Microeconomics - Chapter 2 PDF

Introduction I’ve often wondered what goes into a hot dog. Now I know and I wish I didn’t. — William Zinsser If each of us could get all the food, clothing, and toys we want without working, no one would study economics. Unfortunately, most of the good things in life are scarce—we can’t all have as...

Introduction I’ve often wondered what goes into a hot dog. Now I know and I wish I didn’t. — William Zinsser If each of us could get all the food, clothing, and toys we want without working, no one would study economics. Unfortunately, most of the good things in life are scarce—we can’t all have as much as we want. Thus scarcity is the mother of economics. Microeconomics is the study of how individuals and firms make themselves as well off as possible in a world of scarcity and the consequences of those individual decisions for markets and the entire economy. In studying microeconomics, we examine how individual consumers and firms make decisions and how the interac-tion of many individual decisions affects markets. Microeconomics is often called price theory to emphasize the important role that prices play. Microeconomics explains how the actions of all buyers and sellers deter- mine prices and how prices influence the decisions and actions of individual buyers and sellers.  1 Microeconomics the study of how individu- als and firms make them- selves as well off as possible in a world of scarcity and the conse- quences of those individ- ual decisions for markets and the entire economy Microeconomics: The Allocation of Scarce Resources. Microeconomics is the study of In this chapter, we the allocation of scarce resources. examine three main topics Models. Economists use models to make testable predictions. Uses of Microeconomic Models. Individuals, governments, and firms use microeco- nomic models and predictions in decision making. 1.1 Microeconomics: The Allocation of Scarce Resources Individuals and firms allocate their limited resources to make themselves as well off as possible. Consumers pick the mix of goods and services that makes them as happy as possible given their limited wealth. Firms decide which goods to produce, where to produce them, how much to produce to maximize their profits, and how to produce those levels of output at the lowest cost by using more or less of various inputs such as labor, capital, materials, and energy. The owners of a depletable nat-ural resource such as oil decide when to use it. Government decision makers—to benefit consumers, firms, or government bureaucrats—decide which goods and ser-vices the government produces and whether to subsidize, tax, or regulate industries and consumers. 1 CHAPTER 1 Introduction Trade-Offs People make trade-offs because they can’t have everything. A society faces three key trade-offs: Which goods and services to produce. If a society produces more cars, it must pro-duce fewer of other goods and services, because there are only so many resources— workers, raw materials, capital, and energy—available to produce goods. How to produce. To produce a given level of output, a firm must use more of one input if it uses less of another input. Cracker and cookie manufacturers switch between palm oil and coconut oil, depending on which is less expensive. Who gets the goods and services. The more of society’s goods and services you get, the less someone else gets. Who Makes the Decisions These three allocation decisions may be made explicitly by the government or may reflect the interaction of independent decisions by many individual consumers and firms. In the former Soviet Union, the government told manufacturers how many cars of each type to make and which inputs to use to make them. The government also decided which consumers would get a car. In most other countries, how many cars of each type are produced and who gets them are determined by how much it costs to make cars of a particular quality in the least expensive way and how much consumers are willing to pay for them. More consumers would own a handmade Rolls-Royce and fewer would buy a mass-produced Ford Taurus if a Rolls were not 21 times more expensive than a Taurus. APPLICATION In 2004, the U.S. government expected a record 100 million flu vaccine doses to be available, but one vaccine maker, Chiron, could not ship 46 million doses because Flu Vaccine 1 of contamination. As a consequence, the government expected a shortage at the Shortage traditional price. In response, government and public health officials urged young, healthy people to forgo getting shots until the sick, the elderly, and other high-risk pop-ulations, such as health care providers and pregnant women, were inoculated. Public spirit failed to dissuade enough healthy people. Perversely, the high-priority adult population was the group most likely to show self-control and not ask for a shot (de Janvry et al., 2008). Consequently, federal, state, and local governments restricted access to the shots to high-risk populations. Again, in 2009 and 2010, when faced with shortages of the H1N1 “swine flu” vaccine, most government agencies restricted access to the highest risk groups. In most non-health-related goods markets, prices adjust to prevent short-ages. In contrast, during the flu shot shortage, governments didn’t increase the price to reduce demand, but relied on exhortation and formal allocation schemes. 1 Sources for applications appear at the end of the book.  1.2 Models 3 Prices Determine Allocations An Economist’s Theory of Reincarnation: If you’re good, you come back on a higher level. Cats come back as dogs, dogs come back as horses, and people— if they’ve been real good like George Washington—come back as money. Prices link the decisions about which goods and services to produce, how to pro-duce them, and who gets them. Prices influence the decisions of individual con-sumers and firms, and the interactions of these decisions by consumers, firms, and the government determine price. market Interactions between consumers and firms take place in a market, which is an an exchange mechanism that allows buyers to trade exchange mechanism that allows buyers to trade with sellers. A market may be a town with sellers square where people go to trade food and clothing, or it may be an interna-tional telecommunications network over which people buy and sell financial securi-ties. Typically, when we talk about a single market, we refer to trade in a single good or group of goods that are closely related, such as soft drinks, movies, novels, or automobiles. Most of this book concerns how prices are determined within a market. We show that the number of buyers and sellers in a market and the amount of information they have help determine whether the price equals the cost of production. We also show that if there is no market—and hence no market price—serious problems, such as high levels of pollution, result. APPLICATION Many American, Australian, British, Canadian, New Zealand, and Taiwanese jurisdictions are proposing a “Twinkie tax” on unhealthful fatty and sweet foods to Twinkie Tax reduce obesity and cholesterol problems, particularly among children. One survey found that 45% of adults would support a 1¢ tax per pound of soft drinks, chips, and butter, with the revenues used to fund health education programs. In 2010, many communities around the world debated (and some passed) new taxes on sugar-sweetened soft drinks. At least 25 states differentially tax soft drinks, candy, chewing gum, and snack foods such as potato chips. Today, many school districts throughout the United States ban soft drink vending machines. This ban discourages consumption, as would an extremely high tax. Britain’s largest life insurance firm charges the obese more for life insurance policies. New taxes will affect which foods are produced, as firms offer new low-fat and low-sugar products, and how fast-foods are produced, as manufacturers reformulate their products to lower their tax burden. These taxes will also influence who gets these goods as consumers, especially children, replace them with less expensive, untaxed products. 1.2 Models Everything should be made as simple as possible, but not simpler. —Albert Einstein To explain how individuals and firms allocate resources and how market prices are model determined, economists use a model: a description of the relationship between two or a description of the rela- tionship between two or more economic variables. Economists also use models to predict how a change in one more economic variables variable will affect another. 4 CHAPTER 1 Introduction APPLICATION According to an income threshold model, no one who has an income level below a Income Threshold threshold buys a particular consumer durable, which is a good that can be used for long periods of time, such as a refrigerator or car. The theory also holds that almost Model and China everyone whose income is above the threshold does buy the durable. If this theory is correct, we predict that, as most people’s incomes rise above that threshold in less-developed countries, consumer durable purchases will go from near zero to large numbers virtually overnight. This prediction is consis-tent with evidence from Malaysia, where the income threshold for buying a car is about $4,000. Incomes are rising rapidly in China and are exceeding the threshold levels for many types of durable goods. As a result, many experts predicted that China would experience the greatest consumer durable goods sales boom in history over the next couple of decades. Anticipating this boom, many compa-nies greatly increased their investments in durable goods manufacturing plants in China. Annual foreign direct investments went from $41 billion a year in 2000 to $92.4 billion in 2008 (before dipping slightly in 2009 and then rising again in 2010). In expectation of this growth potential, even traditional polit-ical opponents of the People’s Republic— Taiwan, South Korea, and Russia— invested in China. Li Rifu, a 46-year-old Chinese farmer and watch repairman, thought that buying a car would improve the odds that his 22- and 24-year-old sons would find girlfriends, marry, and produce grandchildren. After Mr. Li purchased his Geely King Kong for the equivalent of $9,000, both sons soon found girl-friends, and his older son quickly married. Four-fifths of all new cars sold in China are bought by first-time customers. An influx of first-time buyers was responsible for China’s more than eightfold increase in car sales from 2000 to 2008 and increased another 75% increase in 2009. Simplifications by Assumption We stated the income threshold model in words, but we could have presented it using graphs or mathematics. Regardless of how the model is described, an eco-nomic model is a simplification of reality that contains only its most important fea-tures. Without simplifications, it is difficult to make predictions because the real world is too complex to analyze fully. By analogy, if the manual accompanying your new TiVo recorder has a diagram showing the relationships between all the parts in the TiVo, the diagram will be overwhelming and useless. In contrast, if it shows a photo of the buttons on the front of the machine with labels describing the purpose of each button, the manual is useful and informative. 2 Economists make many assumptions to simplify their models. When using the income threshold model to explain car purchasing behavior in China we assume that factors other than income, such as the color of cars, are irrelevant to the decision to buy cars. Therefore, we ignore the color of cars that are sold in China in describing the relationship between average income and the number of cars consumers want. If 2 An economist, an engineer, and a physicist are stranded on a desert island with a can of beans but no can opener. How should they open the can? The engineer proposes hitting the can with a rock. The physicist suggests building a fire under it to build up pressure and burst the can open. The economist thinks for a while and then says, “Assume that we have a can opener....”  1.2 Models 5 this assumption is correct, by ignoring color, we make our analysis of the auto mar-ket simpler without losing important details. If we’re wrong and these ignored issues are important, our predictions may be inaccurate. Throughout this book, we start with strong assumptions to simplify our models. Later, we add complexities. For example, in most of the book, we assume that con-sumers know the price each firm charges. In many markets, such as the New York Stock Exchange, this assumption is realistic. It is not realistic in other markets, such as the market for used automobiles, in which consumers do not know the prices each firm charges. To devise an accurate model for markets in which consumers have limited information, we add consumer uncertainty about price into the model in Chapter 19. Testing Theories Blore’s Razor: When given a choice between two theories, take the one that is funnier. Economic theory is the development and use of a model to test hypotheses, which are predictions about cause and effect. We are interested in models that make clear, testable predictions, such as “If the price rises, the quantity demanded falls.” A the-ory that said “People’s behavior depends on their tastes, and their tastes change ran-domly at random intervals” is not very useful because it does not lead to testable predictions. Economists test theories by checking whether predictions are correct. If a predic-tion 3 does not come true, they may reject the theory. Economists use a model until it is refuted by evidence or until a better model is developed. A good model makes sharp, clear predictions that are consistent with reality. Some very simple models make sharp predictions that are incorrect, and other more complex models make ambiguous predictions—any outcome is possible—which are untestable. The skill in model building is to chart a middle ground. The purpose of this book is to teach you how to think like an economist in the sense that you can build testable theories using economic models or apply existing models to new situations. Although economists think alike in that they develop and use testable models, they often disagree. One may present a logically consistent argument that prices will go up next quarter. Another, using a different but equally logical theory, may contend that prices will fall. If the economists are reasonable, they agree that pure logic alone cannot resolve their dispute. Indeed, they agree that they’ll have to use empirical evidence—facts about the real world—to find out which prediction is correct. Although one economist’s model may differ from another’s, a key assumption in most microeconomic models is that individuals allocate their scarce resources so as to make themselves as well off as possible. Of all affordable combinations of goods, consumers pick the bundle of goods that gives them the most possible enjoyment. Firms try to maximize their profits given limited resources and existing technology. That resources are limited plays a crucial role in these models. Were it not for scarcity, people could consume unlimited amounts of goods and services, and sell-ers could become rich beyond limit. 3 We can use evidence on whether a theory’s predictions are correct to refute the theory but not to prove it. If a model’s prediction is inconsistent with what actually happened, the model must be wrong, so we reject it. Even if the model’s prediction is consistent with reality, however, the model’s prediction may be correct for the wrong reason. Hence we cannot prove that the model is correct— we can only fail to reject it. 6 CHAPTER 1 Introduction As we show throughout this book, the maximizing behavior of individuals and firms determines society’s three main allocation decisions: which goods are pro-duced, how they are produced, and who gets them. For example, diamond-studded pocket combs will be sold only if firms find it profitable to sell them. The firms will make and sell these combs only if consumers value the combs at least as much as it costs the firm to produce them. Consumers will buy the combs only if they get more pleasure from the combs than they would from the other goods they could buy with the same resources. Positive Versus Normative The use of models of maximizing behavior sometimes leads to predictions that seem harsh or heartless. For instance, a World Bank economist predicted that if an African government used price controls to keep the price of food low during a drought, food shortages would occur and people would starve. The predicted out-come is awful, but the economist was not heartless. The economist was only mak-ing a scientific prediction about the relationship between cause and effect: Price controls (cause) lead to food positive statement a shortages and starvation (effect). testable hypothesis Such a scientific prediction is known as a positive statement: a testable hypothe-sis about cause and effect about cause and effect. “Positive” does not mean that we are certain about the truth of our statement—it only indicates that we can test the truth of the statement. If the World Bank economist is correct, should the government control prices? If the government believes the economist’s predictions, it knows that the low prices help those consumers who are lucky enough to be able to buy as much food as they want while hurting both the firms that sell food and the people who are unable to buy as much food as they want, some of whom may die. As a result, the govern-ment’s decision whether to use price controls turns on whether the government cares more about the winners or the losers. In other words, to decide on its policy, the government makes a value judgment. Instead of first making a prediction and testing it and then making a value judg-ment to decide whether to use price controls, the government could make a value judgment directly. The value judgment could be based on the belief that “because people should have prepared for the drought, the government should not try to help them by keeping food prices low.” Alternatively, the judgment could be based on the view that “people should be protected against price gouging during a drought, so the government should use price controls.” normative statement These two statements are not scientific predictions. Each is a value judgment or a conclusion as to whether something is normative statement: a conclusion as to whether something is good or bad. A nor- good or bad mative statement cannot be tested because a value judgment cannot be refuted by evidence. It is a prescription rather than a prediction. A normative statement con-cerns what somebody believes should happen; a positive statement concerns what will happen. Although a normative conclusion can be drawn without first conducting a posi-tive 4 analysis, a policy debate will be more informed if positive analyses are con-ducted first. Suppose your normative belief is that the government should help the poor. Should you vote for a candidate who advocates a higher minimum wage (a law that requires that firms pay wages at or above a specified level), a European-style Some economists draw the normative conclusion that, as social scientists, economists should restrict 4 ourselves to positive analyses. Others argue that we shouldn’t give up our right to make value judg-ments just like the next person (who happens to be biased, prejudiced, and pigheaded, unlike us).  1.3 Uses of Microeconomic Models 7 welfare system (guaranteeing health care, housing, and other basic goods and ser-vices), an end to our current welfare system, a negative income tax (in which the less income a person has, the more the government gives that person), or job training pro-grams? Positive economic analysis can be used to predict whether these programs will benefit poor people but not whether they are good or bad. Using these predictions and your value judgment, you can decide for whom to vote. Economists’ emphasis on positive analysis has implications for what we study and even our use of language. For example, many economists stress that they study people’s wants rather than their needs. Although people need certain minimum lev-els of food, shelter, and clothing to survive, most people in developed economies have enough money to buy goods well in excess of the minimum levels necessary to maintain life. Consequently, in wealthy countries, calling something a “need” is often a value judgment. You almost certainly have been told by some elder that “you need a college education.” That person was probably making a value judgment— “you should go to college”—rather than a scientific prediction that you will suffer terrible economic deprivation if you do not go to college. We can’t test such value judgments, but we can test a hypothesis such as “One-third of the college-age pop-ulation wants to go to college at current prices.” 1.3 Uses of Microeconomic Models Have you ever imagined a world without hypothetical situations? —Steven Wright Because microeconomic models explain why economic decisions are made and allow us to make predictions, they can be very useful for individuals, governments, and firms in making decisions. Throughout this book, we consider examples of how microeconomics aids in actual decision making. Individuals can use microeconomics to make purchasing and other decisions (Chapters 4 and 5). Consumers’ purchasing and investing decisions are affected by inflation and cost of living adjustments (Chapter 5). Whether it pays financially to go to college depends, in part, on interest rates (Chapter 16). Consumers decide for whom to vote based on candidates’ views on economic issues. Firms must decide which production methods to use to minimize cost (Chapter and maximize profit (starting with Chapter 8). They may choose a complex pric-ing scheme or advertise to raise profits (Chapter 12). They select strategies to max-imize profit when competing with a small number of other firms (Chapters 13 and Some firms reduce consumer information to raise profits (Chapter 19). Firms use economic principles to structure contracts with other firms (Chapter 20). Your government’s elected and appointed officials use (or could use) economic models in many ways. Recent administrations have placed increased emphasis on economic analysis. Today, economic and environmental impact studies are required before many projects can commence. The President’s Council of Economic Advisers and other federal economists analyze and advise national government agencies on the likely economic effects of all major policies. One major use of microeconomic models by governments is to predict the prob-able impact of a policy before it is adopted. For example, economists predict the likely impact of a tax on the prices consumers pay and on the tax revenues raised (Chapter 3), whether a price control will create a shortage (Chapter 2), the differ-ential effects of tariffs and quotas on trade (Chapter 9), and the effects of regulation on monopoly price and the quantity sold (Chapter 11). CHAPTER 1 Introduction SUMMARY Microeconomics: The Allocation of Scarce affects various sectors of the economy. A good theory is Resources. Microeconomics is the study of the allo- simple to use and makes clear, testable predictions that cation of scarce resources. Consumers, firms, and the are not refuted by evidence. Most microeco-nomic government must make allocation decisions. The three models are based on maximizing behavior. Economists key trade-offs a society faces are which goods and ser- use models to construct positive hypothe-ses concerning vices to produce, how to produce them, and who gets how a cause leads to an effect. These positive questions them. These decisions are interrelated and depend on the can be tested. In contrast, normative statements, which prices that consumers and firms face and on gov- are value judgments, cannot be tested. ernment actions. Market prices affect the decisions of individual consumers and firms, and the interaction of Uses of Microeconomic Models. Individuals, gov- the decisions of individual consumers and firms deter- ernments, and firms use microeconomic models and mines market prices. The organization of the market, predictions to make decisions. For example, to max- especially the number of firms in the market and the imize its profits, a firm needs to know consumers’ information consumers and firms have, plays an decision-making criteria, the trade-offs between vari- important role in determining whether the market price ous ways of producing and marketing its product, is equal to or higher than marginal cost. government regulations, and other factors. For large companies, beliefs about how a firm’s rivals will react Models. Models based on economic theories are used to to its actions play a critical role in how it forms its predict the future or to answer questions about how business strategies. some change, such as a tax increase, Supply and Demand Talk is cheap because supply exceeds demand. 2 Countries around the globe are debating whether to permit firms to grow or sell genetically CHALLENGE modified (GM) foods, which have their DNA altered through genetic engineering rather than 1 Quantities and Prices through conventional breeding. The introduction of GM techniques can affect both the quan- of Genetically tity of a crop farmer’s supply and whether consumers want to buy that crop. Modified Foods The first commercial GM food was Calgene’s Flavr Savr tomato that resisted rotting, which the company claimed could stay on the vine longer to ripen to full flavor. It was first marketed in 1994 without any special labeling. Other common GM crops include canola, corn, cotton, rice, soybean, and sugar cane. Using GM techniques, farmers can produce more output at a given cost. In 2008, farmers in 25 countries (including the United States, Argentina, Canada, Brazil, China, and South Africa) were planting GM crops, which comprised 8% of global cropland. In 2009, more than four-fifths of the U.S. sugar beet crop used GM seeds that were introduced only one year earlier. Some scientists and consumer groups have raised safety con- cerns about GM crops. In the European Union (EU), Australia, and several other countries, governments have required labeling of GM products. Although Japan has not approved the cultivation of GM crops, it is the nation with the greatest GM food consumption and does not require labeling. According to some polls, 70% of con-sumers in Europe object to GM foods. Fears cause some con- sumers to refuse to buy a GM crop (or the entire crop if GM products cannot be distinguished). In some countries, certain GM foods have been banned. In 2008, the EU was forced to end its de facto ban on GM crop imports when the World Trade Organization ruled that the ban lacked scientific merit and hence violated international trade rules. As of 2010, most of the EU still bans planting GM crops. Consumers in other countries, such as the United States, are less concerned about GM foods. In yet other countries, consumers may not even be aware of the use of GM seeds. In 2008, Vietnam announced that it was going to start using GM soybean, corn, and cotton seeds to lower food prices and reduce imports. By 2010, a study found that one-third of crops sampled in Vietnam were genetically modified (many imported). Vietnam’s government has announced labeling regulations but has not yet explained how it will implement these regulations. Whether a country approves GM crops turns on questions of safety and of economics. Will the use of GM seeds lead to lower prices and more food sold? What happens to prices and quantities sold if many consumers refuse to buy GM crops? (We will return to these questions at the end of this chapter.) 1 Sources for Challenges, which appear at the beginning of chapters, and Applications, which appear throughout the chapters, are listed at the end of the book. 9 CHAPTER 2 Supply and Demand To analyze questions concerning the price and quantity responses from introducing new products or technologies, imposing government regulations or taxes, or other events, economists may use the supply-and-demand model. When asked, “What is the most important thing you know about economics?” a common reply is, “Supply equals demand.” This statement is a shorthand description of one of the simplest yet most powerful models of economics. The supply-and-demand model describes how consumers and suppliers interact to determine the quantity of a good or service sold in a market and the price at which it is sold. To use the model, you need to deter-mine three things: buyers’ behavior, sellers’ behavior, and how they interact. After reading this chapter, you should be adept enough at using the supply-and- demand model to analyze some of the most important policy questions facing your country today, such as those concerning international trade, minimum wages, and price controls on health care. After reading that grandiose claim, you may ask, “Is that all there is to eco-nomics? Can I become an expert economist that fast?” The answer to both these questions is no, of course. In addition, you need to learn the limits of this model and what other models to use when this one does not apply. (You must also learn the economists’ secret handshake.) Even with its limitations, the supply-and-demand model is the most widely used economic model. It provides a good description of how competitive markets func-tion. Competitive markets are those with many buyers and sellers, such as most agriculture markets, labor markets, and stock and commodity markets. Like all good theories, the supply-and-demand model can be tested—and possibly shown to be false. But in competitive markets, where it works well, it allows us to make accu-rate predictions easily. In this chapter, Demand. The quantity of a good or service that consumers demand depends on price and we examine six other factors such as consumers’ incomes and the price of related goods. main topics Supply. The quantity of a good or service that firms supply depends on price and other factors such as the cost of inputs firms use to produce the good or service. Market Equilibrium. The interaction between consumers’ demand and firms’ supply determines the market price and quantity of a good or service that is bought and sold. Shocking the Equilibrium. Changes in a factor that affect demand (such as consumers’ incomes), supply (such as a rise in the price of inputs), or a new government policy (such as a new tax) alter the market price and quantity of a good. Equilibrium Effects of Government Interventions. Government policies may alter the equilibrium and cause the quantity supplied to differ from the quantity demanded. When to Use the Supply-and-Demand Model. The supply-and-demand model applies only to competitive markets. 2.1 Demand Potential consumers decide how much of a good or service to buy on the basis of its price and many other factors, including their own tastes, information, prices of other goods, income, and government actions. Before concentrating on the role of price in determining demand, let’s look briefly at some of the other factors. Consumers’ tastes determine what they buy. Consumers do not purchase foods they dislike, artwork they hate, or clothes they view as unfashionable or uncom-fortable. Advertising may influence people’s tastes.  2.1 Demand 11 Similarly, information (or misinformation) about the uses of a good affects con- sumers’ decisions. A few years ago when many consumers were convinced that oat-meal could lower their cholesterol level, they rushed to grocery stores and bought large quantities of oatmeal. (They even ate some of it until they remembered that they couldn’t stand how it tastes.) The prices of other goods also affect consumers’ purchase decisions. Before deciding to buy Levi’s jeans, you might check the prices of other brands. If the price of a close substitute—a product that you view as similar or identical to the one you are considering purchasing—is much lower than the price of Levi’s jeans, you may buy that brand instead. Similarly, the price of a complement—a good that you like to consume at the same time as the product you are considering buying—may affect your decision. If you eat pie only with ice cream, the higher the price of ice cream, the less likely you are to buy pie. Income plays a major role in determining what and how much to purchase. People who suddenly inherit great wealth may purchase a Rolls-Royce or other lux-ury items and would probably no longer buy do-it-yourself repair kits. Government rules and regulations affect purchase decisions. Sales taxes increase the price that a consumer must spend for a good, and government-imposed limits on the use of a good may affect demand. In the nineteenth century, one could buy Bayer heroin, a variety of products containing cocaine, and other drug-related prod-ucts that are now banned in most countries. When a city’s government bans the use of skateboards on its 2 streets, skateboard sales fall. Other factors may also affect the demand for specific goods. Consumers are more likely to have telephones if most of their friends have telephones. The demand for small, dead evergreen trees is substantially higher in December than in other months. Although many factors influence demand, economists usually concentrate on how price affects the quantity demanded. The relationship between price and quan-tity demanded plays a critical role in determining the market price and quantity in a supply- and-demand analysis. To determine how a change in price affects the quan-tity demanded, economists must hold constant other factors such as income and tastes that affect demand. The Demand Curve quantity demanded The amount of a good that consumers are willing to buy at a given price, holding constant the amount of a good that consumers are willing to the other factors that influence purchases, is the quantity demanded. The quantity buy at a given price, hold- demanded of a good or service can exceed the quantity actually sold. For example, as a ing constant the other fac- promotion, a local store might sell DVDs for $1 each today only. At that low price, you tors that influence purchases might want to buy 25 DVDs, but because the store ran out of stock, you can buy only 10 DVDs. The quantity you demand is 25—it’s the amount you want, even though the amount you actually buy is only 10. demand curve We can show the relationship between price and the quantity demanded graphi-cally. the quantity demanded at each possible price, hold- A demand curve shows the quantity demanded at each possible price, holding constant ing constant the other fac- the other factors that influence purchases. Figure 2.1 shows the estimated demand curve, tors that influence 1 purchases D , for processed pork in Canada (Moschini and Meilke, 1992). (Although this demand curve is a straight line, demand curves may also be smooth 2 When a Mississippi woman attempted to sell her granddaughter for $2,000 and a car, state legisla-tors were horrified to discover that they had no law on the books prohibiting the sale of children and quickly passed such a law. (Mac Gordon, “Legislators Make Child-Selling Illegal,” Jackson Free Press, March 16, 2009.) CHAPTER 2 Supply and Demand Figure 2.1 A Demand Curve The estimated demand curve, 1 14.30 p, $ per kg D , for processed pork in Canada (Moschini and Meilke, 1992) shows the rela-tionship 1 between the quantity demanded Demand curve for pork, D per year and the price per kg. The downward slope of the demand curve shows that, holding other fac-tors that influence demand constant, 4.30 consumers demand less of a good when its price is high and 3.30 more when the price is low. A 2.30 change in price causes a movement along the demand curve. 0 200 220 240 286 Q, Million kg of pork per year curves or wavy lines.) By convention, the vertical axis of the graph measures the price, p, per unit of the good—here dollars per kilogram (kg). The horizontal axis measures the quantity, Q, of the good, which is usually expressed in some physical measure (million kg of dressed cold pork carcass weight) per time period (per year). The demand curve hits the vertical axis at $14.30, indicating that no quantity is demanded when the price is $14.30 (or higher). The demand curve hits the hori-zontal quantity axis at 286 million kg—the amount of pork that consumers want if the price is zero. To find out what quantity is demanded at a price between these extremes, pick that price on the vertical axis—say, $3.30 per kg—draw a horizon-tal line across until you hit the demand curve, and then draw a line straight down to the horizontal quantity axis: 220 million kg of pork per year is demanded at that price. One of the most important things to know about a graph of a demand curve is what is not shown. All relevant economic variables that are not explicitly shown on the demand curve graph—tastes, information, prices of other goods (such as beef and chicken), income of consumers, and so on—are held constant. Thus the demand curve shows how quantity varies with price but not how quantity varies with tastes, information, the price 3 Law of Demand of substitute goods, or other variables. consumers demand more of a good the lower its Effect of Prices on the Quantity Demanded Many economists claim that the most price, holding constant important empirical finding in economics is the Law of Demand: Consumers demand tastes, the prices of other more of a good the lower its price, holding constant tastes, the prices of other goods, and goods, and other factors other factors that influence the amount they consume. According to the Law of Demand, that influence consump- 4 tion demand curves slope downward, as in Figure 2.1. 3 Because prices, quantities, and other factors change simultaneously over time, economists use sta- tistical techniques to hold the effects of factors other than the price of the good constant so that they can determine how price affects the quantity demanded (see Appendix 2A). Moschini and Meilke (1992) used such techniques to estimate the pork demand curve. As with any estimate, their esti-mates are probably more accurate in the observed range of prices ($1 to $6 per kg) than at very high or very low prices. 4 Theoretically, a demand curve could slope upward (Chapter 5); however, available empirical evi- dence strongly supports the Law of Demand.  2.1 Demand 13 A downward-sloping demand curve illustrates that consumers demand more of this good when its price is lower and less when its price is higher. What happens to the quantity of pork demanded if the price of pork drops and all other variables remain constant? If the price of pork falls by $1 from $3.30 to $2.30 in Figure 2.1, the quantity 5 consumers want to buy increases from 220 to 240. Similarly, if the price increases from $3.30 to $4.30, the quantity consumers demand decreases from 220 to 200. These changes in the quantity demanded in response to changes in price are movements along the demand curve. Thus the demand curve is a concise sum-mary of the answers to the question “What happens to the quantity demanded as the price changes, when all other factors are held constant?” Effects of Other Factors on Demand If a demand curve measures the effects of price changes when all other factors that affect demand are held constant, how can we use demand curves to show the effects of a change in one of these other factors, such as the price of beef? One solution is to draw the demand curve in a three-dimensional diagram with the price of pork on one axis, the price of beef on a sec-ond axis, and the quantity of pork on the third axis. But just thinking about drawing such a diagram probably makes your head hurt. Economists use a simpler approach to show the effect on demand of a change in a factor that affects demand other than the price of the good. A change in any fac-tor other than the price of the good itself causes a shift of the demand curve rather than a movement along the demand curve. Many people view beef as a close substitute for pork. Thus at a given price of pork, if the price of beef rises, some people will switch from beef to pork. Figure 2.2 shows how 1 the demand curve for pork shifts to the right from the original demand curve D to a new 2 demand curve D as the price of beef rises from $4.00 to $4.60 Figure 2.2 A Shift of the Demand Curve The demand curve for processed pork shifts to 1 2 the right from D to D as the price of beef per Effect of a 60¢ increase in the price of beef kg rises from $4 to $4.60. As a result of the increase in beef prices, more pork is demanded p, $ at any given price. 3.30 2 D 1 D 0 176 220 232 Q, Million kg of pork per year 5 Economists typically do not state the relevant physical and time period measures unless they are particularly useful. They refer to quantity rather than something useful such as “metric tons per year” and price rather than “cents per pound.” I’ll generally follow this convention, usually refer-ring to the price as $3.30 (with the “per kg” understood) and the quantity as 220 (with the “million kg per year” understood). CHAPTER 2 Supply and Demand per kg. (The quantity axis starts at 176 instead of 0 in the figure to emphasize the relevant 2 portion of the demand curve.) On the new demand curve, D , more pork is demanded at 1 any given price than on D. At a price of pork of $3.30, the quan-tity of pork demanded 1 2 goes from 220 on D , before the change in the price of beef, to 232 on D , after the price change. Other factors such as addictiveness may also affect demand. A 2007 Harvard School of Public Health study concluded that cigarette manufacturers raised nico-tine levels in cigarettes by 11% over the last decade to make them more addictive. Although some cigarette makers denied such actions, the Massachusetts Department of Public Health issued a study citing the industry’s own reports that the amount of nicotine that could be inhaled from cigarettes had risen by an aver-age of 10% from 1998 through 2004. Presumably, if cigarettes have become more addictive, the demand curve of existing 6 smokers would shift to the right. To properly analyze the effects of a change in some variable on the quantity demanded, we must distinguish between a movement along a demand curve and a shift of a demand curve. A change in the price of a good causes a movement along a demand curve. A change in any other factor besides the price of the good causes shift of the demand curve. APPLICATION A change in information can also shift the demand curve. New York City started requiring mandatory posting of calories on menus in chain restaurants in mid-2008. Calorie Counting (Some states have since passed similar laws and Congress is con-sidering federal at Starbucks legislation.) Bollinger, Leslie, and Sorensen (2010) found that New York City’s mandatory calorie posting caused average calories per trans-action at Starbucks to fall by 6% due to reduced consumption of high-calorie foods. They found larger responses to information among wealthier and better-educated consumers and among those who prior to the law consumed relatively more calories. The Demand Function In addition to drawing the demand curve, you can write it as a mathematical rela-tionship called the demand function. The processed pork demand function is Q = D(p, pb, pc, Y), (2.1) where Q is the quantity of pork demanded, p is the price of pork, pb is the price of beef, pc is the price of chicken, and Y is the income of consumers. This expression says that the amount of pork demanded varies with the price of pork, the price of substitutes (beef and chicken), and the income of consumers. Any other factors that are not explicitly listed in the demand function are assumed to be irrelevant (the price of llamas in Peru) or held constant (the price of fish). By writing the demand function in this general way, we are not explaining exactly how the quantity demanded varies as p, pb, pc, or Y changes. Instead, we can rewrite Equation 2.1 as a specific function: Q = 171 - 20p + 20pb + 3pc + 2Y. (2.2) Gardiner Harris, “Study Showing Boosted Nicotine Levels Spurs Calls for Controls,” San Francisco 6 Chronicle, January 19, 2007, A-4.  2.1 Demand 15 1 Equation 2.2 is the estimated demand function that corresponds to the demand curve D in 7 Figures 2.1 and 2.2. 1 When we drew the demand curve D in Figures 2.1 and 2.2, we held pb, pc, and Y at their typical values during the period studied: pb = 4 (dollars per kg), pc = 3 13 (dollars per kg), and Y = 12.5 (thousand dollars). If we substitute these values for pb, pc, and Y in Equation 2.2, we can rewrite the quantity demanded as a function of only the price of pork: Q = 171 - 20p + 20pb + 3pc + 2Y 1 171 - 20p + (20 * 4) + (3 * 3 3) + (2 * 12.5) = 286 - 20p (2.3) 1 The straight-line demand curve D in Figures 2.1 and 2.2—where we hold the price of beef, the price of chicken, and disposable income constant at these typical val- See Problems 27 and 28. ues—is described by the linear demand function in Equation 2.3. The constant term, 286, in Equation 2.3 is the quantity demanded if the price is zero. Setting the price equal to zero in Equation 2.3, we find that the quantity demanded is Q = 286 - (20 * 0) = 286. Figure 2.1 shows that Q = 286 where 1 D hits the quantity axis at a price of zero. This equation also shows us how quantity demanded changes with a change in price: a movement along the demand curve. If the price increases from p1 to p2, the change in price, Dp, equals p2 - p1. (The D symbol, the Greek letter delta, means “change in” the following variable, so Dp means “change in price.”) As Figure 2.1 illustrates, if the price of pork increases by $1 from p1 = $3.30 to p2 = $4.30, Dp = $1 and DQ = Q2 - Q1 = 200 - 220 = 220 million kg per year. More generally, the quantity demanded at p1 is Q1 = D(p1), and the quantity demanded at p2 is Q2 = D(p2). The change in the quantity demanded, DQ=Q2 - Q1, in response to the price change (using Equation 2.3) is DQ=Q2-Q1 D(p2) - D(p1) (286 - 20p2) - (286 - 20p1) 220(p2 - p1) 220Dp. Thus the change in the quantity demanded, DQ, is 220 times the change in the price, Dp. If Dp = $1, DQ = 220Dp = 20. The slope of a demand curve is Dp/DQ, the “rise” (Dp, the change along the ver-tical axis) divided by the “run” (DQ, the change along the horizontal axis). The slope of 1 demand curve D in Figures 2.1 and 2.2 is rise Dp $1 per kg Slope = run = DQ = 220 million kg per year = 2$0.05 per million kg per year. The negative sign of this slope is consistent with the Law of Demand. The slope says that the price rises by $1 per kg as the quantity demanded falls by 20 million kg per year. Turning that statement around: The quantity demanded falls by 20 million kg per year as the price rises by $1 per kg. The numbers are rounded slightly from the estimates to simplify the calculation. For example, the estimate of the coefficient on the price of beef is 19.5, not 20, as the equation shows. CHAPTER 2 Supply and Demand Thus we can use the demand curve to answer questions about how a change in price affects the quantity demanded and how a change in the quantity demanded affects price. We can also answer these questions using demand functions. SOLVED How much would the price have to fall for consumers to be willing to buy 1 mil-lion PROBLEM 2.1 more kg of pork per year? Answer Express the price that consumers are willing to pay as a function of quantity. We use algebra to rewrite the demand function as an inverse demand function, where price depends on the quantity demanded. Subtracting Q from both sides of Equation 2.3 and adding 20p to both sides, we find that 20p = 286 - Q. Dividing both sides of the equation by 20, we obtain the inverse demand function: p = 14.30 - 0.05Q(2.4) Use the inverse demand curve to determine how much the price must change for consumers to buy 1 million more kg of pork per year. We take the differ-ence between the inverse demand function, Equation 2.4, at the new quantity, Q2 + 1, and at the original quantity, Q1, to determine how the price must change: Δp = p2 - p1 (14.30 - 0.05Q2) - (14.30 - 0.05Q1) 20.05(Q2 - Q1) 20.05ΔQ. The change in quantity is ΔQ = Q2 - Q1 = (Q1 + 1) - Q1 = 1, so the change in price is Δp = 20.05. That is, for consumers to demand 1 million more kg of pork per See Problem 29. year, the price must fall by 5¢ a kg, which is a movement along the demand curve. Summing Demand Curves If we know the demand curve for each of two consumers, how do we determine the total demand curve for the two consumers combined? The total quantity demanded at a given price is the sum of the quantity each consumer demands at that price. We can use the demand functions to determine the total demand of several con- sumers. Suppose that the demand function for Consumer 1 is 1 Q1 = D (p) and the demand function for Consumer 2 is 2 Q2 = D (p). At price p, Consumer 1 demands Q1 units, Consumer 2 demands Q2 units, and the total demand of both consumers is the sum of the quantities each demands sepa-rately: 1 2 See Problems 30 and 31. Q = Q1 + Q2 = D (p) + D (p). We can generalize this approach to look at the total demand for three or more consumers.  2.2 Supply 17 It makes sense to add the quantities demanded only when all consumers face the same price. Adding the quantity Consumer 1 demands at one price to the quantity Consumer 2 demands at another price would be like adding apples and oranges. APPLICATION We illustrate how to combine individual demand curves to get a total demand curve graphically using estimated demand curves of broadband (high-speed) Internet Aggregating the service (Duffy-Deno, 2003). The figure shows the demand curve for small firms (1– Demand for 19 employees), the demand curve for larger firms, and the total demand curve for all Broadband Service firms, which is the horizontal sum of the other two demand curves. At the current average rate of 40¢ per kilobyte per second (Kbps), the quan-tity demanded by small firms is Qs = 10 (in millions of Kbps) and the quan-tity demanded by larger firms is Ql = 11.5. Thus, the total quantity demanded at that See Problem 32. price is Q = Qs + Ql = 10 + 11.5 = 21.5. Price, ¢ per Kbps Small firms’ Large firms’ demand demand 40¢ Total demand Qs = 10 Ql = 11.5 Q = 21.5 Q, Broadband access capacity in millions of Kbps 2.2 Supply Knowing how much consumers want is not enough, by itself, to tell us what price and quantity are observed in a market. To determine the market price and quantity, we also need to know how much firms want to supply at any given price. Firms determine how much of a good to supply on the basis of the price of that good and other factors, including the costs of production and government rules and regulations. Usually, we expect firms to supply more at a higher price. Before con-centrating on the role of price in determining supply, we’ll briefly describe the role of some of the other factors. Costs of production affect how much firms want to sell of a good. As a firm’s cost falls, it is willing to supply more, all else the same. If the firm’s cost exceeds what it can earn from selling the good, the firm sells nothing. Thus, factors that affect costs, also affect supply. A technological advance that allows a firm to pro-duce a good at lower cost leads the firm to supply more of that good, all else the same. Government rules and regulations affect how much firms want to sell or are allowed to sell. Taxes and many government regulations—such as those covering CHAPTER 2 Supply and Demand pollution, sanitation, and health insurance—alter the costs of production. Other regulations affect when and how the product can be sold. In Germany, retailers may not sell most goods and services on Sundays or during evening hours. In the United States, the sale of cigarettes and liquor to children is prohibited. New York, San Francisco, and many other cities restrict the number of taxicabs. The Supply Curve quantity supplied The quantity supplied is the amount of a good that firms want to sell at a given price, the amount of a good that holding constant other factors that influence firms’ supply decisions, such as costs and firms want to sell at a government actions. We can show the relationship between price and the quan-tity given price, holding con- stant other factors that supplied graphically. A supply curve shows the quantity supplied at each possi-ble price, influence firms’ supply holding constant the other factors that influence firms’ supply decisions. Figure 2.3 decisions, such as costs 1 shows the estimated supply curve, S , for processed pork (Moschini and Meilke, 1992). and government actions As with the demand curve, the price on the vertical axis is measured in dollars per supply curve physical unit (dollars per kg), and the quantity on the horizontal axis is measured in the quantity supplied at physical units per time period (millions of kg per year). Because we hold fixed other each possible price, hold- ing constant the other fac- variables that may affect the supply, such as costs and government rules, the supply curve tors that influence firms’ concisely answers the question “What happens to the quan-tity supplied as the price supply decisions changes, holding all other factors constant?” Effect of Price on Supply We illustrate how price affects the quantity supplied using the supply curve for processed pork in Figure 2.3. The supply curve for pork is upward sloping. As the price of pork increases, firms supply more. If the price is $3.30, the market supplies a quantity of 220 (million kg per year). If the price rises to $5.30, the quantity supplied rises to 300. An increase in the price of pork causes a movement along the supply curve, resulting in more pork being supplied. Although the Law of Demand requires that the demand curve slope downward, there is no “Law of Supply” that requires the market supply curve to have a partic-ular slope. The market supply curve can be upward sloping, vertical, horizontal, or downward sloping. Many supply curves slope upward, such as the one for pork. Figure 2.3 A Supply Curve 1 The estimated supply curve, S , p, $ per kg for processed pork in Canada Supply curve, S 1 5.30 (Moschini and Meilke, 1992) shows the relationship between the quantity supplied per year and the price per kg, holding cost and other factors that influence supply 3.30 constant. The upward slope of this supply curve indicates that firms sup-ply more of this good when its price is high and less when the price is low. An increase in the price of pork causes a move-ment along the supply curve, resulting in a larger quantity of pork 0 176 220 300 supplied. Q, Million kg of pork per year  2.2 Supply 19 Along such supply curves, the higher the price, the more firms are willing to sell, holding costs and government regulations fixed. Effects of Other Variables on Supply A change in a variable other than the price of pork causes the entire supply curve to shift. Suppose the price, ph, of hogs—the main factor used to produce processed pork—increases from $1.50 per kg to $1.75 per kg. Because it is now more expensive to produce pork, firms are willing to sell fewer units at 1 2 8 any given price, so the supply curve shifts to the left, from S to S in Figure 2.4. Firms want to supply less pork at any given price than before the price of hogs rose. At a price 1 of processed pork of $3.30, the quantity supplied falls from 220 on S (before the 2 increase in the hog price) to 205 on S (after the increase in the hog price). Again, it is important to distinguish between a movement along a supply curve and a shift of the supply curve. When the price of pork changes, the change in the quantity supplied reflects a movement along the supply curve. When costs, govern-ment rules, or other variables that affect supply change, the entire supply curve shifts. The Supply Function We can write the relationship between the quantity supplied and price and other fac-tors as a mathematical relationship called the supply function. Written generally, the processed pork supply function is Q = S(p, ph), (2.5) where Q is the quantity of processed pork supplied, p is the price of processed pork, and ph is the price of a hog. The supply function, Equation 2.5, may also be a func-tion of other factors such as wages, but by leaving them out, we are implicitly hold-ing them constant. Figure 2.4 A Shift of a Supply Curve An increase in the price of hogs from $1.50 to $1.75 per kg causes the supply curve for pro-cessed pork p $ per 1 2 to shift from S to S. At the price of processed pork , kg 1 Effect of a 25¢ increase in the price of hogs of $3.30, the quantity supplied falls from 220 on S 2 2 S to 205 on S. S1 3.30 0 176 205 220 Q, Million kg of pork per year 8 Alternatively, we may say that the supply curve shifts up because firms’ costs of production have increased, so that firms will supply a given quantity only at a higher price. CHAPTER 2 Supply and Demand Based on Moschini and Meilke (1992), the linear pork supply function in Canada is Q = 178 + 40p - 60ph, (2.6) where quantity is in millions of kg per year and the prices are in Canadian dollars per kg. If we hold the price of hogs fixed at its typical value of $1.50 per kg, we can rewrite the 9 supply function in Equation 2.6 as See Problem 33. Q = 88 + 40p. (2.7) What happens to the quantity supplied if the price of processed pork increases by Dp = p2 10 - p1? Using the same approach as before, we learn from Equation 2.7 that DQ = 40Dp. A $1 increase in price (Dp = 1) causes the quantity supplied to increase by DQ = 40 million kg per year. This change in the quantity of pork sup-plied as p increases is a movement along the supply curve. Summing Supply Curves The total supply curve shows the total quantity produced by all suppliers at each possible price. For example, the total supply of rice in Japan is the sum of the domestic and foreign supply curves of rice. Suppose that the domestic supply curve (panel a) and foreign supply curve (panel of rice in Japan are as Figure 2.5 shows. The total supply curve, S in panel c, is the d horizontal sum of the Japanese domestic supply curve, S , and the foreign sup-ply curve, f S. In the figure, the Japanese and foreign supplies are zero at any price equal to or less than p, so the total supply is zero. At prices above p, the Japanese and foreign supplies are positive, so the total supply is positive. For example, when price is p*, the quantity * supplied by Japanese firms is Q d (panel a), the quantity sup- * * * * plied by foreign firms is Q f (panel b), and the total quantity supplied is Q = Q d + Q f (panel c). Because the total supply curve is the horizontal sum of the domestic and foreign supply curves, the total supply curve is flatter than either of See Problem 34. the other two supply curves. Effects of Government Import Policies on Supply Curves We can use this approach for deriving the total supply curve to analyze the effect of government policies on the total supply curve. Traditionally, the Japanese govern-ment banned the importation of foreign rice. We want to determine how much less is supplied at any given price to the Japanese market because of this ban. f Without a ban, the foreign supply curve is S in panel b of Figure 2.5. A ban on imports eliminates the foreign supply, so the foreign supply curve after the ban is f imposed, S , is a vertical line at Qf = 0. The import ban has no effect on the domes-tic d supply curve, S , so the supply curve is the same as in panel a. f Because the foreign supply with a ban, S , is zero at every price, the total supply with a d ban, S, in panel c is the same as the Japanese domestic supply, S , at any given 9 Substituting ph = $1.50 into Equation 2.6, we find that Q = 178 + 40p - 60ph = 178 + 40p - (60 * 1.50) = 88 + 40p. 10 As the price increases from p1 to p2, the quantity supplied goes from Q1 to Q2, so the change in quantity supplied is ΔQ = Q2 - Q1 = (88 + 40p2) - (88 + 40p1) = 40(p2 - p1) = 40Δp.  2.2 Supply 21 Figure 2.5 Total Supply: The Sum of Domestic and Foreign Supply If foreigners may sell their rice in Japan, the total Japanese f supply, S. With a ban on foreign imports, the foreign supply supply of rice, S, is the horizontal sum of the domestic f curve, S , is zero at every price, so the total supply curve, S, d d Japanese supply, S , and the imported foreign is the same as the domestic supply curve, S. (a) Japanese Domestic Supply (b) Foreign Supply (c) Total Supply icep p,Pr erto cepe p,Pri rton n P rt p e p e ri c – – , d S f f S (ban) S (no ban) S (ban) S (no ban) p* p* p* p p p – – – Qd* Q f* Q = Qd* Q* = Qd* + Qf* Qd , Tons per year Qf , Tons per year Q, Tons per year price. The total supply curve under the ban lies to the left of the total supply curve without a ban, S. Thus the effect of the import ban is to rotate the total supply curve toward the vertical axis. The limit that a government sets on the quantity of a foreign-produced good that may quota be imported is called a quota. By absolutely banning the importation of rice, the Japanese the limit that a government government sets a quota of zero on rice imports. Sometimes govern-ments set positive sets on the quantity of a foreign-produced good quotas, Q 7 0. The foreign firms may supply as much as they want, Qf, as long as they that may be imported supply no more than the quota: Qf … Q. We investigate the effect of such a quota in Solved Problem 2.2. In most of the solved problems in this book, you are asked to determine how a change in a vari-able or policy affects one or more variables. In this problem, the policy changes from no quota to a quota, which affects the total supply curve. SOLVED How does a quota set by the United States on foreign sugar imports of Q affect the d PROBLEM 2.2 total American supply curve for sugar given the domestic supply curve, S in panel a f of the graph, and the foreign supply curve, S in panel b? Answer Determine the American supply curve without the quota. The no-quota total supply d curve, S in panel c, is the horizontal sum of the U.S. domestic supply curve, S , and f the no-quota foreign supply curve, S. Show the effect of the quota on foreign supply. At prices less than p, foreign suppliers want to supply quantities less than the quota, Q. As a result, the for-eign supply f curve under the quota, S , is the same as the no-quota foreign sup- CHAPTER 2 Supply and Demand f ply curve, S , for prices less than p. At prices above p, foreign suppliers want to f supply more but are limited to Q. Thus the foreign supply curve with a quota, S , is vertical at Q for prices above p. Determine the American total supply curve with the quota. The total supply curve with d f the quota, S, is the horizontal sum of S and S. At any price above p, the total supply equals the quota plus the domestic supply. For example, at p*, the domestic * * supply is Q d and the foreign supply is Qf, so the total supply is Q d + Qf. Above p, S is the domestic supply curve shifted Q units to the right. As a result, the portion d of S above p has the same slope as S. Compare the American total supply curves with and without the quota. At prices less than or equal to p, the same quantity is supplied with and without the quota, so S is the same as S. At prices above p, less is supplied with the quota than without one, so S is steeper than S, indicating that a given increase See Question 1. in price raises the quantity supplied by less with a quota than without one. (a) U.S. Domestic Supply (b) Foreign Supply (c) Total Supply p, Price – p, Price – p, Price f per ton S S d f S S p e o n p e o n S r r t t p* p* p* – – – p p p – – – – – Qd Qd* Qf Q f* Qd + Qf Qd* + Qf Qd* + Qf* Qd, Tons per year Qf , Tons per year Q, Tons per year 2.3 Market Equilibrium The supply and demand curves determine the price and quantity at which goods and services are bought and sold. The demand curve shows the quantities consumers want to buy at various prices, and the supply curve shows the quantities firms want to sell at various prices. Unless the price is set so that consumers want to buy exactly the same amount that suppliers want to sell, either some buyers cannot buy as much as they want or some sellers cannot sell as much as they want. When all traders are able to buy or sell as much as they want, we say that the market is equilibrium in equilibrium: a situation in which no participant wants to change its behavior. A price a situation in which no one wants to change his or her at which consumers can buy as much as they want and sellers can sell as much as they behavior want is called an equilibrium price. The quantity that is bought and sold at the equilibrium price is called the equilibrium quantity.  CHAPTER 2 Supply and Demand Figure 2.7 Equilibrium Effects of a Shift of a Demand or Supply Curve An increase in the price of beef by 60¢ causes the demand price up until it reaches $3.50 at the new equilibrium, E2. 1 2 curve for processed pork to shift outward from D to D. At An increase in the price of hogs by 25¢ causes the sup-ply 1 2 the original equilibrium, E1, price, $3.30, there is excess curve for processed pork to shift to the left from S to S , demand of 12. Market pressures drive the driving the market equilibrium from E1 to E2. (a) Effect of a 60¢ Increase in the Price of Beef (b) Effect of a 25¢ Increase in the Price of Hogs p, $ per kg Effect of a 60¢ increase in the price of beef 3.50 3.30 e 2 S e1 2 D 0 D1 176 228 232