CHAPTER 2 • The Basics of Supply and Demand 61

the percentage change in the quantity demanded can calculate how the market-clearing price and quan-
resulting from a 1-percent increase in price. tity will change as these other variables change. This is a
4. Elasticities pertain to a time frame, and for most goods means of explaining or predicting market behavior.
it is important to distinguish between short-run and 7. Simple numerical analyses can often be done by fit-
long-run elasticities. ting linear supply and demand curves to data on price
5. We can use supply-demand diagrams to see how shifts and quantity and to estimates of elasticities. For many
in the supply curve and/or demand curve can explain markets, such data and estimates are available, and
changes in the market price and quantity. simple “back of the envelope” calculations can help
6. If we can estimate, at least roughly, the supply and us understand the characteristics and behavior of the
demand curves for a particular market, we can calcu- market.
late the market-clearing price by equating the quantity 8. When a government imposes price controls, it keeps
supplied with the quantity demanded. Also, if we know the price below the level that equates supply and
how supply and demand depend on other economic demand. A shortage develops; the quantity demanded
variables, such as income or the prices of other goods, we exceeds the quantity supplied.

QUESTIONS FOR REVIEW

1. Suppose that unusually hot weather causes the and that rents were expected to increase to $900 within
demand curve for ice cream to shift to the right. a year. The city council limits rents to their current
Why will the price of ice cream rise to a new market- $700-per-month level.
clearing level? a. Draw a supply and demand graph to illustrate
2. Use supply and demand curves to illustrate how each what will happen to the rental price of an apart-
of the following events would affect the price of but- ment after the imposition of rent controls.
ter and the quantity of butter bought and sold: (a) an b. Do you think this policy will benefit all students?
increase in the price of margarine; (b) an increase in the Why or why not?
price of milk; (c) a decrease in average income levels. 10. In a discussion of tuition rates, a university official
3. If a 3-percent increase in the price of corn flakes causes argues that the demand for admission is completely
a 6-percent decline in the quantity demanded, what is price inelastic. As evidence, she notes that while the
the elasticity of demand? university has doubled its tuition (in real terms) over
4. Explain the difference between a shift in the supply the past 15 years, neither the number nor quality of
curve and a movement along the supply curve. students applying has decreased. Would you accept
5. Explain why for many goods, the long-run price elas- this argument? Explain briefly. (Hint: The official
ticity of supply is larger than the short-run elasticity. makes an assertion about the demand for admission,
6. Why do long-run elasticities of demand differ from but does she actually observe a demand curve? What
short-run elasticities? Consider two goods: paper towels else could be going on?)
and televisions. Which is a durable good? Would you 11. Suppose the demand curve for a product is given by
expect the price elasticity of demand for paper towels to
be larger in the short run or in the long run? Why? What Q = 10 - 2P + PS
about the price elasticity of demand for televisions?
7. Are the following statements true or false? Explain where P is the price of the product and PS is the price
your answers. of a substitute good. The price of the substitute good
a. The elasticity of demand is the same as the slope of is $2.00.
the demand curve. a. Suppose P = $1.00. What is the price elasticity
b. The cross-price elasticity will always be positive. of demand? What is the cross-price elasticity of
c. The supply of apartments is more inelastic in the demand?
short run than the long run. b. Suppose the price of the good, P, goes to $2.00.
8. Suppose the government regulates the prices of beef and Now what is the price elasticity of demand? What
chicken and sets them below their market-clearing levels. is the cross-price elasticity of demand?
Explain why shortages of these goods will develop and 12. Suppose that rather than the declining demand
what factors will determine the sizes of the shortages. assumed in Example 2.8, a decrease in the cost of copper
What will happen to the price of pork? Explain briefly. production causes the supply curve to shift to the right
9. The city council of a small college town decides to reg- by 40 percent. How will the price of copper change?
ulate rents in order to reduce student living expenses. 13. Suppose the demand for natural gas is perfectly
Suppose the average annual market-clearing rent for inelastic. What would be the effect, if any, of natural
a two-bedroom apartment had been $700 per month gas price controls?
 62 PART 1 • Introduction: Markets and Prices

EXERCISES a. What is the equation for demand? What is the equa-

tion for supply?
1. Suppose the demand curve for a product is given by b. At a price of $9, what is the price elasticity of
Q = 300 - 2P + 4I, where I is average income meas- demand? What is it at a price of $12?
ured in thousands of dollars. The supply curve is c. What is the price elasticity of supply at $9? At $12?
Q = 3P - 50. d. In a free market, what will be the U.S. price and
a. If I = 25, find the market-clearing price and quantity level of fiber imports?
for the product. *5. Much of the demand for U.S. agricultural output has
b. If I = 50, find the market-clearing price and quantity come from other countries. In 1998, the total demand
for the product. for wheat was Q = 3244 - 283P. Of this, total domes-
c. Draw a graph to illustrate your answers. tic demand was QD = 1700 - 107P, and domestic
2. Consider a competitive market for which the quan- supply was QS = 1944 + 207P. Suppose the export
tities demanded and supplied (per year) at various demand for wheat falls by 40 percent.
prices are given as follows: a. U.S. farmers are concerned about this drop in export
demand. What happens to the free-market price of
wheat in the United States? Do farmers have much
PRICE DEMAND SUPPLY
(DOLLARS) (MILLIONS) (MILLIONS) reason to worry?
b. Now suppose the U.S. government wants to buy
60 22 14 enough wheat to raise the price to $3.50 per bushel.
With the drop in export demand, how much wheat
80 20 16 would the government have to buy? How much
100 18 18 would this cost the government?
6. The rent control agency of New York City has found
120 16 20 that aggregate demand is QD = 160 - 8P. Quantity is
a. Calculate the price elasticity of demand when the measured in tens of thousands of apartments. Price, the
price is $80 and when the price is $100. average monthly rental rate, is measured in hundreds
b. Calculate the price elasticity of supply when the of dollars. The agency also noted that the increase in
price is $80 and when the price is $100. Q at lower P results from more three-person families
c. What are the equilibrium price and quantity? coming into the city from Long Island and demanding
d. Suppose the government sets a price ceiling of $80. Will apartments. The city’s board of realtors acknowledges
there be a shortage, and if so, how large will it be? that this is a good demand estimate and has shown
3. Refer to Example 2.5 (page 37) on the market for that supply is QS = 70 + 7P.
wheat. In 1998, the total demand for U.S. wheat was a. If both the agency and the board are right about
Q = 3244 - 283P and the domestic supply was demand and supply, what is the free-market price?
QS = 1944 + 207P. At the end of 1998, both Brazil What is the change in city population if the agency
and Indonesia opened their wheat markets to U.S. sets a maximum average monthly rent of $300 and all
farmers. Suppose that these new markets add 200 mil- those who cannot find an apartment leave the city?
lion bushels to U.S. wheat demand. What will be the b. Suppose the agency bows to the wishes of the board
free-market price of wheat and what quantity will be and sets a rental of $900 per month on all apart-
produced and sold by U.S. farmers? ments to allow landlords a “fair” rate of return. If
4. A vegetable fiber is traded in a competitive world mar- 50 percent of any long-run increases in apartment
ket, and the world price is $9 per pound. Unlimited offerings comes from new construction, how many
quantities are available for import into the United apartments are constructed?
States at this price. The U.S. domestic supply and 7. In 2010, Americans smoked 315 billion cigarettes, or
demand for various price levels are shown as follows: 15.75 billion packs of cigarettes. The average retail price
(including taxes) was about $5.00 per pack. Statistical
U.S. SUPPLY U.S. DEMAND studies have shown that the price elasticity of demand
PRICE (MILLION LBS) (MILLION LBS) is −0.4, and the price elasticity of supply is 0.5.
a. Using this information, derive linear demand and
3 2 34 supply curves for the cigarette market.
6 4 28 b. In 1998, Americans smoked 23.5 billion packs of
cigarettes, and the retail price was about $2.00
9 6 22 per pack. The decline in cigarette consumption
12 8 16 from 1998 to 2010 was due in part to greater pub-
lic awareness of the health hazards from smok-
15 10 10
ing, but was also due in part to the increase in
18 12 4 price. Suppose that the entire decline was due to the
 CHAPTER 2 • The Basics of Supply and Demand 63

increase in price. What could you deduce from that that instead of a decline in supply, OPEC produc-
about the price elasticity of demand? tion increases by 2 billion barrels per year (bb/yr)
8. In Example 2.8 we examined the effect of a 20-percent because the Saudis open large new oil fields.
decline in copper demand on the price of copper, using Calculate the effect of this increase in production
the linear supply and demand curves developed in on the price of oil in both the short run and the
Section 2.6. Suppose the long-run price elasticity of long run.
copper demand were −0.75 instead of −0.5. 11. Refer to Example 2.10 (page 59), which analyzes the
a. Assuming, as before, that the equilibrium price and effects of price controls on natural gas.
quantity are P* = $3 per pound and Q* = 18 mil- a. Using the data in the example, show that the fol-
lion metric tons per year, derive the linear demand lowing supply and demand curves describe the
curve consistent with the smaller elasticity. market for natural gas in 2005–2007:
b. Using this demand curve, recalculate the effect of a
20-percent decline in copper demand on the price Supply: Q = 15.90 + 0.72PG + 0.05PO
of copper.
9. In Example 2.8 (page 52), we discussed the recent Demand: Q = 0.02 - 1.8PG + 0.69PO
increase in world demand for copper, due in part to
China’s rising consumption. Also, verify that if the price of oil is $50, these curves
a. Using the original elasticities of demand and sup- imply a free-market price of $6.40 for natural gas.
ply (i.e., ES = 1.5 and ED = - 0.5), calculate the b. Suppose the regulated price of gas were $4.50 per
effect of a 20-percent increase in copper demand on thousand cubic feet instead of $3.00. How much
the price of copper. excess demand would there have been?
b. Now calculate the effect of this increase in demand c. Suppose that the market for natural gas remained
on the equilibrium quantity, Q*. unregulated. If the price of oil had increased from
c. As we discussed in Example 2.8, the U.S. produc- $50 to $100, what would have happened to the free-
tion of copper declined between 2000 and 2003. market price of natural gas?
Calculate the effect on the equilibrium price and *12. The table below shows the retail price and sales for
quantity of both a 20-percent increase in copper instant coffee and roasted coffee for two years.
demand (as you just did in part a) and of a 20-per- a. Using these data alone, estimate the short-run price
cent decline in copper supply. elasticity of demand for roasted coffee. Derive a lin-
10. Example 2.9 (page 54) analyzes the world oil market. ear demand curve for roasted coffee.
Using the data given in that example: b. Now estimate the short-run price elasticity of
a. Show that the short-run demand and competitive demand for instant coffee. Derive a linear demand
supply curves are indeed given by curve for instant coffee.
c. Which coffee has the higher short-run price elas-
D = 33.6 - .020P ticity of demand? Why do you think this is the
case?
SC = 18.05 + 0.012P

b. Show that the long-run demand and competitive

supply curves are indeed given by YEAR RETAIL PRICE SALES OF RETAIL PRICE SALES OF
OF INSTANT INSTANT OF ROASTED ROASTED
COFFEE COFFEE COFFEE COFFEE
D = 41.6 - 0.120P ($/LB) (MILLION ($/LB) (MILLION
LBS) LBS)
SC = 13.3 + 0.071P
Year 1 10.35 75 4.11 820
c. In Example 2.9 we examined the impact on price
Year 2 10.48 70 3.76 850
of a disruption of oil from Saudi Arabia. Suppose
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Part Two
Producers, Consumers,
and Competitive Markets

Part 2 presents the theoretical core of microeconomics. CHAPTERS

Chapters 3 and 4 explain the principles underlying consumer
demand. We see how consumers make consumption decisions,
3
Consumer Behavior
how their preferences and budget constraints determine their 67
demands for various goods, and why different goods have different
demand characteristics. Chapter 5 contains more advanced mate- 4
rial that shows how to analyze consumer choice under uncertainty. Individual and
We explain why people usually dislike risky situations and show Market Demand
111
how they can reduce risk and choose among risky alternatives.
We also discuss aspects of consumer behavior that can only be 5
explained by delving into the psychological aspects of how people Uncertainty and
make decisions. Consumer Behavior
159
Chapters 6 and 7 develop the theory of the firm. We see how
firms combine inputs, such as capital, labor, and raw materials, to
6
produce goods and services in a way that minimizes the costs of Production
production. We also see how a firm’s costs depend on its rate of 201
production and production experience. Chapter 8 then shows how
firms choose profit-maximizing rates of production. We also see 7
The Cost of Production
how the production decisions of individual firms combine to deter- 229
mine the competitive market supply curve and its characteristics.
Chapter 9 applies supply and demand curves to the analysis of 8
competitive markets. We show how government policies, such as Profit Maximization and
price controls, quotas, taxes, and subsidies, can have wide-ranging Competitive Supply
279
effects on consumers and producers, and we explain how supply-
demand analysis can be used to evaluate these effects.
9
The Analysis of
Competitive Markets
317

65