To see this, consider the increase in the demand for restaurant meals in the United States that developed during the 1970s. This increase in demand for restaurant meals resulted in an increase in the price of eating out, which increased the profits of restauranteurs. The increase in profits attracted investment capital into the industry. As the output of restaurant meals increased, the increased demand for restaurant workers resulted in higher wages and benefits. This attracted workers into the restaurant industry and away from other industries, where the diminished demand for labor resulted in lower wages and benefits. CHAPTER REVIEW The interaction of supply and demand is the primary mechanism for the allocations of goods, services, and productive resources in market economies. A market system comprises markets for productive resources and markets for final goods and services. The law of demand states that a change in quantity demanded of a good or service is inversely related to a change in the selling price, other factors (demand determinants) remaining unchanged. Other demand determinants include income, tastes and preferences, prices of related goods and services, number of buyers, and price expectations. The law of demand is illustrated graphically with a demand curve, which slopes downward from left to right, with price on the vertical axis and quan- tity on the horizontal axis. A change in the quantity demanded of a good, service, or productive resource resulting from a change in the selling price is depicted as a movement along the demand curve.A change in demand for a good or service results from a change in a nonprice demand determinant, other factors held constant, including the price of the good or service under consideration. An increase in per-capita income, for example, results in an increase in the demand for most goods and services and is illustrated as a shift of the demand curve to the right. The law of supply states that a change in quantity supplied of a good or service is directly related to the selling price, other factors (supply deter- minants) held constant. Other supply determinants include factor costs, technology, prices of other goods the producers can supply, number of firms producing the good or service, price expectations, and weather conditions. The law of supply is illustrated graphically with a supply curve, which slopes upward from left to right with price on the vertical axis and quan- tity on the horizontal axis. A change in the quantity supplied of a good or service resulting from a change in the selling price is depicted as a move- ment along the supply curve.A change in supply of a good or service results from a change in some other supply demand determinant, other factors held constant, including the price of the good or service under consideration. An chapter review 137 increase in the number of firms producing the good, for example, will result in a shift of the supply curve to the right. Market equilibrium exists when the quantity supplied is equal to quan- tity demanded. The price that equates quantity supplied with quantity demanded is called the equilibrium price. If the price rises above the equi- librium price, the quantity supplied will exceed the quantity demanded, resulting in a surplus (excess supply). If the price falls below the equilib- rium price, quantity demanded will exceed the quantity supplied, resulting in a shortage (excess demand). An increase or a decrease in price to clear the market of a surplus or a shortage is referred to as the rationing function of prices.The rationing func- tion is considered to be a short-run phenomenon. In the short run, one or more explanatory variables are assumed to be constant. A price ceiling is a government-imposed maximum price for a good or service produced by a given industry. Price ceilings create market shortages that require a non–price rationing mechanism to allocate available supplies of goods and services. There are a number of non-price rationing mechanisms, including ration coupons, queuing, favored customers, and black markets. The allocating function of price, on the other hand, is assumed to be a long-run phenomenon. In the long run, all explanatory variables are assumed to be variable. In the long run, price changes signal consumers and producers to devote more or less of their resources to the consumption and production of goods and services. In other words, the allocating function of price allows for changes in all demand and supply determinants. KEY TERMS AND CONCEPTS Allocating function of price The process by which productive resources are reallocated between and among production processes in response to changes in the prices of goods and services. Change in demand Results from a change in one or more demand deter- minants (income, tastes, prices of complements, prices of substitutes, price expectations, income expectations, number of consumers, etc.) that causes an increase in purchases of a good or service at all prices. An increase in demand is illustrated diagrammatically as a right-shift in the entire demand curve. A decrease in demand is illustrated diagrammati- cally as a left-shift in the entire demand curve. Change in supply Results from a change in one or more supply determi- nants (prices of productive inputs, technology, price expectations, taxes and subsidies, number of firms in the industry, etc.) that causes an increase in the supply of a good or service at all prices. An increase in supply is illustrated diagrammatically as a right-shift in the entire supply curve.A decrease in supply curve is illustrated diagrammatically as a left- shift in the entire supply curve. 138 the essentials of demand and supply Change in quantity demanded Results from a change in the price of a good or service. As the price of a good or service rises (falls), the quan- tity demanded decreases (increases). An increase in the quantity demanded of a good or service is illustrated diagrammatically as a move- ment from the left to the right along a downward-sloping demand curve. A decrease in the quantity demanded of a good or service is illustrated diagrammatically as a movement from the right to the left along a downward-sloping demand curve. Change in quantity supplied Results from a change in the price of a good or service. As the price of a good or service rises (falls), the quantity sup- plied increases (decreases). An increase in the quantity supplied of a good or service is illustrated diagrammatically as a movement from the left to the right to left along an upward-sloping demand curve. A decrease in the quantity supplied of a good or service is illustrated dia- grammatically as a movement from the right to the left along an upward- sloping supply curve. Demand curve A diagrammatic illustration of the quantities of a good or service that consumers are willing and able to purchase at various prices, assuming that the influence of other demand determinants remaining unchanged. Demand determinants Nonprice factors that influence consumers’ deci- sions to purchase a good or service. Demand determinants include, income, tastes, prices of complements, prices of substitutes, price expec- tations, income expectations, and number of consumers. Equilibrium price The price at which the quantity demanded equals the quantity supplied of that good or service. Favored customer Describing a non–price rationing mechanism in which certain individuals receive special treatment. In the extreme, the favored customer as a form of non–price rationing may take the form of racial, religious, and other forms of group discrimination. Law of demand The change in the quantity demanded of a good or a service is inversely related to its selling price, all other influences affect- ing demand remaining unchanged (ceteris paribus). Law of supply The change in the quantity supplied of a good or a service is positively related to its selling price, all other influences affecting supply remaining unchanged (ceteris paribus). Market equilibrium Conditions under which the quantity supplied of a good or a service is equal to quantity demanded of that same good or service. Market equilibrium occurs at the equilibrium price. Market power Refers to the ability to influence the market price of a good by shifting the demand curve or the supply curve of a good or a service. In perfectly competitive markets, individual consumers and individual suppliers do not have market power. Movement along the demand curve The result of a change in the quan- tity demanded of a good or a service. key terms and concepts 139 Movement along the supply curve The result of a change in the quantity supplied of a good or service. Price ceiling The maximum price that firms in an industry can charge for a good or service.Typically imposed by governments to achieve an objec- tive perceived as socially desirable, price ceilings often result in ineffi- cient economic, and social, outcomes. Price floor A legally imposed minimum price that may be charged for a good or service. Queuing A non–price rationing mechanism that involves waiting in line. Ration coupons Coupons or tickets that entitle the holder to purchase a given amount of a particular good or service during a given time period. Ration coupons are sometimes used when the price rationing mechanism of the market is not permitted to operate, as when, say, the government has imposed a price ceiling. Rationing function of price The increase or a decrease in the market price to eliminate a surplus or a shortage of a good or service. The rationing function is considered to operate in the short run because other demand determinants are assumed to be constant. Shift of the demand curve The result of a change in the demand for a good or a service. Shift of the supply curve The result of a change in the supply of a good or a service. Shortage The result that occurs when the quantity demanded of a good or a service exceeds the quantity supplied of that same good or service. Shortages exist when the market price is below the equilibrium (market clearing) price. Supply curve A diagrammatic illustration of the quantities of a good or service firms are willing and able to supply at various prices, assuming that the influence of other supply determinants remains unchanged. Surplus The result that occurs the quantity supplied of a good or a service exceeds the quantity demanded of that same good or service. Surpluses exist when the market price is above the equilibrium (market clearing) price. Waiting list A version of queuing. CHAPTER QUESTIONS 3.1 Define and give an example of each of the following demand terms and concepts. Illustrate diagrammatically a change in each. a. Quantity demanded b. Demand c. Market demand curve 140 the essentials of demand and supply d. Normal good e. Inferior good f. Substitute good g. Complementary good h. Price expectation i. Income expectation j. Advertising k. Population 3.2 Define and give an example of each of the following supply terms and concepts. Illustrate diagrammatically a change in each. a. Quantity supplied b. Supply c. Market supply curve d. Factor price e. Technology f. Price expectation g. Advertising h. Substitute good i. Complementary good j. Taxes k. Subsidies l. Number of firms 3.3 Does the following statement violate the law of demand? The quan- tity demanded of diamonds declines as the price of diamonds declines because the prestige associated with owning diamonds also declines. 3.4 In recent years there has been a sharp increase in commercial and recreational fishing in the waters around Long Island. Illustrate the effect of “overfishing” on inflation-adjusted seafood prices at restaurants in the Long Island area. 3.5 New York City is a global financial center. In the late 1990s the finan- cial and residential real estate markets reached record high price levels.Are these markets related? Explain. 3.6 Large labor unions always support higher minimum wage legislation even though no union member earns just the minimum wage. Explain. 3.7 Discuss the effect of a frost in Florida, which damaged a significant portion of the orange crop, on each of the following a. The price of Florida oranges b. The price of California oranges c. The price of tangerines d. The price of orange juice e. The price of apple juice 3.8 Discuss the effect of an imposition of a wine import tariff on the price of California wine. 3.9 Explain and illustrate diagrammatically how the rent controls that chapter questions 141 were imposed during World War II exacerbated the New York City housing shortage during the 1960s and 1970s. 3.10 Explain what is meant by the rationing function of prices. 3.11 Discuss the possible effect of a price ceiling. 3.12 The use of ration coupons to eliminate a shortage can be effective only if trading ration coupons is effectively prohibited. Explain. 3.13 Scalping tickets to concerts and sporting events is illegal in many states. Yet, it may be argued that both the buyer and seller of “scalped” tickets benefit from the transaction. Why, then, is scalping illegal? Who is really being “scalped”? Explain. 3.14 The U.S. Department of Agriculture (USDA) is committed to a system of agricultural price supports. To maintain the market price of certain agricultural products at a specified level, the USDA has two policy options. What are they? Illustrate diagrammatically the market effects of both policies. 3.15 Minimum wage legislation represents what kind of market inter- ference? What is the government’s justification for minimum wage legisla- tion? Do you agree? Who gains from minimum wage legislation? Who loses? 3.16 Explain the allocating function of prices. How does this differ from the rationing function of prices? CHAPTER EXERCISES 3.1 Yell-O Yew-Boats, Ltd. produces a popular brand of pointy birds called Blue Meanies. Consider the demand and supply equations for Blue Meanies: where Q x = monthly per-family consumption of Blue Meanies P x = price per unit of Blue Meanies I = median annual per-family income = $25,000 P y = price per unit of Apple Bonkers = $5.00 W = hourly per-worker wage rate = $8.60 a. What type of good is an Apple Bonker? b. What are the equilibrium price and quantity of Blue Meanies? c. Suppose that median per-family income increases by $6,000. What are the new equilibrium price and quantity of Blue Meanies? d. Suppose that in addition to the increase in median per-family ncome, collective bargaining by Blue Meanie Local #666 resulted in QPW xxS, .=+ -60 4 2 5 QPIP xx yD, =-+ +150 2 0 001 1 5 142 the essentials of demand and supply a $2.40 hourly increase in the wage rate. What are the new equilib rium price and quantity? e. In a single diagram, illustrate your answers to parts b, c, and d. 3.2 Consider the following demand and supply equations for sugar: where P is the price of sugar per pound and Q is thousands of pounds of sugar. a. What are the equilibrium price and quantity for sugar? b. Suppose that the government wishes to subsidize sugar production by placing a floor on sugar prices of $0.20 per pound. What would be the relationship between the quantity supplied and quantity demand for sugar? 3.3 Occidental Pacific University is a large private university in California that is known for its strong athletics program, especially in football. At the request of the dean of the College of Arts & Sciences, a professor from the economics department estimated a demand equation for student enrollment at the university where Q x is the number of full-time students, P x is the tuition charged per full-time student per semester, I is real gross domestic product (GDP) ($ billions) and P y is the tuition charged per full-time student per semester by Oriental Atlantic University in Maryland, Occidental Pacific’s closest competitor on the grid iron. a. Suppose that full-time enrollment at Occidental is 4,000 students. If I = $7,500 and P y = $6,000, how much tuition is Occidental charging its full-time students per semester? b. The administration is considering a $750,000 promotional campaign to bolster admissions and tuition revenues. The economics professor believes that the promotional campaign will change the demand equation to If the professor is correct, what will Occidental’s full-time enrollment be? c. Assuming no change in real GDP and no change in full-time tuition charged by Oriental, will the promotional campaign be effective? (Hint: Compare Occidental’s tuition revenues before and after the promotional campaign.) QPIP xxy =- ++5 100 0 45 0 1 0 25,. QPIP xxy =-++5000 05 01 025, QP S =+800 1 000, QP D =-1 000 1 000,, chapter exercises 143 d. The director of Occidental’s athletic department claims that the increase in enrollment resulted from the football team’s NCAA Division I national championship. Is this claim reasonable? How would it show up in the new demand equation? 3.4 The market demand and supply equations for a commodity are a. What is the equilibrium price and equilibrium quantity? b. Suppose the government imposes a price ceiling on the commodity of $3.00 and demand increases to Q D = 75 - 10P. What is the impact on the market of the government’s action? c. In a single diagram, illustrate your answers to parts a and b. 3.5 The market demand for brand X has been estimated as where P x is the price of brand X, I is per-capita income, P y is the price of brand Y, and P z is the price of brand Z. Assume that P x = $2, I = $20,000, P y = $4, and P z = $4. a. With respect to changes in per-capita income, what kind of good is brand X? b. How are brands X and Y related? c. How are brands X and Z related? d. How are brands Z and Y related? e. What is the market demand for brand X? SELECTED READINGS Baumol, W. J., and A. S. Blinder. Microeconomics: Principles and Policy, 8th ed. New York: Dryden, 1999. Boulding, K. E. Economic Analysis, Vol. 1, Microeconomics. New York: Harper & Row, 1966. Case, K. E., and R. C. Fair. Principles of Macroeconomics, 5th ed. Upper Saddle River, NJ: Prentice Hall, 1999. Green, W. H. Econometric Analysis, 3rd ed. Upper Saddle River, NJ: Prentice-Hall, 1997. Gujarati, D. Basic Econometrics, 3rd ed. New York: McGraw-Hill, 1995. Marshall, A. Principles of Economics, 8th ed. London: Macmillan, 1920. Ramanathan, R. Introductory Econometrics with Applications, 4th ed. New York: Dryden Press, 1998. Samuelson, P. A., and W. D. Nordhans. Economics, 12th ed. New York: McGraw-Hill, 1985. Silberberg, E. The Structure of Economics: A Mathematical Analysis, 2nd ed. New York: McGraw-Hill, 1990. QPIPP xx yz = +1 500 3 0 05 2 5 7 5, QP S =+20 2 5. QP D =-50 10 144 the essentials of demand and supply APPENDIX 3A FORMAL DERIVATION OF THE DEMAND CURVE The objective of the consumer is to maximize utility subject to a budget constraint. The constrained utility maximization model may be formally written as (3A.1a) (3A.1b) where P 1 and P 2 are the prices of goods Q 1 and Q 2 , respectively, and M is money income. The Lagrangian equation (see Chapter 2) for this problem is (3A.2) The first-order conditions for utility maximization are (3A.3a) (3A.3b) (3A.3c) where ᏸ i =∂ᏸ/∂Q i and U i =∂U/∂Q i . Assuming that the second-order con- ditions for constrained utility maximization are satisfied, 5 the solutions to the system of Equations (3A.3) may be written as (3A.4a) (3A.4b) (3A.4c) Note that the parameters in Equations (3A.4) are prices and money income. Equations (3A.4a) and (3A.4b) indicate the consumption levels for any given set of prices and money income. Thus, these equations are com- monly referred to as the money-held-constant demand curves. Dividing Equation (3A.4a) by (3A.4b) yields (3A.5) or (3A.6) U P U P 1 1 2 2 = U U P P 1 2 1 2 = ll= () M PPM 12 ,, QQ PPM M2212 = () , ,, QQ PPM M1112 = () , ,, ᏸ l =- - =MPQ PQ 11 22 0 ᏸ 22 2 0=- =UPl ᏸ 11 1 0=- =UPl ᏸ = () + () UQ Q M PQ PQ 12 11 22 , l Subject to: MPQ PQ=+ 11 22 Maximize:UUQQ= () 12 , appendix 3a 145 5 For an excellent discussion of the mathematics of utility maximization see Eugene Silberberg (1990), Chapter 10. Equation (3A.6) asserts that to maximize consumption, the consumer must allocate budget expenditures such that the marginal utility obtained from the last dollar spent on good Q 1 is the same as the marginal utility obtained from the last dollar spent on Q 2 . For the n-good case, Equation (3A.6) may be generalized as (3A.7) Problem 3A.1. Suppose that a consumer’s utility function is U = Q 1 2 Q 2 2 . a. If P 1 = 5, P 2 = 10, and the consumer’s money income is M = 1,000, what are the optimal values of Q 1 and Q 2 ? b. Derive the consumer’s demand equations for goods Q 1 and Q 2 . Verify that the demand curves are downward sloping and convex with respect to the origin. Solution a. The consumer’s budget constraint is The Lagrangian equation for this problem is The first-order conditions are 1. ᏸ 1 = 2Q 1 Q 2 2 - 5l=0 2. ᏸ 2 = 2Q 1 2 Q 2 - 10l=0 3. ᏸ l = 1,000 - 5Q 1 - 10Q 2 = 0 Dividing the first equation by the second yields Substituting this result into the budget constraint yields Substituting this result into the budget constraint yields 1 000 5 10 50 5 500 11 , =+ () =+QQ Q 2 50* = 1 000 5 2 10 20 222 , = () +=QQQ QQ 12 2= Q Q 2 1 1 2 = 2 2 5 10 12 2 1 2 2 QQ QQ = ᏸ =+ () QQ Q Q 1 2 2 2 12 1 000 5 10l , 1 000 5 10 12 , =+QQ U P U P U P n n 1 1 2 2 === 146 the essentials of demand and supply [...]... Q2 ) Ë QM ¯ dQ3 Ê Q3 ˆ + dP (P Q3 ) Ë QM ¯ (4.11) Equation (4.11) may be rewritten as e M = w 1e 1 + w 2 e 2 + w 3 e 3 (4.12) where eM is the market price elasticity of demand, wi = Qi/QM (i = 1, 2, 3) the proportion of total market demand that is accounted for by each individual, and ei (i = 1, 2, 3) the individual price elasticities of demand DETERMINANTS OF THE PRICE ELASTICITY OF DEMAND There are... along any linear 1 63 Point-Price Elasticity versus Arc-Price Elasticity TABLE 4.1 Solution to problem 4.6 P Q dQ/dP P/Q ep 0 1 2 3 4 5 6 7 8 80 70 60 50 40 30 20 10 0 -10 -10 -10 -10 -10 -10 -10 -10 -10 0 0.014 0. 033 0.060 0.100 0.167 0 .30 0 0.700 • 0 -0.14 -0 .33 -0.60 -1.00 -1.67 -3. 00 -7.00 -• demand curve the values of ep will become increasingly larger as we move leftward along the demand curve Problem... (dQ/dP)(P/Q) and TR = P ¥ Q The solution values are summarized in Table 4 .3 When the price of the commodity is $6, the quantity demanded is 20 units Total revenue is $120 The price elasticity of demand at the price–quantity 170 Additional Topics in Demand Theory TABLE 4 .3 Solution to problem 4.7 P Q dQ/dP P/Q ep TR 0 1 2 3 4 5 6 7 8 80 70 60 50 40 30 20 10 0 -10 -10 -10 -10 -10 -10 -10 -10 -10 0 0.014 0. 033 0.060... 0.167 0 .30 0 0.700 • 0 -0.14 -0 .33 -0.60 -1.00 -1.67 -3. 00 -7.00 -• 0 70 120 150 160 150 120 70 0 FIGURE 4.10 Price-elastic demand: a decrease (increase) in price and an increase (decrease) in total revenue combination is 3. 00; that is, a 1% decline in price instantaneously will result in 3% increase in the quantity demanded When the price is lowered to $5, the quantity demanded increases to 30 units... the demand curve At P = $3 the quantity demanded is 50 units, for total expenditures of $150 This is shown in Figure 4.11 as the area of the rectangle 0J¢FK¢ We saw in Table 4 .3 that at P = $3, Q = 50, |ep| = 0.60, and TR = $150 When price falls to $2, the quantity demanded increased to 60 units, |ep| = 0 .33 , and TR = $120 In other words, when the price is lowered in the inelastic region of a demand curve... calculated value of the price elasticity of demand For example, if we choose to move from point A to point B, the value of the price elasticity of demand is Ep = (22 - 12) 12 (2.10 - 2 .30 ) 2 .30 = 10 12 0. 833 = = -9.57 -0.20 2 .30 -0.087 On the other hand, if we calculate the price elasticity of demand in moving from point B to point A then Ep = = (12 - 22) 22 (2 .30 - 2.10) 2.10 -10 12 0.455 = = -4.79 0.20... demand curve to be convex with respect to the origin, the second derivative with respect to price must be positive The first and second derivatives of Q1 with respect to P1 are dQ1 500 =- 2 0 2 3 3 dP 1 P1 P1 Similarly for Q2 148 the essentials of demand and supply dQ2 500 =- 2 0 2 dP 2 P3 P3 2 2 4 Additional Topics in Demand Theory. .. elasticity of demand is more useful in theoretical economic analysis INDIVIDUAL AND MARKET PRICE ELASTICITIES OF DEMAND In Chapter 3 it was demonstrated that the market demand curve is the horizontal summation of the individual demand curves What is the relationship between the individual and market price elasticity of demand? It is easily demonstrated that the market price elasticity of demand is the weighted... The weights are equal to each individual’s share of the total quantity demanded at each price To see this, suppose that the market quantity demanded is the sum of three individual demand curves QM (P ) = Q1 (P ) + Q2 (P ) + Q3 (P ) (4.7) where QM is the market quantity demanded and Q1, Q2 and Q3 are the individual quantities demanded, which are each a function of a common selling price, P Taking the... demand, it is assumed that b1 < 0 One possible candidate for a measure of sensitivity of quantity demanded to changes in the price of the product is, of course, the slope of the demand function, which in this case is b1, where b1 = DQD DP 149 150 Additional Topics in Demand Theory P A 2 .30 ⌬P 2.10 QD =127 –50P B C 0 12 ⌬QD 22 Q FIGURE 4.1 The linear demand curve Consider, for example, the linear demand . to the system of Equations (3A .3) may be written as (3A.4a) (3A.4b) (3A.4c) Note that the parameters in Equations (3A.4) are prices and money income. Equations (3A.4a) and (3A.4b) indicate the consumption. $4, and P z = $4. a. With respect to changes in per-capita income, what kind of good is brand X? b. How are brands X and Y related? c. How are brands X and Z related? d. How are brands Z and. . . . E p = - () - () = - = - =- 22 12 12 210 230 230 10 12 020 230 0 833 0 087 957 . . . 152 Additional Topics in Demand Theory sion for the price elasticity of demand is referred to as the midpoint formula.