Chapter2:TheBasicsofSupplyandDemand

CHAPTER2
THEBASICSOFSUPPLYANDDEMAND

QUESTIONSFORREVIEW

1.Supposethatunusuallyhotweathercausesthedemandcurveforicecreamtoshiftto
theright.Whywillthepriceoficecreamrisetoanewmarketclearinglevel?
Assumethesupplycurveisfixed.Theunusuallyhotweatherwillcausearightward
shift inthe demand curve, creating shortrun excess demand at the current price.
Consumers willbegintobidagainst each other for theicecream, putting upward
pressureontheprice. Thepriceoficecreamwillriseuntilthequantitydemanded
andthequantitysuppliedareequal.
Price
S

P2

P1

D1 D2

Q1=Q2 QuantityofIceCream
Figure2.1
2. Usesupplyanddemandcurvestoillustratehoweachofthefollowingeventswould
affectthepriceofbutterandthequantityofbutterboughtandsold:
a. Anincreaseinthepriceofmargarine.
Mostpeopleconsiderbutterandmargarinetobesubstitutegoods.Anincreaseinthe
priceofmargarinewillcausepeopletoincreasetheirconsumptionofbutter,thereby
shiftingthedemandcurveforbutteroutfromD1toD2inFigure2.2.a.Thisshiftin
demand willcausetheequilibriumpricetorisefrom P1 to P2 andtheequilibrium
quantitytoincreasefromQ1toQ2.

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 Chapter2:TheBasicsofSupplyandDemand

Price
S

P2

P1

D1 D2

Q1 Q2 QuantityofButter

Figure2.2.a

b. Anincreaseinthepriceofmilk.
Milkisthemainingredientinbutter.Anincreaseinthepriceofmilkwillincrease
thecostofproducingbutter. Thesupplycurveforbutterwillshiftfrom S1 to S2 in
Figure 2.2.b, resulting in a higher equilibrium price, P2, covering the higher
productioncosts,andalowerequilibriumquantity,Q2.

Price
S2

S1

P2

P1

Q2 Q1 QuantityofButter

Figure2.2.b
Note:Giventhatbutterisinfactmadefromthefatthatisskimmedoffofthemilk,
butterandmilkarejointproducts.Ifyouareawareofthisrelationship,thenyour
answerwillchange.Inthiscase,asthepriceofmilkincreases,sodoesthequantity
supplied.Asthequantitysuppliedofmilkincreases,thereisalargersupplyoffat
availabletomakebutter.Thiswillshiftthesupplyofbuttercurvetotherightand
thepriceofbutterwillfall.

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 Chapter2:TheBasicsofSupplyandDemand
c. Adecreaseinaverageincomelevels.
Assumethatbutterisanormalgood. Adecreaseintheaverageincomelevelwill
causethedemandcurveforbuttertoshiftfromD1toD2.Thiswillresultinadeclinein
theequilibriumpricefromP1toP2,andadeclineintheequilibriumquantityfromQ1
toQ2.SeeFigure2.2.c.

Price
S

P1

P2

D2 D1

Q2 Q1 QuantityofButter

Figure2.2.c

3. Ifa3percent increase in theprice of corn flakes causes a6percent decline in the

quantitydemanded,whatistheelasticityofdemand?
Theelasticityofdemandisthepercentagechangeinthequantitydemandeddivided
bythepercentagechangeintheprice. Theelasticity ofdemandforcornflakesis
6
2 . This is equivalent to saying that a 1% increase in price leads to a 2%
3
decreaseinquantitydemanded. Thisisintheelasticregionofthedemandcurve,
wheretheelasticityofdemandexceeds1.0.
4.Explainthedifferencebetweenashiftinthesupplycurveandamovementalong
thesupplycurve.
Amovementalongthesupplycurveiscausedbyachangeinthepriceorthequantity
ofthegood,sincethesearethevariablesontheaxes. Ashiftofthesupplycurveis
causedbyanyotherrelevantvariablethatcausesachangeinthequantitysuppliedat
anygivenprice. Someexamplesarechangesinproductioncostsandanincreasein
thenumberoffirmssupplyingtheproduct.
5.Explainwhyformanygoods,thelongrunpriceelasticityofsupplyislargerthanthe
shortrunelasticity.
Theelasticityofsupplyisthepercentagechangeinthequantitysupplieddividedby
the percentage change in price. An increase in price induces an increase in the
quantitysuppliedbyfirms. Somefirmsinsomemarketsmayrespondquicklyand
cheaply to price changes. However, other firms may be constrained by their
productioncapacityintheshortrun.Thefirmswithshortruncapacityconstraints
willhaveashortrunsupplyelasticitythatislesselastic.However,inthelongrunall
firms can increase their scale of production and thus have alarger longrun price
elasticity.
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 Chapter2:TheBasicsofSupplyandDemand

6.Whydolongrunelasticitiesofdemanddifferfromshortrunelasticities?Considertwo
goods:papertowelsandtelevisions.Whichisadurablegood?Wouldyouexpecttheprice
elasticity ofdemand forpaper towels tobe larger in theshortrun orin thelongrun?
Why?Whataboutthepriceelasticityofdemandfortelevisions?
Longrunandshortrunelasticitiesdifferbasedonhowrapidlyconsumersrespondto
pricechangesandhowmanysubstitutesareavailable.Ifthepriceofpapertowels,a
nondurablegood,weretoincrease,consumersmightreactonlyminimallyintheshort
run.Inthelongrun,however,demandforpapertowelswouldbemoreelasticasnew
substitutesenteredthemarket(suchasspongesorkitchentowels).Incontrast,the
quantitydemandedofdurablegoods,suchastelevisions,mightchangedramatically
intheshortrunfollowingapricechange. Forexample,theinitialresultofaprice
increasefortelevisionswouldcauseconsumerstodelaypurchasesbecausedurable
goodsarebuilttolastlonger.Eventuallyconsumersmustreplacetheirtelevisionsas
theywearoutorbecomeobsolete,andtherefore,weexpectthedemandfordurablesto
bemoreinelasticinthelongrun.
7.Arethefollowingstatementstrueorfalse?Explainyouranswer.
a. Theelasticityofdemandisthesameastheslopeofthedemandcurve.
False. Elasticityofdemandisthepercentagechangeinquantitydemandedfora
givenpercentagechangeinthepriceoftheproduct.Theslopeofthedemandcurve
isthechangeinpriceforagivenchangeinquantitydemanded,measuredinunitsof
output.Thoughsimilarindefinition,theunitsforeachmeasurearedifferent.
b. Thecrosspriceelasticitywillalwaysbepositive.
False. The cross price elasticity measures the percentage change in the quantity
demanded of one product for a given percentage change in the price of another
product.Thiselasticitywillbepositiveforsubstitutes(anincreaseinthepriceofhot
dogs is likely to cause an increase in the quantity demanded of hamburgers) and
negativeforcomplements(anincreaseinthepriceofhotdogsislikelytocausea
decreaseinthequantitydemandedofhotdogbuns).
c. Thesupplyofapartmentsismoreinelasticintheshortrunthanthelong
run.
True.Intheshortrunitisdifficulttochangethesupplyofapartmentsinresponseto
a change in price. Increasing the supply requires constructing new apartment
buildings,whichcantakeayearormore.Sinceapartmentsareadurablegood,inthe
longrunachangeinpricewillinducesupplierstocreatemoreapartments(ifprice
increases)ordelayconstruction(ifpricedecreases).
8.Supposethegovernmentregulatesthepricesofbeefandchickenandsetsthembelow
theirmarketclearinglevels.Explainwhyshortagesofthesegoodswilldevelopandwhat
factorswilldeterminethesizesoftheshortages.Whatwillhappentothepriceofpork?
Explainbriefly.
Ifthepriceofacommodityissetbelowitsmarketclearinglevel,thequantitythat
firmsarewillingtosupplyislessthanthequantitythatconsumerswishtopurchase.
Theextentoftheexcessdemandimpliedbythisresponsewilldependontherelative
elasticities of demand and supply. For instance, if both supply and demand are
elastic, the shortage is larger than if both are inelastic. Factors such as the

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 Chapter2:TheBasicsofSupplyandDemand
willingnessofconsumerstoeatlessmeatandtheabilityoffarmerstochangethesize
oftheirherdsandhenceproducelesswilldeterminetheseelasticitiesandinfluence
thesizeofexcessdemand. Customerswhosedemandsarenotmetwillattemptto
purchasesubstitutes, thusincreasing thedemand forsubstitutes andraising their
prices.Ifthepricesofbeefandchickenaresetbelowmarketclearinglevels,theprice
ofporkwillrise,assumingthatporkisasubstituteforbeefandchicken.

9. Thecitycouncilofasmallcollegetowndecidestoregulaterentsinordertoreduce
student living expenses. Suppose the average annual marketclearing rent for atwo
bedroomapartmenthadbeen$700permonth,andrentsareexpectedtoincreaseto$900
withinayear.Thecitycouncillimitsrentstotheircurrent$700permonthlevel.
a. Draw a supply and demand graph to illustrate what will happen to the rental
priceofanapartmentaftertheimpositionofrentcontrols.
Therentalpricewillstayattheoldequilibriumlevelof$700permonth.The
expectedincreaseto$900permonthmayhavebeencausedbyanincreasein
demand.Giventhisistrue,thepriceof$700willbebelowthenewequilibriumand
therewillbeashortageofapartments.
b. Doyouthinkthispolicywillbenefitallstudents?Whyorwhynot.
Itwillbenefitthosestudentswhogetanapartment,thoughthesestudentsmayalso
findthatthecostsofsearchingforanapartmentarehighergiventheshortageof
apartments.Thosestudentswhodonotgetanapartmentmayfacehighercostsasa
resultofhavingtoliveoutsideofthecollegetown.Theirrentmaybehigherandthe
transportationcostswillbehigher.
10. In a discussion of tuition rates, a university official argues that the demand for
admissioniscompletelypriceinelastic. Asevidenceshenotesthatwhiletheuniversity
has doubled its tuition (in real terms) over the past 15 years, neither the number nor
qualityofstudentsapplyinghasdecreased. Wouldyouacceptthisargument? Explain
briefly. (Hint:Theofficialmakesanassertionaboutthedemandforadmission,butdoes
sheactuallyobserveademandcurve?Whatelsecouldbegoingon?)
Ifdemandisfixed,theindividualfirm(auniversity)maydeterminetheshapeofthe
demandcurveitfacesbyraisingthepriceandobservingthechangeinquantitysold.
Theuniversityofficialisnotobservingtheentiredemandcurve,butratheronlythe
equilibriumpriceandquantityoverthelast15years.Ifdemandisshiftingupward,
as supply shifts upward, demand could have any elasticity. (See Figure 2.7, for
example.)Demandcouldbeshiftingupwardbecausethevalueofacollegeeducation
hasincreasedandstudentsarewillingtopayahighpriceforeachopening. More
market research would be required to support the conclusion that demand is
completelypriceinelastic.

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 Chapter2:TheBasicsofSupplyandDemand

Price

D1996
S1996

D1986
S1986

D1976
S1976

Quantity

Figure2.10

11.SupposethedemandcurveforaproductisgivenbyQ=102P+P s,wherePistheprice
oftheproductandPsisthepriceofasubstitutegood.Thepriceofthesubstitutegoodis
$2.00.a. SupposeP=$1.00.Whatisthepriceelasticityofdemand?Whatisthecross
priceelasticityofdemand?

Firstyouneedtofindthequantitydemandedatthepriceof$1.00.Q=102(1)+2=10.
P Q 1 2
Priceelasticityofdemand= (2) 0.2.
Q P 10 10

Ps Q 2
Crosspriceelasticityofdemand= (1) 0.2.
Q Ps 10
b. Supposethepriceofthegood,P,goesto$2.00.Nowwhatisthepriceelasticityof
demand?Whatisthecrosspriceelasticityofdemand?

Firstyouneedtofindthequantitydemandedatthepriceof$2.00.Q=102(2)+2=8.

P Q 2 4
Priceelasticityofdemand= (2) 0.5.
Q P 8 8

Ps Q 2
Crosspriceelasticityofdemand= (1) 0.25.
Q Ps 8
12.SupposethatratherthanthedecliningdemandassumedinExample2.8,adecreasein
thecostofcopperproductioncausesthesupplycurvetoshifttotherightby40percent.
Howwillthepriceofcopperchange?

Ifthesupplycurveshiftstotherightby40%thenthenewquantitysuppliedwillbe
140 percent of theold quantity supplied atevery price. The new supply curve is
therefore

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 Chapter2:TheBasicsofSupplyandDemand
Q=1.4*(4.5+16P)=6.3+22.4P.Tofindthenewequilibriumpriceofcopper,setthe
newsupplyequaltodemandsothat6.3+22.4P=13.58P.Solvingforpriceresultsin
P=65centsperpoundforthenewequilibriumprice.Thepricedecreasedby10cents
perpound,or13.3%.

13.Supposethedemandfornaturalgasisperfectlyinelastic.Whatwouldbetheeffect,if
any,ofnaturalgaspricecontrols?

Ifthedemandfornaturalgasisperfectlyinelastic,thenthedemandcurveisvertical.
Consumerswilldemandacertainquantityandwillpayanypriceforthisquantity.In
thiscase,apricecontrolwillhavenoeffectonthequantitydemanded.

EXERCISES

1. SupposethedemandcurveforaproductisgivenbyQ=3002P+4I,whereIisaverage
incomemeasuredinthousandsofdollars.ThesupplycurveisQ=3P50.
a. IfI=25,findthemarketclearingpriceandquantityfortheproduct.
Given I=25, the demand curve becomes Q=3002P+4*25, or Q=4002P. Setting
demandequaltosupplywecansolveforPandthenQ:
4002P=3P50
P=90
Q=220.
b. IfI=50,findthemarketclearingpriceandquantityfortheproduct.
Given I=50, the demand curve becomes Q=3002P+4*50, or Q=5002P. Setting
demandequaltosupplywecansolveforPandthenQ:
5002P=3P50
P=110
Q=280.
c. Drawagraphtoillustrateyouranswers.
Equilibrium price and quantity are found at the intersection of the demand and
supplycurves.Whentheincomelevelincreasesinpartb,thedemandcurvewillshift
upandtotheright.Theintersectionofthenewdemandcurveandthesupplycurveis
thenewequilibriumpoint.
2. Consideracompetitivemarketforwhichthequantitiesdemandedandsupplied(per
year)atvariouspricesaregivenasfollows:

Price Demand Supply

($) (millions) (millions)

60 22 14
80 20 16

100 18 18

120 16 20

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 Chapter2:TheBasicsofSupplyandDemand
a. Calculatethepriceelasticityofdemandwhenthepriceis$80andwhenthepriceis
$100.
Weknowthatthepriceelasticityofdemandmaybecalculatedusingequation2.1
fromthetext:
Q D
QD P Q D
ED .
P Q D P
P
Witheachpriceincreaseof$20,thequantitydemandeddecreasesby2.Therefore,

QD 2 0.1.
P 20
AtP=80,quantitydemandedequals20and
80
ED
20 0.1 0.40.
Similarly,atP=100,quantitydemandedequals18and
100
ED
18 0.1 0.56.
b. Calculatethepriceelasticityofsupplywhenthepriceis$80andwhenthepriceis
$100.
Theelasticityofsupplyisgivenby:
Q S
QS P Q S
ES .
P Q S P
P
Witheachpriceincreaseof$20,quantitysuppliedincreasesby2.Therefore,

QS 2 0.1.
P 20
AtP=80,quantitysuppliedequals16and
80
ES
16 0.1 0.5.
Similarly,atP=100,quantitysuppliedequals18and
100
ES
18 0.1 0.56.
c. Whataretheequilibriumpriceandquantity?
Theequilibriumpriceandquantityarefoundwherethequantitysuppliedequalsthe
quantitydemandedatthesameprice.Asweseefromthetable,theequilibriumprice
is$100andtheequilibriumquantityis18million.
d. Supposethegovernmentsetsapriceceilingof$80.Willtherebeashortage,andif
so,howlargewillitbe?

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 Chapter2:TheBasicsofSupplyandDemand
Withapriceceilingof$80,consumerswouldliketobuy20million,butproducerswill
supplyonly16million.Thiswillresultinashortageof4million.
3. RefertoExample2.5onthemarket forwheat. Attheendof1998, bothBraziland
IndonesiaopenedtheirwheatmarketstoU.S.farmers. Supposethatthesenewmarkets
add200millionbushelstoU.S.wheatdemand.Whatwillbethefreemarketpriceofwheat
andwhatquantitywillbeproducedandsoldbyU.S.farmersinthiscase?
Thefollowingequationsdescribethemarketforwheatin1998:

QS=1944+207P
and
QD=3244283P.
IfBrazilandIndonesiaaddanadditional200millionbushelsofwheattoU.S.wheat
demand,thenewdemandcurvewouldbeequaltoQD+200,or
QD= (3244 - 283P) + 200 = 3444 - 283P.
Equatingsupplyandthenewdemand,wemaydeterminethenewequilibriumprice,

1944+207P=3444283P,or

490P=1500,orP*=$3.06122perbushel.
Tofindtheequilibriumquantity,substitutethepriceintoeitherthesupplyordemand
equation,e.g.,

QS=1944+(207)(3.06122)=2,577.67
and
QD=3444(283)(3.06122)=2,577.67
4.Avegetablefiberistradedinacompetitiveworldmarket,andtheworldpriceis$9per
pound.UnlimitedquantitiesareavailableforimportintotheUnitedStatesatthisprice.
TheU.S.domesticsupplyanddemandforvariouspricelevelsareshownbelow.

Price U.S.Supply U.S.Demand

(millionlbs.) (millionlbs.)

3 2 34
6 4 28
9 6 22
12 8 16
15 10 10
18 12 4

a.Whatistheequationfordemand?Whatistheequationforsupply?
TheequationfordemandisoftheformQ=abP.Firstfindtheslope,whichis
Q 6
2 b. You can figure this out by noticing that every time price
P 3
increasesby3,quantitydemandedfallsby6millionpounds.DemandisnowQ=a2P.
Tofinda,pluginanyofthepricequantitydemandedpointsfromthetable:Q=34=a
2*3sothata=40anddemandisQ=402P.

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 Chapter2:TheBasicsofSupplyandDemand
TheequationforsupplyisoftheformQ=c+dP.Firstfindtheslope,whichis
Q 2
d. Youcanfigurethisoutbynoticingthateverytimepriceincreasesby3,
P 3
2
quantitysuppliedincreasesby2millionpounds.Supplyisnow Q c P. Tofind
3
2
cpluginanyofthepricequantitysuppliedpointsfromthetable: Q 2 c (3)
3
2
sothatc=0andsupplyis Q P.
3
b.Atapriceof$9,whatisthepriceelasticityofdemand?Whatisitatpriceof$12?
P Q 9 18
ElasticityofdemandatP=9is (2) 0.82.
Q P 22 22
P Q 12 24
ElasticityofdemandatP=12is (2) 1.5.
Q P 16 16
c.Whatisthepriceelasticityofsupplyat$9?At$12?
P Q 9 2 18
ElasticityofsupplyatP=9is 1.0.
Q P 6 3 18
P Q 12 2 24
ElasticityofsupplyatP=12is 1.0.
Q P 8 3 24
d.Inafreemarket,whatwillbetheU.S.priceandleveloffiberimports?
Withnorestrictionsontrade,worldpricewillbethepriceintheUnitedStates,so
thatP=$9. Atthisprice,thedomesticsupplyis6millionlbs.,whilethedomestic
demandis22millionlbs.Importsmakeupthedifferenceandare16millionlbs.
5. MuchofthedemandforU.S.agriculturaloutputhascomefromothercountries. In
1998,thetotaldemandforwheatwasQ=3244283P.Ofthis,domesticdemandwasQD=
1700107P.DomesticsupplywasQS=1944+207P.Supposetheexportdemandforwheat
fallsby40percent.
a. U.S.farmersareconcernedaboutthisdropinexportdemand.Whathappenstothe
freemarketpriceofwheatintheUnitedStates?Dothefarmershavemuchreason
toworry?

Giventotaldemand, Q =3244283P,anddomesticdemand, Qd =1700107P,we

maysubtractanddetermineexportdemand,Qe=1544176P.
Theinitialmarketequilibriumpriceisfoundbysettingtotaldemandequaltosupply:

3244283P=1944+207P,or

P=$2.65.
Thebestwaytohandlethe40percentdropinexportdemandistoassumethatthe
exportdemandcurvepivotsdownandtotheleftaroundtheverticalinterceptsothat
atallpricesdemanddecreasesby40percent,andthereservationprice(themaximum
pricethattheforeigncountryiswillingtopay)doesnotchange.Ifyouinsteadshifted
thedemandcurvedowntotheleftinaparallelfashiontheeffectonpriceandquantity
willbequalitativelythesame,butwilldifferquantitatively.

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 Chapter2:TheBasicsofSupplyandDemand
Thenewexportdemandis 0.6Qe=0.6(1544176P)=926.4105.6P. Graphically,export
demandhaspivotedinwardsasillustratedinfigure2.5abelow.
Totaldemandbecomes

QD=Qd+0.6Qe=1700107P+926.4105.6P=2626.4212.6P.

8.77

Qe
926.4 1544

Figure2.5a
Equatingtotalsupplyandtotaldemand,

1944+207P=2626.4212.6P,or

P=$1.63,
whichisasignificantdropfromthemarketclearingpriceof$2.65perbushel.Atthis
price, the marketclearing quantity is 2280.65 million bushels. Total revenue has
decreasedfrom$6614.6millionto$3709.0million.Mostfarmerswouldworry.
b. NowsupposetheU.S.governmentwantstobuyenoughwheateachyeartoraise
thepriceto$3.50perbushel. Withthisdropinexportdemand,howmuchwheat
wouldthegovernmenthavetobuy?Howmuchwouldthiscostthegovernment?
With a price of $3.50, the market is not inequilibrium. Quantity demanded and
suppliedare
QD=2626.4212.6(3.5)=1882.3,and
QS=1944+207(3.5)=2668.5.
Excess supply is therefore 2668.51882.3=786.2 million bushels. The government
mustpurchasethisamounttosupportapriceof$3.5,andwillspend
$3.5(786.2million)=$2751.7millionperyear.
6.TherentcontrolagencyofNewYorkCityhasfoundthataggregatedemandis
QD=1608P.Quantityismeasuredintensofthousandsofapartments.Price,theaverage
monthlyrentalrate,ismeasuredinhundredsofdollars. Theagencyalsonotedthatthe
increaseinQatlowerPresultsfrommorethreepersonfamiliescomingintothecityfrom

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 Chapter2:TheBasicsofSupplyandDemand
LongIslandanddemandingapartments. Thecitysboardofrealtorsacknowledgesthat
thisisagooddemandestimateandhasshownthatsupplyisQS=70+7P.
a. Ifboththeagencyandtheboardarerightaboutdemandandsupply,whatisthe
free market price? What is the change in city population if the agency sets a
maximum average monthly rental of $300, and all those who cannot find an
apartmentleavethecity?
Tofindthefreemarketpriceforapartments,setsupplyequaltodemand:

1608P=70+7P,orP=$600,
sincepriceismeasuredinhundredsofdollars.Substitutingtheequilibriumpriceinto
eitherthedemandorsupplyequationtodeterminetheequilibriumquantity:

QD=160(8)(6)=112
and
QS=70+(7)(6)=112.
Wefindthatattherentalrateof$600,thequantityofapartmentsrentedis1,120,000.
Iftherentcontrolagencysetstherentalrateat$300,thequantitysuppliedwould
thenbe910,000(QS=70+(7)(3)=91),adecreaseof210,000apartmentsfromthefree
marketequilibrium. (Assumingthreepeopleperfamilyperapartment,thiswould
implyalossof630,000people.)Atthe$300rentalrate,thedemandforapartmentsis
1,360,000 units, and the resulting shortage is 450,000 units (1,360,000910,000).
However,excessdemand(supplyshortages)andlowerquantitydemandedarenotthe
sameconcepts.Thesupplyshortagemeansthatthemarketcannotaccommodatethe
newpeoplewhowouldhavebeenwillingtomoveintothecityatthenewlowerprice.
Therefore,thecitypopulationwillonlyfallby630,000,whichisrepresentedbythe
dropinthenumberofactualapartmentsfrom1,120,000(theoldequilibriumvalue)to
910,000,or210,000apartmentswith3peopleeach.

b. Supposetheagencybowstothewishesoftheboardandsetsarentalof$900per
monthonallapartmentstoallowlandlordsafairrateofreturn.If50percentof
anylongrunincreasesinapartmentofferingscomefromnewconstruction, how
manyapartmentsareconstructed?
At a rental rate of $900, the supply of apartments would be 70 + 7(9) = 133, or
1,330,000 units, which is an increase of 210,000 units over the free market
equilibrium. Therefore,(0.5)(210,000)=105,000unitswouldbeconstructed. Note,
however,thatsincedemandisonly880,000units,450,000unitswouldgounrented.
7.In1998,Americanssmoked470billioncigarettes,or23.5billionpacksofcigarettes.The
average retail price was $2 per pack. Statistical studies have shown that the price
elasticityofdemandis0.4,andthepriceelasticityofsupplyis0.5.Usingthisinformation,
derivelineardemandandsupplycurvesforthecigarettemarket.
LetthedemandcurvebeofthegeneralformQ=abPandthesupplycurvebeofthe
generalformQ=c+dP,wherea,b,c,anddaretheconstantsthatyouhavetofind
fromtheinformationgivenabove.Tobegin,recalltheformulaforthepriceelasticity
ofdemand
P Q
EPD .
Q P

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 Chapter2:TheBasicsofSupplyandDemand
Youaregiveninformationaboutthevalueoftheelasticity,P,andQ,whichmeans
thatyoucansolvefortheslope,whichisbintheaboveformulaforthedemandcurve.
2 Q
0.4
23.5 P
Q 23.5
0.4 4.7 b.
P 2
Tofindtheconstanta,substituteforQ,P,andbintotheaboveformulasothat
23.5=a4.7*2anda=32.9.TheequationfordemandisthereforeQ=32.94.7P.Tofind
thesupplycurve,recalltheformulafortheelasticityofsupplyandfollowthesame
methodasabove:
P Q
E PS
Q P
2 Q
0.5
23.5 P
Q 23.5
0.5 5.875 d.
P 2
Tofindtheconstantc,substituteforQ,P,anddintotheaboveformulasothat
23.5=c+5.875*2andc=11.75.TheequationforsupplyisthereforeQ=11.75+5.875P.
8.InExample2.8weexaminedtheeffectofa20percentdeclineincopperdemandonthe
price of copper, using the linear supply and demand curves developed in Section 2.4.
Supposethelongrunpriceelasticityofcopperdemandwere0.4insteadof0.8.
a. Assuming,asbefore,thattheequilibriumpriceandquantityareP*=75centsper
poundand Q* =7.5millionmetrictonsperyear,derivethelineardemandcurve
consistentwiththesmallerelasticity.

FollowingthemethodoutlinedinSection2.6,wesolvefor a and b inthedemand

equation QD = a bP. First, we know that for a linear demand function
P *
ED b . Here ED = 0.4 (the longrun price elasticity), P* = 0.75 (the
Q *
equilibriumprice),andQ*=7.5(theequilibriumquantity).Solvingforb,
0.75
0.4 b
7.5 ,orb=4.
Tofindtheintercept, wesubstitutefor b, QD (= Q*),and P (= P*)inthedemand
equation:

7.5=a(4)(0.75),ora=10.5.
The linear demand equation consistent with a longrun price elasticity of 0.4 is
therefore

QD=10.54P.
b. Usingthisdemandcurve,recalculatetheeffectofa20percentdeclineincopper
demandonthepriceofcopper.

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 Chapter2:TheBasicsofSupplyandDemand
Thenewdemandis20percentbelowtheoriginal(usingourconventionthatquantity
demandedisreducedby20%ateveryprice):

QD 0.810.5 4P 8.4 3.2P .

Equatingthistosupply,

8.43.2P=4.5+16P,or

P=0.672.
Withthe20percentdeclineinthedemand,thepriceofcopperfallsto67.2centsper
pound.
9.Example2.9analyzestheworldoilmarket.Usingthedatagiveninthatexample:
a. Showthattheshortrundemandandcompetitivesupplycurvesareindeedgiven
by
D=24.080.06P
SC=11.74+0.07P.
First,consideringnonOPECsupply:

Sc=Q*=13.

WithES=0.10andP*=$18,ES=d(P*/Q*)impliesd=0.07.

Substitutingford,Sc,andPinthesupplyequation,c=11.74andSc=11.74+0.07P.

Similarly,sinceQD=23,ED=b(P*/Q*)=0.05,andb=0.06.Substitutingforb,QD=23,and
P=18inthedemandequationgives23=a0.06(18),sothata=24.08.

HenceQD=24.080.06P.
b. Showthatthelongrundemandandcompetitivesupplycurvesareindeedgivenby
D=32.180.51P
SC=7.78+0.29P.

Asabove,ES=0.4andED=0.4:ES=d(P*/Q*)andED=b(P*/Q*),implying0.4=d(18/13)
and0.4=b(18/23).Sod=0.29andb=0.51.

Nextsolveforcanda:

Sc=c+dPandQD=abP,implying13=c+(0.29)(18)and23=a(0.51)(18).

Soc=7.78anda=32.18.
c. In2002,SaudiArabiaaccountedfor3billionbarrelsperyearofOPECsproduction.
SupposethatwarorrevolutioncausedSaudiArabiatostopproducingoil.Usethe
modelabovetocalculatewhatwouldhappentothepriceofoilintheshortrunand
thelongrunifOPECsproductionweretodropby3billionbarrelsperyear.

WithOPECssupplyreducedfrom10bb/yrto7bb/yr,addthislowersupplyof7bb/yrtothe
shortrunandlongrunsupplyequations:

Sc=7+Sc=11.74+7+0.07P=18.74+0.07PandS=7+Sc=14.78+0.29P.
Theseareequatedwithshortrunandlongrundemand,sothat:

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 Chapter2:TheBasicsofSupplyandDemand
18.74+0.07P=24.080.06P,

implyingthatP=$41.08intheshortrun;and

14.78+0.29P=32.180.51P,

implyingthatP=$21.75inthelongrun.
10. RefertoExample2.10,whichanalyzestheeffectsofpricecontrolsonnaturalgas.
a. Usingthedataintheexample,showthatthefollowingsupplyanddemandcurves
didindeeddescribethemarketin1975:
Supply:Q=14+2PG+0.25PO
Demand:Q=5PG+3.75PO
wherePGandPOarethepricesofnaturalgasandoil,respectively.Also,verifythat
ifthepriceofoilis$8.00,thesecurvesimplyafreemarketpriceof$2.00fornatural
gas.
Tosolvethisproblem,weapplytheanalysisofSection2.6tothedefinitionofcross
priceelasticityofdemandgiveninSection2.4.Forexample,thecrosspriceelasticity
ofdemandfornaturalgaswithrespecttothepriceofoilis:

Q P
EGO G O .
PO QG

QG
isthechangeinthequantityofnaturalgasdemanded,becauseofasmall
PO
QG
changeinthepriceofoil. Forlineardemandequations, isconstant. Ifwe
PO
representdemandas:
QG=abPG+ePO
QG
(noticethatincomeisheldconstant),then =e.Substitutingthisintothecross
PO
PO*
price elasticity, EPO e * , where PO* and QG* are the equilibrium price and
QG
quantity.Weknowthat PO* =$8and QG* =20trillioncubicfeet(Tcf).Solvingfore,
8
1.5 e
20 ,ore=3.75.
Similarly,ifthegeneralformofthesupplyequationisrepresentedas:

QG=c+dPG+gPO,

PO*
thecrosspriceelasticityofsupplyis g * ,whichweknowtobe0.1.Solvingforg,
QG
8
0.1 g
20 ,org=0.25.

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 Chapter2:TheBasicsofSupplyandDemand
Thevaluesfordandbmaybefoundwithequations2.5aand2.5binSection2.6.We
knowthatES=0.2,P*=2,andQ*=20.Therefore,
2
0.2 d
20 ,ord=2.
Also,ED=0.5,so
2
0.5 b
20 ,orb=5.
Bysubstituting thesevaluesfor d,g,b,and e intoourlinearsupply anddemand
equations,wemaysolveforcanda:

20=c+(2)(2)+(0.25)(8),orc=14,
and
20=a(5)(2)+(3.75)(8),ora=0.
Ifthepriceofoilis$8.00,thesecurvesimplyafreemarketpriceof$2.00fornatural
gas. Substitute the price ofoil in thesupply and demand curves to verify these
equations.Thensetthecurvesequaltoeachotherandsolveforthepriceofgas.

14+2PG+(0.25)(8)=5PG+(3.75)(8)

7PG=14

PG=$2.00.
b. Supposetheregulatedpriceofgasin1975hadbeen$1.50perthousandcubicfeet,
insteadof$1.00.Howmuchexcessdemandwouldtherehavebeen?
Witharegulatedpriceof$1.50fornaturalgasandapriceofoilequalto$8.00per
barrel,
Demand:QD=(5)(1.50)+(3.75)(8)=22.5,and
Supply:QS=14+(2)(1.5)+(0.25)(8)=19.
Withasupplyof19Tcfandademandof22.5Tcf,therewouldbeanexcessdemandof
3.5Tcf.
c. Supposethatthemarketfornaturalgashadnotbeenregulated.Ifthepriceofoil
hadincreasedfrom$8to$16,whatwouldhavehappenedtothefreemarketpriceof
naturalgas?
Ifthepriceofnaturalgashadnotbeenregulatedandthepriceofoilhadincreased
from$8to$16,then

Demand:QD=5PG+(3.75)(16)=605PG,and
Supply:QS=14+2PG+(0.25)(16)=18+2PG.
Equatingsupplyanddemandandsolvingfortheequilibriumprice,

18+2PG=605PG,orPG=$6.
Thepriceofnaturalgaswouldhavetripledfrom$2to$6.
11.Thetablebelowshowstheretailpriceandsalesforinstantcoffeeandroastedcoffee
for1997and1998.

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 Chapter2:TheBasicsofSupplyandDemand
RetailPriceof Salesof RetailPriceof Salesof
InstantCoffee InstantCoffee RoastedCoffee RoastedCoffee
Year ($/lb) (millionlbs) ($/lb) (millionlbs)

1997 10.35 75 4.11 820

1998 10.48 70 3.76 850

a. Usingthisdataalone,estimatetheshortrunpriceelasticityofdemandforroasted
coffee.Derivealineardemandcurveforroastedcoffee.
Tofindelasticity,youmustfirstestimatetheslopeofthedemandcurve:
Q 820 850 30
85.7.
P 4.11 3.76 0.35
Giventheslope,wecannowestimateelasticityusingthepriceandquantitydatafrom
theabovetable.Sincethedemandcurveisassumedtobelinear,theelasticitywill
differin1997and1998becausepriceandquantityaredifferent.Youcancalculate
theelasticityatbothpointsandattheaveragepointbetweenthetwoyears:
P Q 4.11
Ep97 (85.7) 0.43
Q P 820
P Q 3.76
Ep98 (85.7) 0.38
Q P 850
P97 P98
2 Q 3.935
EpAVE (85.7) 0.40.
Q97 Q98 P 835
2
ToderivethedemandcurveforroastedcoffeeQ=abP,notethattheslopeofthe
demandcurveis85.7=b.Tofindthecoefficienta,useeitherofthedatapointsfrom
thetableabovesothata=830+85.7*4.11=1172.3ora=850+85.7*3.76=1172.3.The
equationforthedemandcurveistherefore

Q=1172.385.7P.
b. Nowestimatetheshortrunpriceelasticityofdemandforinstantcoffee.Derivea
lineardemandcurveforinstantcoffee.
Tofindelasticity,youmustfirstestimatetheslopeofthedemandcurve:
Q 75 70 5
38.5.
P 10.35 10.48 0.13
Giventheslope,wecannowestimateelasticityusingthepriceandquantitydatafrom
theabovetable.SincethedemandcurveQ=abPisassumedtobelinear,the
elasticitywilldifferin1997and1998becausepriceandquantityaredifferent.You
cancalculatetheelasticityatbothpointsandattheaveragepointbetweenthetwo
years:
P Q 10.35
Ep97 (38.5) 5.31
Q P 75

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 Chapter2:TheBasicsofSupplyandDemand
P Q 10.48
Ep98 (38.5) 5.76
Q P 70

P97 P98
Q 10.415
E AVE Q 2 Q (38.5) 5.53.
98 P
p
97 72.5
2
Toderivethedemandcurveforinstantcoffee,notethattheslopeofthedemandcurve
is38.5=b.Tofindthecoefficienta,useeitherofthedatapointsfromthetableabove
sothata=75+38.5*10.35=473.5ora=70+38.5*10.48=473.5.Theequationforthe
demandcurveistherefore

Q=473.538.5P.
c. Which coffeehasthehighershortrunpriceelasticityofdemand? Whydoyou
thinkthisisthecase?
Instantcoffeeissignificantlymoreelasticthanroastedcoffee.Infact,thedemandfor
roastedcoffeeisinelasticandthedemandforinstantcoffeeiselastic.Roastedcoffee
mayhaveaninelasticdemandintheshortrunasmanypeoplethinkofcoffeeasa
necessary good. Changes in the price of roasted coffee will not drastically affect
demandbecausepeoplemusthavethisgood. Manypeople,ontheotherhand,may
viewinstantcoffee,asaconvenient,thoughimperfect,substituteforroastedcoffee.
Forexample, iftheprice rises alittle,thequantity demanded willfall byalarge
percentagebecausepeoplewouldratherdrinkroastedcoffeeinsteadofpayingmore
foralowqualitysubstitute.

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