Finance 30210: Managerial
Economics
Supply, Demand, and Equilibrium
Suppose that you are the “Wheat Czar”. You are asked to use the three
farmers to produce 15 bushels of wheat as cheaply as possible.
Farmer #1
Farmer #2
Farmer #3
Bushels of
Wheat
Total
Cost
Bushels of
Wheat
Total
Cost
Bushels of
Wheat
Total
Cost
1
$2
1
$3
1
$1
2
$5
2
$7
2
$3
3
$9
3
$12
3
$6
4
$14
4
$18
4
$10
5
$20
5
$25
5
$15
6
$27
6
$33
6
$21
7
$35
7
$42
7
$28
You decide that farmers 1 and
3 are the cheapest so you
have them produce as much
as possible and then have
farmer 2 make up the rest.
Could you do better?
TC  $28  $35  $3  $66
Suppose that you are the “Wheat Czar”. You are asked to use the three
farmers to produce 15 bushels of wheat as cheaply as possible.
Farmer #1
Farmer #2
Farmer #3
Bushels of
Wheat
Total
Cost
Bushels of
Wheat
Total
Cost
Bushels of
Wheat
Total
Cost
1
$2
1
$3
1
$1
2
$5
2
$7
2
$3
3
$9
3
$12
3
$6
4
$14
4
$18
4
$10
5
$20
5
$25
5
$15
6
$27
6
$33
6
$21
7
$35
7
$42
7
$28
By having farmer #2
scale up by one
bushel, you spend $4
By having farmer #3
scale back by one
bushel, you save $7
TC  $21  $35  $7  $63
The same 15 bushels
are produced at a net
$3 savings!
Average Cost vs. Marginal Cost
Average Cost is simply the total cost divided by quantity produced
Marginal Cost refers to the additional costs incurred by producing on more
unit
Consider the following farmer:
Bushels of
Wheat
Total
Cost
1
$2
2
$5
3
$9
4
$14
5
$20
6
$27
7
$35
AC 
MC 
TC $14

 $3.50
Q
4
TC $14  $9

 $5
Q
43
Bushels of
Wheat
Total
Cost
Average
Cost
Marginal
Cost
1
$2
$2
$2
2
$5
$2.50
$3
3
$9
$3
$4
4
$14
$3.50
$5
5
$20
$4
$6
6
$27
$4.50
$7
7
$35
$5
$8
Suppose that you are the ‘Wheat Czar”. You are asked to use the three
farmers to produce 15 bushels of wheat as cheaply as possible.
The efficient (lowest cost solution) is where marginal costs are
equal across all producers.
Farmer #1
Farmer #2
Farmer #3
Bushels of
Wheat
Marginal
Cost
Bushels of
Wheat
Marginal
Cost
Bushels of
Wheat
Marginal
Cost
1
$2
1
$3
1
$1
2
$3
2
$4
2
$2
3
$4
3
$5
3
$3
4
$5
4
$6
4
$4
5
$6
5
$7
5
$5
6
$7
6
$8
6
$6
7
$8
7
$9
7
$7
TC  $20  $18  $21  $59
Suppose that rather than choosing what each farmer grows you make the
offer ‘I will buy any wheat produced for $6”.
Farmer #1
Bushels of
Wheat
Total
Revenue
(P*Q)
Total
Cost
Profit
1
$6
$2
$4
2
$12
$5
$7
3
$18
$9
$9
4
$24
$14
$10
5
$30
$20
$10
6
$36
$27
$9
7
$42
$35
$7
At a $6 price, Farmer #1 would choose to produce
5 bushels as a profit maximizing decision.
(P=MC)
Farmer #1’s decision is not only individually optimal, but socially optimal
(efficient) as well!! Further, this solution requires no information on individual
farmers’
At a stated market price of $4, each farmer chooses to produce up to the
point where P=MC
Farmer #1
Farmer #2
Farmer #3
Market Supply
Bushels of
Wheat
Marginal
Cost
Bushels of
Wheat
Marginal
Cost
Bushels of
Wheat
Marginal
Cost
Market
Price
Total
Supply
1
$2
1
$3
1
$1
$1
1
2
$3
2
$4
2
$2
$2
3
3
$4
3
$5
3
$3
$3
6
4
$5
4
$6
4
$4
$4
9
5
$6
5
$7
5
$5
$5
12
6
$7
6
$8
6
$6
$6
15
7
$8
7
$9
7
$7
$7
18
The market supply function simply adds up the decisions of each farmer at each
potential market price
A Supply Function represents the rational
decisions made by a representative
firm(s)
“Is a function of”
QS  S P 
Quantity
Supplied
Market
Price (+)
Market Supply
Market
Price
Total
Supply
$1
1
$2
3
$3
6
$4
9
$5
12
$6
15
$7
18
Price
S
$6.00
$4.00
9
15
Bushels
of Wheat
Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your
citizens. To whom do you give the wheat?
Citizen #1
Citizen #2
Citizen #3
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
1
$18
1
$10
1
$14
2
$16
2
$8
2
$12
3
$14
3
$6
3
$10
4
$12
4
$4
4
$8
5
$10
5
$2
5
$6
6
$8
6
$1
6
$4
7
$6
7
$0
7
$2
Total Value = $84
Total Value = $10
Total Value = $56
Note: Marginal value
is the dollar amount
each citizen is
willing to pay for
each additional
bushel of wheat
Total = $150
Suppose we started out with citizens 1 and 3 getting 7 bushels each and
citizen 2 getting one. We could do better, right?
Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your
citizens. To whom do you give the wheat?
Citizen #1
Citizen #2
Citizen #3
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
1
$18
1
$10
1
$14
2
$16
2
$8
2
$12
3
$14
3
$6
3
$10
4
$12
4
$4
4
$8
5
$10
5
$2
5
$6
6
$8
6
$1
6
$4
7
$6
7
$0
7
$2
Total Value = $84
Total Value = $18
Total Value = $54
Note: Marginal value
is the dollar amount
each citizen is
willing to pay for
each additional
bushel of wheat
Total = $156
By taking a bushel from #3 and giving it to #2, we get a net gain of $6 (A loss
of $2 by #3 and a gain of $8 by #2)
Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your
citizens. To whom do you give the wheat?
Citizen #1
Citizen #2
Citizen #3
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
1
$18
1
$10
1
$14
2
$16
2
$8
2
$12
3
$14
3
$6
3
$10
4
$12
4
$4
4
$8
5
$10
5
$2
5
$6
6
$8
6
$1
6
$4
7
$6
7
$0
7
$2
Total Value = $84
Total Value = $24
Total Value = $50
As with the farmers,
the best allocation is
where values by all
citizens (at the
margin) are equal.
Total = $158
By taking a bushel from #3 and giving it to #2, we get a net gain of $6 (A loss
of $2 by #3 and a gain of $8 by #2) – As with the producers, announcing “I
will sell wheat at $6/ bushel” would accomplish the same thing!
At a market price of, say $6, each buyer decides how much to purchase
Citizen #1
Citizen #2
Citizen #3
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Market Price
Bushels of
Wheat
1
$18
1
$10
1
$14
$2
19
2
$16
2
$8
2
$12
$4
17
3
$14
3
$6
3
$10
$6
15
4
$12
4
$4
4
$8
$8
12
5
$10
5
$2
5
$6
$10
9
6
$8
6
$1
6
$4
$12
6
7
$6
7
$0
7
$2
$14
4
The market demand function simply adds up the decisions of each citizen at
each potential market price
A Demand Function represents the
rational decisions made by a
representative consumer(s)
Quantity
Demanded
“Is a function of”
QD  DP
Market
Price (-)
Market Price
Bushels of
Wheat
$2
19
$4
17
$6
15
$8
12
$10
9
$12
6
$14
4
Price
$10
$6
D
Quantity
9
15
Farmer #1
Farmer #2
Farmer #3
Market Supply
Bushels of
Wheat
Marginal
Cost
Bushels of
Wheat
Marginal
Cost
Bushels of
Wheat
Marginal
Cost
Market
Price
Bushels
of Wheat
1
$2
1
$3
1
$1
$1
1
2
$3
2
$4
2
$2
$2
3
3
$4
3
$5
3
$3
$3
6
4
$5
4
$6
4
$4
$4
9
5
$6
5
$7
5
$5
$5
12
6
$7
6
$8
6
$6
$6
15
7
$8
7
$9
7
$7
$7
18
An announcement of “ I will buy and sell at $6” Gets the job done!
Citizen #1
Citizen #2
Citizen #3
Market Demand
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Bushels of
Wheat
Marginal
Value
Market
Price
Bushels
of Wheat
1
$18
1
$10
1
$14
$2
19
2
$16
2
$8
2
$12
$4
17
3
$14
3
$6
3
$10
$6
15
4
$12
4
$4
4
$8
$8
12
5
$10
5
$2
5
$6
$10
9
6
$8
6
$1
6
$4
$12
6
7
$6
7
$0
7
$2
$14
4
There is no need to even set the price.
The market will find the $6 price on its
own!
Price
S
Market Demand
Market Supply
Market
Price
Bushels
of Wheat
Market
Price
Bushels
of Wheat
$2
19
$1
1
$4
17
$2
3
$6
15
$3
6
$8
12
$4
9
$10
9
$5
12
$12
6
$6
15
$14
4
$7
18
$6
D
Quantity
15
We would call the $6 price the
equilibrium price
A market price below the equilibrium price
would create a shortage!
Market Supply
Market Demand
Market
Price
Bushels
of Wheat
Market
Price
Bushels
of Wheat
$1
1
$2
19
$2
3
$4
17
$3
6
$6
15
$4
9
$8
12
$5
12
$10
9
$6
15
$12
6
$7
18
$14
4
Price
S
$2.00
D
At a price of $2.00, total
supply is 3, but demand is
at least 19
Quantity
3
19
A market price above the equilibrium price
would create a surplus!
Market Supply
Market Demand
Market
Price
Bushels
of Wheat
Market
Price
Bushels
of Wheat
$1
1
$2
19
$2
3
$4
17
$3
6
$6
15
$4
9
$8
12
$5
12
$10
9
$6
15
$12
6
$7
18
$14
4
$8
20
S
Price
$8.00
At a price of $8.00, total
supply is 20, but demand is
less than 12
D
Quantity
12
20
Note that citizen #1 would’ve paid up to $14 for the
third bushel of wheat, but was only charged $6 in
the marketplace. The $8 difference is referred to as
consumer surplus
Price
S
$14
Citizen #1
Bushels of
Wheat
Marginal
Value
Consumer
Surplus
1
$18
$12
2
$16
10
3
$14
$8
4
$12
$6
5
$10
$4
6
$8
$2
7
$6
$0
$8
$6
Total = $42
D
Quantity
3
15
Also, note that Farmer #1 would’ve sold that 3rd
bushel of wheat for as low as $4. The difference a
producers marginal cost and the market price is
referred to as producer surplus.
Price
S
$6
Farmer #1
Bushels of
Wheat
Marginal
Cost
Producer
Surplus
1
$2
$4
2
$3
$3
3
$4
$2
4
$5
$1
5
$6
$0
6
$7
---
7
$8
---
Total = $10
$2
$4
D
Quantity
3
15
Farmer #1
Farmer #2
Farmer #3
Bushels of
Wheat
Marginal
Cost
Producer
Surplus
Bushels of
Wheat
Marginal
Cost
Producer
Surplus
Bushels of
Wheat
Marginal
Cost
Producer
Surplus
1
$2
$4
1
$3
$3
1
$1
$5
2
$3
$3
2
$4
$2
2
$2
$4
3
$4
$2
3
$5
$1
3
$3
$3
4
$5
$1
4
$6
$0
4
$4
$2
5
$6
$0
5
$7
$---
5
$5
$1
6
$7
$---
6
$8
$---
6
$6
$0
7
$8
$---
7
$9
$---
7
$7
$---
Total = $10
Citizen #1
Total = $6
Total = $15
Citizen #2
Citizen #3
Bushels of
Wheat
Marginal
Value
Consumer
Surplus
Bushels of
Wheat
Marginal
Value
Consumer
Surplus
Bushels of
Wheat
Marginal
Value
Consumer
Surplus
1
$18
$12
1
$10
$4
1
$14
$8
2
$16
10
2
$8
$2
2
$12
$6
3
$14
$8
3
$6
$0
3
$10
$4
4
$12
$6
4
$4
$---
4
$8
$2
5
$10
$4
5
$2
$---
5
$6
$0
6
$8
$2
6
$1
$---
6
$4
$---
7
$6
$0
7
$0
$---
7
$2
$---
Total = $42
Total = $6
Total = $20
A competitive marketplace maximizes the total
consumer plus producer surplus. An efficient
outcome!
Price
S
Consumer
Surplus
Producer
Surplus
$42
$10
$6
$6
$20
$15
Total = $68
Total = $31
Total = $99
$68
$31
D
Quantity
15
Example: Suppose we have the following petroleum firms. Further suppose that
there is pressure from the public to reduce pollution levels.
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Apache
50
12
BP
50
18
Chevron
50
24
Devon
50
30
Exxon
50
36
First Texas
50
42
Gulf
50
48
Hess
50
54
Industry Total
400
How would you
go about
reducing
emissions by
50%
The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms
to reduce their emissions completely and let the other four firms continue as in the past
$ Per Unit
Pollution
Reduction
Hess
$54
Gulf
$48
First
$42
Exxon
$36
Devon
$30
Chevron
$24
BP
$18
$12
Problems:
•Unfair
•Requires information on
abatement costs
Apache
Quantity of
Emissions
Reduction
We could follow an “across the board” emission reduction program (note:
pollution taxes would have the same basic effect)
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Tons of emission
to be reduced
Total abatement
cost
Apache
50
12
25
300
BP
50
18
25
450
Chevron
50
24
25
600
Devon
50
30
25
750
Exxon
50
36
25
900
First Texas
50
42
25
1,050
Gulf
50
48
25
1,200
Hess
50
54
25
1,350
Industry Total
400
200
6,600
Let markets work for you!!!
Example: Cap and Trade as a solution to pollution reduction.
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Apache
50
12
BP
50
18
Chevron
50
24
Devon
50
30
Exxon
50
36
First Texas
50
42
Gulf
50
48
Hess
50
54
Industry Total
400
Could BP profit from
selling a pollution
permit to Gulf? What
should the selling price
be?
The Market for pollution permits
$ Per Unit
Pollution
Reduction
$54
Hess
Gulf
$48
Equilibrium price range
Hess
Gulf
First
$42
S
$36
First
Exxon
Exxon
Devon
Devon
$33
$30
Chevron
$24
BP
$18
$12
Apache
Chevron
BP
Apache
D
Quantity of
Emissions
Reduction
The cap and trade program lowered the cost of pollution reduction by $2,400
(from $6,600 to $4,200).
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement
Cost ($/Ton)
Initial
Permit
Holdings
Permits
Sold
Permits
Bought
Final Permit
Holdings
Required
Emission
Reduction
Emission
Abatement Cost
Apache
50
12
25
25
0
0
50
$600
BP
50
18
25
25
0
0
50
$900
Chevron
50
24
25
25
0
0
50
$1200
Devon
50
30
25
25
0
0
50
$1500
Exxon
50
36
25
0
25
50
0
$0
First
Texas
50
42
25
0
25
50
0
$0
Gulf
50
48
25
0
25
50
0
$0
Hess
50
54
25
0
25
50
0
$0
Industry
Total
400
200
100
100
400
200
$4,200
Note that cost of purchasing permits equals revenues from selling permits and so
add so additional costs. Lets set the equilibrium permit price at $33.
Firm
Initial
Pollution
Reduction
Final
Pollution
Requirement
Marginal
Abatement
Cost ($/Ton)
Abatement
Cost
Additions/
Savings
Permits
Bought
Permits
Sold
Permit
Cost/Permit
Revenue
Net Gain
Apache
25
50 (+25)
12
$300
0
25
-$825
-$525
BP
25
50 (+25)
18
$450
0
25
-$825
-$375
Chevron
25
50 (+25)
24
$600
0
25
-$825
-$225
Devon
25
50 (+25)
30
$750
0
25
-$825
-$75
Exxon
25
0 (-25)
36
-$900
25
0
$825
-$75
First Texas
25
0 (-25)
42
-$1050
25
0
$825
-$225
Gulf
25
0 (-25)
48
-$1200
25
0
$825
-$375
Hess
25
0 (-25)
54
-$1350
25
0
$825
-$525
Industry
Total
200
200
-$2,400
200
200
$0
-$2,400
The consumer/producer surplus
represents the gains by all firms
$ Per Unit
Pollution
Reduction
$54
Hess
Hess
Gulf
$48
S
Gulf
$525
First
$42
First
$375
$225
Exxon
$36
Exxon
$75
$33
$30
$225
Devon
Devon
$375
$24
Chevron
$525
Chevron
$75
BP
$18
$12
Apache
BP
Apache
D
Quantity of
Emissions
Reduction
So far, we have the following:
“Is a function of”
“Is a function of”
Quantity
Demanded
QS  S P 
QD  DP
Quantity
Supplied
Market
Price (+)
Market
Price (-)
Price
S
Consumer surplus represents all
the gains to buyers in the market
CS
We can find an
equilibrium price where
demand equals supply
P*
Producer surplus represents all
the gains to buyers in the market
PS
D
Quantity
Q*
We could do this numerically as well…
QS  10  4 P
QD  100  2P
Every $1 increase in
price lowers demand by
2 units
QD  QS
100  2P  10  4P
90  6P
P  $15
In Equilibrium
Price
S
Every $1 increase in
price raises supply by 4
units
QD  100  215  70
QS  10  415  70
$15
D
Quantity
70
Consumer and producer surplus give us a numerical value of a
marketplace…
QS  10  4 P
QD  100  2P
Note: a $50 price will
set quantity demanded
equal to zero.
Price
S
Consumer Surplus
1
CS   70 $50  $15  $1,225
2
$50
$1225
$15
$525
Producer Surplus
1
PS   70$15  $0  $525
2
D
$0
Quantity
70
Demand is not simply a function of price, but is, instead, a function of many
variables
“Is a function of”
QD  DP,...
•Income
•Prices of other goods
(Substitutes vs.
Compliments)
•Tastes
•Future Expectations
•Number of Buyers
Price
Demand Shifters
Example
At the initial price of
$10, but with a new
value for one of the
demand shifters,
quantity demanded
has risen to 120 (An
increase in demand)
Price
Holding all the demand
shifters constant at
some level, quantity
demanded at a price of
$10 is 100
$10
D(.’.)
D(…)
Quantity
100
120
Supply is not simply a function of price, but is, instead, a function of many
variables
“Is a function of”
QS  DP,...
Price
Supply Shifters
Example
•Technology
Marginal costs
•Input prices
•Number of sellers
Holding all the supply
shifters constant at
some level, quantity
supplied at a price of
$10 is 100
At the initial price of $10,
but with a new value for
one of the supply shifters,
quantity demanded has
fallen to 80 (A decrease in
Price supply)
S(.’.)
S(…)
$10
Quantity
80
100
Example: How would the loss in income
during the last recession impact the hotel
industry?
S ...
Rate
per
night
At the current $150 market price,
supply is still 50,000, but with a
lower level of income, demand has
fallen to 40,000
$150
DI  $50,000
40,000
50,000
DI  $75,000
# of
Rooms
At the new income level of $50,000, $150 can no longer be
the equilibrium price
Example: How would the loss in income
during the last recession impact the hotel
industry?
S ...
Rate
per
night
$150
$125
DI  $50,000
45,000 50,000
DI  $75,000
# of
Rooms
The decrease in income (which causes a decrease in demand) causes a drop
in sales and a drop in market price
Example: How would a drop in the wage
rate in Columbia influence the price of
coffee?
Price
per
pound
S w  $8
S w  $6
$5
D...
Pounds
10,000
At the current $5
market price, supply
has risen to 18,000,
but demand is still at
10,000
18,000
At the wage level of $6, $5 can no longer be the equilibrium
price
Example: How would a drop in the wage
rate in Columbia influence the price of
coffee?
Price
per
pound
S w  $8
S w  $6
$5
$4
D...
Pounds
10,000
16,000
The lower wage (which causes an increase in supply) , results
in a lower price and higher sales
We could do this numerically as well…
QS  10  4 P
QD  100  2P  .5I
Income in
thousands
Suppose that average
income is $60,000
Price
S
$20
QD  100  2P  .560  130  2P
QD  QS
130  2P  10  4P
120  6P
QD  130  220  90
P  $20
D( I =$60,000)
90
QS  10  420  90
Suppose that income rose to $72,000…
QD  100  2P  .572  136  2P
Suppose that average
income is $72,000
QD  QS
136  2P  10  4P
126  6P
QD  136  221  94
P  $21
Price
QS  10  421  94
S
$21
$20
D( I =$72,000)
D( I =$60,000)
90 94
Demand curves slope downwards – this reflects the negative relationship between price
and quantity. Elasticity of Demand measures this effect quantitatively
%QD  20
D 

 2
% P
10
Price
 2.75  2.50 

 *100  10%
2.50 

$2.75
$2.50
DI  $50,000
Quantity
4
5
 45

 *100  20%
5


Consider the following demand curve
We have the elasticity formula
QD  200  5P
Every dollar
increase in price
lowers quantity
demanded by 5
units
% QD
D 
% P
A little rearranging gives us:
Price
 30 
 D  5   3
 50 
%QD QD P
D 

%P
P QD
$30
Change in
quantity per dollar
change in price
D
Quantity
50
Note that elasticities vary along a linear demand curve
We have the elasticity formula
Every dollar
increase in price
lowers quantity
demanded by 5
units
QD  200  5P
 P 
%QD

D 
 5
%P
 QD 
 30 
  3
 50 
 D  5
 20 
  1
 100 
Price
 D  5
$30
 10 
  .333
 150 
 D  5
$20
$10
D
Quantity
50
100
150
Total revenue equals price times quantity. If you want to increase revenues,
should you raise price or lower price?
TR  PQ
%TR  %P  %Q
Revenues = $1500
 D %P
 30 
 D  5   3
 50 
Revenues = $2000
 20 
 D  5
  1
 100 
Price
$30
Revenues = $1500
 10 
  .333
 150 
 D  5
$20
$10
D
Quantity
50
100
150
%TR  1   D %P
Supply curves slope upwards – this reflects the positive relationship between price and
quantity. Elasticity of Supply measures this effect quantitatively
Price
 3.00  2.00 

 *100  50%
2
.
00


S
$3.00
$2.00
Quantity
200
%QS 25
s 

 .5
%P 50
250
 250  200 

 *100  25%
200


Consider the following supply curve
We have the elasticity formula
Every dollar
increase in price
raises quantity
supplied by 6 units
QS  20  6 P
Price
% Qs
S 
% P
A little rearranging gives us:
 25 
 s  6
  .88
 170 
%QS QS P
s 

%P
P QS
S
Change in
quantity per dollar
change in price
$25
Quantity
170
Example: What effect would a shutdown of oil production in Iran have on oil
prices?
Yom Kippur war
oil embargo
Iranian
Revolution/
Iran Iraq War
OPEC Cuts
Gulf War
911
PDVSA Strike
Iraq War
Asian
Expansion
It would be foolish to consider the entire oil market as perfectly competitive, but
perhaps considering the non-OPEC market as perfectly competitive market is not
entirely crazy
Country
Joined
OPEC
Production (Bar/D)
Algeria
1969
2,180,000
Angola
2007
2,015,000
Ecuador
2007
486,100
Iran
1960
3,707,000
Iraq
1960
There are around 100
Non-OPEC countries
producing collectively
55M Bar/D.
Country
Production (Bar/D)
Russia
9,810,000
United States
8,514,000
China
3,795,000
India
3,720,000
Canada
3,350,000
2,420,000
Kuwait
1960
2,274,000
Libya
1962
1,875,000
Nigeria
1971
2,169,000
Qatar
1961
797,000
Saudi Arabia
1960
10,870,000
United Arab
Emirates
1967
3,046,000
Venezuela
1960
2,643,000
Suppose that we consider the following supply demand model:
Demand
Competitive Supply
Qd  a  bP
Qs  c  dP
Parameters to be
estimated
OPEC Supply
Qs  35
Parameters to be
estimated
To estimate four parameters, we need four pieces of information
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Let’s start with the demand side first. We can relate the equilibrium elasticity
to the parameter ‘b’
%Qd Qd P
d 

%P
P Qd
Qd  a  bP
The parameter ‘b’
represents the
change in quantity
demanded per dollar
change in price
P
 d  b
Qd
A little rearranging…
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qd
b   d
P
 90 
b  .05   .067
 67 
Now that we know ‘b’, we can find ‘a’
Qd  a  .067 P
Again, a little
rearranging…
a  Qd  .067 P
a  90  .06767  94.5
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qd  94.5  .067 P
We are halfway home!
Repeat the process with the supply side. We can relate the equilibrium
elasticity to the parameter ‘d’
%Qs Qs P
s 

%P
P Qs
Qs  c  dP
The parameter ‘c’
represents the
change in quantity
supplied per dollar
change in price
P
s  d
Qs
A little rearranging…
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qs
b   s
P
 55 
d  .10   .082
 67 
We’re estimating the non-OPEC supply, so be
sure to use only the non-OPEC quantity!
Now that we know ‘d’, we can find ‘c’
Qs  c  .082P
Again, a little
rearranging…
c  Qs  .082P
c  55  .08267  49.5
Variable
2010 Value
Market Price
$67
Market Quantity (Bar/D)
90M
OPEC Supply
35M
Non-OPEC Supply (Bar/D)
55M
Elasticity of Supply (Bar/D)
.10
Elasticity of Demand
-.05
Qs  49.5  .082P
That’s it!
Suppose that we consider the following supply demand model:
Demand
Competitive Supply
Qd  94.5  .067 P
Qs  49.5  .082P
OPEC Supply
Qs  35
Let’s double check our results
Qd  Qs
94.5  .067 P  35  49.5  .082 P
10  .149 P
P  $67
Variable
2010 Value
Market Price
$67
Market Quantity
(Bar/D)
90
Qd  94.5  .06767  90
Now, back to the original question. Suppose that Iran’s oil supply is shut down.
OPEC supply drops by 4 BBD
Demand
Competitive Supply
Qd  94.5  .067 P
Qs  49.5  .082P
OPEC Supply
Qs  31
Now factor that into the Supply/Demand Model
Qd  Qs
94.5  .067 P  31  49.5  .082 P
14  .149 P
P  $94
Qd  94.5  .06794  88
Variable
Market Price
$94
Market Quantity
(Bar/D)
88
Now, back to the original question. Suppose that Iran’s oil supply is shut down.
OPEC supply drops by 4 BBD
Price
S
Variable
P' $94
P*  $67
D'
86
88
90
Market Price
$94
Market Quantity
(BBD)
88
OPEC Quantity
31
Non-OPEC Quantity
57
D
Quantity
The drop in OPEC supply pushes price up which gives non-OPEC
countries the incentive to increase supply
Partial Equilibrium vs. General Equilibrium
Price
Suppose that effective
advertising increased
the demand for
lemonade. What would
happen.
S
P*
D'
D
Q
*
Quantity
A rise in demand should increase sales and increase
the price right? Is that all?
Partial equilibrium deals with a disturbance in one market. General
Equilibrium recognizes that markets interact with one another and looks at
the interrelations between markets
Price
S
A rise in demand for lemonade
should increase sales and
increase the price.
P*
D'
Sugar
Price
Lemons
S
Price
S
D
Q
*
Quantity
D
Quantity
This increase in
marginal costs
should lower
supply, right!
The rise in lemonade sales
should raise demand for
lemons and sugar which
increases their prices
D
Quantity
Where would you rather live? South Bend or Chicago?
Why?
What’s better in Chicago?
What’s better in South Bend?
Pretty much everything is
better in Chicago!
It’s cheaper in South Bend!
The indifference principle states that once everything is accounted for, every
city must be equally desirable. Otherwise, who would choose to live in an
inferior city.
Lets say that the key advantage to South Bend is its low housing costs. If
Chicago was still preferred, South Bend residents would start moving to
Chicago – this will magnify the benefits of South Bend (cheaper housing)
Median
Home
Price
Chicago Housing Market
Median
Home
Price
South Bend Housing market
S
S
$238,000
$86,000
D
D
Houses
The difference between housing costs should just offset any
advantages Chicago has!
Houses
Question: Are we in an ‘Education Bubble”?
Can we really justify the rapidly rising costs of college tuition or are
students getting in over their heads taking out loans that they will never
be able to afford?
High School Labor Force
College Educated Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
S
Can these markets be in
equilibrium?
$15,000
D
Enrollment
Consider the earnings across different ages and different education levels.
Age Group
Attainment
25-29
30-34
35-39
40-44
45-49
50-54
55-59
College
$43,121
$55,440
$62,244
$65,973
$66,280
$64,254
$65,240
High School
$28,097
$31,366
$33,443
$35,283
$36,316
$35,270
$37,573
Differential
$15,024
$24,074
$28,801
$30,690
$29,964
$28,984
$27,667
x5
= $75,120
x5
= $120,370
x5
x5
x5
x5
x5
=$926,020
= $144,005 = $153,450 = $149,820 = $144,920 = $138,335
PV 
$15,024 $15,024
$27,667


...

 $350,386
4
5
39
1.05 1.05
1.05
Lets assume
that you could
earn 5%
elsewhere
You receive the first payment 4 years from
now
This isn’t really
right because
you don’t get all
this money up
front
What are the costs of going to college?
Cost
Annual
Expense
Tuition
$15,000
Lost Wages
$20,000
Books, Fees, etc
$1,000
Room & Board
$5,000
$36,000 x 4 = $144,000
Note: we really should
discount these costs as well!
This is not a relevant cost…you
would have paid this anyways!!!
So, a college education costs $144,000 and yields $350,386 in
(discounted) lifetime benefits! Seems worth it!
PV 
$15,024 $15,024
$27,667


...

 $350,386
4
5
39
1.05 1.05
1.05
Alternatively, we can think about the annual salary differential for a college graduate like
the annual payout on a bond. The annual return to a college education would be like
calculating the return necessary so that the PV of the wage differential equals the cost
Cost
Annual
Expense
Tuition
$15,000
Lost Wages
$20,000
Books, Fees, etc
$1,000
$36,000 x 4 = $144,000
Note: we really should
discount these costs as well!
$15,024 $15,024
$27,667
PV 

 ... 
 $144,000
4
5
39
1  i 
1  i 
1  i 
Annual return
i  11%
Thought of as an investment, a college education pays
11% per year!!
High School Labor Force
College Education Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
If the costs of
college were truly
less than the
benefits, we would
see more people go
to school
S
Wage differentials
would fall and
college tuitions
would increase
$15,000
D
Enrollment
High School Labor Force
College Education Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
What we are seeing
is a steady increase
in demand for
skilled labor as
demand for
unskilled labor falls
S
Wage differentials
continue to increase
as college tuitions
increase
$15,000
D
Enrollment