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The Basics ofSupply andDemand2C H A P T E RFernando&Yvonn QuijanoPrepared by:Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.Chapter 2 The Basics of Supply and Demand2 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.CHAPTER 2 OUTLINE2.1 Supply and Demand2.2 The Market Mechanism2.3 Changes in Market Equilibrium2.4 Elasticities of Supply and Demand2.5 Short-Run versus Long-Run Elasticities2.6 Understanding and Predicting the Effects of Changing Market Conditions2.7 Effects of Government InterventionChapter 2 The Basics of Supply and Demand3 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.The Basics of Supply and DemandUnderstanding and predicting how changing world economic conditions affect market price and productionEvaluating the impact of government price controls,minimum wages,price supports,and production incentivesDetermining how taxes,subsidies,tariffs,and import quotas affect consumers and producersSupply-demand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting and important problems.To name a few:Chapter 2 The Basics of Supply and Demand4 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.SUPPLY AND DEMAND2.1The Supply Curve supply curve Relationship between the quantity of a good that producers are willing to sell and the price of the good.The Supply CurveThe supply curve,labeled S in the figure,shows how the quantity of a good offered for sale changes as the price of the good changes.The supply curve is upward sloping:The higher the price,the more firms are able and willing to produce and sell.If production costs fall,firms can produce the same quantity at a lower price or a larger quantity at the same price.The supply curve then shifts to the right(from S to S).Figure 2.1()SSQQ PChapter 2 The Basics of Supply and Demand5 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.SUPPLY AND DEMAND2.1The Supply CurveOther Variables That Affect Supply The quantity supplied can depend on other variables besides price.For example:The quantity that producers are willing to sell depends not only on the price they receive but also on their production costs,including wages,interest charges,and the costs of raw materials.When production costs decrease,output increases no matter what the market price happens to be.The entire supply curve thus shifts to the right.Economists often use the phrase change in supply to refer to shifts in the supply curve,while reserving the phrase change in the quantity supplied to apply to movements along the supply curve.Chapter 2 The Basics of Supply and Demand6 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.The Demand CurveThe demand curve,labeled D,shows how the quantity of a good demanded by consumers depends on its price.The demand curve is downward sloping;holding other things equal,consumers will want to purchase more of a good as its price goes down.The quantity demanded may also depend on other variables,such as income,the weather,and the prices of other goods.For most products,the quantity demanded increases when income rises.A higher income level shifts the demand curve to the right(from D to D).SUPPLY AND DEMAND2.1Figure 2.2The Demand Curve demand curve Relationship between the quantity of a good that consumers are willing to buy and the price of the good.()DDQQPChapter 2 The Basics of Supply and Demand7 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.SUPPLY AND DEMAND2.1The Demand CurveShifting the Demand CurveIf the market price were held constant,we would expect to see an increase in the quantity demanded as a result of consumers higher incomes.Because this increase would occur no matter what the market price,the result would be a shift to the right of the entire demand curve.Substitute and Complementary Goods substitutes Two goods for which an increase in the price of one leads to an increase in the quantity demanded of the plements Two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other.Chapter 2 The Basics of Supply and Demand8 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.THE MARKET MECHANISM2.2Equilibrium equilibrium(or market clearing)price Price that equates the quantity supplied to the quantity demanded.market mechanism Tendency in a free market for price to change until the market clears.Chapter 2 The Basics of Supply and Demand9 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.THE MARKET MECHANISM2.2Supply and DemandThe market clears at price P0 and quantity Q0.At the higher price P1,a surplus develops,so price falls.At the lower price P2,there is a shortage,so price is bid up.Figure 2.3 surplus Situation in which the quantity supplied exceeds the quantity demanded.shortage Situation in which the quantity demanded exceeds the quantity supplied.Chapter 2 The Basics of Supply and Demand10 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.THE MARKET MECHANISM2.2When Can We Use the Supply-Demand Model?We are assuming that at any given price,a given quantity will be produced and sold.This assumption makes sense only if a market is at least roughly competitive.By this we mean that both sellers and buyers should have little market poweri.e.,little ability individually to affect the market price.Suppose that supply were controlled by a single producer.If the demand curve shifts in a particular way,it may be in the monopolists interest to keep the quantity fixed but change the price,or to keep the price fixed and change the quantity.Chapter 2 The Basics of Supply and Demand11 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.CHANGES IN MARKET EQUILIBRIUM2.3New Equilibrium Following Shift in SupplyWhen the supply curve shifts to the right,the market clears at a lower price P3 and a larger quantity Q3.Figure 2.4Chapter 2 The Basics of Supply and Demand12 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.CHANGES IN MARKET EQUILIBRIUM2.3New Equilibrium Following Shift in DemandWhen the demand curve shifts to the right,the market clears at a higher price P3 and a larger quantity Q3.Figure 2.5Chapter 2 The Basics of Supply and Demand13 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.CHANGES IN MARKET EQUILIBRIUM2.3New Equilibrium Following Shifts in Supply and DemandSupply and demand curves shift over time as market conditions change.In this example,rightward shifts of the supply and demand curves lead to a slightly higher price and a much larger quantity.In general,changes in price and quantity depend on the amount by which each curve shifts and the shape of each curve.Figure 2.6Chapter 2 The Basics of Supply and Demand14 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3From 1970 to 2007,the real(constant-dollar)price of eggs fell by 49 percent,while the real price of a college education rose by 105 percent.The mechanization of poultry farms sharply reduced the cost of producing eggs,shifting the supply curve downward.The demand curve for eggs shifted to the left as a more health-conscious population tended to avoid egg.As for college,increases in the costs of equipping and maintaining modern classrooms,laboratories,and libraries,along with increases in faculty salaries,pushed the supply curve up.The demand curve shifted to the right as a larger percentage of a growing number of high school graduates decided that a college education was essential.CHANGES IN MARKET EQUILIBRIUMChapter 2 The Basics of Supply and Demand15 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3CHANGES IN MARKET EQUILIBRIUMMarket for Eggs(a)The supply curve for eggs shifted downward as production costs fell;the demand curve shifted to the left as consumer preferences changed.As a result,the real price of eggs fell sharply and egg consumption rose.Figure 2.6Chapter 2 The Basics of Supply and Demand16 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3CHANGES IN MARKET EQUILIBRIUMMarket for College Education(b)The supply curve for a college education shifted up as the costs of equipment,maintenance,and staffing rose.The demand curve shifted to the right as a growing number of high school graduates desired a college education.As a result,both price and enrollments rose sharply.Figure 2.7Chapter 2 The Basics of Supply and Demand17 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3CHANGES IN MARKET EQUILIBRIUMOver the past two decades,the wages of skilled high-income workers have grown substantially,while the wages of unskilled low-income workers have fallen slightly.From 1978 to 2005,people in the top 20 percent of the income distribution experienced an increase in their average real pretax household income of 50 percent,while those in the bottom 20 percent saw their average real pretax income increase by only 6 percent.While the supply of skilled workers has grown slowly,the demand has risen dramatically,pushing wages up.Chapter 2 The Basics of Supply and Demand18 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3CHANGES IN MARKET EQUILIBRIUMConsumption and Price of CopperAlthough annual consumption of copper has increased about a hundredfold,the real(inflation-adjusted)price has not changed much.Figure 2.8Chapter 2 The Basics of Supply and Demand19 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3CHANGES IN MARKET EQUILIBRIUMLong-Run Movements of Supply and Demand for Mineral ResourcesAlthough demand for most resources has increased dramatically over the past century,prices have fallen or risen only slightly in real(inflation-adjusted)terms because cost reductions have shifted the supply curve to the right just as dramatically.Figure 2.9Chapter 2 The Basics of Supply and Demand20 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.3CHANGES IN MARKET EQUILIBRIUMSupply and Demand for New York City Office SpaceFollowing 9/11 the supply curve shifted to the left,but the demand curve also shifted to the left,so that the average rental price fell.Figure 2.10Chapter 2 The Basics of Supply and Demand21 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4 elasticity Percentage change in one variable resulting from a 1-percent increase in another.price elasticity of demand Percentage change in quantity demanded of a good resulting from a 1-percent increase in its price.Price Elasticity of Demand(2.1)Chapter 2 The Basics of Supply and Demand22 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4 linear demand curve Demand curve that is a straight line.Linear Demand CurveLinear Demand CurveFigure 2.11The price elasticity of demand depends not only on the slope of the demand curve but also on the price and quantity.The elasticity,therefore,varies along the curve as price and quantity change.Slope is constant for this linear demand curve.Near the top,because price is high and quantity is small,the elasticity is large in magnitude.The elasticity becomes smaller as we move down the curve.Chapter 2 The Basics of Supply and Demand23 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4 infinitely elastic demand Principle that consumers will buy as much of a good as they can get at a single price,but for any higher price the quantity demanded drops to zero,while for any lower price the quantity demanded increases without limit.Linear Demand Curve(a)Infinitely Elastic DemandFigure 2.12For a horizontal demand curve,Q/P is infinite.Because a tiny change in price leads to an enormous change in demand,the elasticity of demand is infinite.Chapter 2 The Basics of Supply and Demand24 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4 completely inelastic demand Principle that consumers will buy a fixed quantity of a good regardless of its price.Linear Demand Curve(b)Completely Inelastic DemandFigure 2.12For a vertical demand curve,Q/P is zero.Because the quantity demanded is the same no matter what the price,the elasticity of demand is zero.Chapter 2 The Basics of Supply and Demand25 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4 income elasticity of demand Percentage change in the quantity demanded resulting from a 1-percent increase in income.Other Demand Elasticities cross-price elasticity of demand Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another.price elasticity of supply Percentage change in quantity supplied resulting from a 1-percent increase in price.Elasticities of Supply(2.2)(2.3)Chapter 2 The Basics of Supply and Demand26 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4 point elasticity of demand Price elasticity at a particular point on the demand curve.Point versus Arc Elasticities arc elasticity of demand Price elasticity calculated over a range of prices.Arc Elasticity of Demand(2.4)Chapter 2 The Basics of Supply and Demand27 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4For a few decades,changes in the wheat market had major implications for both American farmers and U.S.agricultural policy.To understand what happened,lets examine the behavior of supply and demand beginning in 1981.By setting the quantity supplied equal to the quantity demanded,we can determine the market-clearing price of wheat for 1981:Chapter 2 The Basics of Supply and Demand28 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.ELASTICITIES OF SUPPLY AND DEMAND2.4Substituting into the supply curve equation,we getWe use the demand curve to find the price elasticity of demand:We can likewise calculate the price elasticity of supply:Because these supply and demand curves are linear,the price elasticities will vary as we move along the curves.Thus demand is inelastic.Chapter 2 The Basics of Supply and Demand29 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5DemandSHORT-RUN VERSUS LONG-RUN ELASTICITIES(a)Gasoline:Short-Run and Long-Run Demand CurvesFigure 2.13In the short run,an increase in price has only a small effect on the quantity of gasoline demanded.Motorists may drive less,but they will not change the kinds of cars they are driving overnight.In the longer run,however,because they will shift to smaller and more fuel-efficient cars,the effect of the price increase will be larger.Demand,therefore,is more elastic in the long run than in the short run.Chapter 2 The Basics of Supply and Demand30 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5DemandSHORT-RUN VERSUS LONG-RUN ELASTICITIES(b)Automobiles:Short-Run and Long-Run Demand CurvesFigure 2.13The opposite is true for automobile demand.If price increases,consumers initially defer buying new cars;thus annual quantity demanded falls sharply.In the longer run,however,old cars wear out and must be replaced;thus annual quantity demanded picks up.Demand,therefore,is less elastic in the long run than in the short run.Demand and DurabilityChapter 2 The Basics of Supply and Demand31 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5DemandSHORT-RUN VERSUS LONG-RUN ELASTICITIESIncome ElasticitiesIncome elasticities also differ from the short run to the long run.For most goods and servicesfoods,beverages,fuel,entertainment,etc.the income elasticity of demand is larger in the long run than in the short run.For a durable good,the opposite is true.The short-run income elasticity of demand will be much larger than the long-run elasticity.Chapter 2 The Basics of Supply and Demand32 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5DemandSHORT-RUN VERSUS LONG-RUN ELASTICITIESGDP and Investment in Durable EquipmentFigure 2.14Annual growth rates are compared for GDP and investment in durable equipment.Because the short-run GDP elasticity of demand is larger than the long-run elasticity for long-lived capital equipment,changes in investment in equipment magnify changes in GDP.Thus capital goods industries are considered“cyclical.”Cyclical Industries cyclical industries Industries in which sales tend to magnify cyclical changes in gross domestic product and national income.Chapter 2 The Basics of Supply and Demand33 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5DemandSHORT-RUN VERSUS LONG-RUN ELASTICITIESConsumption of Durables versus NondurablesFigure 2.15Annual growth rates are compared for GDP,consumer expenditures on durable goods(automobiles,appliances,furniture,etc.),and consumer expenditures on nondurable goods(food,clothing,services,etc.).Because the stock of durables is large compared with annual demand,short-run demand elasticities are larger than long-run elasticities.Like capital equipment,industries that produce consumer durables are“cyclical”(i.e.,changes in GDP are magnified).This is not true for producers of nondurables.Cyclical IndustriesChapter 2 The Basics of Supply and Demand34 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5DemandSHORT-RUN VERSUS LONG-RUN ELASTICITIES TABLE 2.1 Demand for Gasoline Number of Years Allowed to Pass Followinga Price or Income Change Elasticity 1 2 3 5 10 Price 0.2 0.3 0.4 0.5 0.8 Income 0.2 0.4 0.5 0.6 1.0 TABLE 2.2 Demand for Automobiles Number of Years Allowed to Pass Followinga Price or Income Change Elasticity 1 2 3 5 10 Price 1.2 0.9 0.8 0.6 0.4 Income 3.0 2.3 1.9 1.4 1.0Chapter 2 The Basics of Supply and Demand35 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5SupplySHORT-RUN VERSUS LONG-RUN ELASTICITIESSupply and DurabilityCopper:Short-Run and Long-Run Supply CurvesFigure 2.16Like that of most goods,the supply of primary copper,shown in part(a),is more elastic in the long run.If price increases,firms would like to produce more but are limited by capacity constraints in the short run.In the longer run,they can add to capacity and produce more.Chapter 2 The Basics of Supply and Demand36 of 52Copyright 2009 Pearson Education,Inc.Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld,8e.2.5SupplySHORT-RUN VERSUS LONG-RUN ELASTICITIESSupply and DurabilityCopper:Short-Run and Long-Run Supply CurvesFigure 2.16Part(b)shows supply curves for secondary copper.If the price
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