the amount of time consumers have
to respond to a price.
Chapter 1 67
Short-Run Versus
Demand
• 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)
Chapter 1 68
Gasoline: Short-Run and
Long-Run Demand Curves
Price DSR
People tend to
drive smaller and
more fuel efficient
cars in the long-run
Gasoline DLR
Quantity
Chapter 1 69
Automobiles: Short-Run and
Long-Run Demand Curves
Price DLR
People may put
off immediate
consumption, but
eventually older cars
must be replaced.
Automobiles DSR
Quantity
Chapter 1 70
Short-Run Versus
Income Elasticities
• Income elasticity also varies with the

amount of time consumers have to
respond to an income change.
Chapter 1 71
Short-Run Versus
Income Elasticities

– 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.
Chapter 1 72
Short-Run Versus
Income Elasticities
• 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.
Chapter 1 73
Short-Run Versus
The Demand for
Gasoline and Automobiles
• Gasoline and automobiles are

complementary goods.
Chapter 1 74
Short-Run Versus
The Demand for
• 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.
Chapter 1 75
Short-Run Versus
The Demand for Gasoline
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
Price -0.11-0.22 -0.32 -0.49 -0.82 -1.17
Income 0.07 0.13 0.20 0.32 0.54 0.78
Chapter 1 76
Short-Run Versus
The Demand for Automobiles
Years Following Price or Income Change
Elasticity 1 2 3 4 5 6
Price -1.20-0.93 -0.75 -0.55 -0.42 -0.40
Income 3.00 2.33 1.88 1.38 1.02 1.00
Chapter 1 77
Short-Run Versus
The Demand for
• 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.
Chapter 1 78
Short-Run Versus
Supply

– 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
Chapter 1 79
Short-Run Versus
Primary Copper: Short-Run and
Long-Run Supply Curves
SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
Quantity
Chapter 1 80
Short-Run Versus
Secondary Copper: Short-Run and
Long-Run Supply Curves SLR
Price SSR
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long-run, this
stock of scrap copper
begins to fall.
Quantity
Chapter 1 81
Short-Run Versus
Supply of Copper
Price Elasticity of: Short-run Long-run
Primary supply 0.20 1.60
Secondary supply 0.43 0.31
Total supply 0.25 1.50
Chapter 1 82
Short-Run Versus
Weather in Brazil and
the price of Coffee
in New York
• Elasticity explains why coffee prices

are very volatile.
– Due to the differences in supply
elasticity in the long-run and short run.
Chapter 1 83
Price of Brazilian Coffee
Chapter 1 84
Short-Run Versus
Coffee S’ S
Price A freeze or drought
decreases the supply
P1 of coffee
P0
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
Q1 Q0 Quantity
Chapter 1 85
Short-Run Versus
Coffee
Price S’ S
P2
P0
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
3) Quantity falls to Q2
Q2 Q0 Quantity
Chapter 1 86
Short-Run Versus
Coffee
Price
Long-Run
1) Supply is extremely elastic.
2) Price falls back to P0.
3) Quantity increase to Q0.
P0 S
Q0 Quantity
Chapter 1 87
Understanding and Predicting the
Effects of Changing Market Conditions
• 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.
Chapter 1 88
• Available Data
– Equilibrium Price, P*
– Equilibrium Quantity, Q*
– Price elasticity of supply, ES, and
demand, ED.
Chapter 1 89
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
P* ES = dP*/Q*
-c/d Demand: Q = a - bP
Q* Quantity
Chapter 1 90
• Let’s begin with the equations for

supply and demand:
Demand: QD = a - bP
Supply: QS = c + dP
• We must choose numbers for a, b, c,

and d.
Chapter 1 91
• Step 1:
Recall:
E = (P/Q)( ∆Q/∆P)
Chapter 1 92
• For linear demand curves, the

change in quantity divided by the
change in price is constant (equal to
the slope of the curve).
Chapter 1 93
• Substituting the slopes for each into

the formula for elasticity, we get:
ED = - b(P * /Q*)
ES = d(P * /Q*)
Chapter 1 94
• Since we will have values for ED, ES,

P*, and Q*, we can solve for b & d,
and a & c. * *
QD = a − bP
* *
QS = c + dP
Chapter 1 95
• Deriving the long-run supply and

demand for copper:
– The relevant data are:
• Q* = 7.5 mmt/yr.
• P* = 75 cents/pound
• ES = 1.6
• ED = -0.8
Chapter 1 96
• Ed = -b(P*/Q*)
• Es = d(P*/Q*)
• -0.8 = -b(.75/7.5)
• 1.6 = d(75/7.5) = -0.1b
= 0.1d
• b = 0.8/0.1 = 8
• d = 1.6/0.1 = 16
Chapter 1 97
• Supply = QS* = c + • Demand = QD* = a

dP* -bP*
• 7.5 = c + 16(0.75) • 7.5 = a -(8)(.75)
• 7.5 = c + 12 • 7.5 = a - 6
• c = 7.5 - 12 • a = 7.5 + 6
• c = -4.5 • a =13.5
• Q = -4.5 + 16P • Q = 13.5 - 8P
Chapter 1 98
• Setting supply equal to demand gives:

Supply = -4.5 + 16p = 13.5 - 8p =
Demand
16p + 8p = 13.5 + 4.5
p = 18/24 = .75
Chapter 1 99
Price
Supply: QS = -4.5 + 16P
a/b
.75
-c/d Demand: QD = 13.5 - 8P
7.5 Mmt/yr
Chapter 1 100
• We have written supply and demand

so that they only depend upon price.
• Demand could also depend upon
income.
• Demand would then be written as:
Q = a − bP + fI
Chapter 1 101
• We know the following information

regarding the copper industry:
– I = 1.0
– P* = 0.75
– Q* = 7.5
– b=8
– Income elasticity: E = 1.3
Chapter 1 102
• f can be found by substituting known

values into the income elasticity
formula:
E = ( I / Q)(∆ Q / ∆ I )
and
f = ∆Q / ∆I
Chapter 1 103
• Solving for f gives:

1.3 = (1.0/7.5)f
f = (1.3)(7.5)/1.0 = 9.75
Chapter 1 104
• Solving for a gives:

Q = a − bP + fI
* *
7.5 = a - 8(0.75) + 9.75(1.0)
a = 3.75
Chapter 1 105
Declining Demand and the
Behavior of Copper Prices
• The relevant factors leading to a

decrease in the demand for copper
are:
1) A decrease in the growth rate of

power generation
2) The development of substitutes:

fiber optics and aluminum
Chapter 1 106
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 1 107
Real versus Nominal
• 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
Chapter 1 108
Real versus Nominal
• 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
Chapter 1 109
Real versus Nominal
• 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
Chapter 1 110
Real versus Nominal
• The twenty percent decrease in
demand resulted in a reduction in
the equilibrium price to 68.3 cents
from 75 cents, or 10 percent.
Chapter 1 111
Price of Crude Oil
Chapter 1 112
Upheaval in the World Oil Market
• We can predict numerically the
impact of a decrease in the supply of
OPEC oil.
• In 1995:
– P* = $18/barrel
– World demand and total supply = 23
bb/yr.
– OPEC supply = 10 bb/yr.
– Non-OPEC supply = 113 bb/yr
Chapter 113
Price Elasticity Estimates
Short-Run Long-Run
World Demand: -0.05 -0.40
Competitive Supply 0.10 0.40

(non-OPEC)
Chapter 1 114
• Short-Run Impact of a stoppage of
Saudi Production equal to 3 bb/yr.
– Short-run Demand
• D = 24.08 - 0.06P
– Short-run Competitive Supply
• SC = 11.74 + 0.07P
Chapter 1 115
• Short-Run Impact of a stoppage of
Saudi Production equal to 3 bb/yr.
– Short-run Total Supply--before supply
reduction (includes OPEC, 10bb/yr)
• ST = 21.74 + 0.07P
– Short-run Total Supply--after supply
reduction
• ST = 18.74 + 0.07P
Chapter 1 116
• New Price After Reduction
Demand = Supply
24.08 - 0.06P = 18.74 + 0.07P
P = 41.08
Chapter 1 117
Impact of Saudi Production
Cut
SC D S’T ST
Price 45
($ per Short-Run
barrel) 40 Effect
35
30
25
20
18
15
10
5 Quantity
0 5 10 15 20 23 25 30 35 (billions barrels/yr)
Chapter 1 118
• Long-Run Impact of a stoppage Saudi
Production equal to 3 bb/yr..
– Long-run Demand
• D = 32.18 - 0.51P
– Long-run Total Supply
• S = 17.78 + 0.29P
Chapter 1 119
• New Price is found setting long-run
supply equal to long-run demand:
32.18 - 0.51P = 14.78 + 0.29P
P = 21.75
Chapter 1 120
Impact of Saudi Production
Cut
SC S’T ST Long-run Effect

Price 45
D
($ per
barrel) 40
35 Due to the elasticity
of the long-run
30 supply and demand
curves, the long-run
25 effect of a cut
in production is
20 much less.
18
15
10
5 Quantity
(billions barrels/yr)
0 5 10 15 20 23 25 30 35
Chapter 1 121
Effects of Government Intervention
--Price Controls
• If the government decides that the

equilibrium price is too high, they
may establish a maximum allowable
ceiling price.
Chapter 1 122
Effects
Price
of Price Controls
S
If price is regulated to
be no higher than Pmax,
quantity supplied falls
P0 to Q1 and quantity
demanded increases to
Q2. A shortage results
Pmax
D
Excess demand
Q0 Quantity
Chapter 1 123
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.
Chapter 1 124
Price Controls and
• 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.
Chapter 1 125
Price Controls and
The Data: Natural Gas
PES = 0.2
Cross elasticity of supply for oil = 0.1
D
PE = −0.5
Cross elasticity of demand for oil = 1.5
Supply : Q = 14 + 2 PG + .25 PO
Demand : Q = −5 PG + 3.75 PO
Supply = Demand @ $2/TcF
Chapter 1 126
Price Controls and
The Data: Natural Gas
1975 regulated price = $1.00
At $1.00/TcF
QS = 18 TcF and Q = 25 TcF
Shortage = 7 TcF/yr
Chapter 1 127
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
Chapter 1 128
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 Chapter
calculate
1
the market129
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.
Chapter 1 130
End of Chapter 2
The Basics of
Supply and
Demand

The Basics of Supply and Demand

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Chapter 2

• Effects of Government Intervention--

Vertical axis measures

Horizontal axis measures

• The cost of raw P

– More produced at any

Vertical axis measures

Horizontal axis measures

– Demand Curve shifts

– More purchased at any

The curves intersect at

• Characteristics of the equilibrium or

• The market price is above

• The market price is above

Assume the price is P2 , then:

• The market price is below

• Equilibrium prices are determined by

• Supply and demand are determined

• Changes in any one or combination

• Income Increases & P D D’ S S’

• The real price of eggs fell 59% from

• The real price of a college education

8.6 14.9 Q (millions of students enrolled))

• Wage Inequality in the United States

• Fell 10+% for the bottom 20%

D1900 D1950 D1998

• Generally, elasticity is a measure of

• It tells us the percentage change in

• Measures the sensitivity of quantity

• The price elasticity of demand is:

• The percentage change in a variable

• So the price elasticity of demand is

2) If EP > 1, the percent change in

3) If EP < 1, the percent change in

• The primary determinant of price

• Income elasticity of demand

• The income elasticity of demand is:

• Cross elasticity of demand measures

• For example consider the substitute

• The cross elasticity for substitutes is

• Price elasticity of supply measures the

• We can refer to elasticity of supply with

• 1981 Supply Curve for Wheat

Chapter 2: The Basics of Supply and Demand Slide 63

Chapter 2: The Basics of Supply and Demand Slide 64

• Assume the price of wheat is

1981 1800 + 240P 3550 - 266P 1800+240P = 3550-

1998 1,944 + 207P 3,244 - 283P

• Price elasticity of demand varies with

• Most goods and services:

• Other Goods (durables):

• Income elasticity also varies with the

• Most goods and services:

• Other Goods (durables):

• Gasoline and automobiles are

The Demand for Gasoline

Years Following Price or Income Change

Price -0.11-0.22 -0.32 -0.49 -0.82 -1.17

Income 0.07 0.13 0.20 0.32 0.54 0.78