978-0133019933 Chapter 2 Lecture Note

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Chapter 2

Supply and Demand

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Chapter Outline

2.1 Demand

The Demand Function

A Change in a Product’s Price Causes a Movement Along the Demand Curve

A Change in Other Prices Causes the Demand Curve to Shift

Summing Demand Curves

Application: Aggregating the Demand for Broadband Service

2.2 Supply

The Supply Function

Summing Supply Functions

How Government Import Policies Affect Supply Curves

2.3 Market Equilibrium

Finding the Market Equilibrium

Forces That Drive a Market to Equilibrium

2.4 Shocking the Equilibrium: Comparative Statics

Comparative Statics with Discrete (Relatively Large) Changes

Application: Occupational Licensing

Comparative Statics with Small Changes

Solved Problem 2.1

Why the Shapes of Demand and Supply Curves Matter

2.5 Elasticities

Demand Elasticity

Elasticities Along the Demand Curve

Solved Problem 2.2

Other Demand Elasticities

Supply Elasticity

Solved Problem 2.3

Long Run Versus Short Run

Demand Elasticities over Time

Supply Elasticities over Time

6 Perloff • Microeconomics: Theory and Applications with Calculus, Third Edition

Application: Oil Drilling in the Arctic National Wildlife Refuge

Solved Problem 2.4

2.6 Effects of a Sales Tax

Two Types of Sales Taxes

Equilibrium Effects of a Specific Tax

How Specific Tax Effects Depend on Elasticities

Solved Problem 2.5

Application: Subsidizing Ethanol

The Same Equilibrium No Matter Who Is Taxed

The Similar Effects of Ad Valorem and Specific Taxes

2.7 Quantity Supplied Need Not Equal Quantity Demanded

Price Ceiling

Application: Price Controls Kill

Price Floor

2.8 When to Use the Supply–and-Demand Model

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Teaching Tips

This chapter reviews basic supply-and-demand concepts from the principles level. Your interactions with

the class from the first session or two should give you a good indication of how much class time to spend

on it. If it has been some time since their principles course, students may need fairly consistent prompting

to recall the basic supply–and-demand model. For example, many will remember that there is a Law of

Demand but won’t remember the law itself. Encourage students in the strongest terms to read the chapter

carefully. It is well worth the time spent at this stage to make sure everyone has solid recognition of these

basic tools and concepts.

The introduction of demand curves and equations is a good opportunity to review the basic geometric

concepts of slope and intercept. This doesn’t take much time, as most students can recognize the slope and

intercept of a written equation, but there is sometimes a surprising lack of connection between what

appears in an equation and the resulting graph. Draw a demand curve and tell the class that the slope of

this curve is −2. Then ask the students what will happen in the graph if the slope increases to −4. Although

it is likely that several, perhaps most, students will know immediately, some will not. This is also a good

time to introduce nonlinear demand functions to illustrate the use of calculus. Assigning some of the

quantitative problems at the end of the chapter and collecting them (even if you don’t intend to collect

homework throughout the term) is another good diagnostic.

When reviewing demand, be sure students are clear on the difference between movement along the curve

and a shift of the entire curve. Two points should be helpful. First, note to them that both in Equation 2.3

and on the graph in Figure 2.1, price is the only independent variable present. Thus only price can cause

a movement along the curve. Second, underscore the role of other variables. After compiling a list of the

factors that can shift the demand curve (once they get started, the class as a group should be able to provide

you with this list), ask what factors are held constant along a single demand curve. Surprisingly, this question is

often greeted by a protracted silence. By realizing that it is the same factors that shift the curve when they

Chapter 2 Supply and Demand 7

change, students develop a more solid understanding. The text makes this point well in Equations 2.2 and

2.3. It is here that students should realize the use of partial derivatives to determine the size of the demand

shift.

Be sure to review the inverse demand curve and the process of inversion. You can motivate this review

by noting that this process will be needed later when formulating a total revenue equation from a demand

equation. You can combine this with the discussion of the problem of the reversed axes, and reintroduce

the inverse function rule.

Try to keep the discussion of supply parallel to that of demand. For factors that can shift the entire supply

curve, note that they can all be lumped together under the broader heading of costs, government rules and

regulations, and other variables (as is done in the text). The text notes that there is no “Law of Supply,”

and most students have learned this in their principles course. Be aware, however, that some principles

instructors refer to the upward slope of supply curves in the short run as the “Law of Supply.” Adopting a

uniform taxonomy and vocabulary reduces confusion. This includes uniformity with the text with respect

to symbols and upper- versus lower–case labeling.

When combining supply and demand in the discussion of equilibrium, press the students for a usable definition

of the term. You will likely receive the suggestion of “where supply equals demand.” Though incorrect,

this definition is useful in the introduction of price floors and ceilings where the quantity supplied does not

equal quantity demanded at the equilibrium quantity. An important point regarding equilibrium solutions

of supply-and–demand problems is that they are typically stable and self–correcting. To illustrate this point, use

examples of commonly purchased items such as discounted clothing and music CDs, where reduced prices

reflect excess supply.

When discussing own–price elasticities, students need to understand that several formulas yield an elasticity

and the choice of formula is driven mostly by the information that is given. When talking about the formula

as simply a ratio of percentage changes, you might try to find a current newspaper piece that has a

percentage change in prices and the percentage change in quantity that results.

When discussing elasticities, two points require significant attention. The first is to get the students to make

the connection between a verbal description of an elasticity, the slope of the demand curve, the elasticity

formulas, and the graph of a demand curve. You can give the students information in different forms and

ask them to compute an elasticity in each case. The second area of confusion is that linear demand curves

are not of constant elasticity (except when perfectly elastic or inelastic). You can demonstrate using an

equation and a graph; that although the slope is constant, the price/quantity ratio is changing, which changes

the elasticity as price falls. This is illustrated well in Figure 2.9 and also illustrated with the constant

elasticity demand function in Solved Problem 2.2.

Although own-price elasticities are covered in principles, income and cross–price elasticities generally are

not. Thus you should budget significant class time to discuss them. When covering income and cross–price

elasticities, consider using the following approach: Choose a product and ask the students what factors might

influence demand (choose something that has clear substitutes and complements, such as a computer or a

food item). Once you get a list, put a hypothetical demand equation on the board. If you have a computerized

classroom, you can bring in data and estimate a demand equation for the class. It is good to do this, as it

seems to take some of the abstraction out of demand analysis. Either way, once you have an equation, review

how an own-price elasticity can be determined from this equation, and use that as a springboard into the

cross–price and income elasticities. It is useful to change the units of one of the variables, show how the

8 Perloff • Microeconomics: Theory and Applications with Calculus, Third Edition

coefficients would change, and demonstrate that the elasticity would remain unchanged. Once you discuss

this, consider having the class work the following as an in–class problem:

The demand for boxes of nails is estimated to be Q = 100 − 5p + 2I, where income is measured in thousands

of dollars. If p = 4, and I = 10, what is the income elasticity? If the equation is then re-estimated using just

dollars instead of thousands of dollars, what will be the effect on the coefficient for I, and the income elasticity?

How would the income elasticity change if the price were reduced to $2?

While we frequently ignore the negative sign in the own–price elasticity of demand, the negative signs in

both the income and cross–price elasticities are more important, and students often need to be reminded of

when the negative sign is required and when it is redundant.

Discussion of the own-price elasticity of supply will be similar to the discussion of demand elasticity. It is

useful to point out that the size of the shift in supply can be determined from supply elasticities other than

price. Equation 2.6 provides an opportunity to show input price elasticities.

In the discussion of taxes and tax incidence, students need to be clear on two general points. The first is

that the after–tax equilibrium is independent of whether the tax is levied on firms or consumers. The second

is that the incidence is dependent on the elasticities of supply and demand. In this instance, using the special

cases of perfectly inelastic and perfectly elastic supply and demand curves may be very helpful (see chapter

problems 6 and 7). You can then extend this to empirical examples such as the recent debate in Congress

over the settlement with tobacco firms. The chapter discusses the primary and secondary (smuggling) effects

of state–level taxes. A federal tax on cigarettes, however, would raise large amounts of revenue but would

not discourage smoking as much as if demand were elastic. A good contrast for this is the 1990 Federal

Luxury Tax, which raised significant revenues from taxes on high-priced automobiles but devastated the

U.S. boating industry (see Additional Applications, below).

When discussing floors and ceilings, stress the definitions using simple graphs as illustrations. While it

seems counterintuitive to some students that an effective floor must be above the equilibrium price and an

effective ceiling must be below, suggest that they use this as a mnemonic device. In this section, try to

engage the class in a discussion of unintended or secondary effects of government intervention. This issue

deserves significant class discussion time. Most students have not thought much about the consequences of

ceilings and floors beyond the simple price effects. The text has a good description of the unfortunate side

effects of gasoline price controls. Another good example for discussing secondary effects is rent control.

On the supply side, there are distortions of incentives for landlords to provide efficient levels of upkeep

and safety measures in rent-controlled buildings. On the demand side, time spent searching and undesired

doubling-up reduce consumer satisfaction. Secondary effects of floors are also worth noting. You can

discuss the text’s example of the possible negative effects of minimum wages. Again, students are likely

to view minimum wages as strictly a benefit to workers because they have not considered that job loss will

mean that some workers are harmed rather than helped by the establishment of minimums or increases in

their level.

In the section on when to use the supply–and–demand model, be sure to define and discuss transaction costs.

Most students will not be familiar with this term from principles, and it has important implications on the

functioning of thin markets and markets where there is substantial uncertainty.

Chapter 2 Supply and Demand 9



Additional Applications

Tax Revenues from Federal Luxury Taxes

In 1990, ad valorem taxes were imposed on many luxury goods. The tax was 10 percent of the amount over

$100,000 paid for yachts, over $250,000 paid for planes, over $10,000 for furs and jewels, and over $30,000

for cars.1 The idea was to raise tax revenues for the government without harming the poor and middle

class.

Due to a mistaken belief about elasticities, the tax on automobiles raised more revenue than expected.

This portion of the luxury tax was predicted to raise $25 million in 1991 and $1.5 billion over five years.

It actually brought in $98.4 million in the first year alone. Because most of the cars that were taxed were

built abroad, the reduced output—sales of Mercedes fell 27 percent and Lexus sales fell 10 percent in the

first quarter of 1991—affected few American workers except auto salespeople.

In contrast, the taxes on goods other than cars raised relatively little revenue and caused a substantial loss

of domestic output and jobs. As a result, four bills were brought before Congress within a year to remove

those taxes. In mid-1993, the taxes were revoked. A 1996 law phased out the luxury auto tax by 2002.

The yachting industry provides an extreme example of the harm to domestic producers. In the first year of

the yacht tax, sales of yachts costing over $100,000 fell by 71 percent (sales of boats costing less than

$100,000, which were not affected by the tax, fell 28 percent due to the recession). The yacht tax raised

only $7 million, well below the forecast amount, because the drop in sales was not forecast. Congressional

analysts made errors in predicting demand and supply elasticities. The demand curve was thought to be

less elastic than it was because tax–avoiding behavior and the ability of consumers to shift between goods was

ignored. Wealthy boat owners escaped the boat tax by buying yachts in the Bahamas or buying yachts that

cost just under $100,000.

Yacht industry employment fell from 160,000 workers at the start of 1991 to 115,000 a little more

than a year later. Thus the loss of payroll taxes in this industry far outweighed the increase in luxury tax

revenues. According to a study by a trade group, payroll taxes would have fallen by $148 million from

1991 to 1996 had the luxury tax not been removed. Although this is likely to be an overestimate, as it

assumes that workers would not have found work in other industries, the tax clearly failed to achieve its

goal. The unintended effects of this law could have been avoided if Congress had better information about

the elasticities of demand and supply.

1. Can you think of commodities other than those discussed that the government could have chosen that

would have better achieved their goal?

2. Suppose that instead of taxing commodities, the government decided to simply tax the income of

wealthy citizens at a much higher rate. Would this achieve the stated goal?

1This section is based on “Senate Panel Kills Tax on Luxury Items,” Los Angeles Times, June 17, 1992:D1 and D13. Christopher

Byron, “The Bottom Line, High and Dry,” New York, 25(18), May 4, 1992:18, 20. Bernard Baumohl, “Taxes: Tempest in a Yacht

Basin,” Time, 137(26), July 1, 1991:51.

10 Perloff • Microeconomics: Theory and Applications with Calculus, Third Edition

Elasticity of Toll Roads in Pennsylvania and New Jersey2

Turnpike Commissions in Pennsylvania and New Jersey substantially increased tolls on the turnpikes in

those states in 1991 in an effort to cover the increased cost of maintenance and construction of other state

roads. Like any consumers faced with a price increase, drivers, especially truckers, began seeking alternative

routes. The truckers were upset that they were being targeted by the toll increases because they depend on

using the roads to transport goods to major cities like Philadelphia and New York. To save the money that

would otherwise go toward paying the increased tolls (as much as $50 per trip), truckers began (and continue)

to use back roads instead. Unfortunately, this shift creates congestion, road wear, and driver fatigue due to

the increased stress of driving on hilly two-lane highways rather than turnpikes. It also results in additional

wear on the trucks as well as higher fuel costs as the trucks sit longer in traffic.

In Pennsylvania, the tolls increased 30 percent. However, revenue did not increase by 30 percent because

of the substitution of free roads for turnpikes by cars and trucks alike. Truck traffic on turnpikes fell by 13

percent in response to the increase. In northern New Jersey, on roads that lead directly to New York, tolls

were doubled (increased by 100 percent). There, car traffic fell by 7 percent and truck traffic by 12

percent. Some independent truckers gave up completely. “I’m quitting this year” was the response of

Jimmy Williams. In addition to the reduction in traffic due to the substitution, the states must now also cope

with the increased expenditures required to maintain and improve roads that are not designed to

accommodate such heavy volume.

1. For truckers, what is the elasticity of demand for toll roads in Pennsylvania?

2. What are the demand elasticities for cars and trucks in New Jersey? Why do you suppose that they

are different from the elasticities in Pennsylvania?

3. How might the increase in tolls affect consumers in Philadelphia and New York?



Discussion Questions

1. Can you think of any cases in which the Law of Demand might not hold?

2. Would you expect most supply curves to have an upward slope? Why or why not?

3. What are some examples of markets that are competitive?

4. In which markets might transactions costs be so high that the market cannot be competitive?

5. Can you think of situations where the government would want to take actions that cause shortages?

6. In what markets and situations would you expect that the quantity demanded would not equal the

quantity supplied?

7. Give an example of a product where the long–run elasticity of demand is less than the short–run elasticity.

8. Give an example of a product where the long–run elasticity of supply is less than the short–run elasticity.

9. Given what you learned in this chapter about luxury taxes, would you advocate imposing them or

not? Why?

2Based on Agis Salpukas, “Tolls Up, Trucks Take Back Roads,” New York Times, September 17, 1991:D1, D6.

Chapter 2 Supply and Demand 11

10. Why might a government prefer to collect sales taxes from firms rather than consumers?

11. Why might a government prefer one type of sales tax (ad valorem or specific) to the other?

12. Discuss the wisdom of “necessity” taxes as replacements for luxury taxes.



Additional Questions and Problems

1. Suppose you are planning to conduct a study of the running shoe market. List the factors that you

believe would cause changes in the demand for running shoes. In each case, note whether the

relationship would be positive (direct) or negative (inverse). Also list the factors that you believe

would affect the supply, again noting the nature of the relationship.

2. In each case below, identify the effect on the market for steak.

a. An increase in the price of lamb

b. A decrease in the population

c. An increase in consumer income

d. A decrease in the price of steak sauce

e. An increase in advertising by chicken producers

3. In each case below, identify the effect on the market for coal.

a. The development of a new, lower cost mining technique

b. An increase in wages paid to coal miners

c. The imposition of a $2 per ton tax on coal

d. A widespread news report that demand for coal will be much lower next year

e. A new government regulation requiring air purifiers in all work areas

4. In a competitive labor market, demand for workers is QD = 10,000 − 100W, and supply is QS =

2,000 + 1,900W, where Q is the quantity of workers employed and W is the hourly wage. What is

the initial equilibrium wage and employment level? Suppose that the government decides that

$5 per hour is the minimum allowable wage in any market. How would this new minimum wage

alter this market? What would the new employment level be? What would happen to total payments

to labor? Would there be any excess supply of labor? If so, how much?

5. For each sentence below describing changes in the tangerine market, note whether the statement is

true, false, or uncertain, and explain your answer. You will find it helpful to draw a graph for each case.

a. If consumer income increases and worker wages fall, quantity will rise, and prices will fall.

b. If orange prices decrease and taxes on citrus fruits decrease, quantity will fall, and prices will

rise.

c. If the price of canning machinery (a complement) increases and the growing season is unusually

cold, quantity and price will both fall.

6. If demand for show tickets is described by the equation QD = 100 − p, and supply is QS = 20 + p, find

the equilibrium price and quantity. How would your answer change if the supply curve shifted to

′ = 10 + p due to increases in actor salaries?

12 Perloff • Microeconomics: Theory and Applications with Calculus, Third Edition

7. Suppose the demand for onion ice cream was described by the equation QD = 20 − p, and the supply

was described by QS = −40 + p. What are the equilibrium price and quantity? Show your answer using

a graph.

8. If demand for toy drums is described by the equation QD = 300 − 5p, and supply is QS = 60 + 3p, find

the equilibrium price and quantity. How would your answer change if a decrease in consumer income

shifted the demand curve to QD

′ = 220 − 5p?

9. A new chemical cleaning solution is introduced to the market. Initially, demand is QD = 1,000 − 2p,

and supply is QS = 100 + p. Determine the equilibrium price and quantity. The government then decides

that no more than 300 units of this product should be sold per period and imposes a quota at that level.

How does this quota affect the equilibrium price and quantity? Show the solution using a graph and

calculate the numerical answer.

10. Demand for park visits is Q*0 = 10,000 − 100P. If park visits are free, how many visitors will attend?

How will your answer change if the park adds a $20 admission fee? Show using a graph.

11. A firm introduces a new model of MP3 player, which can play both audio and video files. The price

is the same as that of a previous model that can only play audio files. What would happen to the market

of the previous model? What if the new model is more expensive than the previous one?

12. In a competitive labor market, demand for workers is QD = 9,900 − 100W, and supply is QS =

2,000 + 1,900W, where Q is the quantity of workers employed, and W is the hourly wage. Suppose

the government decides to impose a wage ceiling of $3 per hour. What would the equilibrium be in

this labor market?

13. What would you predict about the elasticities of demand and supply for emeralds? Be sure to state

your reasons in each case.

14. Explain why demand curves that are linear (straight lines) generally do not have a constant elasticity.

What types of linear demand curves do have a constant elasticity?

15. If the price of eggs increases from $1.50 per carton to $1.75, and the quantity demanded decreases

from 25 to 20, what is the elasticity of demand?

16. If the equation for the demand for bow ties is Q = 200 – 10p, what is the elasticity of demand when p =

$10?

17. If the price of coffee increases from $0.60 to $0.80 per cup and the quantity supplied increases from

50 cups to 100 cups, what is the elasticity of supply?

18. Suppose demand for inkjet printers is estimated to be Q = 1000 − 5p + 10pX − 2pZ + 0.1Y. If p = 80,

pX = 50, pZ = 150, and Y = 20,000; answer the following:

a. What is the price elasticity of demand?

b. What is the cross–price elasticity with respect to commodity X? Give an example of what

commodity X might be.

c. What is the cross–price elasticity with respect to commodity Z? Give an example of what

commodity Z might be.

d. What is the income elasticity?

Chapter 2 Supply and Demand 13

19. Suppose the demand for antibiotics is Q = 100,000. What is the elasticity of demand? If a specific tax

of $1 per dose were levied, who would bear the burden of the tax?

20. Use a graph to show that the incidence of a $1/lb. tax on grapes is the same whether the tax is

shown as a shift in the supply curve (tax on sellers) or the demand curve (tax on buyers). Under

what circumstances would the incidence of the tax be split equally between buyers and sellers?

21. Suppose a tax on beans of $0.05 per can is levied on firms. As a result of the tax, the equilibrium

price increases from $0.20 to $0.22. What fraction of the incidence falls on consumers? On firms?

Suppose the supply elasticity is 0.6. What must the demand elasticity be?

22. If the market demand curve for triple-scoop ice cream cones is QD = 60 − 8p, use the derivative

formula for elasticities to calculate the elasticity of demand when p = $4.

23. Suppose the market supply curve of wagons is QS = −62.5 + 0.5p2. The demand curve is QD = 325 −

2p2. Use Equation 2.27 to determine the incidence of a small tax on consumers.

24. Show that when demand is perfectly elastic, tax incidence is zero.

25. Show that the supply function Q = Ap

has constant elasticity.



Answers to Additional Questions and Problems

1. Possible responses include:

Demand: Price of running shoes (−)

Sock prices (−)

Prices of other sneaker types (+)

Number of people who are regular runners (+)

Income (+)

Supply: Worker wages (−)

Increases in leather prices (−)

Removal of import tariffs (+)

Unit tax on running shoes (−)

2. a. The demand curve shifts to the right.

b. The demand curve shifts to the left.

c. The demand curve shifts to the right.

d. The demand curve shifts to the right.

e. The demand curve shifts to the left.

3. a. The supply curve shifts to the right.

b. The supply curve shifts to the left.

c. The supply curve shifts to the left.

d. The supply curve shifts to the left.

e. The supply curve shifts to the left.