Chapter 2

The Basics of Supply &

Demand

CHAPTER 2 OUTLINE

2.1 Supply and Demand

2.2 The Market Mechanism
2.3 Changes in Market Equilibrium
2.4 Elasticities of Supply and Demand
2.5 Short-Run versus Long-Run Elasticities
2.7 Effects of Government InterventionPrice Controls

2.1

SUPPLY AND DEMAND

supply

curve Relationship between quantity supplied (Qs) and the

price of the good, holding constant other factors.
QS = QS(P)

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.

Other Variables That Affect Supply

1. Production costs
(e.g. wages, interest charges, and the costs of raw materials.)
2. Technology & Productivity

Shifting
variable
s

3. Taxes & subsidies

4. Expectation
5. The number of suppliers.

change in supply (S)

Shift of the entire
supply curve

VS change in the quantity supplied (Qs)

movements along the
same supply curve.

 Demand curve
Relationship between the quantity of a good that consumers are willing to
buy (QD ) and the price of the good (P), holding constant other factors.

QD = QD(P)
The demand curve is
downward sloping:
holding other things equal,
consumers will want to
purchase more of a good as its
price goes down (i.e., QD
increases)
If consumers incomes
increase, we would expect to
see an increase in demand
say from D to D,

Other Variables That Affect Demand

1. Income (normal good Vs inferior goods)

2. Price of related goods (substitutes Vs complements)
3. Tastes and preferences.

Shiftin
g
variabl
es

4. Expectation (future price, income, product availability)

5. The number of consumers.

change in demand (D)

Shift of the entire

demand curve

VS change in the quantity demanded (QD )

movements along the
same demand curve.

Practice Questions

1. What factors are held constant along a demand curve?

2. Consider the market for Canadian beef. What will be the impact on D
and QD?
a) The price of chicken decreases.
b) Household income increases.
c) Price of Canadian beef decreases.
d) A Canadian cow is found to have mad cow disease.
e) The Canadian government raises the price of Canadian beef.

Practice
A highly successful advertising campaign of New Balance
makes more and more people want to buy its athletic shoes,
as a result:
a. The demand of New Balance athletic shoes increases;
b. The quantity demanded of New Balance athletic shoes
increases;
c. The price of New Balance athletic shoes decrease to
encourage people to buy more;
d. The demand of New Balance athletic shoes is not
affected;
e. None of above.

2.2

THE MARKET MECHANISM

The 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.

Equilibrium
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.

surplus

Situation in which the QS > QD

shortage

Situation in which the QD > QS

2.3

CHANGES IN MARKET EQUILIBRIUM

Shocks:
A new tech is developed
which lowers the production
cost.
S shifts to S
The new equilibrium is E.

CHANGES IN MARKET EQUILIBRIUM

Shocks:
The impact of oil spill in
Mexico gulf on the
demand of Nova Scotia
oyster.
D shifts to D
The new equilibrium is
E.

CHANGES IN MARKET EQUILIBRIUM

Shift in both S and D.

QD increases.

Change in P
depends on the
amount by which
each curve shifts
and the shape of
each curve.

Change in P is
uncertain.

Question 2:
For each of the following scenarios, illustrate
graphically
how the exogenous event change the price of corn in
the U.S. market.
a.

The U.S. Department of Agriculture announces

that exports of corn to Taiwan and Japan were
surprisingly bullish, around 30% higher than
had been expected.

b.

The size of the U.S. corn crop hits a six-year low

because of dry weather.
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c.

The strengthening of El Nino, the meteorological

trend that brings warmer weather to the
western coast of South America, reduces corn
production outside the United States, thereby
increasing foreign countries dependence on the
U.S. corn crop. (Assume that the U.S. doesnt
import corn).

15

Question 3:
In each case below, identify the effect on the
market for coal and illustrate it with a graph.
a) A new government regulation requiring air
purifiers in all work areas.
b) A widespread news report that demand for coal
will be much lower next year.
c)

The development of a new, lower cost mining

technique.

d) A decrease in the population.

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Question 4:
Which of the following would cause an
unambiguous increase in the equilibrium price in a
market?
a) An increase in supply and an increase in demand.
b) An increase in supply and a decrease in demand
c)

A decrease in supply and an increase in demand

d) A decrease in supply and a decrease in demand.

17

Question 5:
Assume that steak and potatoes are complements.
When the price of steak goes up, the demand
curve for potatoes:
A) shifts to the left.
B) shifts to the right.
C) remains constant.
D) shifts to the right initially and then returns to its
original position.
18

Question 6:
The price of good A goes up. As a result, the demand
for good B shifts to the left. From this we can infer
that:
A) good A is used to produce good B.
B) good B is used to produce good A.
C) goods A and B are substitutes.
D) goods A and B are complements.
E) none of the above
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2.4 ELASTICITIES OF SUPPLY AND DEMAND

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.

D
D
D

D
D

(2.1)

 linear demand curve

The price elasticity of

demand depends on the
slope of the demand curve,
the price and quantity.
The elasticity varies along
the curve as price and
quantity change. Slope is
constant for this linear
demand curve.
The elasticity becomes
smaller as we move down
the curve.

Demand curve that is a straight line.

 Example
Price of oil increases 10%
Quantity demanded decreases 1%

-1%
Ep
.1
10%
D

D
P

E =-0.1 means:
1 percent increase in the price would lead
to a 0.1 percent decrease in the quantity
demanded (QD).
22

Points To
1. Please note that Ep is always negative
Emphasize
D

Reason: The law of demand

Exception: a luxury (expensive French
wine, celebrity-endorced perfume etc.)

2. Relative quantities only. The percentage

change will be independent of the units
chosen.
3. The greater the absolute price elasticity
of demand, the greater is the demand
responsiveness to relative price
changes.
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4.Elasticity and slope are not the same thing.

Elasticity of demand is:
D
(1) E
p = ( QD/QD) / ( P/P)
which can be rewritten as:
D
(2)
E

p = ( QD/QD) x (P/ P) = ( QD/ P) x

(P/QD)

Now ( QD)/( P) is the inverse of the

slope, assuming price is on the vertical axis and
quantity on the horizontal axis.
Rewriting D(2) gives:
(3) Ep = (1/slope) x (P/QD )
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 Elastic Demand: EP >1

D

Unit Elastic: EP =1
D

Inelastic Demand: EP <1

25

 infinitely elastic demand

(horizontal)
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.

EP =-

 completely inelastic demand

Principle that consumers

will buy a fixed quantity of
a good regardless of its
price.

EP =0

ELASTICITIES OF SUPPLY AND DEMAND

Other Demand Elasticities
income elasticity of demand Percentage change in the quantity
demanded resulting from a 1-percent increase in income.
(2.2)
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.
(2.3)

Elasticities of Supply
price elasticity of supply Percentage change in quantity supplied
resulting from a 1-percent increase in price.

ELASTICITIES OF SUPPLY AND DEMAND

Point versus Arc
Elasticities
point elasticity of demand
point on the demand curve.

Price elasticity at a particular

Arc Elasticity of
Demand
arc elasticity of demand
range of prices.

Price elasticity calculated over a

D
D

(2.4)

Lets examine the supply and demand in the

wheat market beginning in 1981.

# 1. What is the market-clearing price of wheat for 1981?

Substituting into the supply curve equation:

#2. Find the price elasticity of demand at equilibrium:

Thus demand is inelastic.

#3. We can likewise calculate the price elasticity of
supply:
P QS 3.46
EPS

(240) 0.32
Q P 2630

Question:
The demand for books is: Qd = 120 - P
The supply of books is: Qs = 5P
a) Find equilibrium price and quantity.
b) If P = $15, which of the following is true?
A) There is a surplus equal to 30.
B) There is a shortage equal to 30.
C) There is a surplus, but it is impossible to
determine how large.
D) There is a shortage, but it is impossible to
determine how large.
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At point A, demand is:

A) completely inelastic.
B) inelastic, but not
completely inelastic.
C) unit elastic.
D) elastic, but not infinitely
elastic.
E) infinitely elastic.
33

Question:
The demand for packs of Pokemon cards is
given by the equation QD = 500,000 45,000P.
A) At a price of $2.50 per pack, what is the
quantity demanded?
B) At $5.00 per pack, what is the price
elasticity of demand?
C) Is the demand elastic, inelastic, or unit
elastic, when P=$5?
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Determinants of the
Price Elasticity of Demand
1. The existence, number, and quality of
Substitutes
2. Share of Budget
3. The Length of Time Allowed for
Adjustment

(Exception: Durable goods)

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2.5

SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
(a) Gasoline: Short-Run and
Long-Run Demand Curves

Demand of gasoline is less elastic

in the short run than in the long
run.
Why?

(b) Automobiles: Short-Run

and Long-Run Demand
Curves

Demand of automobiles is
less elastic in the long run
than in the short run.
Why?

Demand
and
Durabili
ty

Income
Elasticities
Income 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.

 cyclical industries Industries in which sales tend to magnify

cyclical changes in gross domestic product and national income.
Consumption of Durables versus Nondurables

Industries that produce consumer durables are

cyclical (i.e., changes in GDP are magnified).
This is not true for producers of nondurables.

EXAMPLE 2.6

THE DEMAND FOR GASOLINE AND

AUTOMOBILES

TABLE 2.1

DEMAND FOR GASOLINE

NUMBER OF YEARS ALLOWED TO PASS
FOLLOWING A PRICE OR INCOME
CHANGE

ELASTICIT
Y

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
FOLLOWING A PRICE OR INCOME
CHANGE

ELASTICIT
Y
Price
Income

10

1.2

0.9

0.8

0.6

0.4

3.0

2.3

1.9

1.4

1.0

Supply and Durability

Primary Copper (production
from the mining and smelting
of ore.

Like that of most goods, the

supply of primary copper,
shown in part (a), is more
elastic in the long run.
Why?

Secondary Copper: melted

own and refabricated.

If the price increases, there is

a greater incentive to convert
scrap copper into new supply.
Initially, therefore, secondary
supply (i.e., supply from scrap)
increases sharply.
But later, as the stock of scrap
falls, secondary supply
contracts.
Secondary supply is therefore
less elastic in the long run than
in the short run.

Table 2.3

Supply of Copper

Price Elasticity of:

Primary supply
Secondary supply
Total supply

Short-Run
0.20
0.43
0.25

Long-Run
1.60
0.31
1.50

EXAMPLE 2.7

THE WEATHER IN BRAZIL AND THE PRICE OF

COFFEE IN NEW YORK

FIGURE 2.17
PRICE OF BRAZILIAN
COFFEE
When droughts or freezes
damage Brazils coffee
trees, the price of coffee
can soar.
The price usually falls
again after a few years, as
demand and supply adjust.

EXAMPLE 2.7

THE WEATHER IN BRAZIL AND THE PRICE OF

COFFEE IN NEW YORK

SUPPLY AND DEMAND FOR

COFFEE
(a) A freeze or drought in Brazil
causes the supply curve to shift to
the left.
In the short run, supply is
completely inelastic; only a fixed
number of coffee beans can be
harvested.
Demand is also relatively inelastic;
consumers change their habits
only slowly.
As a result, the initial effect of the
freeze is a sharp increase in price,
from P0 to P1.

EXAMPLE 2.7

THE WEATHER IN BRAZIL AND THE PRICE OF

COFFEE IN NEW YORK

SUPPLY AND DEMAND FOR

COFFEE
(b) In the intermediate run,
supply and demand are both
more elastic; thus price falls
part of the way back, to P2.

EXAMPLE 2.7

THE WEATHER IN BRAZIL AND THE PRICE OF

COFFEE IN NEW YORK

SUPPLY AND DEMAND FOR

COFFEE
(c) In the long run, supply is

extremely elastic; because new

coffee trees will have had time to
mature, the effect of the freeze will
have disappeared. Price returns to
P0.

2.7

EFFECTS OF GOVERNMENT
INTERVENTION
PRICE CONTROLS

Effects of Price
Controls
Without price controls, the
market clears at the
equilibrium price and quantity
P0 and Q0.
If price is regulated to be no
higher than Pmax, the quantity
supplied falls to Q1, the
quantity demanded increases
to Q2, and a shortage
develops.

Question:
Ice cream can be frozen. In the short run the
magnitude of the own price elasticity of
demand for ice cream:
A) is higher than in the long run.
B) is lower than in the short run.
C) is the same as in the long run.
D) does not depend on the fact that ice cream
can be frozen.

48

Question:
For computers and other business equipment,
small changes in business earnings tend to
generate relatively large short-run changes
in the demand for this equipment. In the
long run, the responsiveness of demand for
business equipment with respect to income
changes tends to be:
A) even more responsive.
B) less responsive.
C) equally responsive.
D) none of the above
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Practice Question

The following two equations are the supply and demand functions

of natural gas. The average price of crude oil PO (which affects

the supply and demand for natural gas) was about $50 per barrel.
Supply:

Q = 15.90 + 0.72PG + 0.05PO

Demand:

Q = 0.02 1.8PG + 0.69PO

Find the cross price elasticity of demand for natural gas and oil at
the point where the market of natural gas clears out.
Are natural gas and oil complements or substitutes?

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