CHAPTER

2
The Basics of
Supply and
Demand

Prepared by:
Fernando & Yvonn Quijano

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e.

 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

Chapter 2 Supply and Demand

2.5 Short-Run versus Long-Run Elasticities

2.6 Understanding and Predicting the Effects of Changi

ng Market Conditions

2.7 Effects of Government Intervention—Price Controls

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 2 of 53

 The Basics of Supply and Demand

Supply-demand analysis is a fundamental and powerful tool th

at can be applied to a wide variety of interesting and important
problems. To name a few:
• Understanding and predicting how changing world economic condition
s affect market price and production
• Evaluating the impact of government price controls, minimum wages,
price supports, and production incentives
• Determining how taxes, subsidies, tariffs, and import quotas affect con
sumers and producers
Chapter 2 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 3 of 53

 2.1 SUPPLY AND DEMAND
q2 p1, bagi produsen h
The Supply Curve
arga produksi turun
● supply curve Relationship between the quantity of a good that produc
ers are willing to sell and the price of the good.

Figure 2.1

The Supply Curve

The supply curve, labeled S in t

he figure, shows how the quanti
ty of a good offered for sale cha
nges as the price of the good c
Chapter 2 Supply and Demand

hanges. The supply curve is up

ward sloping: The higher the pri
ce, the more firms are able and
willing to produce and sell.

If production costs fall, firms ca

n produce the same quantity at
a lower price or a larger quantit
y at the same price. The supply
curve then shifts to the right (fro
m S to S’).

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 4 of 53

 2.1 SUPPLY AND DEMAND

The Supply Curve

The supply curve is thus a relationship between the quantity
supplied and the price. We can write this relationship as an equation:

QS = QS(P)

Other Variables That Affect Supply

The quantity that producers are willing to sell depends not only on the price th
ey receive but also on their production costs, including wages, interest charg
Chapter 2 Supply and Demand

es, and the costs of raw materials.

When production costs decrease, output increases no matter what the marke
t 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 sup
ply curve, while reserving the phrase change in the quantity supplied to apply
to movements along the supply curve.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 5 of 53

 2.1 SUPPLY AND DEMAND

The Demand Curve

● demand curve Relationship betwee

n the quantity of a good that consum
ers are willing to buy and the price of
the good.

We can write this relationship between quantity dem

Chapter 2 Supply and Demand

anded and price as an equation:

QD = QD(P)

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 6 of 53

 2.1 SUPPLY AND DEMAND

The Demand Curve

Figure 2.2

The Demand Curve

The demand curve, labeled D, sh

ows how the quantity of a good d
emanded by consumers depends
on its price. The demand curve is
downward sloping; holding other t
hings equal, consumers will want
to purchase more of a good as its
Chapter 2 Supply and Demand

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 p
roducts, the quantity demanded i
ncreases when income rises.
A higher income level shifts the d
emand curve to the right (from D t
o D’).

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 7 of 53

 2.1 SUPPLY AND DEMAND

The Demand Curve

Shifting the Demand Curve

If 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 th
is increase would occur no matter what the market price, the result would be
a shift to the right of the entire demand curve.
Chapter 2 Supply and Demand

Shifting the Demand Curve

● substitutes Two goods for which an increase in the
price of one leads to an increase in the quantity dema
nded of the other.

● complements Two goods for which an increase in

the price of one leads to a decrease in the quantity de
manded of the other.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 8 of 53

 2.2 THE MARKET MECHANISM

Figure 2.3

Supply and Demand

The market clears at price P0 a

nd quantity Q0.

At the higher price P1, a surplus

develops, so price falls.
Chapter 2 Supply and Demand

At the lower price P2, there is a

shortage, so price is bid up.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 9 of 53

 2.2 THE MARKET MECHANISM

Equilibrium

● equilibrium (or market clearing) price

Price that equates the quantity supplied t
o the quantity demanded.

● market mechanism Tendency in a free mark

et for price to change until the market clears.
Chapter 2 Supply and Demand

● surplus Situation in which the quantity suppli

ed exceeds the quantity demanded.

● shortage Situation in which the quantity dem

anded exceeds the quantity supplied.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 10 of 53

 2.2 THE MARKET MECHANISM

When Can We Use the Supply-Demand Model?

We are assuming that at any given price, a given quantity will be produced an
d 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 powe
r—i.e., little ability individually to affect the market price.
Suppose that supply were controlled by a single producer.
Chapter 2 Supply and Demand

If the demand curve shifts in a particular way, it may be in the monopolist’s int
erest to keep the quantity fixed but change the price, or to keep the price fixed
and change the quantity.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 11 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.4
New Equilibrium Following
Shift in Supply

When the supply curve s

hifts to the right, the mar
ket clears at a lower pric
e P3 and a larger quantit
y Q3.
Chapter 2 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 12 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.5
New Equilibrium Following
Shift in Demand

When the demand curve

shifts to the right,
the market clears at a hi
gher price P3 and a large
r quantity Q3.
Chapter 2 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 13 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.6
New Equilibrium Following Sh
ifts in Supply and Demand
Supply and demand curves
shift over time as market co
nditions change.
In this example, rightward s
hifts of the supply and dem
and curves lead to a slightly
higher price and a much lar
Chapter 2 Supply and Demand

ger quantity.
In general, changes in price
and quantity depend on the
amount by which each curv
e shifts and the shape of ea
ch curve.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 14 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

From 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 perc
ent.
The mechanization of poultry farms sharply reduced the cost of prod
ucing eggs, shifting the supply curve downward. The demand curve
for eggs shifted to the left as a more health-conscious population te
nded to avoid eggs.
Chapter 2 Supply and Demand

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 s
hifted to the right as a larger percentage of a growing number of hig
h school graduates decided that a college education was essential.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 15 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.6

Market for Eggs

(a) The supply curve for eg

gs shifted downward as
production costs fell;
the demand curve shift
ed to the left as consu
mer preferences chang
ed.
Chapter 2 Supply and Demand

As a result, the real pri

ce of eggs fell sharply
and egg consumption r
ose.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 16 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.7

Market for College Educatio

n

(b) The supply curve for a

college education shifted u
p as the costs of equipmen
t, maintenance, and staffin
g rose.
The demand curve shifted
Chapter 2 Supply and Demand

to the right as a growing n

umber of high school grad
uates desired a college ed
ucation.
As a result, both price and
enrollments rose sharply.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 17 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Over the past two decades, the wages of skilled high-income workers
have grown substantially, while the wages of unskilled low-income wor
kers have fallen slightly.
From 1978 to 2005, people in the top 20 percent of the income distribu
tion experienced an increase in their average real pretax household in
come of 50 percent, while those in the bottom 20 percent saw their av
erage real pretax income increase by only 6 percent.
Chapter 2 Supply and Demand

While the supply of unskilled workers—people with limited educations

—has grown substantially, the demand for them has risen only slightly.

On the other hand, while the supply of skilled workers has grown slowl
y, the demand has risen dramatically, pushing wages up.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 18 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.8
Consumption and the Price
of Copper
Although annual consum
ption of copper has incre
ased about a hundredfol
d,
the real (inflation-adjuste
Chapter 2 Supply and Demand

d) price has not changed

much.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 19 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.9

Long-Run Movements of Su
pply and Demand for Miner
al Resources

Although demand for mo

st resources has increas
ed dramatically over the
past century, prices hav
Chapter 2 Supply and Demand

e fallen or risen only slig

htly in real (inflation-adju
sted) terms because cos
t reductions have shifted
the supply curve to the ri
ght just as dramatically.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 20 of 53

 2.3 CHANGES IN MARKET EQUILIBRIUM

Figure 2.10

Supply and Demand for Ne

w York City Office Space

Following 9/11 the suppl

y curve shifted to the left
, but the demand curve a
lso shifted to the left, so t
hat the average rental pri
Chapter 2 Supply and Demand

ce fell.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 21 of 53

 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

● price elasticity of demand Percentage change in quantity dem

anded of a good resulting from a 1-percent increase in its price.
Chapter 2 Supply and Demand

(2.1)

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 22 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

● linear demand curve Demand curve that is a straight line.

Inelastis: sembako
Figure 2.11

Linear Demand Curve

The price elasticity of demand

depends not only on the slope
of the demand curve but also
on the price and quantity.
Chapter 2 Supply and Demand

The elasticity, therefore, varies

along the curve as price and q
uantity change. Slope is const
ant for this linear demand curv
e.
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.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 23 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

Figure 2.12

(a) Infinitely Elastic Demand

For a horizontal demand curve

, ΔQ/ΔP is infinite. Because a t
iny change in price leads to an
enormous change in demand,
the elasticity of demand is infin
ite.
Chapter 2 Supply and Demand

● 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 quantit
y demanded increases without limit.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 24 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

Figure 2.12

(b) Completely Inelastic Demand

For a vertical demand curve, ΔQ

/ΔP is zero. Because the quantit
y demanded is the same no matt
er what the price, the elasticity o
f demand is zero.
Chapter 2 Supply and Demand

● completely inelastic demand Principle that consumers will buy a fi

xed quantity of a good regardless of its price.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 25 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Other Demand Elasticities

● income elasticity of demand Percentage change in the quantity de
manded resulting from a 1-percent increase in income.

(2.2)

● cross-price elasticity of demand Percentage change in the quantit

y demanded of one good resulting from a 1-percent increase in the pri
ce of another.
Chapter 2 Supply and Demand

(2.3)

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

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 26 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Point versus Arc Elasticities

● point elasticity of demand Price elasticity at a particular point on th

e demand curve.

Arc Elasticity of Demand

● arc elasticity of demand Price elasticity calculated over a range of

prices.
Chapter 2 Supply and Demand

(2.4)

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 27 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

For a few decades, changes in the wheat market had ma

jor implications for both American farmers and U.S. agric
ultural policy.

To understand what happened, let’s examine the behavior of supply a

nd demand beginning in 1981.
Chapter 2 Supply and Demand

By setting the quantity supplied equal to the quantity demanded, we ca

n determine the market-clearing price of wheat for 1981:

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 28 of 53

 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

Chapter 2 Supply and Demand

We can likewise calculate the price elasticity of supply:

Because these supply and demand curves are linear, the price elasti
cities will vary as we move along the curves.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 29 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

Figure 2.13
(a) Gasoline: Short-Run and Long-Run De
mand Curves

In the short run, an increase in price h

as only a small effect on the quantity o
f gasoline demanded. Motorists may d
rive less, but they will not change the k
inds of cars they are driving overnight.
Chapter 2 Supply and Demand

In the longer run, however, because th

ey will shift to smaller and more fuel-ef
ficient cars, the effect of the price incre
ase will be larger. Demand, therefore,
is more elastic in the long run than in t
he short run.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 30 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Demand and Durability

Figure 2.13
(b) Automobiles: Short-Run and Long-Run
Demand Curves

The opposite is true for automobile de

mand. If price increases, consumers in
itially defer buying new cars; thus ann
ual quantity demanded falls sharply.
Chapter 2 Supply and Demand

In the longer run, however, old cars w

ear out and must be replaced; thus an
nual quantity demanded picks up. De
mand, therefore, is less elastic in the l
ong run than in the short run.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 31 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Income Elasticities

Income elasticities also differ from the short run to the long run.
For most goods and services—foods, beverages, fuel, entertainment, et
c.— 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 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 32 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Cyclical Industries

● cyclical industries Industries in which sales tend to magnify cyclical

changes in gross domestic product and national income.

Figure 2.14
GDP and Investment in Durable
Equipment

Annual growth rates are comp

ared for GDP and investment i
Chapter 2 Supply and Demand

n durable equipment.
Because the short-run GDP el
asticity of demand is larger tha
n the long-run elasticity for lon
g-lived capital equipment, cha
nges in investment in equipme
nt magnify changes in GDP. T
hus capital goods industries ar
e considered “cyclical.”

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 33 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Cyclical Industries
Figure 2.15
Consumption of Durables versus No
ndurables
Annual growth rates are compared
for GDP, consumer expenditures o
n durable goods (automobiles, app
liances, furniture, etc.), and consu
mer expenditures on nondurable g
oods (food, clothing, services, etc.
Chapter 2 Supply and Demand

).
Because the stock of durables is l
arge compared with annual deman
d, short-run demand elasticities ar
e larger than long-run elasticities.
Like capital equipment, industries t
hat produce consumer durables ar
e “cyclical” (i.e., changes in GDP a
re magnified). This is not true for p
roducers of nondurables.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 34 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

TABLE 2.1 Demand for Gasoline

Number of Years Allowed to Pass Following
a 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
Chapter 2 Supply and Demand

TABLE 2.2 Demand for Automobiles

Number of Years Allowed to Pass Following
a 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 1.0

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 35 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Supply
Supply and Durability
Figure 2.16
Copper: Short-Run and Long-Run
Supply Curves

Like that of most goods, the su

pply of primary copper, shown i
n part (a), is more elastic in the
long run.
If price increases, firms would li
Chapter 2 Supply and Demand

ke to produce more but are limi

ted by capacity constraints in th
e short run.
In the longer run, they can add
to capacity and produce more.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 36 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Supply
Supply and Durability
Figure 2.16
Copper: Short-Run and Long-Run
Supply Curves

Part (b) shows supply curves fo

r secondary copper.
If the price increases, there is a
greater incentive to convert scr
ap copper into new supply. Initi
Chapter 2 Supply and Demand

ally, therefore, secondary suppl

y (i.e., supply from scrap) incre
ases sharply.
But later, as the stock of scrap f
alls, secondary supply contract
s.
Table 2.3 Supply of Copper
Secondary supply is therefore l
ess elastic in the long run than i Price Elasticity of: Short-Run Long-Run
n the short run. Primary supply 0.20 1.60
Secondary supply 0.43 0.31
Total supply 0.25 1.50

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 37 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.17

Price of Brazilian Coffee

When droughts or fre

ezes damage Brazil’s
coffee trees, the price
Chapter 2 Supply and Demand

of coffee can soar.

The price usually falls
again after a few year
s, as demand and su
pply adjust.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 38 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18
Supply and Demand for Coffee

(a) A freeze or drought in

Brazil causes the supply cu
rve to shift to the left.

In the short run, supply is c

ompletely inelastic; only a fi
Chapter 2 Supply and Demand

xed number of coffee bean

s can be harvested.

Demand is also relatively in

elastic; consumers change
their habits only slowly.
As a result, the initial effect
of the freeze is a sharp incr
ease in price, from P0 to P1.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 39 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18
Supply and Demand for Coffee

(b) In the intermediate run,

supply and demand are bot
h more elastic; thus price fa
lls part of the way back, to
P2.
Chapter 2 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 40 of 53

 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18
Supply and Demand for Coffee

(c) In the long run, supply i

s extremely elastic; becaus
e new coffee trees will have
had time to mature, the effe
ct of the freeze will have dis
appeared. Price returns to
Chapter 2 Supply and Demand

P0.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 41 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Figure 2.19
Fitting Linear Supply and Demand
Curves to Data
Linear supply and demand cur
ves provide a convenient tool f
or analysis.
Given data for the equilibrium p
rice and quantity P* and Q*, as
well as estimates of the elastici
Chapter 2 Supply and Demand

ties of demand and supply ED a

nd ES, we can calculate the par
ameters c and d for the supply
curve and a and b for the dema
nd curve. (In the case drawn he
re, c < 0.) The curves can then
be used to analyze the behavio
r of the market quantitatively.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 42 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Demand: Q = a − bP (2.5a)

Supply: Q = c + dP (2.5b)

Step 1:
E = (P/Q)(ΔQ/ΔP)

Demand: ED = −b(P*/Q*) (2.6a)

Chapter 2 Supply and Demand

Supply: ES = d(P*/Q*) (2.6b)

Step 2:

a = Q* + bP*

Q = a − bP + fI (2.7)

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 43 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

After reaching a level of about $1.00 per pound in 1980, the price
of copper fell sharply to about 60 cents per pound in 1986.
Worldwide recessions in 1980 and 1982 contributed to the decline
of copper prices.
Why did the price increase sharply in 2005–2007? First, the dema
nd for copper from China and other Asian countries began increasi
ng dramatically. Second, because prices had dropped so much fro
Chapter 2 Supply and Demand

m 1996 through 2003, producers closed unprofitable mines and cu

t production.
What would a decline in demand do to the price of copper? To find
out, we can use linear supply and demand curves.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 44 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Figure 2.20

Copper Prices, 1965–2007

Chapter 2 Supply and Demand

Copper prices are shown in both nominal (no adjustment for inflation) and real (infl
ation-adjusted) terms. In real terms, copper prices declined steeply from the early
1970s through the mid-1980s as demand fell. In 1988–1990, copper prices rose in
response to supply disruptions caused by strikes in Peru and Canada but later fell
after the strikes ended. Prices declined during the 1996–2002 period but then incr
eased sharply during 2005–2007.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 45 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Figure 2.21

Copper Supply and Demand

The shift in the demand c

urve corresponding to a 2
0-percent decline in dema
nd leads to a 10.5-percen
t decline in price.
Chapter 2 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 46 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Since the early 1970s, the world oil market

has been buffeted by the OPEC cartel and
by political turmoil in the Persian Gulf.

Figure 2.22

Price of Crude Oil

Chapter 2 Supply and Demand

The OPEC cartel and poli

tical events caused the pr
ice of oil to rise sharply at
times. It later fell as suppl
y and demand adjusted.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 47 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Because this example is set in 2005–2007, all prices are measured in 200
5 dollars. Here are some rough figures:
•2005–7 world price = $50 per barrel
•World demand and total supply = 34 billion barrels per year (bb/yr)
•OPEC supply = 14 bb/yr
•Competitive (non-OPEC) supply = 20 bb/yr
The following table gives price elasticity estimates for oil supply and dema
Chapter 2 Supply and Demand

nd:

Short-Run Long-Run
World Demand: -0.05 -0.40

Competitive Supply: 0.10 0.40

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 48 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Figure 2.23

Impact of Saudi Production Cut

The total supply is the sum of

competitive (non-OPEC) suppl
y and the 14 bb/yr of OPEC su
pply.
Part (a) shows the short-run s
upply and demand curves.
Chapter 2 Supply and Demand

If Saudi Arabia stops producin

g, the supply curve will shift to
the left by 3 bb/yr.
In the short-run, price will incre
ase sharply.
(a)

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 49 of 53

 2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Figure 2.23

Impact of Saudi Production Cut

The total supply is the sum of

competitive (non-OPEC) sup
ply and the 14 bb/yr of OPEC
supply.
Part (b) shows long-run curve
s.
Chapter 2 Supply and Demand

In the long run, because dem

and and competitive supply a
re much more elastic, the imp
act on price will be much sma
ller.

(b)

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 50 of 53

 2.7 EFFECTS OF GOVERNMENT INTERVENTION—
PRICE CONTROLS

Figure 2.24

Effects of Price Controls

Without price controls, the mar

ket clears at the equilibrium pri
ce and quantity P0 and Q0.
If price is regulated to be no hig
her than Pmax, the quantity sup
Chapter 2 Supply and Demand

plied falls to Q1, the quantity de

manded increases to Q2, and a
shortage develops.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 51 of 53

 2.7 EFFECTS OF GOVERNMENT INTERVENTION—
PRICE CONTROLS

Figure 2.25

Price of Natural Gas

Chapter 2 Supply and Demand

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 52 of 53

 2.7 EFFECTS OF GOVERNMENT INTERVENTION—
PRICE CONTROLS

The (free-market) wholesale price of natural gas was $6.40 per mcf (tho
usand cubic feet);
Production and consumption of gas were 23 Tcf (trillion cubic feet);
The average price of crude oil (which affects the supply and demand for
natural gas) was about $50 per barrel.
Supply: Q = 15.90 + 0.72PG + 0.05PO
Chapter 2 Supply and Demand

Demand: Q = -10.35 - 0.18PG + 0.69PO

Substitute $3.00 for PG in both the supply and demand equations (keepi
ng the price of oil, PO, fixed at $50).
You should find that the supply equation gives a quantity supplied of 20.
6 Tcf and the demand equation a quantity demanded of 23.6 Tcf.
Therefore, these price controls would create an excess demand of
23.6 − 20.6 = 3.0 Tcf.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 53 of 53