CHAPTER 2

Provide definition, meaning and example with all. Diagram where needed
must draw.

1. Suppose that unusually hot weather causes the demand curve for
ice cream to shift to the right. Why will the price of ice cream rise to
a new market clearing level?
Definition & Meaning:
 Demand Curve: A graph showing the relationship between the
price of a good and the quantity demanded by consumers.
 Market-Clearing Price (Equilibrium Price): The price at which
the quantity of a good demanded by consumers equals the quantity
supplied by producers.
 Shift in Demand Curve: When a non-price factor (like weather)
changes, it shifts the entire demand curve, either to the right
(increase in demand) or to the left (decrease in demand).

Explanation:
Hot weather increases the desire for ice cream, which causes the
demand curve to shift to the right. This means that at every
price level, people are willing to buy more ice cream.
When demand increases and supply remains the same:
 There is a shortage at the original price.
 To eliminate the shortage, the price rises.
 The market reaches a new equilibrium where the new demand
curve intersects the supply curve at a higher price and quantity.

Example:
 Original demand: At $3, people buy 5 units.
 After hot weather: At $3, people now want 7 units.
 Supply at $3 remains 5 units → shortage → price increases to
balance.

Diagram Interpretation:
In the diagram above:
 The dashed line shows the original demand.
 The solid line is the new demand after hot weather.
 The dot-dashed line is the supply.
 The intersection of the new demand and supply is the new higher
price and higher quantity of ice cream sold.
2. Use supply and demand curves to illustrate how each of the
following events would affect the price of butter and the quantity of
butter bought and sold: (a) an increase in the price of margarine; (b)
an increase in the price of milk; (c) a decrease in average income
levels.
Impact on Butter Market (with Diagram above)
 (a) Price of Margarine ↑: Margarine is a substitute for butter.
When its price rises, more people buy butter → demand for butter
increases (rightward shift).
 (b) Price of Milk ↑: Milk is an input for butter. Higher milk prices
increase production costs → supply of butter decreases (leftward
shift).
 (c) Income ↓: If butter is a normal good, lower income means less
buying power → demand decreases (leftward shift).

3. If a 3-percent increase in the price of corn flakes causes a 6-percent

decline in the quantity demanded, what is the elasticity of demand?
Elasticity of Demand
 Given: Price ↑ 3%, Quantity Demanded ↓ 6%
 Elasticity Formula:
Ed=−6%3%=−2E_d = \frac{-6\%}{3\%} = -2Ed=3%−6%=−2
 Meaning: Elastic demand. Consumers are very responsive to price
changes.

4. Explain the difference between a shift in the supply curve and a

movement along the supply curve.
Shift vs. Movement in Supply Curve
 Movement Along: Caused by a change in the good’s own price.
 Shift of Curve: Caused by changes in non-price factors like input
cost, technology, etc.
 Example:
o Movement: Price ↑ → Quantity Supplied ↑
o Shift: New machinery reduces cost → more supply at same
price.

5. Explain why for many goods, the long-run price elasticity of supply
is larger than the short-run elasticity
Long-Run Supply Elasticity > Short-Run
 Definition: Elasticity measures responsiveness to price changes.
 In Short Run: Firms can't easily expand production (e.g., need time
to build factories).
 In Long Run: Firms can fully adjust → greater responsiveness.
6. Why do long-run elasticities of demand differ from short-run
elasticities? Consider two goods: paper towels and televisions.
Which is a durable good? Would you expect the price elasticity of
demand for paper towels to be larger in the short run or in the long
run? Why? What about the price elasticity of demand for televisions?
Long-Run vs. Short-Run Demand Elasticities
 Durable Good: Television (lasts years)
 Non-Durable Good: Paper towels
 Short-Run: Less elastic for both (habits, contracts)
 Long-Run:
o Paper Towels → More elastic (people switch brands or reduce
use)
o Televisions → More elastic (buyers can delay or cancel
purchase)

7. Are the following statements true or false? Explain your answers. a.

The elasticity of demand is the same as the slope of the demand
curve. b. The cross-price elasticity will always be positive. c. The
supply of apartments is more inelastic in the short run than the long
run.
True or False
 a. False – Elasticity ≠ slope. Elasticity measures percentage
changes; slope is absolute.
 b. False – Cross-price elasticity is positive for substitutes, negative
for complements.
 c. True – In the short run, apartments are fixed; long run allows
construction → more elastic.

8. Suppose the government regulates the prices of beef and chicken

and sets them below their market-clearing levels. Explain why
shortages of these goods will develop and what factors will
determine the sizes of the shortages. What will happen to the price
of pork? Explain briefly.
Price Regulation of Beef and Chicken
 Prices below equilibrium → Quantity demanded > Quantity
supplied → Shortages
 Size of Shortage depends on:
o Elasticity of demand and supply
o How far price is below market level
 Price of Pork ↑ (substitute good)

9. The city council of a small college town decides to regulate rents in

order to reduce student living expenses. Suppose the average
 annual market-clearing rent for a two-bedroom apartment had been
$700 per month and that rents were expected to increase to $900
within a year. The city council limits rents to their current $700-per-
month level. a. Draw a supply and demand graph to illustrate what
will happen to the rental price of an apartment after the imposition
of rent controls. b. Do you think this policy will benefit all students?
Why or why not?
Rent Control at $700 (vs $900)
 Diagram: Rent is kept artificially low → excess demand → shortage
of apartments
 Who Benefits?
o Students who get apartments at $700
 Who Loses?
o New students or those unable to find apartments
o Landlords may stop maintaining or building housing

10. In a discussion of tuition rates, a university official argues that

the demand for admission is completely price inelastic. As evidence,
she notes that while the university has doubled its tuition (in real
terms) over the past 15 years, neither the number nor quality of
students applying has decreased. Would you accept this argument?
Explain briefly. (Hint: The official makes an assertion about the
demand for admission, but does she actually observe a demand
curve? What else could be going on?)
Is Admission Demand Perfectly Inelastic?
 Claim: Tuition doubled, but applicants unchanged → demand is
inelastic
 BUT:
o Other factors could be at play: better reputation, more
scholarships
o Cannot see full demand curve, only observed point

11. Suppose the demand curve for a product is given by Q = 10 -

2P + PS where P is the price of the product and PS is the price of a
substitute good. The price of the substitute good is $2.00. a.
Suppose P = $1.00. What is the price elasticity of demand? What is
the cross-price elasticity of demand? b. Suppose the price of the
good, P, goes to $2.00. Now what is the price elasticity of demand?
What is the cross-price elasticity of demand?
Demand Equation: Q = 10 - 2P + PS; PS = 2
 a. P = 1
o Q = 10 - 2(1) + 2 = 10
 o Elasticity = Ed=dQdP⋅PQ=−2⋅110=−0.2E_d = \frac{dQ}{dP} \
cdot \frac{P}{Q} = -2 \cdot \frac{1}{10} = -0.2Ed=dPdQ⋅QP
=−2⋅101=−0.2
o Cross-price elasticity = ∂Q∂PS⋅PSQ=1⋅210=0.2\frac{\partial Q}
{\partial PS} \cdot \frac{PS}{Q} = 1 \cdot \frac{2}{10} =
0.2∂PS∂Q⋅QPS=1⋅102=0.2
 b. P =2
o Q = 10 - 4 + 2 = 8
o Elasticity = -2 × (2/8) = -0.5
o Cross-price elasticity = 1 × (2/8) = 0.25

12. Suppose that rather than the declining demand assumed in

Example 2.8, a decrease in the cost of copper production causes the
supply curve to shift to the right by 40 percent. How will the price of
copper change?
Cost of Copper Production ↓ → Supply ↑
 Supply Curve Shifts Right by 40%
 Result: Price of copper falls, quantity increases
 Producers can sell more at lower prices

13. Suppose the demand for natural gas is perfectly inelastic.

What would be the effect, if any, of natural gas price controls?
Natural Gas Demand is Perfectly Inelastic
 Perfectly Inelastic = Quantity demanded does not change with
price
 Price Controls:
o Lower price → still same demand, but shortage arises
o Suppliers won’t supply enough at low prices

EXCERCISE

1. Suppose the demand curve for a product is given by Q = 300 - 2P +

4I, where I is average income measured in thousands of dollars. The
supply curve is Q = 3P - 50. a. If I = 25, find the market-clearing
price and quantity for the product. b. If I = 50, find the market-
clearing price and quantity for the product. c. Draw a graph to
illustrate your answers.
2. Consider a competitive market for which the quantities demanded
and supplied (per year) at various prices are given as follows: PRICE
(DOLLARS) DEMAND (MILLIONS) SUPPLY (MILLIONS) 60 22 14 80 20
16 100 18 18 120 16 20 a. Calculate the price elasticity of demand
 when the price is $80 and when the price is $100. b. Calculate the
price elasticity of supply when the price is $80 and when the price is
$100. c. What are the equilibrium price and quantity? d. Suppose
the government sets a price ceiling of $80. Will there be a shortage,
and if so, how large will it be?
3. Refer to Example 2.5 (page 37) on the market for wheat. In 1998,
the total demand for U.S. wheat was Q = 3244 - 283P and the
domestic supply was QS = 1944 + 207P. At the end of 1998, both
Brazil and Indonesia opened their wheat markets to U.S. farmers.
Suppose that these new markets add 200 million bushels to U.S.
wheat demand. What will be the free-market price of wheat and
what quantity will be produced and sold by U.S. farmers?
4. A vegetable fiber is traded in a competitive world market, and the
world price is $9 per pound. Unlimited quantities are available for
import into the United States at this price. The U.S. domestic supply
and demand for various price levels are shown as follows: PRICE
U.S. SUPPLY (MILLION LBS) U.S. DEMAND (MILLION LBS) 3 2 34 6 4
28 9 6 22 12 8 16 15 10 10 18 12 4hat is the equation for demand?
What is the equation for supply? b. At a price of $9, what is the price
elasticity of demand? What is it at a price of $12? c. What is the
price elasticity of supply at $9? At $12? d. In a free market, what will
be the U.S. price and level of fiber imports?
5. Much of the demand for U.S. agricultural output has come from
other countries. In 1998, the total demand for wheat was Q = 3244 -
283P. Of this, total domestic demand was QD = 1700 - 107P, and
domestic supply was QS = 1944 + 207P. Suppose the export
demand for wheat falls by 40 percent.
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 reason to worry? b. Now suppose
the U.S. government wants to buy enough wheat to raise the
price to $3.50 per bushel. With the drop in export demand, how
much wheat would the government have to buy? How much
would this cost the government?
6. The rent control agency of New York City has found that aggregate
demand is QD = 160 - 8P. Quantity is measured in tens of thousands
of apartments. Price, the average monthly rental rate, is measured
in hundreds of dollars. The agency also noted that the increase in Q
at lower P results from more three-person families coming into the
city from Long Island and demanding apartments. The city’s board
of realtors acknowledges that this is a good demand estimate and
has shown that supply is QS = 70 + 7P. a. If both the agency and
the board are right about demand and supply, what is the free-
 market price? What is the change in city population if the agency
sets a maximum average monthly rent of $300 and all those who
cannot find an apartment leave the city? b. Suppose the agency
bows to the wishes of the board and sets a rental of $900 per month
on all apartments to allow landlords a “fair” rate of return. If 50
percent of any long-run increases in apartment offerings comes
from new construction, how many apartments are constructed?
7. In 2010, Americans smoked 315 billion cigarettes, or 15.75 billion
packs of cigarettes. The average retail price (including taxes) was
about $5.00 per pack. Statistical studies have shown that the price
elasticity of demand is −0.4, and the price elasticity of supply is 0.5.
a. Using this information, derive linear demand and supply curves
for the cigarette market. b. In 1998, Americans smoked 23.5 billion
packs of cigarettes, and the retail price was about $2.00 per pack.
The decline in cigarette consumption from 1998 to 2010 was due in
part to greater public awareness of the health hazards from
smoking, but was also due in part to the increase in price. Suppose
that the entire decline was due to the increase in price. What could
you deduce from that about the price elasticity of demand?
8. In Example 2.8 we examined the effect of a 20-percent decline in
copper demand on the price of copper, using the linear supply and
demand curves developed in Section 2.6. Suppose the long-run
price elasticity of copper demand were −0.75 instead of −0.5. a.
Assuming, as before, that the equilibrium price and quantity are P*
= $3 per pound and Q* = 18 million metric tons per year, derive the
linear demand curve consistent with the smaller elasticity. b. Using
this demand curve, recalculate the effect of a 20-percent decline in
copper demand on the price of copper.
9. In Example 2.8 (page 52), we discussed the recent increase in world
demand for copper, due in part to China’s rising consumption. a.
Using the original elasticities of demand and supply (i.e., ES = 1.5
and ED = -0.5), calculate the effect of a 20-percent increase in
copper demand on the price of copper. b. Now calculate the effect of
this increase in demand on the equilibrium quantity, Q*. c. As we
discussed in Example 2.8, the U.S. production of copper declined
between 2000 and 2003. Calculate the effect on the equilibrium
price and quantity of both a 20-percent increase in copper demand
(as you just did in part a) and of a 20-percent decline in copper
supply.
10. Example 2.9 (page 54) analyzes the world oil market. Using
the data given in that example: a. Show that the short-run demand
and competitive supply curves are indeed given by D = 33.6 - .020P
SC = 18.05 + 0.012P b. Show that the long-run demand and
 competitive supply curves are indeed given by D = 41.6 - 0.120P SC
= 13.3 + 0.071P c. In Example 2.9 we examined the impact on price
of a disruption of oil from Saudi Arabia. Suppose hat instead of a
decline in supply, OPEC production increases by 2 billion barrels per
year (bb/yr) because the Saudis open large new oil fields. Calculate
the effect of this increase in production on the price of oil in both the
short run and the long run.
11. Refer to Example 2.10 (page 59), which analyzes the effects of
price controls on natural gas. a. Using the data in the example, show
that the following supply and demand curves describe the market
for natural gas in 2005–2007: Supply: Q = 15.90 + 0.72PG + 0.05PO
Demand: Q = 0.02 - 1.8PG + 0.69PO Also, verify that if the price of
oil is $50, these curves imply a free-market price of $6.40 for
natural gas. b. Suppose the regulated price of gas were $4.50 per
thousand cubic feet instead of $3.00. How much excess demand
would there have been? c. Suppose that the market for natural gas
remained unregulated. If the price of oil had increased from $50 to
$100, what would have happened to the freemarket price of natural
gas?
12. The table below shows the retail price and sales for instant
coffee and roasted coffee for two years. a. Using these data alone,
estimate the short-run price elasticity of demand for roasted coffee.
Derive a linear demand curve for roasted coffee. b. Now estimate
the short-run price elasticity of demand for instant coffee. Derive a
linear demand curve for instant coffee. c. Which coffee has the
higher short-run price elasticity of demand? Why do you think this is
the case? YEAR RETAIL PRICE OF INSTANT COFFEE ($/LB) SALES OF
INSTANT COFFEE (MILLION LBS) RETAIL PRICE OF ROASTED COFFEE
($/LB) SALES OF ROASTED COFFEE (MILLION LBS) Year 1 10.35 75
4.11 820 Year 2 10.48 70 3.76 850