Short-Run Versus Long-Run Elasticities
Chapter 2: The Basics of Supply and
Slide 2
Topics to Be Discussed
Understanding and Predicting the Effects
of Changing Market Conditions
Effects of Government Intervention--Price
Controls
Chapter 2: The Basics of Supply and
Slide 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 2: The Basics of Supply and
Slide 4
Introduction
Applications of Supply and Demand
Analysis
Analyzing
how taxes, subsidies, and import
restrictions affect consumers and producers
Chapter 2: The Basics of Supply and
Slide 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 2: The Basics of Supply and
Slide 6
Supply and Demand
The Supply Curve
This
price-quantity relationship can be shown
by the equation:
Qs QS (P )
Chapter 2: The Basics of Supply and
Slide 7
Supply and Demand
The
TheSupply
Supply
Curve
CurveGraphically
Graphically
Price
($ 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 2: The Basics of Supply and
Slide 8
Supply and Demand
Price
($ per unit)
S
The
TheSupply
Supply
Curve
CurveGraphically
Graphically
P2
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output
P1
Q1
Q2
Quantity
Chapter 2: The Basics of Supply and
Slide 9
Supply and Demand
Non-price Determining Variables of
Supply
Costs
of Production
Labor
Capital
Raw Materials
Chapter 2: The Basics of Supply and
Slide
Supply and Demand
Change
Changein
inSupply
Supply
The cost of raw
materials falls
At P1, produce Q2
At P2, produce Q1
Supply curve shifts right
to S’
P
S
S’
P1
P2
More produced at any
price on S’ than on S
Q0
Chapter 2: The Basics of Supply and
Q1
Q2
Slide
Q
Supply and Demand
Supply - A Review
Supply
is determined by non-price supplydetermining variables as such as the cost of
labor, capital, and raw materials.
Changes
in supply are shown by shifting the
entire supply curve.
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
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.
D
Quantity
Chapter 2: The Basics of Supply and
Slide
Supply and Demand
Non-price Determining Variables of
Demand
Income
Consumer
Price
Tastes
of Related Goods
Substitutes
Complements
Chapter 2: The Basics of Supply and
Slide
Supply and Demand
Change
Changein
inDemand
Demand
Income Increases
P
D’
P2
At P1, produce Q2
At P2, produce Q1
Demand Curve shifts right P1
D
More purchased at any
price on D’ than on D
Q0
Chapter 2: The Basics of Supply and
Q1
Q2
Slide
Q
Shifts in Supply and Demand
Demand - A Review
Demand
is determined by non-price demanddetermining 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 2: The Basics of Supply and
Slide
The Market Mechanism
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Quantity
Chapter 2: The Basics of Supply and
Slide
The Market Mechanism
Characteristics of the equilibrium or
market clearing price:
QD
= QS
No
shortage
No
excess supply
No
pressure on the price to change
Chapter 2: The Basics of Supply and
Slide
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
If price is above equilibrium:
1) Price is above the
market clearing price
2) Qs > Qd
3) Price falls to the
market-clearing price
P0
D
Q0
Quantity
Chapter 2: The Basics of Supply and
Slide
The Market Mechanism
A
ASurplus
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 2: The Basics of Supply and
Slide
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Qs : Q1 > Qd : Q2
2) Excess supply is Q1:Q2.
3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
P2
D
Q1
Q3
Q2 Quantity
Chapter 2: The Basics of Supply and
Slide
The Market Mechanism
Surplus
Surplus -- Review:
Review:
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 2: The Basics of Supply and
Slide
The Market Mechanism
Price
($ per unit)
S
P3
P2
Shortage
Q1
Q3
Assume the price is P2 , then:
1) Qd : Q2 > Qs : Q1
2) Shortage is Q1:Q2.
3) Producers raise price.
4) Quantity supplied increases
and quantity demanded
decreases.
5) Equilibrium at P3, Q3
D
Q2 Quantity
Chapter 2: The Basics of Supply and
Slide
The Market Mechanism
Shortage
Shortage
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.
Chapter 2: The Basics of Supply and
Slide
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.
Chapter 2: The Basics of Supply and
Slide
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.
Chapter 2: The Basics of Supply and
Slide
Changes In Market Equilibrium
Raw material prices
fall
P
D
S
S’
S shifts to S’
Surplus
@ P1 of Q1,
Q2
Equilibrium
P1
P3
@ P3, Q3
Q1 Q3 Q2
Chapter 2: The Basics of Supply and
Slide
Q
Changes In Market Equilibrium
Income Increases
Demand
Shortage
P
D
D’
S
shifts to D1
@ P1 of Q1, Q2 P3
Equilibrium
@ P3 , Q 3
P1
Q2 Q1 Q3
Chapter 2: The Basics of Supply and
Slide
Q
Changes In Market Equilibrium
Income Increases &
raw material prices fall
increase in D is
greater than the
increase in S
P
D
D’
S
S’
The
P2
P1
Equilibrium
price and
quantity increase to P2,
Q2
Q1
Chapter 2: The Basics of Supply and
Q2
Slide
Q
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 2: The Basics of Supply and
Slide
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.
Chapter 2: The Basics of Supply and
Slide
Market for Eggs
P
Prices fell until
a new equilibrium
was reached at $0.26
and a quantity
of 5,300 million dozen
S1970
(1970
dollars per
dozen)
S1998
$0.61
$0.26
D1970
5,300 5,500
D1998
Q (million dozens)
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Market for a College Education
P
S1995
(annual cost
in 1970
dollars)
$4,248
Prices rose until
a new equilibrium
was reached at $4,573
and a quantity
of 12.3 million students
S1970
$2,530
D1970
8.6
14.9
D1995
Q (millions of students enrolled))
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Consumption & Price of Copper
1880-1998
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Changes In Market Equilibrium
Price
S1900
S1950
S1998
Long-Run Path of
Price and Consumption
D1900
D1950
D1998
Quantity
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Price
PriceElasticity
Elasticityof
ofDemand
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
The price elasticity of demand is:
EP (%Q)/(%P)
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Price
PriceElasticity
Elasticityof
ofDemand
Demand
The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable.
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Price
PriceElasticity
Elasticityof
ofDemand
Demand
So the price elasticity of demand is also:
Q/Q P Q
EP
P/P Q P
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Price
PriceElasticity
Elasticityof
ofDemand
Demand
The primary determinant of price
elasticity of demand is the availability of
substitutes.
Many
Few
substitutes demand is price elastic
substitutes demand is price inelastic
Chapter 2: The Basics of Supply and
Slide
Price Elasticities of Demand
Price
4
EP -
Q = 8 - 2P
The lower portion of
a downward sloping
demand curve is less elastic
than the upper portion.
Ep = -1
2
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Ep = 0
4
Chapter 2: The Basics of Supply and
8
Q
Slide
Price Elasticities of Demand
Price
Infinitely Elastic Demand
D
P*
EP -
Quantity
Chapter 2: The Basics of Supply and
Slide
Price Elasticities of Demand
Price
Completely Inelastic Demand
EP 0
Q*
Quantity
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Other
OtherDemand
DemandElasticities
Elasticities
Income elasticity of demand measures
the percentage change in quantity
demanded resulting from a one percent
change in income.
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Other
OtherDemand
DemandElasticities
Elasticities
The income elasticity of demand is:
Q/Q
I Q
EI
I/I
Q I
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Other
OtherDemand
DemandElasticities
Elasticities
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Elasticities
Elasticitiesof
ofSupply
Supply
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 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
Elasticities
Elasticitiesof
ofSupply
Supply
We can refer to elasticity of supply with
respect to interest rates, wage rates, and the
cost of raw materials.
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
The
TheMarket
Marketfor
forWheat
Wheat
1981 Supply Curve for Wheat
QS
= 1,800 + 240P
1981 Demand Curve for Wheat
QD
= 3,550 - 266P
Chapter 2: The Basics of Supply and
Slide
Elasticities of Supply and Demand
The
TheMarket
Marketfor
forWheat
Wheat
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 62
Elasticities of Supply and Demand
The
TheMarket
Marketfor
forWheat
Wheat
P QD
3.46
E
(2.66) .035 Inelastic
Q P
2,630
D
P
P QS
3.46
E
(2.40) .032 Inelastic
Q P 2,630
S
P
Chapter 2: The Basics of Supply and Demand
Slide 63
Elasticities of Supply and Demand
The
TheMarket
Marketfor
forWheat
Wheat
Assume the price of wheat is $4.00/bushel
QD 3,550 ( 266)(4.00) 2,486
4.00
Q
( 266) 0.43
2,486
D
P
Chapter 2: The Basics of Supply and
Slide
Changes in the Market: 1981-1998
The
TheMarket
Marketfor
forWheat
Wheat
Price elasticity of demand varies with the
amount of time consumers have to
respond to a price.
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Demand
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 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Income
IncomeElasticities
Elasticities
Income elasticity also varies with the
amount of time consumers have to
respond to an income change.
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Income
IncomeElasticities
Elasticities
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.
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Income
IncomeElasticities
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 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
The
TheDemand
Demandfor
for
Gasoline
Gasolineand
andAutomobiles
Automobiles
Gasoline and automobiles are
complementary goods.
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
The
TheDemand
Demandfor
for
Gasoline
Gasolineand
andAutomobiles
Automobiles
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 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
The
TheDemand
Demandfor
forGasoline
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
Chapter 2: The Basics of Supply and
0.54
0.78
Slide
Short-Run Versus
Long-Run Elasticities
The
TheDemand
Demandfor
forAutomobiles
Automobiles
Years Following Price or Income Change
Elasticity
Price
Income
1
2
3
4
5
6
-1.20 -0.93 -0.75 -0.55 -0.42 -0.40
3.00 2.33
1.88
1.38
Chapter 2: The Basics of Supply and
1.02
1.00
Slide
Short-Run Versus
Long-Run Elasticities
The
TheDemand
Demandfor
for
Gasoline
Gasolineand
andAutomobiles
Automobiles
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 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Supply
Supply
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
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Primary
and
PrimaryCopper:
Copper:Short-Run
Short-Run
and
Long-Run
Elasticities
Long-Run
Long-RunSupply
SupplyCurves
Curves
Price
SSR
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
Quantity
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Secondary
Copper:
and
Secondary
Copper:Short-Run
Short-Run
and
Long-Run
Elasticities
Long-Run
Long-RunSupply
SupplyCurves
Curves
Price
SLR
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 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Supply
Supplyof
of Copper
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 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Weather
Weatherin
in Brazil
Brazil and
and
the
theprice
priceof
of Coffee
Coffee
in
inNew
New York
York
Elasticity explains why coffee prices are
very volatile.
Due
to the differences in supply elasticity in
the long-run and short run.
Chapter 2: The Basics of Supply and
Slide
Price of Brazilian Coffee
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Coffee
Coffee
S’ S
Price
A freeze or drought
decreases the supply
of coffee
P1
P0
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
D
Q1
Q0
Quantity
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Coffee
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
D
Q2 Q0
Quantity
Chapter 2: The Basics of Supply and
Slide
Short-Run Versus
Long-Run Elasticities
Coffee
Coffee
Price
Long-Run
1) Supply is extremely elastic.
2) Price falls back to P0.
3) Quantity increase to Q0.
S
P0
D
Q0
Quantity
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Available Data
Equilibrium
Price, P*
Equilibrium
Quantity, Q*
Price
elasticity of supply, ES, and
demand, ED.
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
-c/d
Demand: Q = a - bP
Q*
Quantity
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
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 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Step 1:
Recall:
E (P/Q)( Q/P)
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
For linear demand curves, the change in
quantity divided by the change in price is
constant (equal to the slope of the curve).
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Substituting the slopes for each into the
formula for elasticity, we get:
ED - b(P * /Q*)
ES d(P * /Q*)
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
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 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
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 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Es = d(P*/Q*)
Ed = -b(P*/Q*)
1.6 = d(75/7.5)
= 0.1d
-0.8 = -b(.75/7.5)
= -0.1b
d = 1.6/0.1 = 16
b = 0.8/0.1 = 8
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Supply = QS* = c + dP*
Demand = QD* = a -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 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Understanding and Predicting the Effects
of Changing Market Conditions
Price
Supply: QS = -4.5 + 16P
a/b
.75
-c/d
Demand: QD = 13.5 - 8P
7.5
Mmt/yr
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
We have written supply and demand so
that they only depend upon price.
Demand could also depend upon income.
Demand would then be written as:
Q a bP fI
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
We know the following information
regarding the copper industry:
I
= 1.0
P*
= 0.75
Q*
= 7.5
b
=8
Income
elasticity: E = 1.3
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
f can be found by substituting known
values into the income elasticity formula:
E ( I / Q)(Q / I )
and
f Q / I
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Solving for f gives:
1.3 = (1.0/7.5)f
f = (1.3)(7.5)/1.0 = 9.75
Chapter 2: The Basics of Supply and
Slide
Understanding and Predicting the Effects
of Changing Market Conditions
Solving for a gives:
Q a bP fI
*
*
7.5 = a - 8(0.75) + 9.75(1.0)
a = 3.75
Chapter 2: The Basics of Supply and
Slide
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 2: The Basics of Supply and
Slide
Real versus Nominal
Prices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and
Slide
Real versus Nominal
Prices of Copper 1965 - 1999
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 2: The Basics of Supply and
Slide
Real versus Nominal
Prices of Copper 1965 - 1999
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 2: The Basics of Supply and
Slide
Real versus Nominal
Prices of Copper 1965 - 1999
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 2: The Basics of Supply and
Slide
Real versus Nominal
Prices of Copper 1965 - 1999
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 2: The Basics of Supply and
Slide
Price of Crude Oil
Chapter 2: The Basics of Supply and
Slide
Upheaval in the World Oil Market
We can predict numerically the impact of
a decrease in the supply of OPEC oil.
In 1995:
P*
= $18/barrel
World
demand and total supply = 23 bb/yr.
OPEC
supply = 10 bb/yr.
Non-OPEC
supply = 13 bb/yr
Chapter 2: The Basics of Supply and
Slide
Price Elasticity Estimates
Short-Run Long-Run
World Demand:
Competitive Supply
(non-OPEC)
-0.05
-0.40
0.10
0.40
Chapter 2: The Basics of Supply and
Slide
Upheaval in the World Oil Market
Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr.
Short-run
D = 24.08 - 0.06P
Short-run
Demand
Competitive Supply
SC = 11.74 + 0.07P
Chapter 2: The Basics of Supply and
Slide
Upheaval in the World Oil Market
Short-Run Impact of a stoppage of Saudi
Production equal to 3 bb/yr.
Short-run
Total Supply--before supply
reduction (includes OPEC, 10bb/yr)
ST = 21.74 + 0.07P
Short-run
Total Supply--after supply reduction
ST = 18.74 + 0.07P
Chapter 2: The Basics of Supply and
Slide
Upheaval in the World Oil Market
New Price After Reduction
Demand = Supply
24.08 - 0.06P = 18.74 + 0.07P
P = 41.08
Chapter 2: The Basics of Supply and
Slide
Impact of Saudi Production Cut
SC
D S’T ST
Price 45
($ per
barrel) 40
Short-Run
Effect
35
30
25
20
18
15
10
5
0
5
10
15
20 23 25
Chapter 2: The Basics of Supply and
30
Quantity
35 (billions barrels/yr)
Slide
Upheaval in the World Oil Market
Long-Run Impact of a stoppage Saudi
Production equal to 3 bb/yr..
Long-run
D = 32.18 - 0.51P
Long-run
Demand
Total Supply
S = 17.78 + 0.29P
Chapter 2: The Basics of Supply and
Slide
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
Chapter 2: The Basics of Supply and
Slide
Impact of Saudi Production Cut
Price 45
SC
D
($ per
barrel) 40
S’T ST
Long-run Effect
Due to the elasticity
of the long-run
supply and demand
curves, the long-run
effect of a cut
in production is
much less.
35
30
25
20
18
15
10
5
0
5
10
15
20 23 25
Chapter 2: The Basics of Supply and
30
35
Quantity
(billions barrels/yr)
Slide
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 2: The Basics of Supply and
Slide
Effects of Price Controls
Price
S
If price is regulated to
be no higher than Pmax,
quantity supplied falls
to Q1 and quantity
demanded increases to
Q2. A shortage results
P0
Pmax
D
Excess demand
Q0
Chapter 2: The Basics of Supply and
Quantity
Slide
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 2: The Basics of Supply and
Slide
Price Controls and
Natural Gas Shortages
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 2: The Basics of Supply and
Slide
Price Controls and
Natural Gas Shortages
The
TheData:
Data: Natural
NaturalGas
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 2: The Basics of Supply and
Slide
Price Controls and
Natural Gas Shortages
The
TheData:
Data: Natural
NaturalGas
Gas
1975 regulated price $1.00
At $1.00/TcF
QS 18 TcF and Q 25 TcF
Shortage 7 TcF/yr
Chapter 2: The Basics of Supply and