Microeconomics Chapter 3-4 PDF

Chapter 3 DEMAND, SUPPLY, AND PRICE ∂ C hoice in the face of scarcity is the fundamental concern of economics. But if scarcity is such a concern for economists, why is it that whenever I go to my local grocery store...

Chapter 3 DEMAND, SUPPLY, AND PRICE ∂ C hoice in the face of scarcity is the fundamental concern of economics. But if scarcity is such a concern for economists, why is it that whenever I go to my local grocery store it has all the tomatoes I want to buy? Tomatoes might be more expensive one week and less expensive the next, but they are always avail- able. In what sense are tomatoes scarce? The same is true for most goods most of the time; as long as I am willing to pay the market price, I can buy the good. A key economic insight is that when the forces of supply and demand operate freely, the price of a good measures its scarcity. If bad weather destroys part of the tomato crop, tomatoes are more scarce, and their price will rise to reflect that condition. But price does more than simply measure scarcity. Prices also convey critical economic infor- mation. When the price of a resource—such as land, labor, or capital—used by a firm is high, the company has a greater incentive to economize on its use. When the price of a good that the firm produces is high, the company has a greater incentive to pro- duce more of that good, and its customers have an incentive to economize on its use. Thus, prices provide our economy with incentives to use scarce resources efficiently, and a major objective of economists is to understand the forces that determine prices. This chapter describes how prices are determined in competitive market economies. The Role of Prices The price of a good or service is what must be given in exchange for the good. Usually we identify the price of something with how much it costs in dollars. But price can include other factors—for example, if you have to wait to buy something, the total price includes the value of your time spent in line. For most of our discussion, however, we will keep things simple and just think of the price as the number of dollars paid to obtain a good or service. 53  Prices are the way participants in the economy communicate with one another. Assume a drought hits the country, drastically reducing the supply of corn. Households will need to lower their consumption of corn or there will not be enough to go around. But how will they know this? Suppose newspapers across the country ran an article informing people they would have to eat less corn because of a drought. What incen- tive would they have to pay attention to it? How would each family know how much it ought to reduce its consumption? Alternatively, consider the effect of an increase in the price of corn. The higher price conveys all the relevant information. It simul- taneously tells families corn is scarce and provides incentives for them to consume less of it. Consumers do not need to know anything about why corn is scarce, nor do they need to be told how much to reduce their consumption of it. Price changes and differences present interesting problems and puzzles. In the early 2000s, while the price of an average house in Los Angeles went up by 76 per- cent, the price of a house in Milwaukee, Wisconsin, increased by only 32 percent. Why? During the same period, the price of computers fell dramatically, while the price of bread rose, but at a much slower rate than the price of housing in Los Angeles. Why? The “price” of labor is just the wage or salary that is paid. Why does a physi- cian earn three times as much as a college professor, though the college professor may have performed better in the college courses they took together? Why is the price of water, without which we cannot live, very low in most cases, but the price of dia- monds very high? The simple answer to all these questions is that in market economies like that of the United States, price is determined by supply and demand. Changes in prices are determined by changes in supply and demand. Understanding the causes of changes in prices and being able to predict their occurrence are not just matters of academic interest. One of the events that pre- cipitated the French Revolution was the rise in the price of bread, for which the people blamed the government. And gas price increases were a topic of political debate in the 2004 U.S. presidential election. Demand Economists use the concept of demand to describe the quantity of a good or serv- ice that a household or firm chooses to buy at a given price. It is important to under- stand that economists are concerned not just with what people desire but with what they choose to buy given the spending limits imposed by their budget constraint and given the prices of various goods. In analyzing demand, the first question econ- omists ask is how the quantity of a good purchased by an individual changes as the price changes, when everything else is kept constant. THE INDIVIDUAL DEMAND CURVE Think about what happens as the price of candy bars changes. At a price of $5.00, you might never buy one. At $3.00, you might buy one as a special treat. At $1.25, 54 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE you might buy a few, and if the price declined to $0.50, you might buy a lot. The table in Figure 3.1 summarizes the weekly demand of 5.00 Price Quantity demanded one individual, Roger, for candy bars at these different prices. We can see that the lower the price, the larger the quantity demanded. $ 5.00 0 We can also draw a graph that shows the quantity Roger demands 4.00 $ 3.00 1 $ 2.00 2 at each price. The quantity demanded is measured along the hori- $ 1.50 3 zontal axis, and the price is measured along the vertical axis. The $ 1.25 4 PRICE ($) 3.00 $ 1.00 6 graph in Figure 3.1 plots the points. $ 0.75 9 A smooth curve can be drawn to connect the points. This curve $ 0.50 15 is called the demand curve. The demand curve gives the quantity 2.00 demanded at each price. Thus, if we want to know how many candy B 1.50 bars a week Roger will demand at a price of $1.00, we simply look A along the vertical axis at the price $1.00, find the corresponding point 1.00 Demand curve A along the demand curve, and then read down the horizontal axis. 0.50 At a price of $1.00, Roger buys 6 candy bars each week. Alternatively, if we want to know at what price he will buy just 3 candy bars, we 0 2 4 6 8 10 12 14 16 look along the horizontal axis at the quantity 3, find the correspon- QUANTITY OF CANDY BARS ding point B along the demand curve, and then read across to the Figure 3.1 vertical axis. Roger will buy 3 candy bars at a price of $1.50. AN INDIVIDUAL’S DEMAND CURVE As the price of candy bars increases, the quantity demanded decreases. This can be seen from the numbers in the table in Figure This demand curve shows the quantity of candy bars that 3.1 and in the shape of the demand curve, which slopes downward from Roger consumes at each price. Notice that quantity demanded increases as the price falls, and the demand left to right. This relationship is typical of demand curves and makes curve slopes down. common sense: the cheaper a good is (the lower down we look on the vertical axis), the more of it a person will buy (the farther right on the horizontal axis); the more expensive, the less a person will buy. Wrap-Up DEMAND CURVE The demand curve gives the quantity of the good demanded at each price. THE MARKET DEMAND CURVE Suppose there was a simple economy made up of two people, Roger and Jane. Figure 3.2 illustrates how to add up the demand curves of these two individuals to obtain a demand curve for the market as a whole. We “add” the demand curves horizontally by taking, at each price, the quantities demanded by Roger and by Jane and adding the two together. Thus, in the figure, at the price of $0.75, Roger demands 9 candy bars and Jane demands 11, so that the total market demand is 20 candy bars. The same principles apply no matter how many people there are in the economy. The market demand curve gives the total quantity of the good that will be demanded at each price. The table in Figure 3.3 summarizes the information for our example of candy DEMAND ∂ 55  Roger’s Jane’s Market PRICE ($) PRICE ($) PRICE ($) demand demand demand 1.50 1.50 1.50 curve curve curve 0.75 0.75 0.75 0 0 0 2 4 6 8 10 12 2 4 6 8 10 12 14 2 4 6 8 10 12 14 16 18 20 22 24 QUANTITY OF CANDY BARS QUANTITY OF CANDY BARS QUANTITY OF CANDY BARS Figure 3.2 The market demand curve is constructed by adding up, at each price, the total of the quantities consumed by each individual. The curve here shows what market demand DERIVING THE MARKET would be if there were only two consumers. Actual market demand, as depicted in DEMAND CURVE Figure 3.3, is much larger because there are many consumers. bars; it gives the total quantity of candy bars demanded by everybody in the econ- omy at various prices. If we had a table like the one in Figure 3.1 for each person in the economy, we would construct Figure 3.3 by adding up, at each price, the total quantity of candy bars purchased. Figure 3.3 tells us, for instance, that at a price of $3.00 per candy bar, the total market demand for candy bars is 1 million candy bars, and that lowering the price to $2.00 increases market demand to 3 million candy bars. Figure 3.3 also depicts the same information in a graph. As in Figure 3.1, price lies along the vertical axis, but now the horizon- 5.00 Price Quantity demanded (millions) tal axis measures the quantity demanded by everyone in the econ- omy. Joining the points in the figure together, we get the market $ 5.00 0 4.00 $ 3.00 1 demand curve. If we want to know what the total demand for candy $ 2.00 3 bars will be when the price is $1.50 per candy bar, we look on the $ 1.50 4 vertical axis at the price $1.50, find the corresponding point A along PRICE ($) $ 1.25 8 3.00 the demand curve, and read down to the horizontal axis; at that Market $ 1.00 13 demand $ 0.75 20 price, total demand is 4 million candy bars. If we want to know curve $ 0.50 30 what the price of candy bars will be when the demand equals 20 mil- 2.00 A lion, we find 20 million along the horizontal axis, look up to find 1.50 the corresponding point B along the market demand curve, and 1.00 B read across to the vertical axis; the price at which 20 million candy 0.75 bars are demanded is $0.75. 0.50 Notice that just as when the price of candy bars increases, the 0 4 8 12 16 20 24 28 32 individual’s demand decreases, so too when the price of candy QUANTITY OF CANDY BARS (MILLIONS) bars increases, market demand decreases. At successively higher prices, more and more individuals exit the market. Thus, the Figure 3.3 market demand curve also slopes downward from left to right. THE MARKET DEMAND CURVE This general rule holds both because each individual’s demand The market demand curve shows the quantity of the good curve is downward sloping and because as the price is increased, demanded by all consumers in the market at each price. some individuals will decide to stop buying altogether. In Figure The market demand curve is downward sloping, for two 3.1, for example, Roger exits the market—consumes a quantity of reasons: at a higher price, each consumer buys less, and at zero—at the price of $5.00, at which his demand curve hits the high-enough prices, some consumers decide not to buy vertical axis. at all—they exit the market. 56 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE SHIFTS IN DEMAND CURVES 1.25 When the price of a good increases, the demand for that good 1.00 decreases—when everything else is held constant. But in the real world, everything is not held constant. Any changes other than in the Market E2000 E 1960 PRICE ($) demand price of the good in question shift the (whole) demand curve—that 0.75 curve, is, they alter the amount that will be demanded at each price. How 1960 the demand curve for candy has shifted as Americans have become 0.50 more weight conscious provides a good example. Figure 3.4 shows Market hypothetical demand curves for candy bars in 1960 and in 2000. We 0.25 demand can see from the figure that the demand for candy bars at a price of curve, $0.75 has decreased from 20 million candy bars (point E1960) to 10 2000 million (point E2000), as people have reduced their taste for candy. 0 10 20 30 QUANTITY OF CANDY BARS (MILLIONS) Figure 3.4 SOURCES OF SHIFTS IN SHIFTS IN THE DEMAND CURVE DEMAND CURVES A leftward shift in the demand curve means that a lesser Two of the factors that shift the demand curve—changes in income amount will be demanded at every given market price. and in the price of other goods—are specifically economic factors. As an individual’s income increases, she normally purchases more of any good. Thus, rising incomes shift the demand curve to the right, as illustrated in Figure 3.5. At each price, more of the good D0 D1 is consumed. Changes in the price of other goods, particularly closely related PRICE OF CANDY BARS goods, will also shift the demand curve for a good. For example, when the price of margarine increases, some individuals will sub- Demand curve stitute butter. Two goods are substitutes if an increase in the price after change of one increases the demand for the other. Butter and margarine are thus substitutes. When people choose between butter and mar- garine, one important factor is the relative price, that is, the ratio of the price of butter to the price of margarine. An increase in the Initial demand price of butter and a decrease in the price of margarine increase the curve relative price of butter. Thus, both induce individuals to substitute margarine for butter. Candy bars and granola bars can also be considered substitutes, QUANTITY OF CANDY BARS as the two goods satisfy a similar need. Thus, an increase in the Figure 3.5 price of granola bars makes candy bars relatively more attractive, and hence leads to a rightward shift in the demand curve for candy A RIGHTWARD SHIFT IN THE DEMAND bars. (At each price, the demand for candy is greater.) CURVE Sometimes, however, an increase in a price of other goods has If, at each price, there is an increase in the quantity just the opposite effect. Consider an individual who takes sugar in demanded, then the demand curve will shift to the his coffee. In deciding on how much coffee to demand, he is con- right, as depicted. An increase in income, an increase cerned with the price of a cup of coffee with sugar. If sugar becomes in the price of a substitute, or a decrease in the price of a complement can cause a rightward shift in the more expensive, he will demand less coffee. For this person, sugar demand curve. and coffee are complements; an increase in the price of one decreases the demand for the other. A price increase for sugar shifts the DEMAND ∂ 57  demand curve for coffee to the left: at each price, the demand for coffee is less. Similarly a decrease in the price of sugar shifts the demand curve for coffee to the right. Market demand curves can also be shifted by noneconomic factors. The major ones are changes in tastes, cultural factors, and changes in the composition of the population. The candy example discussed earlier reflected a change in tastes. Other taste changes in recent years in the United States include shifts in food choices as a result of new health information or (often short-lived) fads associated with diets. Health concerns led to a shift from high-cholesterol to low-cholesterol foods, and the Atkins diet produced a temporary shift away from high-carbohydrate foods such as bread. Cultural factors also affect demand curves. During the late twentieth cen- tury, increasing numbers of women entered the workforce as attitudes toward mar- ried middle-class women working outside the home shifted; and with this change, the demand curves for child care services shifted. Population changes that shift demand curves are often related to age. Young families with babies purchase disposable diapers. The demand for new houses and apartments is closely related to the number of new households, which in turn depends on the number of individuals of marriageable age. The U.S. population has been growing older, on average, both because life expectancies are increasing and because birthrates fell somewhat after the baby boom that followed World War II. So there has been a shift in demand away from diapers and new houses. Economists work- ing for particular firms and industries spend considerable energy ascertaining such demographic effects on the demand for the goods their firms sell. Sometimes demand curves shift as the result of new information. The shifts in demand for alcohol and meat—and even more strongly for cigarettes—are related to improved consumer information about health risks. Changes in the cost and available of credit can also shift demand curves—for goods such as cars and houses that people typically buy with the help of loans. When interest rates rise and borrowing money becomes more expensive, the demand curves for cars and houses shift; at each price, the quantity demanded is less. Finally, what people expect to happen in the future can shift demand curves. If people think they may become unemployed, they will reduce their spending. In this case, economists say that their demand curves depend on expectations. Wrap-Up SOURCES OF SHIFTS IN MARKET DEMAND CURVES A change in income A change in the price of a substitute A change in the price of a complement A change in the composition of the population A change in tastes or cultural attitudes A change in information A change in the availability of credit A change in expectations 58 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE Case in Point GASOLINE PRICES AND THE DEMAND FOR SUVS When demand for several products is intertwined, conditions affecting the price of one will affect the demand for the other. Changes in gasoline prices in the United States, for example, have affected the types of cars Americans buy. Gasoline prices soared twice in the 1970s, once when the Organization of Petroleum Exporting Countries (OPEC) shut off the flow of oil to the United States in 1973 and again when the overthrow of the shah of Iran in 1979 led to a disruption in oil supplies. The price of gasoline at the pump rose from $0.35 a gallon in 1971 to $1.35 a gallon by 1981 (see Figure 3.6). In response to the price increases, Americans had to cut back demand. But how could they conserve on gasoline? The distance from home to office was not going to shrink, and people had to get to their jobs. One solution was for American drivers to replace their old cars with smaller cars that offered more miles to the gallon. Analysts classify car sales according to car size, and usually the smaller the car, the better the gas mileage. Just after the first rise in gas prices, about 2.5 million large cars, 2.8 million compacts, and 2.3 million subcompacts were bought each year. By 1985, the proportions had shifted dramatically. About 1.5 million large cars were sold that year, representing a significant decline from the mid-1970s. The number of subcompacts sold was relatively unchanged at 2.2 million, but the number of compacts sold soared to 3.7 million. The demand curve for any good (like cars) assumes that the price of comple- mentary goods (like gasoline) is fixed. The rise in gasoline prices caused the demand curve for small cars to shift out to the right and the demand curve for large cars to shift back to the left. By the late 1980s, the price of gasoline had fallen significantly from its peak in 1981, but in the 1990s, gasoline prices again rose markedly. However, the prices of other goods were also rising over the thirty-five-year period shown in the figure. When Low gas prices in 1990s and early 2000s led to higher demand for SUVs. DEMAND ∂ 59  $1.60 $1.40 Price in $1.20 current dollars PRICE PER GALLON $1.00 $0.80 $0.60 Price of gas $0.40 adjusted for inflation $0.20 $0.00 1970 1975 1980 1985 1990 1995 2000 Figure 3.6 Adjusted for inflation, gasoline prices over the past decade have been about the same as they were before the price increases of the 1970s. U.S. GASOLINE PRICES SOURCE: Department of Energy, Annual Energy Review 2003, September 7, 2004 (www.eia. doe.gov/emeu/aer/petro.html). gas prices are adjusted for inflation, the real price of gasoline—the price of gas relative to the prices of other goods—was lower in the 1990s than it had been before the big price increases of the 1970s (Figure 3.6). As a consequence, the demand curve for large cars shifted back to the right. This time, the change in demand was reflected in booming sales of sports utility vehicles, or SUVs. The registrations of light-duty trucks (which include SUVs, minivans, and pickups) jumped from less than 20 percent of all vehicles in 1980 to 46 percent in 1996.1 SHIFTS IN A DEMAND CURVE VERSUS MOVEMENTS ALONG A DEMAND CURVE The distinction between changes that result from a shift in the demand curve and changes that result from a movement along the demand curve is crucial to under- standing economics. A movement along a demand curve is simply the change in the quantity demanded as the price changes. Figure 3.7A illustrates a movement along the demand curve from point A to point B; given a demand curve, at lower prices, more is consumed. Figure 3.7B illustrates a shift in the demand curve to the right; at a given price, more is consumed. 1 P. S. Hu, S. D. Davis, and R. L. Schmoyer, Registrations and Vehicle Miles of Travel for Light-Duty Vehicles, 1985–1995 (publication ORNL-6936) (Oakridge, Tenn.: Center for Transportation Analysis, February 1998), p. 1. 60 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE  In practice, both effects are often present. Thus, in panel C of Fig- A PRICE OF CANDY BARS (p) ure 3.7, the movement from point A to point C—where the quantity demanded has been increased from Q0 to Q2—consists of two parts: a change in quantity demanded resulting from a shift in the demand A p0 curve (the increase in quantity from Q 0 to Q 1 ), and a movement along the demand curve due to a change in the price (the increase in quantity from Q1 to Q2). B p1 Demand The distinction will be important for understanding how quantities curve and prices are determined once we combine our analysis of demand with an analysis of supply. For example, along a given demand curve Q0 Q1 for gasoline, a rise in the price of gasoline causes a reduction in the QUANTITY OF CANDY BARS (Q ) quantity demanded. In contrast, the introduction of a new rapid transit system in a city would shift the demand curve for gasoline to the left; B in this example, at each price of gasoline, the quantity demanded would PRICE OF CANDY BARS (p) be less because alternative transportation services are available. B New p0 demand A curve WRAP UP SHIFTS VERSUS MOVEMENTS ALONG Original demand DEMAND CURVES curve A change in price, given a demand curve, is reflected in a movement Q0 Q1 along the given demand curve. QUANTITY OF CANDY BARS (Q ) A shift in the demand curve causes the quantity demanded to change, C PRICE OF CANDY BARS (p) at a given price. A B New p0 demand C FUNDAMENTALS OF DEMAND, p1 curve SUPPLY, AND PRICE 1 Original demand DEMAND DECLINES AS PRICE RISES curve Q0 Q1 Q2 As the price of a good increases, the quantity demanded falls. Changes QUANTITY OF CANDY BARS (Q ) in factors other than price—such as incomes, consumer tastes, or the prices of other substitutes or complements—shift the demand Figure 3.7 curve. MOVEMENT ALONG THE DEMAND CURVE VERSUS SHIFT IN THE DEMAND CURVE Panel A shows an increase in quantity demanded caused by a lower price—a movement along a given demand curve. Panel B illustrates an increase in quantity demanded Supply caused by a shift in the entire demand curve, so that a greater quantity is demanded at every market price. Economists use the concept of supply to describe the quantity of Panel C shows a combination of a shift in the demand a good or service that a household or firm would like to sell at a curve (the movement from point A to B) and a movement particular price. Supply in economics refers to such seemingly along the demand curve (the movement from B to C). SUPPLY ∂ 61 e-Insight THE DEMAND FOR COMPUTERS AND INFORMATION TECHNOLOGY The demand for computers and other information technol- age of 29 percent over the period shown (1990–2003). This ogy investments rose markedly during the 1980s and 1990s. growth in the demand for computers occurred for a simple Panel A shows an index of real investment in computers reason: the effective price of computers fell enormously. and related equipment; the index is scaled so that it equals Even though the average price of a personal computer 100 in the year 2000. Real investment has grown an aver- remained relatively stable, today’s computer delivers much A 160 Nonresidential computer and peripheral equipment investment 140 INDEX: 2000 = 100 120 100 80 60 40 20 0 1990 1992 1994 1996 1998 2000 2002 2004 800 B Computer price index 700 600 INDEX: 2000 = 100 500 400 300 200 100 0 1990 1992 1994 1996 1998 2000 2002 2004 62 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE  higher performance at that price. Adjusting for this change in quality, between 1990 and 2003 the price of computers is estimated to have fallen an average of 17 percent per year (see panel B). At the lower price, we see a higher quantity demanded. A major reason for the decline in computer prices is technological innovations that have lowered the cost of pro- ducing computers. Firms able to take advantage of these tech- nological improvements have increased their profits, as their costs have fallen faster than the prices of the computers they sell. Other firms have been less successful, and the fall in prices has forced them to leave the market. The demand for computers rose markedly during the 1980s and 1990s. disparate choices as the number of candy bars a firm wants to sell and the number of hours a worker is willing to work. As with 5.00 Price Supply Supply demand, the first question economists ask is, How does the quan- curve tity supplied change when price changes, if everything else is kept $ 5.00 100,000 the same? $ 3.00 95,000 $ 2.00 85,000 Figure 3.8 shows the number of candy bars that a candy com- $ 1.50 70,000 PRICE ($) pany would like to sell, or supply to the market, at each price. If 3.00 $ 1.25 50,000 the price of a candy bar is only 75 cents, the firm does not find $ 1.00 25,000 $ 0.75 0 it profitable to produce and sell any candy bars. At a higher price, $ 0.50 0 however, the firm can make a profit. If the price is $2.00, the 2.00 firm wants to sell 85,000 candy bars. At an even higher price—for 1.50 example, $5.00 per candy bar—it wants to sell even more candy A 1.00 bars, 100,000. Figure 3.8 also depicts these points in a graph. The curve drawn 0.50 by connecting the points is called the firm’s supply curve. It shows the quantity that the candy company will supply at each price, when 0 10 20 30 40 50 60 70 80 90 100 QUANTITY OF CANDY BARS (THOUSANDS) all other factors are held constant. For this curve, like the demand curve, we put the price on the horizontal axis. Thus, we can read Figure 3.8 point A on the curve as indicating that at a price of $1.50, the firm ONE FIRM’S SUPPLY CURVE would like to supply 70,000 candy bars. The supply curve shows the quantity of a good a firm is In direct contrast to the demand curve, the typical supply curve willing to produce at each price. Normally a firm is willing slopes upward from left to right; at higher prices, firms will supply to produce more as the price increases, which is why the more. This is because higher prices yield suppliers higher profits— supply curve slopes upward. giving them an incentive to produce more. SUPPLY ∂ 63  Total market Price supply 5.00 (millions) Market $ 5.00 82 supply $ 3.00 80 curve 4.00 $ 2.00 70 $ 1.50 59 PRICE ($) $ 1.25 47 3.00 $ 1.00 34 $ 0.75 20 $ 0.50 5 2.00 1.50 1.25 1.00 A 0.75 0.50 0 10 20 30 40 50 60 70 80 90 100 QUANTITY OF CANDY BARS (MILLIONS) Figure 3.9 THE MARKET SUPPLY CURVE The market supply curve shows the quantity of a good all firms in the market are willing to supply at each price. The market supply curve is normally upward sloping, both because each firm is willing to supply more of the good at a higher price and because higher prices entice new firms to produce. MARKET SUPPLY The market supply of a good is the total quantity that all the firms in the economy are willing to supply at a given price. Similarly, the market supply of labor is the total quantity of labor that all the households in the economy are willing to supply at a given wage. Figure 3.9 tells us, for instance, that at a price of $2.00, firms will supply 70 million candy bars, while at a price of $0.50, they will supply only 5 million. Figure 3.9 also shows the same information graphically. The curve joining the points in the figure is the market supply curve. The market supply curve gives the total quantity of a good that firms are willing to produce at each price. Thus, we read point A on the market supply curve as showing that at a price of $0.75, the firms in the economy would like to sell 20 million candy bars. As the price of candy bars increases, the quantity supplied increases, other things being equal. The market supply curve slopes upward from left to right for two reasons: at higher prices, each firm in the market is willing to produce more; and at higher prices, more firms are willing to enter the market to produce the good. The market supply curve is calculated from the supply curves of the different firms in the same way that the market demand curve is calculated from the demand curves of the different households: at each price, we add horizontally the quantities that each of the firms is willing to produce. 64 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE Wrap-Up SUPPLY CURVE The supply curve gives the quantity of the good supplied at each price. SHIFTS IN SUPPLY CURVES Just as demand curves can shift, supply curves too can shift, so that the quantity supplied at each price increases or decreases. Suppose a drought hits the bread- basket states of mid-America. Figure 3.10 illustrates the situation. The supply curve for wheat shifts to the left, which means that at each price of wheat, the quantity firms are willing to supply is smaller. SOURCES OF SHIFTS IN SUPPLY CURVES There are several sources of shifts in market supply curves, just as we saw for market demand curves. One is changing prices of the inputs used to produce a good. Figure 3.11 shows that as corn becomes less expensive, the supply curve for cornflakes shifts to the right. Producing cornflakes costs less, so at every price, firms are willing to supply S0 S1 Postdrought supply curve PRICE OF CORNFLAKES PRICE OF WHEAT (p) Predrought p supply curve Cornflake supply curves Q2 Q1 QUANTITY OF WHEAT (Q ) QUANTITY OF CORNFLAKES Figure 3.10 Figure 3.11 SHIFTING THE SUPPLY CURVE TO THE LEFT SHIFTING THE SUPPLY CURVE TO THE RIGHT A drought or other disaster (among other possible factors) will An improvement in technology or a reduction in input prices cause the supply curve to shift to the left, so that at each price, (among other possible factors) will cause the supply curve to shift a smaller quantity is supplied. to the right, so that at each price, a larger quantity is supplied. SUPPLY ∂ 65  a greater quantity. That is why the quantity supplied along the curve S1 is greater than the quantity supplied, at the same price, along the curve S0. Another source of shifts is changes in technology. The technological improve- ments in the computer industry over the past two decades have led to a rightward shift in the market supply curve. Yet another source of shifts is nature. The supply curve for agricultural goods may shift to the right or left depending on weather conditions, insect infestations, or animal diseases. Firms often borrow to obtain inputs needed for production, and a rise in inter- est rates will increase the cost of borrowing. This increase too will induce a left- ward shift in the supply curve. Finally, changed expectations can also lead to a shift in the supply curve. If firms believe that a new technology for making cars will become available in two years, they will discourage investment today, leading to a temporary leftward shift in the supply curve. Wrap-Up SOURCES OF SHIFTS IN MARKET SUPPLY CURVES A change in the prices of inputs A change in technology A B Supply curve Original supply PRICE OF CANDY BARS (p ) PRICE OF CANDY BARS (p ) curve New supply curve p1 p0 p0 Q0 Q1 Q0 Q1 QUANTITY OF CANDY BARS (Q ) QUANTITY OF CANDY BARS (Q ) Figure 3.12 Panel A shows an increase in quantity supplied caused by a higher price—a movement along a given supply curve. Panel B illustrates an increase in quantity supplied caused by MOVEMENT ALONG THE a shift in the entire supply curve, so that a greater quantity is supplied at every market SUPPLY CURVE VERSUS SHIFT IN price. THE SUPPLY CURVE 66 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE A change in the natural environment A change in the availability of credit A change in expectations SHIFTS IN A SUPPLY CURVE VERSUS MOVEMENTS ALONG A SUPPLY CURVE Distinguishing between a movement along a curve and a shift in the curve itself is just as important for supply curves as it is for demand curves. In Figure 3.12A, the price of candy bars has gone up, with a corresponding increase in quantity supplied. Thus, there has been a movement along the supply curve. By contrast, in Figure 3.12B, the supply curve has shifted to the right, perhaps because a new production technique has made it cheaper to produce candy bars. Now, even though the price does not change, the quantity supplied increases. The quantity supplied in the market can increase either because the price of the good has increased, so that for a given supply curve, the quantity produced is higher; or because the supply curve has shifted, so that at a given price, the quantity supplied has increased. FUNDAMENTALS OF DEMAND, SUPPLY, AND PRICE 2 SUPPLY INCREASES AS PRICE RISES As the price of a good increases, the quantity firms are willing to supply rises. Changes in factors other than price—such as the costs of production or changes in technology—shift the supply curve. Law of Supply and Demand This chapter began with the assertion that supply and demand work together to determine the market price in competitive markets. Figure 3.13 puts a market supply curve and a market demand curve on the same graph to show how this happens. The price actually paid and received in the market will be determined by the inter- section of the two curves. This point is labeled E0, for equilibrium, and the corre- sponding price ($0.75) and quantity (20 million) are called, respectively, the equilibrium price and the equilibrium quantity. Since the term equilibrium will recur throughout the book, it is important to understand the concept clearly. Equilibrium describes a situation where there are no forces (reasons) for change. No one has an incentive to change the result—the price or quantity consumed or produced, in the case of supply and demand. Physicists also speak of equilibrium in describing a weight hanging from a spring. Two forces are working on the weight. Gravity is pulling it down; the spring is pulling LAW OF SUPPLY AND DEMAND ∂ 67  Market it up. When the weight is at rest, it is in equilibrium, with the two 1.25 demand forces just offsetting each other. If someone pulls the weight down curve a little bit, the force of the spring will be greater than the force B A of gravity, and the weight will spring up. In the absence of any 1.00 further interventions, the weight will bob back and forth and E0 Market PRICE ($) eventually return to its equilibrium position. 0.75 supply curve An economic equilibrium is established in the same way. At D C the equilibrium price, consumers get precisely the quantity of 0.50 the good they are willing to buy at that price, and producers sell precisely the quantity they are willing to sell at that price. The 0.25 market clears. To emphasize this condition, economists some- times refer to the equilibrium price as the market clearing price. In equilibrium, neither producers nor consumers have 0 5 10 15 20 25 30 35 any incentive to change. QUANTITY OF CANDY BARS (MILLIONS) But consider the price of $1.00 in Figure 3.13. There is no Figure 3.13 equilibrium quantity here. First find $1.00 on the vertical axis. Now look across to find point A on the supply curve, and read SUPPLY AND DEMAND EQUILIBRIUM down to the horizontal axis; point A tells you that a price of Equilibrium occurs at the intersection of the demand and $1.00, firms want to supply 34 million candy bars. Now look at supply curves, at point E0. At any price above E0, the quantity point B on the demand curve. Point B shows that at a price of supplied will exceed the quantity demanded, the market will be out of equilibrium, and there will be excess supply. At any price $1.00 consumers want to buy only 13 million candy bars. Like below E0, the quantity demanded will exceed the quantity sup- the weight bobbing on a spring however, this market will work plied, the market will be out of equilibrium, and there will be its way back to equilibrium in the following way. At a price of excess demand. $1.00, there is excess supply. As producers discover that they cannot sell as much as they would like at this price, some of them will lower their prices slightly, hoping to take business from other produc- ers. When one producer lowers prices, his competitors will have to respond, for fear that they will end up unable to sell their goods. As prices come down, consumers will also buy more, and so on until the market reaches the equilibrium price and quantity. Similarly, assume that the price is lower than $0.75, say $0.50. At the lower price, there is excess demand: individuals want to buy 30 million candy bars (point C), while firms want to produce only 5 million (point D). Consumers unable to purchase all they want will offer to pay a bit more; other consumers, afraid of having to do without, will match these higher bids or exceed them. As prices start to increase, suppliers will also have a greater incentive to produce more. Again the market will tend toward the equilibrium point. To repeat for emphasis: at equilibrium, no purchaser and no supplier has an incentive to change the price or quantity. In competitive market economies, actual prices tend to be the equilibrium prices at which demand equals supply. This is called the law of supply and demand. Note: this law does not mean that at every moment of time the price is precisely at the intersection of the demand and supply curves. Like the weight on a spring described above, the market may bounce around a little bit when it is in the process of adjusting. What the law of supply and demand does say is that when a market is out of equilibrium, there are predictable forces for change. 68 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE USING DEMAND AND SUPPLY CURVES The concepts of demand and supply curves—and market equilibrium as the inter- section of demand and supply curves—constitute the economist’s basic model of demand and supply. This model has proved to be extremely useful. It helps explain why the price of a given commodity is high, and that of some other commodity is low. It also helps predict the consequences of certain changes. Its predictions can then be tested against what actually happens. One of the reasons that the model is so useful is that it gives reasonably accurate predictions. Figure 3.14 repeats the demand and supply curve for candy bars. But assume now that sugar becomes more expensive. As a result, at each price the amount of candy firms are willing to supply is reduced. The supply curve shifts to the left, as in panel A. There will be a new equilibrium, at a higher price and a lower quantity of candy consumed. Alternatively, assume that Americans become more health conscious, and as a result, at each price fewer candy bars are consumed: the demand curve shifts to the left, as shown in panel B. Again, there will be a new equilibrium, at a lower price and a lower quantity of candy consumed. This illustrates how changes in observed prices can be related either to shifts in the demand curve or to shifts in the supply curve. To take a different example, when the war in Kuwait interrupted the supply of oil from the Middle East in 1990, the supply curve shifted. The model predicted the result: an increase in the price of oil. This increase was the natural outcome of the law of supply and demand. A B Supply Supply curve curve PRICE OF SUGAR (p) PRICE OF SUGAR (p) E1 p1 p2 E0 p1 E0 Demand E1 curve p2 Demand curve Q1 Q2 Q2 Q1 QUANTITY OF CANDY BARS (Q ) QUANTITY OF CANDY BARS (Q ) Figure 3.14 Initially the market for candy bars is in equilibrium at E0. An increase in the cost of sugar shifts the supply curve to the left, as shown in panel A. At the new equilibrium, USING SUPPLY AND DEMAND E1, the price is higher and the quantity consumed is lower. A shift in taste away from CURVES TO PREDICT PRICE candy results in a leftward shift in the demand curve as shown in panel B. At the new CHANGES equilibrium, E1, the price and the quantity consumed are lower. LAW OF SUPPLY AND DEMAND ∂ 69  CONSENSUS ON THE DETERMINATION OF PRICES The law of supply and demand plays such a prominent role in economics that there is a joke about teaching a parrot to be an economist simply by training it to say “supply and demand.” That prices are determined by the law of supply and demand is one of the most long-standing and widely accepted ideas of economists. In com- petitive markets, prices are determined by the law of supply and demand. Shifts in the demand and supply curves lead to changes in the equilibrium price. Similar principles apply to the labor and capital markets. The price for labor is the wage, and the price for capital is the interest rate; thus in later chapters we can use the same principles of demand and supply developed in this chapter to study labor and capital markets. FUNDAMENTALS OF DEMAND, SUPPLY, AND PRICE 3 THE MARKET CLEARS AT THE EQUILIBRIUM PRICE The price at which the quantity demanded and the quantity supplied are equal is the equilibrium price. At the equilibrium price, consumers are able to obtain the quantity they wish to purchase and firms are able to sell the quantity they wish to produce. When the market clears, there are no shortages or surpluses. The law of supply and demand allows us to predict how price and quantity will change in response to shifts in the demand and supply curves. Price, Value, and Cost To an economist, price is what is given in exchange for a good or service. Price, in this sense, is determined by the forces of supply and demand. Adam Smith, often thought of as the founder of modern economics, called our notion of price “value in exchange,” and contrasted it to the notion of “value in use”: The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.2 The law of supply and demand can help to explain the diamond-water paradox and many similar examples where “value in use” is very different from “value in 2 The Wealth of Nations (1776), Book One, Chapter IV. 70 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE Internet Connection THE DEMAND AND SUPPLY IN THE OIL MARKET The U.S. Energy Information Administration (EIA) has a slide increases during the 1970s affected the types of cars Americans presentation at www.eia.doe.gov/emeu/25opec/anniversary.html bought and how they heated their homes. that illustrates some of the major ways that the energy price exchange.” Figure 3.15 presents a demand and a supply curve for water. Individuals are willing to pay a high price for the water they need to live, as illustrated by point A on the demand curve. But above some quantity, B, people will pay almost nothing more for additional water. In most of the inhabited parts of the world, water is read- ily available, so it is supplied in plentiful quantities at low prices. Thus, the supply curve of water intersects the demand curve to the right of B, as in the figure—hence, the low equilibrium price. (Of course, in the desert the water supply may be very limited and the price, as a result, very high.) To an economist, the observations that the price of diamonds is high and the price of water is low are statements about supply and A demand conditions. They say nothing about whether diamonds are “more important” or “better” than water. In Adam Smith’s terms, PRICE OF WATER Demand they are not statements about value in use. for water Price is related to the marginal value of an object: that is, the value Supply of an additional unit of the object. Water has a low price not because the of water total value of water is low—it is obviously high, since we could not live without it—but because the marginal value, what we would be willing to pay to be able to drink one more glass of water a year, is low. B Just as economists take care to distinguish between the words “price” and “value,” so they also distinguish the price of an object (what it sells for) from its cost (the expense of making the object). This is another crucial distinction in economics. The costs of producing a Quantity Quantity Equilibrium needed beyond good affect the price at which firms are willing to supply that good. to live which extra quantity An increase in the costs of production will normally cause prices to water has rise. And in the competitive model, in equilibrium, the price of an object little use will normally equal its (marginal) cost of production (including the QUANTITY OF WATER amount needed to pay a firm’s owner to stay in business rather than Figure 3.15 seek some other form of employment). But there are important cases— as we will see in later chapters—where price does not equal cost. SUPPLY AND DEMAND FOR WATER As we think about the relationship of price and cost, it is inter- Point A shows that people are willing to pay a relatively high esting to consider the case of a good in fixed supply, such as land. price for the first few units of water. But to the right of B, Normally, land is something that cannot be produced, so its cost of people have plenty of water already and are not willing to production can be considered infinite (though sometimes land can pay much for an additional amount. The price of water will be determined at the point where the supply curve crosses be produced, as when Chicago filled in part of Lake Michigan to the demand curve. In most cases, the resulting price is expand its lake shore). Yet there is still an equilibrium price of land— extremely low. where the demand for land is equal to its (fixed) supply. PRICE, VALUE, AND COST ∂ 71 Review and Practice SUMMARY KEY TERMS 1. An individual’s demand curve gives the quantity demanded price of a good at each possible price. It normally slopes down, demand which means that the person demands a greater quan- demand curve tity of the good at lower prices and a lesser quantity at market demand curve higher prices. substitutes 2. The market demand curve gives the total quantity of complements a good demanded by all individuals in an economy at demographic effects each price. As the price rises, demand falls, both supply because each person demands less of the good and supply curve because some people exit the market. market supply curve 3. A firm’s supply curve gives the amount of a good the equilibrium price firm is willing to supply at each price. It is normally equilibrium quantity upward sloping, which means that firms supply a equilibrium greater quantity of the good at higher prices and a market clearing price lesser quantity at lower prices. excess supply 4. The market supply curve gives the total quantity of excess demand a good that all firms in the economy are willing to law of supply and demand produce at each price. As the price rises, supply rises, both because each firm supplies more of the good and because some additional firms enter the REVIEW QUESTIONS market. 1. Why does an individual’s demand curve normally slope 5. The law of supply and demand says that in competitive down? Why does a market demand curve normally markets, the equilibrium price is that price at which slope down? quantity demanded equals quantity supplied. It is 2. Why does a firm’s supply curve normally slope up? represented on a graph by the intersection of the Why does a market supply curve normally slope up? demand and supply curves. 3. What is the significance of the point where supply and 6. A demand curve shows only the relationship between demand curves intersect? quantity demanded and price. Changes in tastes, in 4. Explain why, if the price of a good is above the equilib- demographic factors, in income, in the prices of other rium price, the forces of supply and demand will tend goods, in information, in the availability of credit, or to push the price toward equilibrium. Explain why, if in expectations are reflected in a shift of the entire the price of the good is below the equilibrium price, the demand curve. market will tend to adjust toward equilibrium. 7. A supply curve shows only the relationship between 5. Name some factors that could shift the demand curve quantity supplied and price. Changes in factors such out to the right. as technology, the prices of inputs, the natural environ- 6. Name some factors that could shift the supply curve in ment, expectations, or the availability of credit are to the left. reflected in a shift of the entire supply curve. 8. It is important to distinguish movements along a demand curve from shifts in the demand curve, and PROBLEMS movements along a supply curve from shifts in the 1. Imagine a company lunchroom that sells pizza by the supply curve. slice. Using the following data, plot the points and graph 72 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE  the demand and supply curves. What is the equilibrium consequence for the supply curve of beef of restricting price and quantity? Find a price at which excess demand feed to grain? What are the consequences for the price would exist and a price at which excess supply would of beef (a) if the new restrictions fail to restore confi- exist, and plot them on your diagram. dence in beef and (b) if the new restrictions succeed in restoring confidence so that the demand curve returns to its original position? Price Demand Supply At about the same time in Europe, there was an out- per slice (number of slices) (number of slices) break of hoof-and-mouth disease; to stop the spread of the $1 420 0 disease, large numbers of cattle were killed. What does $2 210 100 this do to the supply curve of beef? to the equilibrium $3 140 140 price of beef? $4 105 160 7. Many advanced industrialized countries subsidize farm- $5 84 170 ers. Assume that the effect of the subsidy is to shift the supply curve of agricultural products by farmers in the 2. Suppose a severe drought hits the sugarcane crop. Predict advanced industrialized countries to the right. Why might how this will affect the equilibrium price and quantity in less-developed countries be unhappy with such policies? the market for sugar and the market for honey. Draw 8. Farm output is extremely sensitive to the weather. In supply and demand diagrams to illustrate your answers. 1988, the midwestern region of the United States expe- 3. Imagine that a new invention allows each mine worker rienced one of the worst droughts ever recorded; corn to mine twice as much coal. Predict how this will affect production fell by 35 percent, wheat production by more the equilibrium price and quantity in the market for coal than 10 percent, and oat and barley production by more and the market for heating oil. Draw supply and demand than 40 percent. What do you suppose happened to the diagrams to illustrate your answers. prices of these commodities? 4. Americans’ tastes have shifted away from beef and These grains are an input into the production of toward chicken. Predict how this change has affected cattle. The higher cost of grain led many ranchers to the equilibrium price and quantity in the market for slaughter their cattle earlier. What do you think hap- beef, the market for chicken, and the market for road- pened to the price of beef in the short run? In the side hamburger stands. Draw supply and demand intermediate run? diagrams to illustrate your answers. Why did the drought in the Midwest lead to increased 5. During the 1970s, the postwar baby boomers reached prices for vegetables and fruits? working age, and it became more acceptable for mar- 9. Suppose that there are 1,000 one-bedroom apartments in ried women with children to work. Predict how this a small town and that this number is fixed. The table gives increase in the number of workers is likely to affect the the quantity demand in the market for one-bedroom equilibrium wage and quantity of employment. Draw apartments. supply and demand curves to illustrate your answers. 6. In 2001, Europeans became very concerned about what is called mad cow disease, and thus about the dangers Price Demand (Rent per month) (Apartment units) posed by eating contaminated meat. What would this concern do to the demand curve for beef? to the demand $500 1,600 curves for chicken and fish? to the equilibrium price of $600 1,400 $700 1,200 beef, chicken, and fish? $800 1,000 Mad cow disease is spread by feeding cows food that $900 800 contains parts from infected animals. Presumably the $1,000 600 reason why cows are fed this food is that doing so is $1,200 400 cheaper than relying exclusively on grain. What is the REVIEW AND PRACTICE ∂ 73  (a) What is the equilibrium rental for a one-bedroom only $900. Using the data from Problem 9, answer each apartment? of the following questions. (b) Suppose 200 new one-bedroom apartments are con- (a) Using the data from Problem 9, draw the demand structed. What happens to the equilibrium rent? curve before the subsidy. How does this subsidy affect (c) Suppose more people move into the town, increas- the demand for one-bedroom apartments? Draw the ing the demand for one-bedroom apartments by new demand curve after the subsidy is introduced. 200 units at each price. What is the new equilib- (b) If the supply of apartments is fixed at 1,200 units, rium price? (Assume the supply remains fixed at what is the equilibrium price before the subsidy? 1,200 units.) What is the equilibrium price after the subsidy? 10. Suppose a town decides to give a $100 subsidy to each (c) At the new equilibrium price, what is the out-of- renter to help with rent payments. Thus if initially the pocket cost to a renter for a one-bedroom apartment? rent had been $1,000, with the $100 subsidy the out-of- (d) Have renters benefited from the town’s rent subsidy? pocket cost to the renter of a one-bedroom apartment is Have apartment owners (suppliers)? 74 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE This page intentionally left blank  Learning Goals In this chapter, you will learn 1 What is meant by the concept of elasticity 2 How elasticity helps explain the effects on prices and quantities of shifts in demand and supply 3 How government policies such as rent control or agri- cultural price supports that interfere with market out- comes lead to shortages and surpluses  Chapter 4 USING DEMAND AND SUPPLY ∂ W hy are doctors, on average, paid more than lawyers? And why are lawyers paid more than schoolteachers? Why does your economics professor probably make more than your literature professor? And why has the wage gap between college graduates and those with only a high school education widened in recent years? The concepts of demand and supply developed in the pre- vious chapter can help us answer these questions. Moreover, these concepts help us predict what will happen if the government increases the tax on cigarettes or the tax on gasoline. But economists are usually interested in more specific predictions. They want to know how much the tax on gasoline would need to be raised if the goal is to lower gasoline consumption by, say, 10 percent, or how much a frost in Florida that reduces the orange crop will increase the price of orange juice. In this chapter, we develop some of the concepts needed to make these sorts of predictions. In addition, we examine what happens when governments intervene with the workings of competitive markets. High rents and expensive food may seem to block poor people’s access to adequate housing and nutrition, farmers may feel that the prices of their crops are too low, and textile workers may object to competing with laborers producing similar goods in low-wage countries. Political pressures are con- stantly brought to bear on government to intervene on behalf of groups that feel disadvantaged by the workings of the market. In the second part of this chapter, we track some of the consequences of these political interventions. The Price Elasticity of Demand To predict the effects of a tax on gasoline on how much people drive or of a frost on the price of orange juice, we must start by asking what substitutes exist for the good 77  in question. If the price of orange juice rises, consumers have an incentive to buy less orange juice and to buy apple juice, cranberry juice, or any one of a number of other drinks instead. If a new tax pushes up the price of gasoline, drivers likewise have an incentive to reduce their consumption of gas; but doing so may be difficult for those who have to drive to work in cars with conventional engines. Some may be able to ride the bus, but many will be hard-pressed to find an alternative means of transportation. And switching to an electric or hybrid vehicle can be costly. As these examples illustrate, substitutes exist for almost every good or service, but substitution will be more difficult for some goods and services than for others. When substitution is difficult, an increase in the price of a good will not cause the quantity demanded to decrease by much, and a decrease in the price will not cause the quantity demanded to increase much. In terms of the demand curves we discussed in Chapter 3, the demand curve for a good with few substitutes will be relatively steep: changes in price do not cause very large changes in the quantity demanded. When substitution is easy, as in the case of orange juice, an increase in price may lead to a large decrease in the quantity demanded. Ice cream is another example of a good with many close substitutes. A price increase for ice cream means that frozen yogurt, gelato, and similar products become relatively less expensive, and the demand for ice cream would thus significantly decrease. The demand curve for a good with many substitutes will be relatively flat: changes in price cause large changes in the quantity demanded. For many purposes, economists need to be precise about how steep or how flat the demand curve is. They therefore use the concept of the price elasticity of demand (for short, the price elasticity or the elasticity of demand), which is defined as the percentage change in the quantity demanded divided by the percentage change in price. In mathematical terms, percentage change in quantity demanded elasticity of demand =. percentage change in price If the quantity demanded changes 8 percent in response to a 2 percent change in price, then the elasticity of demand is 4. (Price elasticities of demand are really negative numbers; that is, when the price increases, quantities demanded are reduced. But the convention is to simply give the elasticity’s absolute value with the understanding that it is negative.) It is easiest to calculate the elasticity of demand when there is just a 1 percent change in price. Then the elasticity of demand is just the percentage change in the quantity demanded. In the telescoped portion of Figure 4.1A, we see that increas- ing the price of orange juice from $2.00 a gallon to $2.02—a 1 percent increase in price—reduces the demand from 100 million gallons to 98 million, a 2 percent decline. So the price elasticity of demand for ice cream is 2. By contrast, assume that the price of gas increases from $2.00 a gallon to $2.02 (again a 1 percent increase in price), as shown in the telescoped portion of Figure 4.1B. This reduces demand from 100 million gallons per year to 99.8 million. Demand has gone down by 0.2 percent, so the price elasticity of demand is therefore 0.2. Larger values for price elasticity indicate that demand is more sensitive to changes in price. Smaller values indicate that demand is less sensitive to price changes. 78 ∂ CHAPTER 4 USING DEMAND AND SUPPLY  A B Demand for PRICE ($) PRICE ($) Demand for gasoline 2.02 orange juice 2.00 2.02 2.00 2.10 0 98 100 2.10 2.00 0 99.8 100 2.00 0 90 100 0 99 100 GALLONS OF ORANGE JUICE (MILLIONS)