demand and supply - ModPhD

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PART T W O HOW MARKETS WORK

3

DEMAND AND SUPPLY ◆

After studying this chapter, you will be able to: ◆ Describe a competitive market and think about a

price as an opportunity cost ◆ Explain the influences on demand ◆ Explain the influences on supply ◆ Explain how demand and supply determine prices

and quantities bought and sold ◆ Use the demand and supply model to make

predictions about changes in prices and quantities

In 2011, the price of peanut butter rose by 40 percent. Another price that just keeps rising is that of attending college—tuition. Why do some prices rise? And why do some prices fall, and some fluctuate? This chapter answers these questions. The demand and supply model that you’re about to study is the main tool of economics. It explains how prices are determined and how they guide the use of resources to influence What, How, and For Whom goods and services are produced. We’ll return to the rise in the price of peanut butter at the end of the chapter, in Reading Between the Lines. We’ll also apply the demand and supply model to the market for college and explain why tuition keeps rising.

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CHAPTER 3 Demand and Supply

◆ Markets and Prices When you need a new pair of running shoes, want a bagel and a latte, plan to upgrade your cell phone, or need to fly home for Thanksgiving, you must find a place where people sell those items or offer those services. The place in which you find them is a market. You learned in Chapter 2 (p. 44) that a market is any arrangement that enables buyers and sellers to get information and to do business with each other. A market has two sides: buyers and sellers. There are markets for goods such as apples and hiking boots, for services such as haircuts and tennis lessons, for factors of production such as computer programmers and earthmovers, and for other manufactured inputs such as memory chips and auto parts. There are also markets for money such as Japanese yen and for financial securities such as Yahoo! stock. Only our imagination limits what can be traded in markets. Some markets are physical places where buyers and sellers meet and where an auctioneer or a broker helps to determine the prices. Examples of this type of market are the New York Stock Exchange and the wholesale fish, meat, and produce markets. Some markets are groups of people spread around the world who never meet and know little about each other but are connected through the Internet or by telephone and fax. Examples are the e-commerce markets and the currency markets. But most markets are unorganized collections of buyers and sellers. You do most of your trading in this type of market. An example is the market for basketball shoes. The buyers in this $3 billion-a-year market are the 45 million Americans who play basketball (or who want to make a fashion statement). The sellers are the tens of thousands of retail sports equipment and footwear stores. Each buyer can visit several different stores, and each seller knows that the buyer has a choice of stores. Markets vary in the intensity of competition that buyers and sellers face. In this chapter, we’re going to study a competitive market—a market that has many buyers and many sellers, so no single buyer or seller can influence the price. Producers offer items for sale only if the price is high enough to cover their opportunity cost. And consumers respond to changing opportunity cost by seeking cheaper alternatives to expensive items. We are going to study how people respond to prices and the forces that determine prices. But to

pursue these tasks, we need to understand the relationship between a price and an opportunity cost. In everyday life, the price of an object is the number of dollars that must be given up in exchange for it. Economists refer to this price as the money price. The opportunity cost of an action is the highestvalued alternative forgone. If, when you buy a cup of coffee, the highest-valued thing you forgo is some gum, then the opportunity cost of the coffee is the quantity of gum forgone. We can calculate the quantity of gum forgone from the money prices of the coffee and the gum. If the money price of coffee is $1 a cup and the money price of gum is 50¢ a pack, then the opportunity cost of one cup of coffee is two packs of gum. To calculate this opportunity cost, we divide the price of a cup of coffee by the price of a pack of gum and find the ratio of one price to the other. The ratio of one price to another is called a relative price, and a relative price is an opportunity cost. We can express the relative price of coffee in terms of gum or any other good. The normal way of expressing a relative price is in terms of a “basket” of all goods and services. To calculate this relative price, we divide the money price of a good by the money price of a “basket” of all goods (called a price index). The resulting relative price tells us the opportunity cost of the good in terms of how much of the “basket” we must give up to buy it. The demand and supply model that we are about to study determines relative prices, and the word “price” means relative price. When we predict that a price will fall, we do not mean that its money price will fall—although it might. We mean that its relative price will fall. That is, its price will fall relative to the average price of other goods and services.

REVIEW QUIZ 1 2 3

What is the distinction between a money price and a relative price? Explain why a relative price is an opportunity cost. Think of examples of goods whose relative price has risen or fallen by a large amount.

You can work these questions in Study Plan 3.1 and get instant feedback.

MyEconLab

Let’s begin our study of demand and supply, starting with demand.

Demand

◆ Demand If you demand something, then you 1. Want it. 2. Can afford it. 3. Plan to buy it. Wants are the unlimited desires or wishes that people have for goods and services. How many times have you thought that you would like something “if only you could afford it” or “if it weren’t so expensive”? Scarcity guarantees that many—perhaps most—of our wants will never be satisfied. Demand reflects a decision about which wants to satisfy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price. The quantity demanded is not necessarily the same as the quantity actually bought. Sometimes the quantity demanded exceeds the amount of goods available, so the quantity bought is less than the quantity demanded. The quantity demanded is measured as an amount per unit of time. For example, suppose that you buy one cup of coffee a day. The quantity of coffee that you demand can be expressed as 1 cup per day, 7 cups per week, or 365 cups per year. Many factors influence buying plans, and one of them is the price. We look first at the relationship between the quantity demanded of a good and its price. To study this relationship, we keep all other influences on buying plans the same and we ask: How, other things remaining the same, does the quantity demanded of a good change as its price changes? The law of demand provides the answer.

The Law of Demand The law of demand states: Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.

Why does a higher price reduce the quantity demanded? For two reasons: ■ ■

Substitution effect Income effect

57

Substitution Effect When the price of a good rises,

other things remaining the same, its relative price— its opportunity cost—rises. Although each good is unique, it has substitutes—other goods that can be used in its place. As the opportunity cost of a good rises, the incentive to economize on its use and switch to a substitute becomes stronger. Income Effect When a price rises, other things

remaining the same, the price rises relative to income. Faced with a higher price and an unchanged income, people cannot afford to buy all the things they previously bought. They must decrease the quantities demanded of at least some goods and services. Normally, the good whose price has increased will be one of the goods that people buy less of. To see the substitution effect and the income effect at work, think about the effects of a change in the price of an energy bar. Several different goods are substitutes for an energy bar. For example, an energy drink could be consumed instead of an energy bar. Suppose that an energy bar initially sells for $3 and then its price falls to $1.50. People now substitute energy bars for energy drinks—the substitution effect. And with a budget that now has some slack from the lower price of an energy bar, people buy even more energy bars—the income effect. The quantity of energy bars demanded increases for these two reasons. Now suppose that an energy bar initially sells for $3 and then the price doubles to $6. People now buy fewer energy bars and more energy drinks—the substitution effect. And faced with a tighter budget, people buy even fewer energy bars—the income effect. The quantity of energy bars demanded decreases for these two reasons.

Demand Curve and Demand Schedule You are now about to study one of the two most used curves in economics: the demand curve. You are also going to encounter one of the most critical distinctions: the distinction between demand and quantity demanded. The term demand refers to the entire relationship between the price of a good and the quantity demanded of that good. Demand is illustrated by the demand curve and the demand schedule. The term quantity demanded refers to a point on a demand curve—the quantity demanded at a particular price.

CHAPTER 3 Demand and Supply

Figure 3.1 shows the demand curve for energy bars. A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. The table in Fig. 3.1 is the demand schedule for energy bars. A demand schedule lists the quantities demanded at each price when all the other influences on consumers’ planned purchases remain the same. For example, if the price of a bar is 50¢, the quantity demanded is 22 million a week. If the price is $2.50, the quantity demanded is 5 million a week. The other rows of the table show the quantities demanded at prices of $1.00, $1.50, and $2.00. We graph the demand schedule as a demand curve with the quantity demanded on the x-axis and the price on the y-axis. The points on the demand curve labeled A through E correspond to the rows of the demand schedule. For example, point A on the graph shows a quantity demanded of 22 million energy bars a week at a price of 50¢ a bar.

The Demand Curve

FIGURE 3.1 Price (dollars per bar)

58

3.00

E

2.50

D

2.00

C

1.50

B

1.00

A

0.50

5

0

10 25 15 20 Quantity demanded (millions of bars per week)

Willingness and Ability to Pay Another way of look-

ing at the demand curve is as a willingness-and-ability-to-pay curve. The willingness and ability to pay is a measure of marginal benefit. If a small quantity is available, the highest price that someone is willing and able to pay for one more unit is high. But as the quantity available increases, the marginal benefit of each additional unit falls and the highest price that someone is willing and able to pay also falls along the demand curve. In Fig. 3.1, if only 5 million energy bars are available each week, the highest price that someone is willing to pay for the 5 millionth bar is $2.50. But if 22 million energy bars are available each week, someone is willing to pay 50¢ for the last bar bought.

A Change in Demand When any factor that influences buying plans changes, other than the price of the good, there is a change in demand. Figure 3.2 illustrates an increase in demand. When demand increases, the demand curve shifts rightward and the quantity demanded at each price is greater. For example, at $2.50 a bar, the quantity demanded on the original (blue) demand curve is 5 million energy bars a week. On the new (red) demand curve, at $2.50 a bar, the quantity demanded is 15 million bars a week. Look closely at the numbers in the table and check that the quantity demanded at each price is greater.

Demand for energy bars

Quantity demanded Price (dollars per bar)

(millions of bars per week)

A

0.50

22

B

1.00

15

C

1.50

10

D

2.00

7

E

2.50

5

The table shows a demand schedule for energy bars. At a price of 50¢ a bar, 22 million bars a week are demanded; at a price of $1.50 a bar, 10 million bars a week are demanded. The demand curve shows the relationship between quantity demanded and price, other things remaining the same. The demand curve slopes downward: As the price falls, the quantity demanded increases. The demand curve can be read in two ways. For a given price, the demand curve tells us the quantity that people plan to buy. For example, at a price of $1.50 a bar, people plan to buy 10 million bars a week. For a given quantity, the demand curve tells us the maximum price that consumers are willing and able to pay for the last bar available. For example, the maximum price that consumers will pay for the 15 millionth bar is $1.00.

MyEconLab animation

Demand

Price (dollars per bar)

Six main factors bring changes in demand. They are changes in

An Increase in Demand

FIGURE 3.2



3.00

■ ■

E'

E

2.50

■ ■

D'

D

2.00



C'

C

1.50

B'

B

1.00

Demand for energy bars (original)

0.50

5

0

Demand for energy bars (new) A'

A

15 20 35 25 30 10 Quantity demanded (millions of bars per week)

Original demand schedule

New demand schedule

Original income

New higher income

Quantity demanded Price (dollars per bar)

(millions of bars per week)

A

0.50

22

B

1.00

C

Quantity demanded Price

59

The prices of related goods Expected future prices Income Expected future income and credit Population Preferences

Prices of Related Goods The quantity of energy bars that consumers plan to buy depends in part on the prices of substitutes for energy bars. A substitute is a good that can be used in place of another good. For example, a bus ride is a substitute for a train ride; a hamburger is a substitute for a hot dog; and an energy drink is a substitute for an energy bar. If the price of a substitute for an energy bar rises, people buy less of the substitute and more energy bars. For example, if the price of an energy drink rises, people buy fewer energy drinks and more energy bars. The demand for energy bars increases. The quantity of energy bars that people plan to buy also depends on the prices of complements with energy bars. A complement is a good that is used in conjunction with another good. Hamburgers and fries are complements, and so are energy bars and exercise. If the price of an hour at the gym falls, people buy more gym time and more energy bars.

(dollars per bar)

(millions of bars per week)

A'

0.50

32

Expected Future Prices If the expected future price of

15

B'

1.00

25

1.50

10

C'

1.50

20

D

2.00

7

D'

2.00

17

E

2.50

5

E'

2.50

15

a good rises and if the good can be stored, the opportunity cost of obtaining the good for future use is lower today than it will be in the future when people expect the price to be higher. So people retime their purchases—they substitute over time. They buy more of the good now before its price is expected to rise (and less afterward), so the demand for the good today increases. For example, suppose that a Florida frost damages the season’s orange crop. You expect the price of orange juice to rise, so you fill your freezer with enough frozen juice to get you through the next six months. Your current demand for frozen orange juice has increased, and your future demand has decreased. Similarly, if the expected future price of a good falls, the opportunity cost of buying the good today is high relative to what it is expected to be in the future. So again, people retime their purchases. They buy less of the good now before its price is expected

A change in any influence on buying plans other than the price of the good itself results in a new demand schedule and a shift of the demand curve. A change in income changes the demand for energy bars. At a price of $1.50 a bar, 10 million bars a week are demanded at the original income (row C of the table) and 20 million bars a week are demanded at the new higher income (row C'). A rise in income increases the demand for energy bars. The demand curve shifts rightward, as shown by the shift arrow and the resulting red curve.

MyEconLab animation

60

CHAPTER 3 Demand and Supply

to fall, so the demand for the good decreases today and increases in the future. Computer prices are constantly falling, and this fact poses a dilemma. Will you buy a new computer now, in time for the start of the school year, or will you wait until the price has fallen some more? Because people expect computer prices to keep falling, the current demand for computers is less (and the future demand is greater) than it otherwise would be. Income Consumers’ income influences demand. When income increases, consumers buy more of most goods; and when income decreases, consumers buy less of most goods. Although an increase in income leads to an increase in the demand for most goods, it does not lead to an increase in the demand for all goods. A normal good is one for which demand increases as income increases. An inferior good is one for which demand decreases as income increases. As incomes increase, the demand for air travel (a normal good) increases and the demand for long-distance bus trips (an inferior good) decreases. Expected Future Income and Credit When expected

future income increases or credit becomes easier to get, demand for a good might increase now. For example, a salesperson gets the news that she will receive a big bonus at the end of the year, so she goes into debt and buys a new car right now, rather than waiting until she receives the bonus.

TABLE 3.1

The Demand for Energy Bars

The Law of Demand The quantity of energy bars demanded Decreases if: ■

The price of an energy bar rises

Increases if: ■

The price of an energy bar falls

Changes in Demand The demand for energy bars Decreases if:

Increases if:



The price of a substitute falls



The price of a substitute rises



The price of a complement rises



The price of a complement falls



The expected future price of an energy bar falls



The expected future price of an energy bar rises



Income falls*



Income rises*



Expected future income falls or credit becomes harder to get*



Expected future income rises or credit becomes easier to get*



The population decreases



The population increases

*An energy bar is a normal good.

Population Demand also depends on the size and the

age structure of the population. The larger the population, the greater is the demand for all goods and services; the smaller the population, the smaller is the demand for all goods and services. For example, the demand for parking spaces or movies or just about anything that you can imagine is much greater in New York City (population 7.5 million) than it is in Boise, Idaho (population 150,000). Also, the larger the proportion of the population in a given age group, the greater is the demand for the goods and services used by that age group. For example, during the 1990s, a decrease in the college-age population decreased the demand for college places. During those same years, the number of Americans aged 85 years and over increased by more than 1 million. As a result, the demand for nursing home services increased.

Preferences Demand depends on preferences. Preferences determine the value that people place on each good and service. Preferences depend on such things as the weather, information, and fashion. For example, greater health and fitness awareness has shifted preferences in favor of energy bars, so the demand for energy bars has increased. Table 3.1 summarizes the influences on demand and the direction of those influences.

A Change in the Quantity Demanded Versus a Change in Demand Changes in the influences on buying plans bring either a change in the quantity demanded or a change in demand. Equivalently, they bring either a movement along the demand curve or a shift of the demand curve. The distinction between a change in

Demand

FIGURE 3.3

A Change in the Quantity Demanded Versus a Change in Demand

Price

the quantity demanded and a change in demand is the same as that between a movement along the demand curve and a shift of the demand curve. A point on the demand curve shows the quantity demanded at a given price, so a movement along the demand curve shows a change in the quantity demanded. The entire demand curve shows demand, so a shift of the demand curve shows a change in demand. Figure 3.3 illustrates these distinctions.

61

Decrease in quantity demanded

Movement Along the Demand Curve If the price of

the good changes but no other influence on buying plans changes, we illustrate the effect as a movement along the demand curve. A fall in the price of a good increases the quantity demanded of it. In Fig. 3.3, we illustrate the effect of a fall in price as a movement down along the demand curve D0. A rise in the price of a good decreases the quantity demanded of it. In Fig. 3.3, we illustrate the effect of a rise in price as a movement up along the demand curve D0. A Shift of the Demand Curve If the price of a good

remains constant but some other influence on buying plans changes, there is a change in demand for that good. We illustrate a change in demand as a shift of the demand curve. For example, if more people work out at the gym, consumers buy more energy bars regardless of the price of a bar. That is what a rightward shift of the demand curve shows—more energy bars are demanded at each price. In Fig. 3.3, there is a change in demand and the demand curve shifts when any influence on buying plans changes, other than the price of the good. Demand increases and the demand curve shifts rightward (to the red demand curve D1) if the price of a substitute rises, the price of a complement falls, the expected future price of the good rises, income increases (for a normal good), expected future income or credit increases, or the population increases. Demand decreases and the demand curve shifts leftward (to the red demand curve D2) if the price of a substitute falls, the price of a complement rises, the expected future price of the good falls, income decreases (for a normal good), expected future income or credit decreases, or the population decreases. (For an inferior good, the effects of changes in income are in the opposite direction to those described above.)

Decrease in

Increase in

demand

demand Increase in quantity demanded

D1

D0 D2

Quantity

0

When the price of the good changes, there is a movement along the demand curve and a change in the quantity demanded, shown by the blue arrows on demand curve D0. When any other influence on buying plans changes, there is a shift of the demand curve and a change in demand. An increase in demand shifts the demand curve rightward (from D0 to D1). A decrease in demand shifts the demand curve leftward (from D0 to D2).

MyEconLab animation

REVIEW QUIZ 1 2 3 4

5

Define the quantity demanded of a good or service. What is the law of demand and how do we illustrate it? What does the demand curve tell us about the price that consumers are willing to pay? List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand. Why does demand not change when the price of a good changes with no change in the other influences on buying plans?

You can work these questions in Study Plan 3.2 and get instant feedback.

MyEconLab

62

CHAPTER 3 Demand and Supply

◆ Supply If a firm supplies a good or service, the firm 1. Has the resources and technology to produce it. 2. Can profit from producing it. 3. Plans to produce it and sell it. A supply is more than just having the resources and the technology to produce something. Resources and technology are the constraints that limit what is possible. Many useful things can be produced, but they are not produced unless it is profitable to do so. Supply reflects a decision about which technologically feasible items to produce. The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price. The quantity supplied is not necessarily the same amount as the quantity actually sold. Sometimes the quantity supplied is greater than the quantity demanded, so the quantity sold is less than the quantity supplied. Like the quantity demanded, the quantity supplied is measured as an amount per unit of time. For example, suppose that GM produces 1,000 cars a day. The quantity of cars supplied by GM can be expressed as 1,000 a day, 7,000 a week, or 365,000 a year. Without the time dimension, we cannot tell whether a particular quantity is large or small. Many factors influence selling plans, and again one of them is the price of the good. We look first at the relationship between the quantity supplied of a good and its price. Just as we did when we studied demand, to isolate the relationship between the quantity supplied of a good and its price, we keep all other influences on selling plans the same and ask: How does the quantity supplied of a good change as its price changes when other things remain the same? The law of supply provides the answer.

The Law of Supply The law of supply states: Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.

Why does a higher price increase the quantity supplied? It is because marginal cost increases. As the quantity produced of any good increases, the marginal cost of producing the good increases. (See Chapter 2, p. 35 to review marginal cost.) It is never worth producing a good if the price received for the good does not at least cover the marginal cost of producing it. When the price of a good rises, other things remaining the same, producers are willing to incur a higher marginal cost, so they increase production. The higher price brings forth an increase in the quantity supplied. Let’s now illustrate the law of supply with a supply curve and a supply schedule.

Supply Curve and Supply Schedule You are now going to study the second of the two most used curves in economics: the supply curve. You’re also going to learn about the critical distinction between supply and quantity supplied. The term supply refers to the entire relationship between the price of a good and the quantity supplied of it. Supply is illustrated by the supply curve and the supply schedule. The term quantity supplied refers to a point on a supply curve—the quantity supplied at a particular price. Figure 3.4 shows the supply curve of energy bars. A supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. The supply curve is a graph of a supply schedule. The table in Fig. 3.4 sets out the supply schedule for energy bars. A supply schedule lists the quantities supplied at each price when all the other influences on producers’ planned sales remain the same. For example, if the price of an energy bar is 50¢, the quantity supplied is zero—in row A of the table. If the price of an energy bar is $1.00, the quantity supplied is 6 million energy bars a week—in row B. The other rows of the table show the quantities supplied at prices of $1.50, $2.00, and $2.50. To make a supply curve, we graph the quantity supplied on the x-axis and the price on the y-axis. The points on the supply curve labeled A through E correspond to the rows of the supply schedule. For example, point A on the graph shows a quantity supplied of zero at a price of 50¢ an energy bar. Point E shows a quantity supplied of 15 million bars at $2.50 an energy bar.

Supply

Price (dollars per bar)

FIGURE 3.4

Minimum Supply Price The supply curve can be

The Supply Curve

3.00 Supply of energy bars 2.50

E

2.00

D

1.50

C

1.00

63

B

interpreted as a minimum-supply-price curve—a curve that shows the lowest price at which someone is willing to sell. This lowest price is the marginal cost. If a small quantity is produced, the lowest price at which someone is willing to sell one more unit is low. But as the quantity produced increases, the marginal cost of each additional unit rises, so the lowest price at which someone is willing to sell an additional unit rises along the supply curve. In Fig. 3.4, if 15 million bars are produced each week, the lowest price at which someone is willing to sell the 15 millionth bar is $2.50. But if 10 million bars are produced each week, someone is willing to accept $1.50 for the last bar produced.

0.50 A

A Change in Supply 0

5

10 25 15 20 Quantity supplied (millions of bars per week)

Price

Quantity supplied

(dollars per bar)

(millions of bars per week)

When any factor that influences selling plans other than the price of the good changes, there is a change in supply. Six main factors bring changes in supply. They are changes in ■ ■

A

0.50

0

B

1.00

6

C

1.50

10

D

2.00

13

E

2.50

15

■ ■ ■ ■

The prices of factors of production The prices of related goods produced Expected future prices The number of suppliers Technology The state of nature

Prices of Factors of Production The prices of the facThe table shows the supply schedule of energy bars. For example, at a price of $1.00, 6 million bars a week are supplied; at a price of $2.50, 15 million bars a week are supplied. The supply curve shows the relationship between the quantity supplied and the price, other things remaining the same. The supply curve slopes upward: As the price of a good increases, the quantity supplied increases. A supply curve can be read in two ways. For a given price, the supply curve tells us the quantity that producers plan to sell at that price. For example, at a price of $1.50 a bar, producers are planning to sell 10 million bars a week. For a given quantity, the supply curve tells us the minimum price at which producers are willing to sell one more bar. For example, if 15 million bars are produced each week, the lowest price at which a producer is willing to sell the 15 millionth bar is $2.50.

MyEconLab animation

tors of production used to produce a good influence its supply. To see this influence, think about the supply curve as a minimum-supply-price curve. If the price of a factor of production rises, the lowest price that a producer is willing to accept for that good rises, so supply decreases. For example, during 2008, as the price of jet fuel increased, the supply of air travel decreased. Similarly, a rise in the minimum wage decreases the supply of hamburgers. Prices of Related Goods Produced The prices of

related goods that firms produce influence supply. For example, if the price of energy gel rises, firms switch production from bars to gel. The supply of energy bars decreases. Energy bars and energy gel are substitutes in production—goods that can be produced by using the same resources. If the price of beef rises, the supply of cowhide increases. Beef and cowhide are complements in production—goods that must be produced together.

64

CHAPTER 3 Demand and Supply

Expected Future Prices If the expected future price of

The Number of Suppliers The larger the number of

firms that produce a good, the greater is the supply of the good. As new firms enter an industry, the supply in that industry increases. As firms leave an industry, the supply in that industry decreases.

An Increase in Supply

FIGURE 3.5 Price (dollars per bar)

a good rises, the return from selling the good in the future increases and is higher than it is today. So supply decreases today and increases in the future.

3.00

2.50

to mean the way that factors of production are used to produce a good. A technology change occurs when a new method is discovered that lowers the cost of producing a good. For example, new methods used in the factories that produce computer chips have lowered the cost and increased the supply of chips.

2.00

Changes in the influences on selling plans bring either a change in the quantity supplied or a change in supply. Equivalently, they bring either a movement along the supply curve or a shift of the supply curve. A point on the supply curve shows the quantity supplied at a given price. A movement along the supply curve shows a change in the quantity supplied. The entire supply curve shows supply. A shift of the supply curve shows a change in supply.

B'

B

A'

A

0

A Change in the Quantity Supplied Versus a Change in Supply

C'

C

5

15 20 35 25 30 10 Quantity supplied (millions of bars per week)

The State of Nature The state of nature includes all

the natural forces that influence production. It includes the state of the weather and, more broadly, the natural environment. Good weather can increase the supply of many agricultural products and bad weather can decrease their supply. Extreme natural events such as earthquakes, tornadoes, and hurricanes can also influence supply. Figure 3.5 illustrates an increase in supply. When supply increases, the supply curve shifts rightward and the quantity supplied at each price is larger. For example, at $1.00 per bar, on the original (blue) supply curve, the quantity supplied is 6 million bars a week. On the new (red) supply curve, the quantity supplied is 15 million bars a week. Look closely at the numbers in the table in Fig. 3.5 and check that the quantity supplied is larger at each price. Table 3.2 summarizes the influences on supply and the directions of those influences.

D'

D

1.00

0.50

E'

E

1.50

Technology The term “technology” is used broadly

Supply of energy bars (new)

Supply of energy bars (original)

Original supply schedule

New supply schedule

Old technology

New technology

Quantity supplied Price (dollars per bar)

Quantity supplied Price

(millions of bars per week)

(dollars per bar)

(millions of bars per week)

A

0.50

0

A'

0.50

7

B

1.00

6

B'

1.00

15

C

1.50

10

C'

1.50

20

D

2.00

13

D'

2.00

25

E

2.50

15

E'

2.50

27

A change in any influence on selling plans other than the price of the good itself results in a new supply schedule and a shift of the supply curve. For example, a new, cost-saving technology for producing energy bars changes the supply of energy bars. At a price of $1.50 a bar, 10 million bars a week are supplied when producers use the old technology (row C of the table) and 20 million energy bars a week are supplied when producers use the new technology (row C'). An advance in technology increases the supply of energy bars. The supply curve shifts rightward, as shown by the shift arrow and the resulting red curve.

MyEconLab animation

Supply

TABLE 3.2

FIGURE 3.6

S1

Increase in quantity supplied

Decrease in

Increase in

supply

supply

The Supply of Energy Bars Decrease in quantity supplied

The quantity of energy bars supplied Decreases if: The price of an energy bar falls

Increases if: ■

The price of an energy bar rises

Changes in Supply The supply of energy bars Decreases if:

Increases if: The price of a factor of production used to produce energy bars falls

When the price of the good changes, there is a movement along the supply curve and a change in the quantity supplied, shown by the blue arrows on supply curve S0. When any other influence on selling plans changes, there is a shift of the supply curve and a change in supply. An increase in supply shifts the supply curve rightward (from S0 to S1), and a decrease in supply shifts the supply curve leftward (from S0 to S2).





The price of a substitute in production rises



The price of a substitute in production falls



The price of a complement in production falls



The price of a complement in production rises

1



The expected future price of an energy bar rises



The expected future price of an energy bar falls

3



The number of suppliers of bars decreases





A technology change decreases energy bar production



A technology change increases energy bar production



A natural event decreases energy bar production



A natural event increases energy bar production

The number of suppliers of bars increases

Quantity

0

The price of a factor of production used to produce energy bars rises



S0

S2

The Law of Supply



A Change in the Quantity Supplied Versus a Change in Supply

Price

Figure 3.6 illustrates and summarizes these distinctions. If the price of the good changes and other things remain the same, there is a change in the quantity supplied of that good. If the price of the good falls, the quantity supplied decreases and there is a movement down along the supply curve S0. If the price of the good rises, the quantity supplied increases and there is a movement up along the supply curve S0. When any other influence on selling plans changes, the supply curve shifts and there is a change in supply. If supply increases, the supply curve shifts rightward to S1. If supply decreases, the supply curve shifts leftward to S2.

65

MyEconLab animation

REVIEW QUIZ 2

4 5

Define the quantity supplied of a good or service. What is the law of supply and how do we illustrate it? What does the supply curve tell us about the producer’s minimum supply price? List all the influences on selling plans, and for each influence, say whether it changes supply. What happens to the quantity of cell phones supplied and the supply of cell phones if the price of a cell phone falls?

You can work these questions in Study Plan 3.3 and get instant feedback.

MyEconLab

Now we’re going to combine demand and supply and see how prices and quantities are determined.

CHAPTER 3 Demand and Supply

◆ Market Equilibrium We have seen that when the price of a good rises, the quantity demanded decreases and the quantity supplied increases. We are now going to see how the price adjusts to coordinate buying plans and selling plans and achieve an equilibrium in the market. An equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances buying plans and selling plans. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. A market moves toward its equilibrium because ■ ■

Price regulates buying and selling plans. Price adjusts when plans don’t match.

FIGURE 3.7 Price (dollars per bar)

66

3.00 Surplus of 6 million bars at $2.00 a bar

2.50

Supply of energy bars

2.00

Equilibrium

1.50

1.00

Demand for energy bars Shortage of 9 million bars at $1.00 a bar

0.50

0

Price as a Regulator The price of a good regulates the quantities demanded and supplied. If the price is too high, the quantity supplied exceeds the quantity demanded. If the price is too low, the quantity demanded exceeds the quantity supplied. There is one price at which the quantity demanded equals the quantity supplied. Let’s work out what that price is. Figure 3.7 shows the market for energy bars. The table shows the demand schedule (from Fig. 3.1) and the supply schedule (from Fig. 3.4). If the price is 50¢ a bar, the quantity demanded is 22 million bars a week but no bars are supplied. There is a shortage of 22 million bars a week. The final column of the table shows this shortage. At a price of $1.00 a bar, there is still a shortage but only of 9 million bars a week. If the price is $2.50 a bar, the quantity supplied is 15 million bars a week but the quantity demanded is only 5 million. There is a surplus of 10 million bars a week. The one price at which there is neither a shortage nor a surplus is $1.50 a bar. At that price, the quantity demanded equals the quantity supplied: 10 million bars a week. The equilibrium price is $1.50 a bar, and the equilibrium quantity is 10 million bars a week. Figure 3.7 shows that the demand curve and the supply curve intersect at the equilibrium price of $1.50 a bar. At each price above $1.50 a bar, there is a surplus of bars. For example, at $2.00 a bar, the surplus is 6

Equilibrium

Price (dollars per bar)

10

5

Quantity demanded

25 15 20 Quantity (millions of bars per week)

Quantity supplied

Shortage (–) or surplus (+)

(millions of bars per week)

0.50

22

0

–22

1.00

15

6

–9

1.50

10

10

0

2.00

7

13

+6

2.50

5

15

+10

The table lists the quantity demanded and the quantity supplied as well as the shortage or surplus of bars at each price. If the price is $1.00 a bar, 15 million bars a week are demanded and 6 million bars are supplied. There is a shortage of 9 million bars a week, and the price rises. If the price is $2.00 a bar, 7 million bars a week are demanded and 13 million bars are supplied. There is a surplus of 6 million bars a week, and the price falls. If the price is $1.50 a bar, 10 million bars a week are demanded and 10 million bars are supplied. There is neither a shortage nor a surplus, and the price does not change. The price at which the quantity demanded equals the quantity supplied is the equilibrium price, and 10 million bars a week is the equilibrium quantity.

MyEconLab animation

Market Equilibrium

million bars a week, as shown by the blue arrow. At each price below $1.50 a bar, there is a shortage of bars. For example, at $1.00 a bar, the shortage is 9 million bars a week, as shown by the red arrow.

Price Adjustments You’ve seen that if the price is below equilibrium, there is a shortage and that if the price is above equilibrium, there is a surplus. But can we count on the price to change and eliminate a shortage or a surplus? We can, because such price changes are beneficial to both buyers and sellers. Let’s see why the price changes when there is a shortage or a surplus. A Shortage Forces the Price Up Suppose the price of

an energy bar is $1. Consumers plan to buy 15 million bars a week, and producers plan to sell 6 million bars a week. Consumers can’t force producers to sell more than they plan, so the quantity that is actually offered for sale is 6 million bars a week. In this situation, powerful forces operate to increase the price and move it toward the equilibrium price. Some producers, noticing lines of unsatisfied consumers, raise the price. Some producers increase their output. As producers push the price up, the price rises toward its equilibrium. The rising price reduces the shortage because it decreases the quantity demanded and increases the quantity supplied. When the price has increased to the point at which there is no longer a shortage, the forces moving the price stop operating and the price comes to rest at its equilibrium.

The Best Deal Available for Buyers and Sellers

When the price is below equilibrium, it is forced upward. Why don’t buyers resist the increase and refuse to buy at the higher price? The answer is because they value the good more highly than its current price and they can’t satisfy their demand at the current price. In some markets—for example, the markets that operate on eBay—the buyers might even be the ones who force the price up by offering to pay a higher price. When the price is above equilibrium, it is bid downward. Why don’t sellers resist this decrease and refuse to sell at the lower price? The answer is because their minimum supply price is below the current price and they cannot sell all they would like to at the current price. Sellers willingly lower the price to gain market share. At the price at which the quantity demanded and the quantity supplied are equal, neither buyers nor sellers can do business at a better price. Buyers pay the highest price they are willing to pay for the last unit bought, and sellers receive the lowest price at which they are willing to supply the last unit sold. When people freely make offers to buy and sell and when demanders try to buy at the lowest possible price and suppliers try to sell at the highest possible price, the price at which trade takes place is the equilibrium price—the price at which the quantity demanded equals the quantity supplied. The price coordinates the plans of buyers and sellers, and no one has an incentive to change it.

REVIEW QUIZ

A Surplus Forces the Price Down Suppose the price

of a bar is $2. Producers plan to sell 13 million bars a week, and consumers plan to buy 7 million bars a week. Producers cannot force consumers to buy more than they plan, so the quantity that is actually bought is 7 million bars a week. In this situation, powerful forces operate to lower the price and move it toward the equilibrium price. Some producers, unable to sell the quantities of energy bars they planned to sell, cut their prices. In addition, some producers scale back production. As producers cut the price, the price falls toward its equilibrium. The falling price decreases the surplus because it increases the quantity demanded and decreases the quantity supplied. When the price has fallen to the point at which there is no longer a surplus, the forces moving the price stop operating and the price comes to rest at its equilibrium.

67

1 2

3

4

5

What is the equilibrium price of a good or service? Over what range of prices does a shortage arise? What happens to the price when there is a shortage? Over what range of prices does a surplus arise? What happens to the price when there is a surplus? Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price? Why is the equilibrium price the best deal available for both buyers and sellers?

You can work these questions in Study Plan 3.4 and get instant feedback.

MyEconLab

CHAPTER 3 Demand and Supply

◆ Predicting Changes in Price and Quantity

The demand and supply model that we have just studied provides us with a powerful way of analyzing influences on prices and the quantities bought and sold. According to the model, a change in price stems from a change in demand, a change in supply, or a change in both demand and supply. Let’s look first at the effects of a change in demand.

An Increase in Demand If more people join health clubs, the demand for energy bars increases. The table in Fig. 3.8 shows the original and new demand schedules for energy bars as well as the supply schedule of energy bars. The increase in demand creates a shortage at the original price and to eliminate the shortage, the price must rise. Figure 3.8 shows what happens. The figure shows the original demand for and supply of energy bars. The original equilibrium price is $1.50 an energy bar, and the equilibrium quantity is 10 million energy bars a week. When demand increases, the demand curve shifts rightward. The equilibrium price rises to $2.50 an energy bar, and the quantity supplied increases to 15 million energy bars a week, as highlighted in the figure. There is an increase in the quantity supplied but no change in supply—a movement along, but no shift of, the supply curve.

The Effects of a Change in Demand

FIGURE 3.8 Price (dollars per bar)

68

3.00

Supply of energy bars

2.50

2.00

1.50 Demand for energy bars (new)

1.00

0.50

0

Demand for energy bars (original) 10

5

15

20 35 25 30 Quantity (millions of bars per week)

Quantity demanded Price

(millions of bars per week)

Quantity supplied

(dollars per bar)

Original

New

(millions of bars per week)

0.50

22

32

0

1.00

15

25

6

1.50

10

20

10

2.00

7

17

13

2.50

5

15

15

A Decrease in Demand We can reverse this change in demand. Start at a price of $2.50 a bar with 15 million energy bars a week being bought and sold, and then work out what happens if demand decreases to its original level. Such a decrease in demand might arise if people switch to energy gel (a substitute for energy bars). The decrease in demand shifts the demand curve leftward. The equilibrium price falls to $1.50 a bar, the quantity supplied decreases, and the equilibrium quantity decreases to 10 million bars a week. We can now make our first two predictions: 1. When demand increases, the price rises and the quantity increases. 2. When demand decreases, the price falls and the quantity decreases.

Initially, the demand for energy bars is the blue demand curve. The equilibrium price is $1.50 a bar, and the equilibrium quantity is 10 million bars a week. When more healthconscious people do more exercise, the demand for energy bars increases and the demand curve shifts rightward to become the red curve. At $1.50 a bar, there is now a shortage of 10 million bars a week. The price of a bar rises to a new equilibrium of $2.50. As the price rises to $2.50, the quantity supplied increases—shown by the blue arrow on the supply curve—to the new equilibrium quantity of 15 million bars a week. Following an increase in demand, the quantity supplied increases but supply does not change—the supply curve does not shift.

MyEconLab animation

Predicting Changes in Price and Quantity

ECONOMICS IN THE NEWS The Market for College Education Obama Decries Rising Cost of College Education President Obama told colleges, “You can’t assume that you’ll just jack up tuition every single year. . . . In the coming decade, 60 percent of new jobs will require more than a high school diploma . . . Higher education is not a luxury. It’s an economic imperative that every family in America should be able to afford.” Source: The Associated Press, January 27, 2012 THE DATA

Tuition (thousands of 2010 dollars per year)

The scatter diagram provides data on college enrollments and tuition from 1981 through 2010.

In 2001, the demand for college education was D2001. The equilibrium tuition was $15,000 and 16 million students were enrolled in college. Between 2001 and 2010: 1) Income per person increased 2) Population increased, and 3) More new jobs required higher education. These (and possibly other) factors increased the demand for a college education. The demand curve shifted rightward to D2010. Equilibrium tuition increased to $21,000 and the quantity supplied increased to 21 million students.



25 10

20 15

01

05



91

10 81

5



0

5

10 15 20 25 Enrollment (millions)

■ ■

What does the scatter diagram tell us? Why has college tuition increased? Is it because demand increased or supply increased?

THE ANSWERS ■







■ ■

The scatter diagram tells us that both tuition and enrollments have increased every year. An increase in demand brings a rise in the price (tuition) and an increase in the quantity (enrollments). An increase in supply brings a fall in the price and an increase in the quantity. Because both the price (tuition) and quantity (enrollments) have increased, the demand for college education has increased. The figure shows the market for college education. The supply curve of college education, S, slopes upward because the principle of increasing opportunity cost applies to college education just as it does to other goods and services.

Tuition (thousands of 2010 dollars per year)

THE QUESTIONS

40

An increase in population, a rise in income, and changes in jobs increased the demand for college education ...

S 30

... and the quantity supplied increased

21 15 10

D2010

... tuition increased ...

D2001

0

10

16

21

The Market for College Education

30 40 Enrollment (millions)

69

CHAPTER 3 Demand and Supply

An Increase in Supply When Nestlé (the producer of PowerBar) and other energy bar producers switch to a new cost-saving technology, the supply of energy bars increases. Figure 3.9 shows the new supply schedule (the same one that was shown in Fig. 3.5). What are the new equilibrium price and quantity? The price falls to $1.00 a bar, and the quantity increases to 15 million bars a week. You can see why by looking at the quantities demanded and supplied at the old price of $1.50 a bar. The new quantity supplied at that price is 20 million bars a week, and there is a surplus. The price falls. Only when the price is $1.00 a bar does the quantity supplied equal the quantity demanded. Figure 3.9 illustrates the effect of an increase in supply. It shows the demand curve for energy bars and the original and new supply curves. The initial equilibrium price is $1.50 a bar, and the equilibrium quantity is 10 million bars a week. When supply increases, the supply curve shifts rightward. The equilibrium price falls to $1.00 a bar, and the quantity demanded increases to 15 million bars a week, highlighted in the figure. There is an increase in the quantity demanded but no change in demand—a movement along, but no shift of, the demand curve.

A Decrease in Supply Start out at a price of $1.00 a bar with 15 million bars a week being bought and sold. Then suppose that the cost of labor or raw materials rises and the supply of energy bars decreases. The decrease in supply shifts the supply curve leftward. The equilibrium price rises to $1.50 a bar, the quantity demanded decreases, and the equilibrium quantity decreases to 10 million bars a week. We can now make two more predictions: 1. When supply increases, the price falls and the quantity increases. 2. When supply decreases, the price rises and the quantity decreases. You’ve now seen what happens to the price and the quantity when either demand or supply changes while the other one remains unchanged. In real markets, both demand and supply can change together. When this happens, to predict the changes in price and quantity, we must combine the effects that you’ve just seen. That is your final task in this chapter.

FIGURE 3.9 Price (dollars per bar)

70

The Effects of a Change in Supply

3.00

Supply of energy bars (original)

Supply of energy bars (new)

2.50

2.00

1.50

1.00

Demand for energy bars

0.50

0

5

10

15

Quantity Price

demanded

(dollars per bar)

(millions of bars per week)

20 35 25 30 Quantity (millions of bars per week)

Quantity supplied (millions of bars per week) Original

New

0.50

22

0

7

1.00

15

6

15

1.50

10

10

20

2.00

7

13

25

2.50

5

15

27

Initially, the supply of energy bars is shown by the blue supply curve. The equilibrium price is $1.50 a bar, and the equilibrium quantity is 10 million bars a week. When the new cost-saving technology is adopted, the supply of energy bars increases and the supply curve shifts rightward to become the red curve. At $1.50 a bar, there is now a surplus of 10 million bars a week. The price of an energy bar falls to a new equilibrium of $1.00 a bar. As the price falls to $1.00, the quantity demanded increases—shown by the blue arrow on the demand curve—to the new equilibrium quantity of 15 million bars a week. Following an increase in supply, the quantity demanded increases but demand does not change—the demand curve does not shift.

MyEconLab animation

Predicting Changes in Price and Quantity

71

ECONOMICS IN THE NEWS The Market for Gasoline Gas Prices: Down and Headed Lower The price of gasoline has been falling for more than a month. With oil prices also falling, more falls at the pump are expected. Source: CNN Money, May 4, 2012 THE DATA

April 6, 2012

Quantity (millions of gallons per week) 365

Price (dollars per gallon) 4.00

May 4, 2012

372

3.85

THE QUESTIONS ■ ■

What does the data table tell us? Why did the price of gasoline decrease? Is it because demand changed or because supply changed, and in which direction?











■ ■



The data table tells us that between April and May 2012, the quantity of gasoline used increased and the price of gasoline fell. An increase in demand brings an increase in the quantity and a rise in the price. An increase in supply brings an increase in the quantity and a fall in the price. Because the quantity of gasoline used increased and the price of gasoline fell, there must have been in increase in the supply of gasoline. The supply of gasoline increases if the price of a factor of production used to produce gasoline falls. The news clip says the price of oil, which is used to produce gasoline, is falling. So the fall in the price of oil is the source of the increase in the supply. The figure illustrates the market for gasoline in 2012. The demand curve DApril shows the demand. In early April, the supply curve was S0, the price was $4.00 per gallon, and the quantity used was 365 million gallons per day. By the end of April and early May, the lower price of oil had increased the supply of gasoline to S1. The price fell to $3.85 per gallon and the quantity used increased to 372 million gallons per day.

Price (dollars per gallon)

THE ANSWERS

4.30 4.20

A fall in the price of oil increases the supply of gasoline ...

4.10 4.00 3.90

... the price of gasoline falls ...

S0

S1

... and the quantity demanded increases

3.85 3.80

DApril

3.70

0

360

365 370 372 375 Quantity (millions of gallons per day)

The Market for Gasoline in April 2012 ■

The lower price brought an increase in the quantity of gasoline demanded, which is shown by the movement along the demand curve.

72

CHAPTER 3 Demand and Supply

All the Possible Changes in Demand and Supply Figure 3.10 brings together and summarizes the effects of all the possible changes in demand and supply. With what you’ve learned about the effects of a change in either demand or supply, you can predict what happens if both demand and supply change together. Let’s begin by reviewing what you already know. Change in Demand with No Change in Supply The first row of Fig. 3.10, parts (a), (b), and (c), summarizes the effects of a change in demand with no change in supply. In part (a), with no change in either demand or supply, neither the price nor the quantity changes. With an increase in demand and no change in supply in part (b), both the price and quantity increase. And with a decrease in demand and no change in supply in part (c), both the price and the quantity decrease. Change in Supply with No Change in Demand The first column of Fig. 3.10, parts (a), (d), and (g), summarizes the effects of a change in supply with no change in demand. With an increase in supply and no change in demand in part (d), the price falls and quantity increases. And with a decrease in supply and no change in demand in part (g), the price rises and the quantity decreases. Increase in Both Demand and Supply You’ve seen

that an increase in demand raises the price and increases the quantity. And you’ve seen that an increase in supply lowers the price and increases the quantity. Fig. 3.10(e) combines these two changes. Because either an increase in demand or an increase in supply increases the quantity, the quantity also increases when both demand and supply increase. But the effect on the price is uncertain. An increase in demand raises the price and an increase in supply lowers the price, so we can’t say whether the price will rise or fall when both demand and supply increase. We need to know the magnitudes of the changes in demand and supply to predict the effects on price. In the example in Fig. 3.10(e), the price does not change. But notice that if demand increases by slightly more than the amount shown in the figure, the price will rise. And if supply increases by slightly more than the amount shown in the figure, the price will fall.

Decrease in Both Demand and Supply Figure 3.10(i) shows the case in which demand and supply both decrease. For the same reasons as those we’ve just reviewed, when both demand and supply decrease, the quantity decreases, and again the direction of the price change is uncertain. Decrease in Demand and Increase in Supply You’ve seen that a decrease in demand lowers the price and decreases the quantity. And you’ve seen that an increase in supply lowers the price and increases the quantity. Fig. 3.10(f) combines these two changes. Both the decrease in demand and the increase in supply lower the price, so the price falls. But a decrease in demand decreases the quantity and an increase in supply increases the quantity, so we can’t predict the direction in which the quantity will change unless we know the magnitudes of the changes in demand and supply. In the example in Fig. 3.10(f), the quantity does not change. But notice that if demand decreases by slightly more than the amount shown in the figure, the quantity will decrease; if supply increases by slightly more than the amount shown in the figure, the quantity will increase. Increase in Demand and Decrease in Supply Figure 3.10(h) shows the case in which demand increases and supply decreases. Now, the price rises, and again the direction of the quantity change is uncertain.

REVIEW QUIZ What is the effect on the price and quantity of MP3 players (such as the iPod) if 1 The price of a PC falls or the price of an MP3 download rises? (Draw the diagrams!) 2 More firms produce MP3 players or electronics workers’ wages rise? (Draw the diagrams!) 3 Any two of the events in questions 1 and 2 occur together? (Draw the diagrams!) You can work these questions in Study Plan 3.5 and get instant feedback.

MyEconLab

◆ To complete your study of demand and supply,

take a look at Reading Between the Lines on pp. 74–75, which explains why the price of peanut butter increased in 2011. Try to get into the habit of using the demand and supply model to understand the movements in prices in your everyday life.

Predicting Changes in Price and Quantity

Supply

3.00 2.50 2.00

Equilibrium

1.50

2.50 2.00 Demand (new)

1.50

Demand (original)

0.50

15 20 10 Quantity (millions of bars)

(a) No change in demand or supply

(b) Increase in demand Price (dollars per bar)

Supply (original)

3.00 2.50

Supply (new)

2.00

2.00

1.00

1.00 Demand

0.50

?

15 20 10 Quantity (millions of bars)

Supply (original)

3.00 2.50

Supply (new)

2.00 1.50

? Demand (new)

0.50

15 20 10 Quantity (millions of bars)

6

0

10

Demand (original)

0.50

15 20 Quantity (millions of bars)

0

? 5

?

Demand (new)

15 20 10 Quantity (millions of bars)

(d) Increase in supply

(e) Increase in both demand and supply

(f) Decrease in demand; increase in supply Price (dollars per bar)

0

Demand (original)

1.00

Price (dollars per bar)

5

Demand (new)

Price (dollars per bar)

0

Supply (new)

2.50

1.50

Demand (original)

(c) Decrease in demand Supply (original)

3.00

1.50

2.00

0.50

15 20 10 Quantity (millions of bars)

5

0

Price (dollars per bar)

5

2.50

1.00

Price (dollars per bar)

Demand

0.50

Supply

3.00

1.50

1.00

1.00

0

Supply

3.00

Price (dollars per bar)

The Effects of All the Possible Changes in Demand and Supply Price (dollars per bar)

Price (dollars per bar)

FIGURE 3.10

73

Supply (new)

3.00

Supply (original)

2.50 2.00

Supply (new)

3.00

Supply (original)

2.50 2.00

Demand (new)

2.00

1.50

1.50

1.00

1.00

1.00

Demand

Demand (original)

0.50

15 20 10 Quantity (millions of bars)

0

0.50 ?

0

5

15 20 10 Quantity (millions of bars)

(g) Decrease in supply

0

5

Supply (original)

2.50

1.50

0.50

Supply (new)

3.00

? ?

Demand (original)

Demand (new)

?

(h) Increase in demand; decrease in supply

5

15 20 10 Quantity (millions of bars)

(i) Decrease in both demand and supply

MyEconLab animation

R EA DIN G B ETW EE N T H E LINES

Demand and Supply: The Price of Peanut Butter Peanut Butter Prices Expected to Rise After Dry Summer The Augusta Chronicle October 12, 2011 Another hot, dry summer in key producing states and competition from more profitable crops including cotton have significantly shrunk the U.S. peanut crop this year. U.S. farmers are expected to produce roughly 1.8 million tons of peanuts this year, down nearly 13 percent from last year, according to a survey released Wednesday by the Department of Agriculture. Assuming that estimate holds, it would be the smallest harvest since 2006. Peanut butter producers already have plans to raise prices for peanut butter significantly in the next few weeks. . . . The J.M. Smucker Co., which makes Jif peanut butter, plans to raise its wholesale prices 30 percent in November. Kraft Foods Co., which launched its Planters peanut butter in June, is raising prices 40 percent on Oct. 31. A spokesperson for ConAgra Foods Inc., which makes Peter Pan peanut butter, was not immediately available to comment but multiple media outlets report that the company plans to raise its prices as well. Unilever, which makes Skippy brand peanut butter, said the company is watching the commodities market very closely. Georgia, the largest peanut-producing state in the country, saw record-breaking heat and a lack of rainfall that prevented some peanut seeds from even germinating in the field. Plants that did grow were baked in the hot summer sun, producing poor-quality nuts. According to USDA estimates this week, farmers who had runner peanuts—the most common kind and the type used for peanut butter—could sell their crop for nearly $1,200 a ton, up from nearly $450 a ton last year. Copyright Associated Press and The Augusta Chronicle, 2011. Reprinted with permission.

74

ESSENCE OF THE STORY ■

A hot and dry 2011 summer resulted in a poor peanut harvest.



Because cotton was more profitable, some farmers switched from peanuts to cotton.



U.S. peanut production in 2011 was 1.8 million tons, down nearly 13 percent from 2010.



The price of peanuts increased from $450 per ton in 2010 to $1,200 per ton in 2011.



Peanut butter producers raised their prices by up to 40 percent.

This news article reports events in two markets: the market for peanuts and the market for peanut butter.



In the market for peanuts, a hot, dry summer decreased supply.



Also, a rise in the price of cotton, a substitute in production for peanuts, led farmers to plant more cotton acres and fewer peanuts acres, so the supply of peanuts decreased for a second reason.



The decrease in supply led to a large increase in price, a decrease in the quantity demanded, and a decrease in the equilibrium quantity of peanuts.



Figure 1 illustrates the market for peanuts in 2010 and 2011.



The demand curve for peanuts is D. In 2010, the supply curve was S0. The equilibrium price was $450 per ton and 2 million tons of peanuts were produced.



In 2011, supply decreased and the supply curve shifted leftward to S1. The equilibrium price increased to $1,200 per ton and the equilibrium quantity decreased to 1.8 million tons. The quantity demanded decreased, shown by the movement along the demand curve D.



Peanuts along with labor and capital are used to make peanut butter.



So the rise in the price of peanuts increased the cost of producing peanut butter and decreased its supply.



The decrease in the supply of peanut butter led to an increase in price, a decrease in the quantity demanded, and a decrease in the equilibrium quantity of peanut butter.



Figure 2 illustrates the market for peanut butter in 2010 and 2011.



The demand curve for peanut butter is D. In 2010, the supply curve was S0. The equilibrium price was $2.00 per pound and 350 million pounds of peanut butter were produced.



In 2011, supply decreased and the supply curve shifted leftward to S1. The equilibrium price increased to $2.80 per pound and the equilibrium quantity decreased to 300 million pounds. The quantity of peanut butter demanded decreased, shown by the movement along the demand curve D.

A hot, dry summer and competition from cotton decreased the supply of peanuts ...

2,000

1,600

1,200

... the price of peanuts increased, and ...

S0

S1

800

450

0

... the equilibrium D quantity and the quantity of peanuts demanded decreased 1.6

1.8

2.0 2.2 2.4 Quantity (millions of tons per year)

Figure 1 The Market for Peanuts

Price (dollars per pound)



Price (dollars per ton)

ECONOMIC ANALYSIS

S1

3.50

A rise in the price of peanuts decreased the supply of peanut butter ...

S0

3.00 2.80 2.50

2.00

1.50

0

... the price of peanut butter increased, and ...

275

D ... the equilibrium quantity and the quantity of peanut butter demanded decreased 300

325 350 375 400 Quantity (millions of pounds per year)

Figure 2 The Market for Peanut Butter



Notice that the increase in the price of peanut butter, a 40 percent increase, was much smaller than the increase in the price of peanuts, an increase from $450 to $1,200 or a 167 percent increase. Can you explain why?

75

CHAPTER 3 Demand and Supply

76

MATHEMATICAL NOTE Demand, Supply, and Equilibrium Demand Curve The law of demand says that as the price of a good or service falls, the quantity demanded of that good or service increases. We can illustrate the law of demand by drawing a graph of the demand curve or writing down an equation. When the demand curve is a straight line, the following equation describes it: P = a - bQ D, where P is the price and QD is the quantity demanded. The a and b are positive constants. The demand equation tells us three things:

a

The law of supply says that as the price of a good or service rises, the quantity supplied of that good or service increases. We can illustrate the law of supply by drawing a graph of the supply curve or writing down an equation. When the supply curve is a straight line, the following equation describes it: P = c + dQ S, where P is the price and QS is the quantity supplied. The c and d are positive constants. The supply equation tells us three things: 1. The price at which sellers are not willing to supply the good (QS is zero). That is, if the price is c, then no one is willing to sell the good. You can see the price c in Fig. 2. It is the price at which the supply curve hits the y-axis—what we call the supply curve’s “y-intercept.” 2. As the price rises, the quantity supplied increases. If QS is a positive number, then the price P must be greater than c. As QS increases, the price P becomes larger. That is, as the quantity increases, the minimum price that sellers are willing to accept for the last unit rises. 3. The constant d tells us how fast the minimum price at which someone is willing to sell the good rises as the quantity increases. That is, the constant d tells us about the steepness of the supply curve. The equation tells us that the slope of the supply curve is d.

Price ( P )

Price ( P )

1. The price at which no one is willing to buy the good (QD is zero). That is, if the price is a, then the quantity demanded is zero. You can see the price a in Fig. 1. It is the price at which the demand curve hits the y-axis—what we call the demand curve’s “y-intercept.” 2. As the price falls, the quantity demanded increases. If QD is a positive number, then the price P must be less than a. As QD gets larger, the price P becomes smaller. That is, as the quantity increases, the maximum price that buyers are willing to pay for the last unit of the good falls. 3. The constant b tells us how fast the maximum price that someone is willing to pay for the good falls as the quantity increases. That is, the constant b tells us about the steepness of the demand curve. The equation tells us that the slope of the demand curve is –b.

Supply Curve

y-intercept is a

Supply

y-intercept is c

Slope is –b

Slope is d

c Demand 0

Quantity demanded (QD)

Figure 1 Demand Curve

0 Figure 2 Supply Curve

Quantity supplied (QS)

Mathematical Note

Market Equilibrium

77

Using the demand equation, we have

Demand and supply determine market equilibrium. Figure 3 shows the equilibrium price (P*) and equilibrium quantity (Q*) at the intersection of the demand curve and the supply curve. We can use the equations to find the equilibrium price and equilibrium quantity. The price of a good adjusts until the quantity demanded QD equals the quantity supplied QS. So at the equilibrium price (P*) and equilibrium quantity (Q*),

P* = a - b a P* =

a1b + d2 - b1a - c2

b + d ad + bc P* = . b + d Alternatively, using the supply equation, we have

Q D = Q S = Q*.

P* = c + d a

To find the equilibrium price and equilibrium quantity, substitute Q* for QD in the demand equation and Q* for QS in the supply equation. Then the price is the equilibrium price (P*), which gives

P* =

P* = a - bQ*

P* =

P* = c + dQ*. Notice that

a - c b b + d

a - c b b + d

c1b + d2 + d1a - c2 b + d

ad + bc . b + d

An Example

a - bQ* = c + dQ*.

The demand for ice-cream cones is P = 800 - 2Q D .

Now solve for Q*: a - c = bQ* + dQ* a - c = ( b + d ) Q* a - c . Q* = b + d To find the equilibrium price, (P*), substitute for Q* in either the demand equation or the supply equation.

The supply of ice-cream cones is P = 200 + 1Q S. The price of a cone is expressed in cents, and the quantities are expressed in cones per day. To find the equilibrium price (P*) and equilibrium quantity (Q*), substitute Q* for QD and QS and P* for P. That is, P* = 800 - 2Q*

Price

P* = 200 + 1Q* Now solve for Q*: Supply

800 - 2Q* = 200 + 1Q*

Market equilibrium

600 = 3Q* Q* = 200.

P*

And Demand 0

Q* Quantity

Figure 3 Market Equilibrium

P* = 800 - 2 1 200 2 = 400.

The equilibrium price is $4 a cone, and the equilibrium quantity is 200 cones per day.

78

CHAPTER 3 Demand and Supply

SUMMARY Key Points



Markets and Prices (p. 56) ■

■ ■

A competitive market is one that has so many buyers and sellers that no single buyer or seller can influence the price. Opportunity cost is a relative price. Demand and supply determine relative prices.

Working Problem 1 will give you a better understanding of markets and prices.

Working Problems 6 to 9 will give you a better understanding of supply.

Market Equilibrium (pp. 66–67) ■



Demand (pp. 57–61) ■





Demand is the relationship between the quantity demanded of a good and its price when all other influences on buying plans remain the same. The higher the price of a good, other things remaining the same, the smaller is the quantity demanded—the law of demand. Demand depends on the prices of related goods (substitutes and complements), expected future prices, income, expected future income and credit, the population, and preferences.

Working Problems 2 to 5 will give you a better understanding of demand.





Supply is the relationship between the quantity supplied of a good and its price when all other influences on selling plans remain the same. The higher the price of a good, other things remaining the same, the greater is the quantity supplied—the law of supply.

At the equilibrium price, the quantity demanded equals the quantity supplied. At any price above the equilibrium price, there is a surplus and the price falls. At any price below the equilibrium price, there is a shortage and the price rises.

Working Problems 10 and 11 will give you a better understanding of market equilibrium.

Predicting Changes in Price and Quantity (pp. 68–73) ■



Supply (pp. 62–65) ■

Supply depends on the prices of factors of production used to produce a good, the prices of related goods produced, expected future prices, the number of suppliers, technology, and the state of nature.



An increase in demand brings a rise in the price and an increase in the quantity supplied. A decrease in demand brings a fall in the price and a decrease in the quantity supplied. An increase in supply brings a fall in the price and an increase in the quantity demanded. A decrease in supply brings a rise in the price and a decrease in the quantity demanded. An increase in demand and an increase in supply bring an increased quantity but an uncertain price change. An increase in demand and a decrease in supply bring a higher price but an uncertain change in quantity.

Working Problems 12 and 13 will give you a better understanding of predicting changes in price and quantity.

Key Terms Change in demand, 58 Change in supply, 63 Change in the quantity demanded, 61 Change in the quantity supplied, 64 Competitive market, 56 Complement, 59 Demand, 57

Demand curve, 58 Equilibrium price, 66 Equilibrium quantity, 66 Inferior good, 60 Law of demand, 57 Law of supply, 62 Money price, 56 Normal good, 60

Quantity demanded, 57 Quantity supplied, 62 Relative price, 56 Substitute, 59 Supply, 62 Supply curve, 62

Study Plan Problems and Applications

79

STUDY PLAN PROBLEMS AND APPLICATIONS MyEconLab You can work Problems 1 to 17 in MyEconLab Chapter 3 Study Plan and get instant feedback. Markets and Prices (Study Plan 3.1)

1. William Gregg owned a mill in South Carolina. In December 1862, he placed a notice in the Edgehill Advertiser announcing his willingness to exchange cloth for food and other items. Here is an extract: 1 yard of cloth for 1 pound of bacon 2 yards of cloth for 1 pound of butter 4 yards of cloth for 1 pound of wool 8 yards of cloth for 1 bushel of salt a. What is the relative price of butter in terms of wool? b. If the money price of bacon was 20¢ a pound, what do you predict was the money price of butter? c. If the money price of bacon was 20¢ a pound and the money price of salt was $2.00 a bushel, do you think anyone would accept Mr. Gregg’s offer of cloth for salt? Demand (Study Plan 3.2)

2. The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to all other goods and services. b. Explain how the substitution effect influences food purchases and provide some examples of substitutions that people might make when the price of food rises and other things remain the same. c. Explain how the income effect influences food purchases and provide some examples of the income effect that might occur when the price of food rises and other things remain the same. 3. Place the following goods and services into pairs of likely substitutes and pairs of likely complements. (You may use an item in more than one pair.) The goods and services are coal, oil, natural gas, wheat, corn, rye, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPod, cell phone, text message, email, phone call, voice mail 4. During 2010, the average income in China increased by 10 percent. Compared to 2009,

how do you expect the following would change: a. The demand for beef. Explain your answer. b. The demand for rice. Explain your answer. 5. In January 2010, the price of gasoline was $2.70 a gallon. By spring 2010, the price had increased to $3.00 a gallon. Assume that there were no changes in average income, population, or any other influence on buying plans. Explain how the rise in the price of gasoline would affect a. The demand for gasoline. b. The quantity of gasoline demanded. Supply (Study Plan 3.3)

6. In 2008, the price of corn increased by 35 percent and some cotton farmers in Texas stopped growing cotton and started to grow corn. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. b. Why would a cotton farmer grow corn? Use the following information to work Problems 7 to 9. Dairies make low-fat milk from full-cream milk. In the process of making low-fat milk, the dairies produce cream, which is made into ice cream. In the market for low-fat milk, the following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With the period of low rainfall extending, dairies raise their expected price of low-fat milk next year. (v) With advice from health-care experts, dairy farmers decide to switch from producing full-cream milk to growing vegetables. (vi) A new technology lowers the cost of producing ice cream. 7. Explain the effect of each event on the supply of low-fat milk. 8. Use a graph to illustrate the effect of each event. 9. Does any event (or events) illustrate the law of supply?

80

CHAPTER 3 Demand and Supply

Market Equilibrium (Study Plan 3.4)

10. “As more people buy computers, the demand for Internet service increases and the price of Internet service decreases. The fall in the price of Internet service decreases the supply of Internet service.” Explain what is wrong with this statement. 11. The demand and supply schedules for gum are Price (cents per pack)

20 40 60 80 100

Quantity demanded

Quantity supplied

(millions of packs a week)

180 140 100 60 20

60 100 140 180 220

a. Draw a graph of the market for gum and mark in the equilibrium price and quantity. b. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts. c. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

14. Indian Weddings Boost Gold Price Hopes Indian weddings traditionally take place between late September and December. The predilection for jewelery at this time usually gives a big boost to gold sales, and the record shows the price of gold has generally risen during this period. Source: Financial News, September 9, 2011 a. Describe the changes in demand and supply in the market for gold in India during the wedding season. b. Given that the wedding season is a predictable event, how might expectations influence the market for gold in India? 15. Pump Prices on Pace to Top 2009 High by Weekend The cost of filling up the car is rising as the crude oil price soars and pump prices may exceed the peak price of 2009. Source: USA Today, January 7, 2010 a. Does demand for or the supply of gasoline or both change when the price of oil soars? b. Use a demand-supply graph to illustrate what happens to the equilibrium price of gasoline and the equilibrium quantity of gasoline bought when the price of oil soars.

Predicting Changes in Price and Quantity

Economics in the News (Study Plan 3.N)

(Study Plan 3.5)

16. American to Cut Flights, Charge for Luggage American Airlines announced that it will charge passengers $15 for their first piece of checked luggage and cut domestic flights as it grapples with record-high fuel prices. Source: Boston Herald, May 22, 2008 a. According to the news clip, what is the influence on the supply of American Airlines flights? b. Explain how supply changes. 17. Frigid Florida Winter is Bad News for Tomato Lovers An unusually cold January in Florida destroyed entire fields of tomatoes. Florida’s growers are shipping only a quarter of their usual 5 million pounds a week. The price has risen from $6.50 for a 25pound box a year ago to $30 now. Source: USA Today, March 3, 2010 a. Make a graph to illustrate the market for tomatoes in January 2009 and January 2010. b. On the graph, show how the events in the news clip influence the market for tomatoes. c. Why is the news “bad for tomato lovers”?

12. The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs. Which of these events will increase or decrease (state which occurs) a. The demand for gasoline? b. The supply of gasoline? c. The quantity of gasoline demanded? d. The quantity of gasoline supplied? 13. In Problem 11, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes. b. If at the time the fire occurs there is an increase in the teenage population, which increases the quantity of gum demanded by 40 million packs a week at each price, what are the new equilibrium price and quantity of gum? Illustrate these changes on your graph.

Additional Problems and Applications

81

ADDITIONAL PROBLEMS AND APPLICATIONS MyEconLab You can work these problems in MyEconLab if assigned by your instructor. Markets and Prices

Supply

18. What features of the world market for crude oil make it a competitive market? 19. The money price of a textbook is $90 and the money price of the Wii game Super Mario Galaxy is $45. a. What is the opportunity cost of a textbook in terms of the Wii game? b. What is the relative price of the Wii game in terms of textbooks?

22. Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Bottled water and health club memberships b. French fries and baked potatoes c. Leather purses and leather shoes d. Hybrids and SUVs e. Diet coke and regular coke 23. As the prices of homes fell across the United States in 2008, the number of homes offered for sale decreased. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. b. Why would home owners decide not to sell?

20. The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services. b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same. c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same. 21. Think about the demand for the three game consoles: Xbox, PS3, and Wii. Explain the effect of the following events on the demand for Xbox games and the quantity of Xbox games demanded, other things remaining the same. a. The price of an Xbox falls. b. The prices of a PS3 and a Wii fall. c. The number of people writing and producing Xbox games increases. d. Consumers’ incomes increase. e. Programmers who write code for Xbox games become more costly to hire. f. The expected future price of an Xbox game falls. g. A new game console that is a close substitute for Xbox comes onto the market.

24. G.M. Cuts Production for Quarter General Motors cut its fourth-quarter production schedule by 10 percent because Ford Motor, Chrysler, and Toyota sales declined in August. Source: The New York Times, September 5, 2007 Explain whether this news clip illustrates a change in the supply of cars or a change in the quantity supplied of cars. Market Equilibrium

Use the following figure to work Problems 25 and 26. Price (dollars per pizza)

Demand

16 14 12

10

0

100

200 300 400 Quantity (pizzas per day)

25. a. Label the curves. Which curve shows the willingness to pay for a pizza? b. If the price of a pizza is $16, is there a shortage or a surplus and does the price rise or fall?

82

CHAPTER 3 Demand and Supply

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza? 26. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall? b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza? 27. The demand and supply schedules for potato chips are Price (cents per bag)

Quantity demanded

Quantity supplied

(millions of bags per week)

50 160 130 60 150 140 70 140 150 80 130 160 90 120 170 100 110 180 a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity. b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust? Predicting Changes in Price and Quantity

28. In Problem 27, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change. b. How do the equilibrium price and equilibrium quantity of chips change? 29. In Problem 27, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change? 30. If the virus in Problem 29 hits just as the new dip in Problem 28 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change? 31. Strawberry Prices Drop as Late Harvest Hits Market Shoppers bought strawberries in March for $1.25 a pound rather than the $3.49 a pound they paid last year. With the price so low, some growers plowed over their strawberry plants to make way for spring melons; others froze their harvests and sold them to juice and jam makers. Source: USA Today, April 5, 2010 a. Explain how the market for strawberries would have changed if growers had not plowed in their plants but offered locals “you pick for free.”

b. Describe the changes in demand and supply in the market for strawberry jam. 32. “Popcorn Movie” Experience Gets Pricier Cinemas are raising the price of popcorn. Demand for field corn, which is used for animal feed, corn syrup, and ethanol, has increased and its price has exploded. That’s caused some farmers to shift from growing popcorn to easier-togrow field corn. Source: USA Today, May 24, 2008 Explain and illustrate graphically the events described in the news clip in the market for a. Popcorn b. Movie tickets 33. Watch Out for Rising Dry-Cleaning Bills In the past year, the price of dry-cleaning solvent doubled. More than 4,000 dry cleaners across the United States disappeared as budget-conscious consumers cut back. This year the price of hangers used by dry cleaners is expected to double. Source: CNN Money, June 4, 2012 a. Explain the effect of rising solvent prices on the market for dry cleaning. b. Explain the effect of consumers becoming more budget conscious along with the rising price of solvent on the price of dry cleaning. c. If the price of hangers does rise this year, do you expect additional dry cleaners to disappear? Explain why or why not. Economics in the News

34. After you have studied Reading Between the Lines on pp. 74–75, answer the following questions. a. What happened to the price of peanut butter in 2011? b. What substitutions do you expect might have been made to decrease the quantity of peanut butter demanded? c. What is the main complement of peanut butter and what do you predict happened in its market in 2011? d. What is one of the main substitutes in production for peanuts and what do you predict happened in its market in 2011? e. Do you predict that the higher prices of peanuts and peanut butter will persist or will they return to normal after one year? f. Why did the percentage rise in the price of peanuts exceed the percentage rise in the price of peanut butter?

4

After studying this chapter, you will be able to: ◆ Define, calculate, and explain the factors that

influence the price elasticity of demand ◆ Define, calculate, and explain the factors that

influence the income elasticity of demand and the cross elasticity of demand ◆ Define, calculate, and explain the factors that

influence the elasticity of supply

ELASTICITY ◆ In the winter of 2010, a Florida frost destroyed the state’s tomato crop, driving the price to almost five times its normal level. Why did the price rise so  much? To answer this and similar questions, we use the neat tool that you study in this chapter: elasticity. At the end of the chapter, in Reading Between the Lines, we use the concept of elasticity to explain what was happening in the Florida tomatoes market during the winter of 2010. But we begin by explaining elasticity in a familiar setting: the market for pizza.

83

84

CHAPTER 4 Elasticity

◆ Price Elasticity of Demand You know that when supply decreases, the equilibrium price rises and the equilibrium quantity decreases. But does the price rise by a large amount and the quantity decrease by a little? Or does the price barely rise and the quantity decrease by a large amount? The answer depends on the responsiveness of the quantity demanded of a good to a change in its price. If the quantity demanded is not very responsive to a change in the price, the price rises a lot and the equilibrium quantity doesn’t change much. If the quantity demanded is very responsive to a change in the price, the price barely rises and the equilibrium quantity changes a lot. You might think about the responsiveness of the quantity demanded of a good to a change in its price in terms of the slope of the demand curve. If the demand curve is steep, the quantity demanded of the good isn’t very responsive to a change in the price. If the demand curve is almost flat, the quantity demanded is very responsive to a change in the price. But the slope of a demand curve depends on the units in which we measure the price and the quantity—we can make the curve steep or almost flat just by changing the units in which we measure the price and the quantity. Also we often want to compare the demand for different goods and services and quantities of these goods are measured in unrelated units. For example, a pizza producer might want to compare the demand for pizza with the demand for soft drinks. Which quantity demanded is more responsive to a price change? This question can’t be answered by comparing the slopes of two demand curves. The units of measurement of pizza and soft drinks are unrelated. But the question can be answered with a measure of responsiveness that is independent of units of measurement. Elasticity is such a measure. The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same.

Calculating Price Elasticity of Demand We calculate the price elasticity of demand by using the formula: Percentage change in quantity damanded Price elasticity of = . demand Percentage change in price

To calculate the price elasticity of demand for pizza, we need to know the quantity demanded of pizza at two different prices, when all other influences on buying plans remain the same. Figure 4.1 zooms in on a section of the demand curve for pizza and shows how the quantity demanded responds to a small change in price. Initially, the price is $20.50 a pizza and 9 pizzas an hour are demanded—the original point. The price then falls to $19.50 a pizza, and the quantity demanded increases to 11 pizzas an hour—the new point. When the price falls by $1 a pizza, the quantity demanded increases by 2 pizzas an hour. To calculate the price elasticity of demand, we express the change in price as a percentage of the average price and the change in the quantity demanded as a percentage of the average quantity. By using the average price and average quantity, we calculate the elasticity at a point on the demand curve midway between the original point and the new point. The original price is $20.50 and the new price is $19.50, so the price change is $1 and the average price is $20 a pizza. Call the percentage change in the price %∆P, then ,∆P = ∆P/Pave * 100 = (+1/+20) * 100 = 5,. The original quantity demanded is 9 pizzas and the new quantity demanded is 11 pizzas, so the quantity change is 2 pizzas and the average quantity demanded is 10 pizzas. Call the percentage change in the quantity demanded %∆Q, then ,∆Q = ∆Q/Q ave * 100 = (2/10) * 100 = 20,. The price elasticity of demand equals the percentage change in the quantity demanded (20 percent) divided by the percentage change in price (5 percent) and is 4. That is, Price elasticity of demand = =

,∆Q ,∆P 20, = 4. 5,

Average Price and Quantity Notice that we use the

average price and average quantity. We do this because it gives the most precise measurement of elasticity—at the midpoint between the original price and the new price. If the price falls from $20.50 to $19.50, the $1 price change is 4.9 percent of $20.50. The 2 pizza change in quantity is 22.2 percent of 9 pizzas, the original quantity. So if we use

Price Elasticity of Demand

Price (dollars per pizza)

FIGURE 4.1

85

Percentages and Proportions Elasticity is the ratio of two percentage changes, so when we divide one percentage change by another, the 100s cancel. A percentage change is a proportionate change multiplied by 100. The proportionate change in price is ∆P/Pave, and the proportionate change in quantity demanded is ∆Q/Qave. So if we divide ∆Q/Qave by ∆P/Pave we get the same answer as we get by using percentage changes.

Calculating the Elasticity of Demand Original point

20.50 = $1

A Units-Free Measure Now that you’ve calculated a

Elasticity = 4 20.00

Pave = $20 New point 19.50

D Qave = 10 0

9

10

11 Quantity (pizzas per hour)

The elasticity of demand is calculated by using the formula:*

Price elasticity of demand =

Percentage change in quantity demanded Percentage change in price

,∆Q = ,∆P =

=

∆Q/Qave ∆P/Pave 2/10 = 4. 1/20

This calculation measures the elasticity at an average price of $20 a pizza and an average quantity of 10 pizzas an hour. * In the formula, the Greek letter delta (∆) stands for “change in” and %∆ stands for “percentage change in.”

MyEconLab animation these numbers, the price elasticity of demand is 22.2 divided by 4.9, which equals 4.5. But if the price rises from $19.50 to $20.50, the $1 price change is 5.1 percent of $19.50. The 2 pizza change in quantity is 18.2 percent of 11 pizzas, the original quantity. So if we use these numbers, the price elasticity of demand is 18.2 divided by 5.1, which equals 3.6. By using percentages of the average price and average quantity, we get the same value for the elasticity regardless of whether the price falls from $20.50 to $19.50 or rises from $19.50 to $20.50.

price elasticity of demand, you can see why it is a units-free measure. Elasticity is a units-free measure because the percentage change in each variable is independent of the units in which the variable is measured. The ratio of the two percentages is a number without units. Minus Sign and Elasticity When the price of a good

rises, the quantity demanded decreases. Because a positive change in price brings a negative change in the quantity demanded, the price elasticity of demand is a negative number. But it is the magnitude, or absolute value, of the price elasticity of demand that tells us how responsive the quantity demanded is. So to compare price elasticities of demand, we use the magnitude of the elasticity and ignore the minus sign.

Inelastic and Elastic Demand If the quantity demanded remains constant when the price changes, then the price elasticity of demand is zero and the good is said to have a perfectly inelastic demand. One good that has a very low price elasticity of demand (perhaps zero over some price range) is insulin. Insulin is of such importance to some diabetics that if the price rises or falls, they do not change the quantity they buy. If the percentage change in the quantity demanded equals the percentage change in the price, then the price elasticity equals 1 and the good is said to have a unit elastic demand. Between perfectly inelastic demand and unit elastic demand is a general case in which the percentage change in the quantity demanded is less than the percentage change in the price. In this case, the price elasticity of demand is between zero and 1 and the good is said to have an inelastic demand. Food and shelter are examples of goods with inelastic demand. If the quantity demanded changes by an infinitely large percentage in response to a tiny price change, then the price elasticity of demand is infinity and the good is said to have a perfectly elastic demand. An example of a good that has a very high elasticity of

CHAPTER 4 Elasticity

86

The Factors that Influence the Elasticity of Demand

demand (almost infinite) is a soft drink from two campus machines located side by side. If the two machines offer the same soft drinks for the same price, some people buy from one machine and some from the other. But if one machine’s price is higher than the other’s, by even a small amount, no one buys from the machine with the higher price. Drinks from the two machines are perfect substitutes. The demand for a good that has a perfect substitute is perfectly elastic. Between unit elastic demand and perfectly elastic demand is another general case in which the percentage change in the quantity demanded exceeds the percentage change in price. In this case, the price elasticity of demand is greater than 1 and the good is said to have an elastic demand. Automobiles and furniture are examples of goods that have elastic demand. Figure 4.2 shows three demand curves that cover the entire range of possible elasticities of demand that you’ve just reviewed. In Fig. 4.2(a), the quantity demanded is constant regardless of the price, so this demand is perfectly inelastic. In Fig. 4.2(b), the percentage change in the quantity demanded equals the percentage change in price, so this demand is unit elastic. In Fig. 4.2(c), the price is constant regardless of the quantity demanded, so this figure illustrates a perfectly elastic demand. You now know the distinction between elastic and inelastic demand. But what determines whether the demand for a good is elastic or inelastic?

■ ■ ■

The closeness of substitutes The proportion of income spent on the good The time elapsed since the price change

Closeness of Substitutes The closer the substitutes for a

good, the more elastic is the demand for it. Oil as fuel or raw material for chemicals has no close substitutes so the demand for oil is inelastic. Plastics are close substitutes for metals, so the demand for metals is elastic. The degree of substitutability depends on how narrowly (or broadly) we define a good. For example, a personal computer has no close substitutes, but a Dell PC is a close substitute for a HewlettPackard PC. So the elasticity of demand for personal computers is lower than the elasticity of demand for a Dell or a Hewlett-Packard. In everyday language we call goods such as food and shelter necessities and goods such as exotic vacations luxuries. A necessity has poor substitutes, so it generally has an inelastic demand. A luxury usually has many substitutes, one of which is not buying it. So a luxury generally has an elastic demand. Proportion of Income Spent on the Good Other

things remaining the same, the greater the proportion of income spent on a good, the more elastic (or less inelastic) is the demand for it.

D1

Price

Price

Inelastic and Elastic Demand

FIGURE 4.2 Price

The elasticity of demand for a good depends on

Elasticity = 0

Elasticity =

Elasticity = 1

12

12

6

6

12

D3

6

D2 0 (a) Perfectly inelastic demand

Quantity

0

1

2

(b) Unit elastic demand

Each demand illustrated here has a constant elasticity. The demand curve in part (a) illustrates the demand for a good that has a zero elasticity of demand. The demand curve in

3

Quantity

0

Quantity

(c) Perfectly elastic demand

part (b) illustrates the demand for a good with a unit elasticity of demand. And the demand curve in part (c) illustrates the demand for a good with an infinite elasticity of demand.

MyEconLab animation

Price Elasticity of Demand

FIGURE 4.3 Price (dollars per pizza)

Think about your own elasticity of demand for chewing gum and housing. If the price of gum rises, you consume almost as much as before. Your demand for gum is inelastic. If apartment rents rise, you look for someone to share with. Your demand for housing is not as inelastic as your demand for gum. Why the difference? Housing takes a big chunk of your budget, and gum takes little. You barely notice the higher price of gum, while the higher rent puts your budget under severe strain.

25.00

Elasticity Along a Linear Demand Curve

Elasticity = 4

20.00 Elastic 15.00

Time Elapsed Since Price Change The longer the

time that has elapsed since a price change, the more elastic is demand. When the price of oil increased by 400 percent during the 1970s, people barely changed the quantity of oil and gasoline they bought. But gradually, as more efficient auto and airplane engines were developed, the quantity bought decreased. The demand for oil became more elastic as more time elapsed following the huge price hike.

Elasticity Along a Linear Demand Curve Elasticity of demand is not the same as slope. And a good way to see this fact is by studying a demand curve that has a constant slope but a varying elasticity. The demand curve in Fig. 4.3 is linear, which means that it has a constant slope. Along this demand curve, a $5 rise in the price brings a decrease of 10 pizzas an hour. But the price elasticity of demand is not constant along this demand curve. To see why, let’s calculate some elasticities. At the midpoint of the demand curve, the price is $12.50 and the quantity is 25 pizzas per hour. If the price rises from $10 to $15 a pizza the quantity demanded decreases from 30 to 20 pizzas an hour and the average price and average quantity are at the midpoint of the demand curve. So 10/25 5/12.50 = 1.

Price elasticity of demand =

That is, at the midpoint of a linear demand curve, the price elasticity of demand is 1. At prices above the midpoint, the price elasticity of demand is greater than 1: Demand is elastic. To see that demand is elastic, let’s calculate the elasticity when the price rises from $15 to $25 a pizza. You can see that quantity demanded decreases from 20 to zero pizzas an hour. The average price is $20 a pizza, and

87

Elasticity = 1

12.50 Inelastic

10.00

Elasticity = 1/4

5.00

0

10

20

25

30

50 40 Quantity (pizzas per hour)

On a linear demand curve, demand is unit elastic at the midpoint (elasticity is 1), elastic above the midpoint, and inelastic below the midpoint.

MyEconLab animation the average quantity is 10 pizzas. Putting these numbers into the elasticity formula, Price elasticity of demand =

∆Q/Q ave ∆P/Pave

20/10 10/20 = 4. =

That is, the price elasticity of demand at an average price of $20 a pizza is 4. At prices below the midpoint, the price elasticity of demand is less than 1: Demand is inelastic. For example, if the price rises from zero to $10 a pizza, the quantity demanded decreases from 50 to 30 pizzas an hour. The average price is now $5 and the average quantity is 40 pizzas an hour. So 20/40 10/5 = 1/4.

Price elasticity of demand =

That is, the price elasticity of demand at an average price of $5 a pizza is 1/4.

CHAPTER 4 Elasticity

The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold. When a price changes, total revenue also changes. But a cut in the price does not always decrease total revenue. The change in total revenue depends on the elasticity of demand in the following way: ■





If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases. If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change.

In Fig. 4.4(a), over the price range from $25 to $12.50, demand is elastic. Over the price range from $12.50 to zero, demand is inelastic. At a price of $12.50, demand is unit elastic. Figure 4.4(b) shows total revenue. At a price of $25, the quantity sold is zero, so total revenue is zero. At a price of zero, the quantity demanded is 50 pizzas an hour and total revenue is again zero. A price cut in the elastic range brings an increase in total revenue—the percentage increase in the quantity demanded is greater than the percentage decrease in price. A price cut in the inelastic range brings a decrease in total revenue—the percentage increase in the quantity demanded is less than the percentage decrease in price. At unit elasticity, total revenue is at a maximum. Figure 4.4 shows how we can use this relationship between elasticity and total revenue to estimate elasticity using the total revenue test. The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in the price, when all other influences on the quantity sold remain the same. ■





If a price cut increases total revenue, demand is elastic. If a price cut decreases total revenue, demand is inelastic. If a price cut leaves total revenue unchanged, demand is unit elastic.

FIGURE 4.4 Price (dollars per pizza)

Total Revenue and Elasticity

Elasticity and Total Revenue

25.00

Elastic demand 20.00

Unit elastic

15.00 12.50 10.00

Inelastic demand

5.00

25

0

50 Quantity (pizzas per hour)

(a) Demand

Total revenue (dollars)

88

350.00

Maximum total revenue

312.50

250.00 200.00

150.00 100.00 50.00

When demand is elastic, a price cut increases total revenue

0

When demand is inelastic, a price cut decreases total revenue

25

50 Quantity (pizzas per hour)

(b) Total revenue

When demand is elastic, in the price range from $25 to $12.50, a decrease in price (part a) brings an increase in total revenue (part b). When demand is inelastic, in the price range from $12.50 to zero, a decrease in price (part a) brings a decrease in total revenue (part b). When demand is unit elastic, at a price of $12.50 (part a), total revenue is at a maximum (part b).

MyEconLab animation

Price Elasticity of Demand

89

Economics in Action

Price Elasticities of Demand for Food

Elastic and Inelastic Demand

The price elasticity of demand for food in the United States is estimated to be 0.12. This elasticity is an average over all types of food. The demand for most food items is inelastic, but there is a wide range of elasticities as the figure below shows for a range of fruits, vegetables, and meats. The demand for grapes and beef is elastic. The demand for oranges is unit elastic. These food items, especially grapes and beef, have many good substitutes. Florida winter tomatoes have closer substitutes than tomatoes in general, so the demand for the Florida winter variety is more elastic (less inelastic) than the demand for tomatoes. Carrots and cabbage, on which we spend a very small proportion of income, have an almost zero elastic demand.

The real-world price elasticities of demand in the table range from 1.52 for metals, the item with the most elastic demand in the table, to 0.05 for oil, the item with the most inelastic demand in the table. The demand for food is also inelastic. Oil and food, which have poor substitutes and inelastic demand, might be classified as necessities. Furniture and motor vehicles, which have good substitutes and elastic demand, might be classified as luxuries. Price Elasticities of Demand Good or Service

Elasticity

Elastic Demand Metals

1.52

Electrical engineering products

1.39

Mechanical engineering products

1.30

Furniture

1.26

Motor vehicles

1.14

Instrument engineering products

1.10

Transportation services

1.03

Grapes Beef Oranges Pork Tomatoes

(Florida winter)

Tomatoes

(all types)

Bananas

Inelastic Demand

Celery

Gas, electricity, and water

0.92

Grapefruit

Chemicals

0.89

Chicken

Clothing

0.64

Onions

Banking and insurance services

0.56

Apples

Housing services

0.55

Lettuce

Agricultural and fish products

0.42

Cabbage

Books, magazines, and newspapers

0.34

Carrots

Food

0.12

Cigarettes

0.11

Soft drinks

0.05

Oil

0.05

Sources of data: Ahsan Mansur and John Whalley, “Numerical Specification of Applied General Equilibrium Models: Estimation, Calibration, and Data,” in Applied General Equilibrium Analysis, eds. Herbert E. Scarf and John B. Shoven (New York: Cambridge University Press, 1984), 109, and Henri Theil, ChingFan Chung, and James L. Seale, Jr., Advances in Econometrics, Supplement I, 1989, International Evidence on Consumption Patterns (Greenwich, Conn.: JAI Press Inc., 1989), Emilio Pagoulatos and Robert Sorensen, “What Determines the Elasticity of Industry Demand,” International Journal of Industrial Organization, 1986, and Geoffrey Heal, Columbia University, Web site.

Inelastic

0

0.5

Elastic

1.0

1.5

Price elasticity of demand Price Elasticities of Demand for Food

Sources of data: Kuo S. Huang, U.S. demand for food: A complete system of price and income effects U.S. Dept. of Agriculture, Economic Research Service, Washington, DC, 1985, J. Scott Shonkwiler and Robert D. Emerson, “Imports and the Supply of Winter Tomatoes: An Application of Rational Expectations”, American Journal of Agricultural Economics, Vol. 64, No. 4 (Nov., 1982), pp. 634–641 and Kuo S. Huang, “A Further Look at Flexibilities and Elasticities”, American Journal of Agricultural Economics, Vol. 76, No. 2 (May, 1994), pp. 313–317.

CHAPTER 4 Elasticity

90

ECONOMICS IN THE NEWS The Elasticity of Demand for Peanut Butter

The data table says the price of peanut butter increased by $0.80 with an average price of $2.40, so the price increased by 33.3 percent. The quantity demanded decreased by 50 million tons with an average quantity of 325 million tons, so the quantity demanded decreased by 15.4 percent. The price elasticity of demand is 15.4 percent divided by 33.3 percent, which equals 0.46.



THE DATA

2011 2012

Quantity (millions of tons per year) 350 300

Price (dollars per pound) 2.00 2.80

Price (dollars per pound)

Peanut Butter Prices to Rise 30 to 40 Percent Scott Karns, president and CEO of Karns Foods, said “People are still going to need it for their family. It’s still an extremely economical item.” Patty Nolan, who is on a fixed income, said “I love peanut butter so I’m using a little less so I don’t go through it.” Source: The Patriot-News, November 2, 2011

New point 2.80

Elasticity = 0.46

THE QUESTIONS ■



Does the news clip imply that the demand for peanut butter is elastic or inelastic? If the data are two points on the demand curve for peanut butter, what is the price elasticity of demand?

2.40

Pave = $2.40

Original point

= $0.80 2.00

THE ANSWERS ■

The two remarks in the news clip suggest that the quantity of peanut butter demanded will decrease when the price rises, but not by much. The demand for peanut butter is inelastic.

D Qave = 325 0







If your demand for the good is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases. If your demand for the good is inelastic, a 1 percent price cut increases the quantity you buy by less than 1 percent and your expenditure on the item decreases. If your demand for the good is unit elastic, a 1 percent price cut increases the quantity you buy by 1 percent and your expenditure on the item does not change.

So if you spend more on an item when its price falls, your demand for that item is elastic; if you spend the same amount, your demand is unit elastic; and if you spend less, your demand is inelastic.

350 325 Quantity (millions of tons per year)

Calculating the Price Elasticity of Demand for Peanut Butter

Your Expenditure and Your Elasticity When the price of a good changes, the change in your expenditure on the good depends on your elasticity of demand.

300

REVIEW QUIZ 1

2 3 4

5

Why do we need a units-free measure of the responsiveness of the quantity demanded of a good or service to a change in its price? Define the price elasticity of demand and show how it is calculated. What makes the demand for some goods elastic and the demand for other goods inelastic? Why is the demand for a luxury generally more elastic (or less inelastic) than the demand for a necessity? What is the total revenue test?

You can work these questions in Study Plan 4.1 and get instant feedback.

MyEconLab

You’ve now completed your study of the price elasticity of demand. Two other elasticity concepts tell us about the effects of other influences on demand. Let’s look at these other elasticities of demand.

More Elasticities of Demand

◆ More Elasticities of Demand Suppose the economy is expanding and people are enjoying rising incomes. You know that a change in income changes demand. So this increased prosperity brings an increase in the demand for most types of goods and services. By how much will a rise in income increase the demand for pizza? This question is answered by the income elasticity of demand.

Income Elasticity of Demand The income elasticity of demand is a measure of the responsiveness of the demand for a good or service to a change in income, other things remaining the same. It tells us by how much a demand curve shifts at a given price. The income elasticity of demand is calculated by using the formula: Percentage change in quantity demanded Income elasticity . = of demand Percentage change in income Income elasticities of demand can be positive or negative and they fall into three interesting ranges: ■





Positive and greater than 1 (normal good, income elastic) Positive and less than 1 (normal good, income inelastic) Negative (inferior good)

Income Elastic Demand Suppose that the price of pizza is constant and 9 pizzas an hour are bought. Then incomes rise from $975 to $1,025 a week. No other influence on buying plans changes and the quantity of pizzas sold increases to 11 an hour. The change in the quantity demanded is +2 pizzas. The average quantity is 10 pizzas, so the quantity demanded increases by 20 percent. The change in income is +$50 and the average income is $1,000, so incomes increase by 5 percent. The income elasticity of demand for pizza is

20, = 4. 5, The demand for pizza is income elastic. The percentage increase in the quantity of pizza demanded exceeds the percentage increase in income.

91

Economics in Action Necessities and Luxuries The table shows estimates of some real-world income elasticities of demand. The demand for a necessity such as food or clothing is income inelastic, while the demand for a luxury such as transportation, which includes airline and foreign travel, is income elastic. But what is a necessity and what is a luxury depends on the level of income. For people with a low income, food and clothing can be luxuries. So the level of income has a big effect on income elasticities of demand. The figure shows this effect on the income elasticity of demand for food in 10 countries. In countries with low incomes, such as Tanzania and India, the income elasticity of demand for food is high. In countries with high incomes, such as the United States, the income elasticity of

Some Real-World Income Elasticities of Demand Income Elastic Demand Airline travel

5.82

Movies

3.41

Foreign travel

3.08

Electricity

1.94

Restaurant meals

1.61

Local buses and trains

1.38

Haircuts

1.36

Automobiles

1.07

Income Inelastic Demand Tobacco

0.86

Alcoholic drinks

0.62

Furniture

0.53

Clothing

0.51

Newspapers and magazines

0.38

Telephone

0.32

Food

0.14

Sources of data: H.S. Houthakker and Lester D. Taylor, Consumer Demand in the United States (Cambridge, Mass.: Harvard University Press, 1970), and Henri Theil, Ching-Fan Chung, and James L. Seale, Jr., Advances in Econometrics, Supplement 1, 1989, International Evidence on Consumption Patterns (Greenwich, Conn.: JAI Press, Inc., 1989).

92

CHAPTER 4 Elasticity

demand for food is low. That is, as income increases, the income elasticity of demand for food decreases. Low-income consumers spend a larger percentage of any increase in income on food than do high-income consumers. Income (percentage of U.S. income)

Country Tanzania

3.3

India

5.2

Korea

20.4

Brazil

36.8

Greece

41.3

Spain

55.9

Japan

61.6

France

81.1

Canada

99.2

United States

100.0 0

0.2

0.4

0.6

0.8

1.0

Income elasticity of demand

Cross Elasticity of Demand The burger shop next to your pizzeria has just raised the prices of its burgers. You know that pizzas and burgers are substitutes. You also know that when the price of a substitute for pizza rises, the demand for pizza increases. But how big is the influence of the price of burgers on the demand for pizza? You know, too, that pizza and soft drinks are complements. And you know that if the price of a complement of pizza rises, the demand for pizza decreases. So you wonder, by how much will a rise in the price of a soft drink decrease the demand for your pizza? To answer this question, you need to know about the cross elasticity of demand for pizza. Let’s examine this elasticity measure. We measure the influence of a change in the price of a substitute or complement by using the concept of the cross elasticity of demand. The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same. We calculate the cross elasticity of demand by using the formula:

Income Elasticities in 10 Countries

Income Inelastic Demand If the income elasticity of

demand is positive but less than 1, demand is income inelastic. The percentage increase in the quantity demanded is positive but less than the percentage increase in income. Whether demand is income elastic or income inelastic has an important implication for the percentage of income spent on a good. If the demand for a good is income elastic, the percentage of income spent on that good increases as income increases. And if the demand for a good is income inelastic, the percentage of income spent on that good decreases as income increases. Inferior Goods If the income elasticity of demand is

negative, the good is an inferior good. The quantity demanded of an inferior good and the amount spent on it decrease when income increases. Goods in this category include small motorcycles, potatoes, and rice. Low-income consumers buy these goods and spend a large percentage of their incomes on them.

Percentage change in quantity demanded Cross elasticity . = of demand Percentage change in price of a substitute or complement The cross elasticity of demand can be positive or negative. If the cross elasticity of demand is positive, demand and the price of the other good change in the same direction, so the two goods are substitutes. If the cross elasticity of demand is negative, demand and the price of the other good change in opposite directions, so the two goods are complements. Substitutes Suppose that the price of pizza is constant and people buy 9 pizzas an hour. Then the price of a burger rises from $1.50 to $2.50. No other influence on buying plans changes and the quantity of pizzas bought increases to 11 an hour. The change in the quantity demanded at the current price is +2 pizzas—the new quantity, 11 pizzas, minus the original quantity, 9 pizzas. The average quantity is 10 pizzas. So the quantity of pizzas demanded increases by 20 percent. That is,

∆Q/Q ave * 100 = ( +2/10) * 100 = +20,.

More Elasticities of Demand

The change in the price of a burger, a substitute for pizza, is +$1—the new price, $2.50, minus the original price, $1.50. The average price is $2 a burger. So the price of a burger rises by 50 percent. That is,

Cross Elasticity of Demand

Price of pizza

FIGURE 4.5

∆P/Pave * 100 = ( + +1/+2) * 100 = +50,.

93

Price of a burger, a substitute, rises. Positive cross elasticity

So the cross elasticity of demand for pizza with respect to the price of a burger is +20, = 0.4. +50, Figure 4.5 illustrates the cross elasticity of demand. Because pizza and burgers are substitutes, when the price of a burger rises, the demand for pizza increases. The demand curve for pizza shifts rightward from D0 to D1. Because a rise in the price of a burger brings an increase in the demand for pizza, the cross elasticity of demand for pizza with respect to the price of a burger is positive. Both the price and the quantity change in the same direction.

Price of a soft drink, a complement, rises. Negative cross elasticity 0

D1 D0 D2 Quantity of pizza

A burger is a substitute for pizza. When the price of a burger rises, the demand for pizza increases and the demand curve for pizza shifts rightward from D0 to D1. The cross elasticity of demand is positive. A soft drink is a complement of pizza. When the price of a soft drink rises, the demand for pizza decreases and the demand curve for pizza shifts leftward from D0 to D2. The cross elasticity of demand is negative.

Complements Now suppose that the price of pizza is

constant and 11 pizzas an hour are bought. Then the price of a soft drink rises from $1.50 to $2.50. No other influence on buying plans changes and the quantity of pizzas bought falls to 9 an hour.

MyEconLab animation

ECONOMICS IN THE NEWS More Peanut Butter Demand Elasticities



Peanut Butter Related Markets Professor Timothy Mathews teaches economics at Kennesaw State University, Georgia, the nation’s number one peanut producing state. The data table below shows his guesses about some demand elasticities for peanut butter. Source: Timothy Mathews

THE ANSWERS

THE DATA



Income elasticity

– 0.31

Cross elasticity peanut butter and grape jelly

– 0.27

Cross elasticity peanut butter and American cheese

+ 0.18

THE QUESTIONS ■



What do the data provided tell us about the demand for peanut butter? Is it a normal good?



Is grape jelly a substitute for or a complement of peanut butter? Is American cheese a substitute for or a complement of peanut butter?

The income elasticity of demand for peanut butter is negative, which means that peanut butter is an inferior good. People buy less peanut butter as income rises. The cross elasticity of demand of peanut butter with respect to the price of grape jelly is negative, which means that peanut butter and grape jelly are complements. The cross elasticity of demand of peanut butter with respect to the price of American cheese is positive, which means that peanut butter and American cheese are substitutes.

94

CHAPTER 4 Elasticity

The change in the quantity demanded is the opposite of what we’ve just calculated: The quantity of pizzas demanded decreases by 20 percent (–20%). The change in the price of a soft drink, a rise of $1 from $1.50 to $2.50, is the same as the change in the price of a burger that we’ve just calculated. That is, the price rises by 50 percent (+50%). So the cross elasticity of demand for pizza with respect to the price of a soft drink is -20, = -0.4. +50, Because pizza and soft drinks are complements, when the price of a soft drink rises, the demand for pizza decreases. In Fig. 4.5, when the price of soft drinks rises the demand curve for pizza shifts leftward from D0 to D2. Because a rise in the price of a soft drink brings a decrease in the demand for pizza, the cross elasticity of demand for pizza with respect to the price of a soft drink is negative. The price and quantity change in opposite directions. The magnitude of the cross elasticity of demand determines how far the demand curve shifts. The larger the cross elasticity (absolute value), the greater is the change in demand and the larger is the shift in the demand curve. If two items are close substitutes, such as two brands of spring water, the cross elasticity is large. If two items are close complements, such as movies and popcorn, the cross elasticity is large. If two items are somewhat unrelated to each other, such as newspapers and orange juice, the cross elasticity is small—perhaps even zero.

2 3 4

What does the income elasticity of demand measure? What does the sign (positive/negative) of the income elasticity tell us about a good? What does the cross elasticity of demand measure? What does the sign (positive/negative) of the cross elasticity of demand tell us about the relationship between two goods?

You can work these questions in Study Plan 4.2 and get instant feedback.

You know that when demand increases, the equilibrium price rises and the equilibrium quantity increases. But does the price rise by a large amount and the quantity increase by a little? Or does the price barely rise and the quantity increase by a large amount? The answer depends on the responsiveness of the quantity supplied to a change in the price. If the quantity supplied is not very responsive to price, then an increase in demand brings a large rise in the price and a small increase in the equilibrium quantity. If the quantity supplied is highly responsive to price, then an increase in demand brings a small rise in the price and a large increase in the equilibrium quantity. The problems that arise from using the slope of the supply curve to indicate responsiveness are the same as those we considered when discussing the responsiveness of the quantity demanded, so we use a units-free measure—the elasticity of supply.

Calculating the Elasticity of Supply The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. It is calculated by using the formula: Percentage change in quantity supplied Elasticity = . of supply Percentage change in price We use the same method that you learned when you studied the elasticity of demand. (Refer back to p. 85 to check this method.)

REVIEW QUIZ 1

◆ Elasticity of Supply

MyEconLab

Elastic and Inelastic Supply If the elasticity of supply is greater than 1, we say that supply is elastic and if the elasticity of supply is less than 1, we say that supply is inelastic. Suppose that when the price rises from $20 to $21, the quantity supplied increases from 10 to 20 pizzas per hour. The price rise is $1 and the average price is $20.50, so the price rises by 4.9 percent of the average price. The quantity increases from 10 to 20 pizzas an hour, so the increase is 10 pizzas, the average quantity is 15 pizzas, and the quantity

Elasticity of Supply

The Factors That Influence the Elasticity of Supply

increases by 67 percent. The elasticity of supply is equal to 67 percent divided by 4.9 percent, which equals 13.67. Because the elasticity of supply exceeds 1 (in this case by a lot), supply is elastic. In contrast, suppose that when the price rises from $20 to $30, the quantity of pizza supplied increases from 10 to 13 per hour. The price rise is $10 and the average price is $25, so the price rises by 40 percent of the average price. The quantity increases from 10 to 13 pizzas an hour, so the increase is 3 pizzas, the average quantity is 11.5 pizzas an hour, and the quantity increases by 26 percent. The elasticity of supply is equal to 26 percent divided by 40 percent, which equals 0.65. Now, because the elasticity of supply is less than 1, supply is inelastic. Figure 4.6 shows the range of elasticities of supply. If the quantity supplied is fixed regardless of the price, the supply curve is vertical and the elasticity of supply is zero. Supply is perfectly inelastic. This case is shown in Fig. 4.6(a). A special intermediate case occurs when the percentage change in price equals the percentage change in quantity. Supply is then unit elastic. This case is shown in Fig. 4.6(b). No matter how steep the supply curve is, if it is linear and passes through the origin, supply is unit elastic. If there is a price at which sellers are willing to offer any quantity for sale, the supply curve is horizontal and the elasticity of supply is infinite. Supply is perfectly elastic. This case is shown in Fig. 4.6(c).

The elasticity of supply of a good depends on ■ ■

Resource substitution possibilities Time frame for the supply decision

Resource Substitution Possibilities Some goods and

services can be produced only by using unique or rare productive resources. These items have a low, perhaps even a zero, elasticity of supply. Other goods and services can be produced by using commonly available resources that could be allocated to a wide variety of alternative tasks. Such items have a high elasticity of supply. A Van Gogh painting is an example of a good with a vertical supply curve and a zero elasticity of supply. At the other extreme, wheat can be grown on land that is almost equally good for growing corn, so it is just as easy to grow wheat as corn. The opportunity cost of wheat in terms of forgone corn is almost constant. As a result, the supply curve of wheat is almost horizontal and its elasticity of supply is very large. Similarly, when a good is produced in many different countries (for example, sugar and beef), the supply of the good is highly elastic. The supply of most goods and services lies between these two extremes. The quantity produced

S1

Price

Inelastic and Elastic Supply Price

Price

FIGURE 4.6

95

S 2A

Elasticity of supply =

Elasticity of supply = 0

Elasticity of supply = 1

S3 S 2B

0 (a) Perfectly inelastic supply

Quantity

0 (b) Unit elastic supply

Each supply illustrated here has a constant elasticity. The supply curve in part (a) illustrates the supply of a good that has a zero elasticity of supply. Each supply curve in part (b) illustrates the supply of a good with a unit elasticity of

Quantity

0

Quantity

(c) Perfectly elastic supply

supply. All linear supply curves that pass through the origin illustrate supplies that are unit elastic. The supply curve in part (c) illustrates the supply of a good with an infinite elasticity of supply.

MyEconLab animation

96

CHAPTER 4 Elasticity

can be increased but only by incurring a higher cost. If a higher price is offered, the quantity supplied increases. Such goods and services have an elasticity of supply between zero and infinity. Time Frame for the Supply Decision To study the

influence of the amount of time elapsed since a price change, we distinguish three time frames of supply: ■ ■ ■

Momentary supply Short-run supply Long-run supply

When the price of a good changes, the immediate response of the quantity supplied is determined by the momentary supply of that good. Some goods, such as fruits and vegetables, have a perfectly inelastic momentary supply—a vertical supply curve. The quantities supplied depend on crop-planting decisions made earlier. In the case of oranges, for example, planting decisions have to be made many years in advance of the crop being available. Momentary supply is perfectly inelastic because, on a given day, no matter what the price of oranges, producers cannot change their output. They have picked, packed, and shipped their crop to market, and the quantity available for that day is fixed. In contrast, some goods have a perfectly elastic momentary supply. Long-distance phone calls are an example. When many people simultaneously make a call, there is a big surge in the demand for telephone cables, computer switching, and satellite time. The quantity supplied increases, but the price remains constant. Long-distance carriers monitor fluctuations in demand and reroute calls to ensure that the quantity supplied equals the quantity demanded without changing the price.

Momentary Supply

The response of the quantity supplied to a price change when only some of the possible adjustments to production can be made is determined by short-run supply. Most goods have an inelastic short-run supply. To increase output in the short run, firms must work their labor force overtime and perhaps hire additional workers. To decrease their output in the short run, firms either lay off workers or reduce their hours of work. With the passage of time, firms can make more adjustments, perhaps training additional workers or buying additional tools and other equipment. Short-Run Supply

For the orange grower, if the price of oranges falls, some pickers can be laid off and oranges left on the trees to rot. Or if the price of oranges rises, the grower can use more fertilizer and improved irrigation to increase the yields of their existing trees. But an orange grower can’t change the number of trees producing oranges in the short run. Long-Run Supply The response of the quantity supplied to a price change after all the technologically possible ways of adjusting supply have been exploited is determined by long-run supply. For most goods and services, long-run supply is elastic and perhaps perfectly elastic. For the orange grower, the long run is the time it takes new tree plantings to grow to full maturity— about 15 years. In some cases, the long-run adjustment occurs only after a completely new production plant has been built and workers have been trained to operate it—typically a process that might take several years.

REVIEW QUIZ 1

2 3

4

5

Why do we need a units-free measure of the responsiveness of the quantity supplied of a good or service to a change in its price? Define the elasticity of supply and show how it is calculated. What are the main influences on the elasticity of supply that make the supply of some goods elastic and the supply of other goods inelastic? Provide examples of goods or services whose elasticities of supply are (a) zero, (b) greater than zero but less than infinity, and (c) infinity. How does the time frame over which a supply decision is made influence the elasticity of supply? Explain your answer.

You can work these questions in Study Plan 4.3 and get instant feedback.

MyEconLab

◆ You have now learned about the elasticities of

demand and supply. Table 4.1 summarizes all the elasticities that you’ve met in this chapter. In the next chapter, we study the efficiency of competitive markets. But first study Reading Between the Lines on pp. 98–99, which puts the elasticity of demand to work and looks at the market for winter tomatoes.

Elasticity of Supply

TABLE 4.1

A Compact Glossary of Elasticities

Price Elasticities of Demand A relationship is described as

When its magnitude is

Which means that

Perfectly elastic

Infinity

Elastic

Less than infinity

The smallest possible increase in price causes an infinitely large decrease in the quantity demanded* The percentage decrease in the quantity demanded

Unit elastic

1

exceeds the percentage increase in price The percentage decrease in the quantity demanded

Inelastic

Less than 1 but

equals the percentage increase in price The percentage decrease in the quantity demanded

Perfectly inelastic

greater than zero Zero

is less than the percentage increase in price The quantity demanded is the same at all prices

A relationship is described as

When its value is

Which means that

Close substitutes

Large

The smallest possible increase in the price of one good

Substitutes

Positive

causes an infinitely large increase in the quantity* demanded of the other good If the price of one good increases, the quantity

Unrelated goods

Zero

demanded of the other good also increases If the price of one good increases, the quantity

Complements

Negative

demanded of the other good remains the same If the price of one good increases, the quantity

Cross Elasticities of Demand

demanded of the other good decreases

Income Elasticities of Demand A relationship is described as

When its value is

Which means that

Income elastic

Greater than 1

The percentage increase in the quantity demanded is

(normal good) Income inelastic

Less than 1 but

(normal good)

greater than zero

greater than the percentage increase in income* The percentage increase in the quantity demanded is greater than zero but less than the percentage increase in

Negative

Less than zero

income When income increases, quantity demanded

(inferior good)

decreases

Elasticities of Supply A relationship is described as

When its magnitude is

Perfectly elastic

Infinity

The smallest possible increase in price causes an

Elastic

Less than infinity but

infinitely large increase in the quantity supplied* The percentage increase in the quantity supplied

Unit elastic

greater than 1 1

Inelastic Perfectly inelastic

Greater than zero but less than 1 Zero

Which means that

exceeds the percentage increase in the price The percentage increase in the quantity supplied equals the percentage increase in the price The percentage increase in the quantity supplied is less than the percentage increase in the price The quantity supplied is the same at all prices

*In each description, the directions of change may be reversed. For example, in this case, the smallest possible decrease in price causes an infinitely large increase in the quantity demanded.

97

R EA DIN G BET W EE N T H E L INE S

The Elasticities of Demand and Supply for Tomatoes Frigid Florida Winter Is Bad News for Tomato Lovers USA Today March 5, 2010 ST. PETERSBURG, Fla.—A frigid Florida winter is taking its toll on your sandwich. The Sunshine State is the main U.S. source for fresh winter tomatoes, and its growers lost some 70 percent of their crop during January’s prolonged cold snap. . . . The average wholesale price for a 25-pound box of tomatoes is now $30, up from $6.50 a year ago. Florida’s growers would normally ship about 25 million pounds of tomatoes a week; right now, they’re shipping less than a quarter of that, according to Reggie Brown of the Florida Tomato Grower’s Exchange, a tomato farmer cooperative in Maitland. . . . And because high demand has driven up domestic prices, many wholesalers are buying from Mexico instead. “We’re obviously losing market share to Mexico, and there’s always a price to pay to get the customer to get back into the Florida market,” Brown said. Florida is the only place where tomatoes are grown on a large scale in the United States during winter. California doesn’t grow them until later in the year, and much of that state’s crop is used for processed foods, such as ketchup, sauce, and juice. Other states grow tomatoes in greenhouses year-round, but Florida’s winter tomato crop is by far the largest. . . . Some Wendy’s restaurants posted signs saying tomatoes would only be provided upon request because of limited availability. . . . Used with permission of The Associated Press. Copyright © 2010. All rights reserved.

98

ESSENCE OF THE STORY ■

Florida is the main U.S. source for fresh winter tomatoes.



California tomatoes come to market later in the year and are mainly used for ketchup, sauce, and juice.



Other states grow tomatoes in greenhouses year-round.



In January 2010, a prolonged cold snap wiped out 70 percent of the Florida crop.



The average wholesale price for a 25-pound box of tomatoes rose from $6.50 in 2009 to $30 in 2010.



The quantity of tomatoes shipped decreased from a normal 25 million pounds per week to less than a quarter of that quantity.



The “high demand has driven up prices” and wholesalers are buying from Mexico.



Some restaurants provided tomatoes only on request.



According to J. Scott Shonkwiler and Robert D. Emerson, two agricultural economists at the University of Florida, the price elasticity of demand for winter tomatoes is 0.8.



A 1 percent rise in the price of these tomatoes brings a 0.8 percent decrease in the quantity demanded, other things remaining the same.















According to the news article, in a normal period, the price of Florida winter tomatoes is $6.50 a box (25 pounds) and growers normally ship 25 million pounds a week. With the information just stated, we can determine the demand for winter tomatoes. It is the curve D in Figs. 1 and 2. This demand curve passes through the point that shows that 25 million pounds are demanded at a price of $6.50 a box. The elasticity of demand for winter tomatoes is 0.8.

Other growers (using greenhouses or in Mexico) make up the difference between what the Florida growers supply and the quantity demanded. The supply curve in 2010, S1, must pass through the equilibrium point at that time of 8 million pounds and $30 a box. It also passes through the point 6 million pounds and $6.50 a box because that is the quantity that Florida growers would ship even if the price remained at $6.50 a box. Figure 3 zooms in on the supply curve S1. We can calculate the elasticity of supply by using the numbers in Fig. 3 and the midpoint formula. The elasticity of supply is 0.22, which means that the supply of winter tomatoes is inelastic.

30.00

S0

Prolonged cold snap decreased supply

20.00

6.50

D

0

68

20 25 30 40 Quantity (millions of pounds per week)

Figure 1 The Market for Winter Tomatoes

40.00 New point

Price elasticity of demand = 0.8

30.00

18.25

Figure 2 shows the calculation that confirms the price elasticity of demand is 0.8. When the price rises from $6.50 to $30 a box, as it did in 2010, the quantity demanded decreases from 25 million to 8 million pounds. Use the numbers and the midpoint formula to confirm that the elasticity of demand is 0.8. The news article says that Florida growers (the main producers of winter tomatoes) shipped less than a quarter of their normal 25 million pounds a week. So assume that they shipped 6 million pounds a week.

S1

40.00

10.00

Price (dollars per box)

Using the information provided in this news article supplemented with an independent estimate of the price elasticity of demand, we can find the demand and supply curves in the market for winter tomatoes shown in Fig. 1.

Original point

Pave 10.00 6.50

D

Q ave 0

8

16.5 25 30 40 Quantity (millions of pounds per week)

Figure 2 Price Elasticity of Demand for Winter Tomatoes Price (dollars per box)



Price (dollars per box)

ECONOMIC ANALYSIS

S1

40.00 New point 30.00 Elasticity of supply = 0.22 18.25

Pave 10.00

Original point

6.50

Q ave 0

4

7 6 8 10 Quantity (millions of pounds per week)

Figure 3 Price Elasticity of Supply of Winter Tomatoes

99

100

CHAPTER 4 Elasticity

SUMMARY Key Points Price Elasticity of Demand (pp. 84–90) ■











Elasticity is a measure of the responsiveness of the quantity demanded of a good to a change in its price, other things remaining the same. Price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The larger the magnitude of the price elasticity of demand, the greater is the responsiveness of the quantity demanded to a given price change. If demand is elastic, a cut in price leads to an increase in total revenue. If demand is unit elastic, a cut in price leaves total revenue unchanged. And if demand is inelastic, a cut in price leads to a decrease in total revenue. Price elasticity of demand depends on how easily one good serves as a substitute for another, the proportion of income spent on the good, and the length of time elapsed since the price change.



Working Problems 9 to 16 will give you a better understanding of cross and income elasticities of demand.

Elasticity of Supply (pp. 94–96) ■





Working Problems 1 to 8 will give you a better understanding of the price elasticity of demand.



More Elasticities of Demand (pp. 91–94) ■





Income elasticity of demand measures the responsiveness of demand to a change in income, other things remaining the same. For a normal good, the income elasticity of demand is positive. For an inferior good, the income elasticity of demand is negative. When the income elasticity of demand is greater than 1 (income elastic), the percentage of income spent on the good increases as income increases. When the income elasticity of demand is less than 1 (income inelastic and inferior), the percentage of

income spent on the good decreases as income increases. Cross elasticity of demand measures the responsiveness of the demand for one good to a change in the price of a substitute or a complement, other things remaining the same. The cross elasticity of demand with respect to the price of a substitute is positive. The cross elasticity of demand with respect to the price of a complement is negative.





Elasticity of supply measures the responsiveness of the quantity supplied of a good to a change in its price, other things remaining the same. The elasticity of supply is usually positive and ranges between zero (vertical supply curve) and infinity (horizontal supply curve). Supply decisions have three time frames: momentary, short run, and long run. Momentary supply refers to the response of the quantity supplied to a price change at the instant that the price changes. Short-run supply refers to the response of the quantity supplied to a price change after some of the technologically feasible adjustments in production have been made. Long-run supply refers to the response of the quantity supplied to a price change when all the technologically feasible adjustments in production have been made.

Working Problems 17 and 18 will give you a better understanding of the elasticity of supply.

Key Terms Cross elasticity of demand, 92 Elastic demand, 86 Elasticity of supply, 94 Income elasticity of demand, 91

Inelastic demand, 85 Perfectly elastic demand, 85 Perfectly inelastic demand, 85 Price elasticity of demand, 84

Total revenue, 88 Total revenue test, 88 Unit elastic demand, 85

Study Plan Problems and Applications

101

STUDY PLAN PROBLEMS AND APPLICATIONS MyEconLab You can work Problems 1 to 18 in MyEconLab Chapter 4 Study Plan and get instant feedback. Price Elasticity of Demand (Study Plan 4.1)

1. Rain spoils the strawberry crop, the price rises from $4 to $6 a box, and the quantity demanded decreases from 1,000 to 600 boxes a week. a. Calculate the price elasticity of demand over this price range. b. Describe the demand for strawberries. 2. If the quantity of dental services demanded increases by 10 percent when the price of dental services falls by 10 percent, is the demand for dental services inelastic, elastic, or unit elastic? 3. The demand schedule for hotel rooms is Price

Quantity demanded

(dollars per night)

(millions of rooms per night)

200 250 400 500 800

100 80 50 40 25

Price (dollars per pen)

a. What happens to total revenue when the price falls from $400 to $250 a night and from $250 to $200 a night? b. Is the demand for hotel rooms elastic, inelastic, or unit elastic? 4. The figure shows the demand for pens. 12 10 8 6 4 2

D

0

20

40

60

80

100 120 Pens per day

Calculate the elasticity of demand when the price rises from $4 to $6 a pen. Over what price range is the demand for pens elastic? 5. In 2003, when music downloading first took off, Universal Music slashed the average price of a CD from $21 to $15. The company expected the price cut to boost the quantity of CDs sold by 30 percent, other things remaining the same.

a. What was Universal Music’s estimate of the price elasticity of demand for CDs? b. If you were making the pricing decision at Universal Music, what would be your pricing decision? Explain your decision. 6. The demand for illegal drugs is inelastic. Much of the expenditure on illegal drugs comes from crime. Assuming these statements to be correct, a. How will a successful campaign that decreases the supply of drugs influence the price of illegal drugs and the amount spent on them? b. What will happen to the amount of crime? c. What is the most effective way of decreasing the quantity of illegal drugs bought and decreasing the amount of drug-related crime? 7. The Grip of Gas U.S. drivers are ranked as the least sensitive to changes in the price of gasoline. For example, if the price rose from $3 to $4 per gallon and stayed there for a year U.S. purchases of gasoline would fall only about 5 percent. Source: Slate, September 27, 2005 a. Calculate the price elasticity of demand for gasoline. Is the demand for gasoline elastic, unit elastic, or inelastic? b. Explain how the price rise from $3 to $4 a gallon changes the total revenue from gasoline sales. 8. Spam Sales Rise as Food Costs Soar Sales of Spam are rising as consumers realize that Spam and other lower-cost foods can be substituted for costlier cuts of meat as a way of controlling their already stretched food budgets. Source: AOL Money & Finance, May 28, 2008 a. Is Spam a normal good or an inferior good? Explain. b. Would the income elasticity of demand for Spam be negative or positive? Explain. More Elasticities of Demand (Study Plan 4.2)

9. When Judy’s income increased from $130 to $170 a week, she increased her demand for concert tickets by 15 percent and decreased her demand for bus rides by 10 percent. Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

102

CHAPTER 4 Elasticity

10. If a 12 percent rise in the price of orange juice decreases the quantity of orange juice demanded by 22 percent and increases the quantity of apple juice demanded by 14 percent, calculate the a. Price elasticity of demand for orange juice. b. Cross elasticity of demand for apple juice with respect to the price of orange juice. 11. If a 5 percent rise in the price of sushi increases the quantity of soy sauce demanded by 2 percent and decreases the quantity of sushi demanded by 1 percent, calculate the a. Price elasticity of demand for sushi. b. Cross elasticity of demand for soy sauce with respect to the price of sushi. 12. Swelling Textbook Costs Have College Students Saying “Pass” Textbook prices have doubled and risen faster than average prices for the past two decades. Sixty percent of students do not buy textbooks. Some students hunt for used copies and sell them back at the end of the semester; some buy online, which is often cheaper than the campus store; some use the library copy and wait till it’s free; some share the book with a classmate. Source: Washington Post, January 23, 2006 Explain what this news clip implies about a. The price elasticity of demand for college textbooks. b. The income elasticity of demand for college textbooks. c. The cross elasticity of demand for college textbooks from the campus bookstore with respect to the online price of a textbook. Use the following information to work Problems 13 to 15. As Gas Costs Soar, Buyers Flock to Small Cars Faced with high gas prices, Americans are substituting smaller cars for SUVs. In April 2008, Toyota Yaris sales increased 46 percent and Ford Focus sales increased 32 percent from a year earlier. SUV sales decreased 25 percent in 2008 and Chevrolet Tahoe sales fell 35 percent. Full-size pickup sales decreased 15 percent in 2008 and Ford F-Series pickup sales decreased by 27 percent in April 2008. The effect of a downsized vehicle fleet on fuel consumption is unknown. In California in January 2008, gasoline consumption was 4 percent lower and the price of gasoline 30 percent higher than in January 2007. Source: The New York Times, May 2, 2009

13. Calculate the price elasticity of demand for gasoline in California. 14. Calculate the cross elasticity of demand for a. Toyota Yaris with respect to the price of gasoline. b. Ford Focus with respect to the price of gasoline. 15. Calculate the cross elasticity of demand for a. Chevrolet Tahoe with respect to the price of gasoline. b. A full-size pickup with respect to the price of gasoline. 16. Home Depot Earnings Hammered As gas and food prices increased and home prices slumped, people had less extra income to spend on home improvements. And the improvements that they made were on small inexpensive types of repairs and not major big-ticket items. Source: CNN, May 20, 2008 a. What does this news clip imply about the income elasticity of demand for big-ticket home-improvement items? b. Would the income elasticity of demand be greater or less than 1? Explain. Elasticity of Supply (Study Plan 4.3)

17. The table sets out the supply schedule of jeans. Price

Quantity supplied

(dollars per pair)

(millions of pairs per year)

120 24 125 28 130 32 135 36 Calculate the elasticity of supply when a. The price rises from $125 to $135 a pair. b. The average price is $125 a pair. 18. Study Ranks Honolulu Third Highest for “Unaffordable Housing” A study ranks Honolulu number 3 in the world for the most unaffordable housing market in urban locations, behind Los Angeles and San Diego and is deemed “severely unaffordable.” With significant constraints on the supply of land for residential development, housing inflation has resulted. Source: Hawaii Reporter, September 11, 2007 a. Would the supply of housing in Honolulu be elastic or inelastic? b. Explain how the elasticity of supply plays an important role in influencing how rapidly housing prices in Honolulu rise.

Additional Problems and Applications

103

ADDITIONAL PROBLEMS AND APPLICATIONS MyEconLab You can work these problems in MyEconLab if assigned by your instructor. Price Elasticity of Demand

Price (dollars per DVD)

19. With higher fuel costs, airlines raised their average fare from 75¢ to $1.25 per passenger mile and the number of passenger miles decreased from 2.5 million a day to 1.5 million a day. a. What is the price elasticity of demand for air travel over this price range? b. Describe the demand for air travel. 20. The figure shows the demand for DVD rentals. 6 5 4 3 2 1

D

0

25

50

75

100 125 150 DVD rentals per day

a. Calculate the elasticity of demand when the price of a DVD rental rises from $3 to $5. b. At what price is the elasticity of demand for DVD rentals equal to 1? Use the following table to work Problems 21 to 23. The demand schedule for computer chips is Price

Quantity demanded

(dollars per chip)

(millions of chips per year)

200 250 300 350 400

50 45 40 35 30

21. a. What happens to total revenue if the price falls from $400 to $350 a chip and from $350 to $300 a chip? b. At what price is total revenue at a maximum? 22. At an average price of $350, is the demand for chips elastic, inelastic, or unit elastic? Use the total revenue test to answer this question. 23. At $250 a chip, is the demand for chips elastic or inelastic? Use the total revenue test to answer this question.

24. Your price elasticity of demand for bananas is 4. If the price of bananas rises by 5 percent, what is a. The percentage change in the quantity of bananas you buy? b. The change in your expenditure on bananas? 25. As Gasoline Prices Soar, Americans Slowly Adapt As gas prices rose in March 2008, Americans drove 11 billion fewer miles than in March 2007. Realizing that prices are not going down, Americans are adapting to higher energy costs. Americans spend 3.7 percent of their disposable income on transportation fuels. How much we spend on gasoline depends on the choices we make: what car we drive, where we live, how much time we spend driving, and where we choose to go. For many people, higher energy costs mean fewer restaurant meals, deferred weekend outings with the kids, less air travel, and more time closer to home. Source: International Herald Tribune, May 23, 2008 a. List and explain the elasticities of demand that are implicitly referred to in the news clip. b. Why, according to the news clip, is the demand for gasoline inelastic? More Elasticities of Demand

Use this information to work Problems 26 and 27. Economy Forces Many to Shorten Summer Vacation Plans This year Americans are taking fewer exotic holidays by air and instead are visiting local scenic places by car. The global financial crisis has encouraged many Americans to cut their holiday budgets. Source: USA Today, May 22, 2009 26. Given the prices of the two holidays, is the income elasticity of demand for exotic holidays positive or negative? Are exotic holidays a normal good or an inferior good? Are local holidays a normal good or an inferior good? 27. Are exotic holidays and local holidays substitutes? Explain your answer. 28. When Alex’s income was $3,000, he bought 4 bagels and 12 donuts a month. Now his income is $5,000 and he buys 8 bagels and 6 donuts a month.

104

CHAPTER 4 Elasticity

Calculate Alex’s income elasticity of demand for a. Bagels. b. Donuts. 29. Wal-Mart’s Recession-Time Pet Project During the recession, Wal-Mart moved its pet food and supplies to in front of its other fastgrowing business, baby products. Retail experts point out that kids and pets tend to be fairly recession-resistant businesses—even in a recession, dogs will be fed and kids will get their toys. Source: CNN, May 13, 2008 a. What does this news clip imply about the income elasticity of demand for pet food and baby products? b. Would the income elasticity of demand be greater or less than 1? Explain. 30. If a 5 percent fall in the price of chocolate sauce increases the quantity of chocolate sauce demanded by 10 percent and increases the quantity of ice cream demanded by 15 percent, calculate the a. Price elasticity of demand for chocolate sauce. b. Cross elasticity of demand for ice cream with respect to the price of chocolate sauce. 31. Netflix to Offer Online Movie Viewing Online movie rental service Netflix has introduced a new feature to allow customers to watch movies and television series on their personal computers. Netflix competes with video rental retailer Blockbuster, which added an online rental service to the in-store rental service. Source: CNN, January 16, 2007 a. How will online movie viewing influence the price elasticity of demand for in-store movie rentals? b. Would the cross elasticity of demand for online movies and in-store movie rentals be negative or positive? Explain. c. Would the cross elasticity of demand for online movies with respect to high-speed Internet service be negative or positive? Explain. 32. To Love, Honor, and Save Money In a survey of caterers and event planners, nearly half of them said that they were seeing declines in wedding spending in response to the economic slowdown; 12% even reported wedding cancellations because of financial concerns. Source: Time, June 2, 2008 a. Based upon this news clip, are wedding events a normal good or inferior good? Explain.

b. Are wedding events more a necessity or a luxury? Would the income elasticity of demand be greater than 1, less than 1, or equal to 1? Explain. Elasticity of Supply

33. The supply schedule of long-distance phone calls is Price

Quantity supplied

(cents per minute)

(millions of minutes per day)

10 20 30 40

200 400 600 800

Calculate the elasticity of supply when a. The price falls from 40¢ to 30¢ a minute. b. The average price is 20¢ a minute. 34. Weak Coal Prices Hit China’s Third-Largest Coal Miner The chairman of Yanzhou Coal Mining reported that the recession had decreased the demand for coal, with its sales falling by 11.9 percent to 7.92 million tons from 8.99 million tons a year earlier, despite a 10.6 percent cut in the price. Source: Dow Jones, April 27, 2009 Calculate the price elasticity of supply of coal. Is the supply of coal elastic or inelastic? Economics in the News

35. After you have studied Reading Between the Lines on pp. 98–99, answer the following questions. a. Which demand is more price elastic and why: tomatoes in general or Florida winter tomatoes? b. When cold weather destroyed the Florida crop and more tomatoes came from Mexico and greenhouses, what happened to the supply of tomatoes and the quantity of tomatoes supplied? c. The news article says the “high demand has driven up prices” and “wholesalers are buying from Mexico.” What does this statement mean? Did demand increase? Did it decrease? Is the news article correct? d. Reggie Brown says “We’re obviously losing market share to Mexico, and there’s always a price to pay to get the customer to get back into the Florida market.” What does he mean and what does that imply about the elasticity of demand for Florida tomatoes when the price rises and when the price falls?

5

EFFICIENCY AND EQUITY ◆

After studying this chapter, you will be able to: ◆ Describe the alternative methods of allocating

scarce resources ◆ Explain the connection between demand and

marginal benefit and define consumer surplus; and explain the connection between supply and marginal cost and define producer surplus ◆ Explain the conditions under which markets are

efficient and inefficient ◆ Explain the main ideas about fairness and evaluate

claims that markets result in unfair outcomes

When you order a pizza, your self-interested choice influences how resources are used. A market coordinates your choice with the self-interested choices of a pizza cook and a delivery person to fill your order. Do markets allocate resources between pizza and everything else efficiently? Markets generate huge income inequality: You can afford to buy a pizza but it might be an unaffordable luxury for a very poor person. Is this situation fair? You’re now going to learn how economists approach these questions. At the end of the chapter, in Reading Between the Lines, you will apply what you’ve learned to see how congestion pricing could end the rush-hour crawl and make our road use efficient. 105

106

CHAPTER 5 Efficiency and Equity

◆ Resource Allocation Methods Resources are scarce, so they must be allocated somehow. The goal of this chapter is to evaluate the ability of markets to allocate resources efficiently and fairly. But to see whether the market does a good job, we must compare it with its alternatives. What are the alternative methods of allocating scarce resources? Eight alternative methods might be used. They are ■ ■ ■ ■ ■ ■ ■ ■

Market price Command Majority rule Contest First-come, first-served Lottery Personal characteristics Force Let’s briefly examine each method.

Market Price When a market price allocates a scarce resource, the people who are willing and able to pay that price get the resource. Two kinds of people decide not to pay the market price: those who can afford to pay but choose not to buy and those who are too poor and simply can’t afford to buy. For many goods and services, distinguishing between those who choose not to buy and those who can’t afford to buy doesn’t matter. But for a few items, it does matter. For example, poor people can’t afford to pay school fees and doctors’ fees. Because poor people can’t afford items that most people consider to be essential, these items are usually allocated by one of the other methods.

Command A command system allocates resources by the order (command) of someone in authority. In the U.S. economy, the command system is used extensively inside firms and government departments. For example, if you have a job, most likely someone tells you what to do. Your labor is allocated to specific tasks by a command. A command system works well in organizations in which the lines of authority and responsibility are clear and it is easy to monitor the activities being per-

formed. But a command system works badly when the range of activities to be monitored is large and when it is easy for people to fool those in authority. North Korea uses a command system and it works so badly that it even fails to deliver an adequate supply of food.

Majority Rule Majority rule allocates resources in the way that a majority of voters choose. Societies use majority rule to elect representative governments that make some of the biggest decisions. For example, majority rule decides the tax rates that end up allocating scarce resources between private use and public use. And majority rule decides how tax dollars are allocated among competing uses such as education and health care. Majority rule works well when the decisions being made affect large numbers of people and selfinterest must be suppressed to use resources most effectively.

Contest A contest allocates resources to a winner (or a group of winners). Sporting events use this method. Andy Roddick competes with other tennis professionals, and the winner gets the biggest payoff. But contests are more general than those in a sports arena, though we don’t normally call them contests. For example, Bill Gates won a contest to provide the world’s personal computer operating system. Contests do a good job when the efforts of the “players” are hard to monitor and reward directly. When a manager offers everyone in the company the opportunity to win a big prize, people are motivated to work hard and try to become the winner. Only a few people end up with a big prize, but many people work harder in the process of trying to win. The total output produced by the workers is much greater than it would be without the contest.

First-Come, First-Served A first-come, first-served method allocates resources to those who are first in line. Many casual restaurants won’t accept reservations. They use first-come, first-served to allocate their scarce tables. Highway space is allocated in this way too: The first to arrive at the on-ramp gets the road space. If too many

Resource Allocation Methods

vehicles enter the highway, the speed slows and people wait in line for some space to become available. First-come, first-served works best when, as in the above examples, a scarce resource can serve just one user at a time in a sequence. By serving the user who arrives first, this method minimizes the time spent waiting for the resource to become free.

Lottery Lotteries allocate resources to those who pick the winning number, draw the lucky cards, or come up lucky on some other gaming system. State lotteries and casinos reallocate millions of dollars worth of goods and services every year. But lotteries are more widespread than jackpots and roulette wheels in casinos. They are used to allocate landing slots to airlines at some airports, places in the New York and Boston marathons, and have been used to allocate fishing rights and the electromagnetic spectrum used by cell phones. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource.

Personal Characteristics When resources are allocated on the basis of personal characteristics, people with the “right” characteristics get the resources. Some of the resources that matter most to you are allocated in this way. For example, you will choose a marriage partner on the basis of personal characteristics. But this method can also be used in unacceptable ways. Allocating the best jobs to white, Anglo-Saxon males and discriminating against visible minorities and women is an example.

Force Force plays a crucial role, for both good and ill, in allocating scarce resources. Let’s start with the ill. War, the use of military force by one nation against another, has played an enormous role historically in allocating resources. The economic supremacy of European settlers in the Americas and Australia owes much to the use of this method. Theft, the taking of the property of others without their consent, also plays a large role. Both large-scale organized crime and small-scale petty crime collectively allocate billions of dollars worth of resources annually.

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But force plays a crucial positive role in allocating resources. It provides the state with an effective method of transferring wealth from the rich to the poor, and it provides the legal framework in which voluntary exchange in markets takes place. A legal system is the foundation on which our market economy functions. Without courts to enforce contracts, it would not be possible to do business. But the courts could not enforce contracts without the ability to apply force if necessary. The state provides the ultimate force that enables the courts to do their work. More broadly, the force of the state is essential to uphold the principle of the rule of law. This principle is the bedrock of civilized economic (and social and political) life. With the rule of law upheld, people can go about their daily economic lives with the assurance that their property will be protected—that they can sue for violations against their property (and be sued if they violate the property of others). Free from the burden of protecting their property and confident in the knowledge that those with whom they trade will honor their agreements, people can get on with focusing on the activity in which they have a comparative advantage and trading for mutual gain.

REVIEW QUIZ 1 2 3 4

Why do we need methods of allocating scarce resources? Describe the alternative methods of allocating scarce resources. Provide an example of each allocation method that illustrates when it works well. Provide an example of each allocation method that illustrates when it works badly.

You can work these questions in Study Plan 5.1 and get instant feedback.

MyEconLab

In the next sections, we’re going to see how a market can achieve an efficient use of resources, examine the obstacles to efficiency, and see how sometimes an alternative method might improve on the market. After looking at efficiency, we’ll turn our attention to the more difficult issue of fairness.

CHAPTER 5 Efficiency and Equity

◆ Benefit, Cost, and Surplus

In Fig. 5.1(a), Lisa is willing to pay $1 for the 30th slice of pizza and $1 is her marginal benefit from that slice. In Fig. 5.1(b), Nick is willing to pay $1 for the 10th slice of pizza and $1 is his marginal benefit from that slice. But at what quantity is the market willing to pay $1 for the marginal slice? The answer is provided by the market demand curve.

Resources are allocated efficiently and in the social interest when they are used in the ways that people value most highly. You saw in Chapter 2 that this outcome occurs when the quantities produced are at the point on the PPF at which marginal benefit equals marginal cost (see pp. 35–37). We’re now going to see whether competitive markets produce the efficient quantities. We begin on the demand side of a market.

Individual Demand and Market Demand The relationship between the price of a good and the quantity demanded by one person is called individual demand. And the relationship between the price of a good and the quantity demanded by all buyers is called market demand.

Demand, Willingness to Pay, and Value In everyday life, we talk about “getting value for money.” When we use this expression, we are distinguishing between value and price. Value is what we get, and price is what we pay. The value of one more unit of a good or service is its marginal benefit. We measure marginal benefit by the maximum price that is willingly paid for another unit of the good or service. But willingness to pay determines demand. A demand curve is a marginal benefit curve.

3.00 2.50 Lisa is willing to pay $1 for the 30th slice

2.00 1.50 1.00 0.50

0

Figure 5.1(c) illustrates the market demand for pizza if Lisa and Nick are the only people in the market. Lisa’s demand curve in part (a) and Nick’s demand curve in part (b) sum horizontally to the market demand curve in part (c).

Individual Demand, Market Demand, and Marginal Social Benefit Price (dollars per slice)

Price (dollars per slice)

FIGURE 5.1

The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price.

Price (dollars per slice)

108

3.00 2.50 2.00 1.50

Nick is willing to pay $1 for the 10th slice

Lisa's D = MB 10

(a) Lisa's demand

20 30 40 50 Quantity (slices per month)

0.50

0

2.50 Society is willing to pay $1 for the 40th slice

2.00 1.50

1.00 30 slices

3.00

1.00 10 slices 10

Nick's D = MB 20 30 40 50 Quantity (slices per month)

(b) Nick's demand

At a price of $1 a slice, the quantity demanded by Lisa is 30 slices and the quantity demanded by Nick is 10 slices, so the quantity demanded by the market is 40 slices. Lisa’s demand

0.50

30 + 10 = 40 slices Market D = MSB

0

10

20 30 40 50 60 70 Quantity (slices per month)

(c) Market demand

curve in part (a) and Nick’s demand curve in part (b) sum horizontally to the market demand curve in part (c). The market demand curve is the marginal social benefit (MSB) curve.

MyEconLab animation

Benefit, Cost, and Surplus

At a price of $1 a slice, Lisa demands 30 slices and Nick demands 10 slices, so the market quantity demanded at $1 a slice is 40 slices. For Lisa and Nick, their demand curves are their marginal benefit curves. For society, the market demand curve is the marginal benefit curve. We call the marginal benefit to the entire society marginal social benefit. So the market demand curve is also the marginal social benefit (MSB) curve.

Consumer Surplus We don’t always have to pay as much as we are willing to pay. We get a bargain. When people buy something for less than it is worth to them, they receive a consumer surplus. Consumer surplus is the excess of the benefit received from a good over the amount paid for it. We can calculate consumer surplus as the marginal benefit (or value) of a good minus its price, summed over the quantity bought. Figure 5.2(a) shows Lisa’s consumer surplus from pizza when the price is $1 a slice. At this price, she buys 30 slices a month because the 30th slice is worth exactly $1 to her. But Lisa is willing to pay $2 for the 10th slice, so her marginal benefit from this slice is

2.50

Lisa's consumer surplus Lisa's surplus from the 10th slice

2.00

Supply and Marginal Cost Your next task is to see how market supply reflects marginal cost. The connection between supply and cost closely parallels the related ideas about demand and benefit that you’ve just studied. Firms are in business to make a profit. To do so, they must sell

Price (dollars per slice)

3.00

$1 more than she pays for it—she receives a surplus of $1 on the 10th slice. Lisa’s consumer surplus is the sum of the surpluses on all of the slices she buys. This sum is the area of the green triangle—the area below the demand curve and above the market price line. The area of this triangle is equal to its base (30 slices) multiplied by its height ($1.50) divided by 2, which is $22.50. The area of the blue rectangle in Fig. 5.2(a) shows what Lisa pays for 30 slices of pizza. Figure 5.2(b) shows Nick’s consumer surplus, and part (c) shows the consumer surplus for the market. The consumer surplus for the market is the sum of the consumer surpluses of Lisa and Nick. All goods and services have decreasing marginal benefit, so people receive more benefit from their consumption than the amount they pay.

Demand and Consumer Surplus Price (dollars per slice)

Price (dollars per slice)

FIGURE 5.2

3.00 2.50 2.00

Nick's consumer surplus

3.00

2.00

1.50

1.50

1.00

1.00

1.00

0.50

Lisa's D = MB 10

20 30 40 50 Quantity (slices per month)

(a) Lisa's consumer surplus

0.50

0

Nick's D = MB 10

20 30 40 50 Quantity (slices per month)

(b) Nick's consumer surplus

Lisa is willing to pay $2 for her 10th slice of pizza in part (a). At a market price of $1 a slice, Lisa receives a surplus of $1 on the 10th slice. The green triangle shows her consumer surplus on the 30 slices she buys at $1 a slice. The

Consumer surplus

2.50

1.50

0

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Market price

0.50 Market D = MSB 0

10

20 30 40 50 60 70 Quantity (slices per month)

(c) Market consumer surplus

green triangle in part (b) shows Nick’s consumer surplus on the 10 slices that he buys at $1 a slice. The green area in part (c) shows the consumer surplus for the market. The blue rectangles show the amounts spent on pizza.

MyEconLab animation

CHAPTER 5 Efficiency and Equity

Individual Supply and Market Supply

their output for a price that exceeds the cost of production. Let’s investigate the relationship between cost and price.

The relationship between the price of a good and the quantity supplied by one producer is called individual supply. And the relationship between the price of a good and the quantity supplied by all producers is called market supply.

Supply, Cost, and Minimum Supply-Price Firms make a profit when they receive more from the sale of a good or service than the cost of producing it. Just as consumers distinguish between value and price, so producers distinguish between cost and price. Cost is what a firm gives up when it produces a good or service and price is what a firm receives when it sells the good or service. The cost of producing one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale. But the minimum supply-price determines supply. A supply curve is a marginal cost curve. In Fig. 5.3(a), Maria is willing to produce the 100th pizza for $15, her marginal cost of that pizza. In Fig. 5.3(b), Max is willing to produce the 50th pizza for $15, his marginal cost. What quantity is this market willing to produce for $15 a pizza? The answer is provided by the market supply curve.

30.00 Maria's S = MC 25.00 20.00

100 pizzas

15.00

30.00 Max's S = MC 25.00

50 pizzas

20.00 15.00

10.00

Maria is willing to supply the 100th pizza for $15

5.00

0

Figure 5.3(c) illustrates the market supply of pizzas if Maria and Max are the only producers. Maria’s supply curve in part (a) and Max’s supply curve in part (b) sum horizontally to the market supply curve in part (c). At a price of $15 a pizza, Maria supplies 100 pizzas and Max supplies 50 pizzas, so the quantity supplied by the market at $15 a pizza is 150 pizzas. For Maria and Max, their supply curves are their marginal cost curves. For society, the market supply curve is its marginal cost curve. We call the society’s marginal cost marginal social cost. So the market supply curve is also the marginal social cost (MSC) curve.

Individual Supply, Market Supply, and Marginal Social Cost Price (dollars per pizza)

Price (dollars per pizza)

FIGURE 5.3

The market supply curve is the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price.

50

100 150 200 250 Quantity (pizzas per month)

(a) Maria's supply

30.00

100 + 50 = 150 pizzas Market S = MSC

25.00 20.00 15.00

10.00

Max is willing to supply the 50th pizza for $15

5.00

0

Price (dollars per pizza)

110

50

(b) Max's supply

At a price of $15 a pizza, the quantity supplied by Maria is 100 pizzas and the quantity supplied by Max is 50 pizzas, so the quantity supplied by the market is 150 pizzas. Maria’s

100 150 200 250 Quantity (pizzas per month)

10.00

Society is willing to supply the 150th pizza for $15

5.00

0

50

150 250 350 Quantity (pizzas per month)

(c) Market supply

supply curve in part (a) and Max’s supply curve in part (b) sum horizontally to the market supply curve in part (c). The market supply curve is the marginal social cost (MSC) curve.

MyEconLab animation

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demand and supply - ModPhD

PART T W O HOW MARKETS WORK 3 DEMAND AND SUPPLY ◆ After studying this chapter, you will be able to: ◆ Describe a competitive market and think about...

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