Description
Do problem 2 on page 59 of the textbook.2. Consider the following supply and demand curves for a certain product. Qs = 25,000P Qd = 50,000 – 10,000P Plot the demand and supply curves.What are the equilibrium price and equilibrium quantity for the industry? Determine the answer both algebraically and graphically. (Round to the nearest cent.)
Unformatted Attachment Preview
Chapter 3 Supply and Demand
Learning Objectives
Upon completion of this chapter, readers should be able to:
Define supply, demand, and equilibrium price.
List and provide specific examples of the nonprice determinants of supply and demand.
Distinguish between the short-run rationing function and the long-run guiding function of price.
Illustrate how the concepts of supply and demand can be used to analyze market conditions in which management decisions
about price and allocations of resources must be made.
Use supply and demand diagrams to show how the determinants of supply and demand interact to determine market price in
the short run and in the long run.
The Situation
While sipping a cup of green tea with honey and ginseng, CEO Bob Burns began to reminisce. It seemed like yesterday, but it was
actually more than 10 years ago when he had convinced the board of directors of Global Foods, Inc., to go into the soft drink
business. Here he was a decade later, sampling a product that his VP of Marketing, Nicole Goodman, was telling him would be an
even stronger “growth engine” for the company than bottled water. She had pointed out to him that in 2003 American
consumers spent $5 billion on tea. Although this amount was far less than the $20 billion spent annually for coffee, it was five
times as much as people spent on tea a decade ago.1 “It’s obvious,” she told him, “Global Foods must get into the tea business.”
As he poured his second cup of tea, Bob had to admit that even he had begun to prefer tea over coffee. He decided to call Nicole
into his office to discuss the matter further.
1 Much of the situation and solution is based on Elizabeth Olsen, “A Tea Party, and All Boomers Are Invited,” New York Times,
October 17, 2004.
“Okay, Nicole,” Bob began, “You’ve always had a good instinct for what’s new in the market. But before we leap into this, I want a
report on exactly why you believe tea will be the real spark to our company’s growth in the coming 5 years. After all, in our
business it’s all about ‘share of stomach.’ If people are drinking more tea, then they might be drinking fewer soft drinks and
bottled water, so we’d be cannibalizing our own products. I’d feel much better if you could help me understand why this wouldn’t
be the case. Furthermore, what are the key determinants of the demand for tea? Could this be just a fad? Already people are
starting to tire of their low-carb diets. Nicole, I want you to provide me with a report on the elements that are driving the
demand for tea. How responsive will people be to price changes, to changes in the price of competing products such as bottled
water and carbonated soft drinks? Is tea a ‘luxury’ good, or is it a necessity? The answers to these questions will help us better
understand how to price and position our brand in the marketplace.”
Introduction
In this chapter, we introduce the basic elements of supply and demand. Although for some of you, this chapter serves as a review
of material covered in an economics principles course, it has been included because it is essential for every reader to have a
thorough grounding in supply and demand before proceeding to the particulars of managerial economics. There may be
situations—such as those described in this chapter’s “The Situation” vignette—in which you may be required to conduct or
evaluate a study with a considerable use of supply-and-demand analysis. Regardless of how directly this chapter’s material may
apply to your work, most of the material covered in this book relates in some way to supply or demand. Indeed, supply and
demand can be considered the conceptual framework within which the specifics of managerial economics are discussed.
Market Demand
The demand for a good or service is defined as
Quantities of a good or service that people are ready to buy at various prices within some given time period, other factors
besides price held constant.
Note that in this definition “ready” implies that consumers are prepared to buy a good or service both because they are willing
(i.e., they have a preference for it) and they are able (i.e., they have the income to support this preference).
Demand can first be illustrated with an example in which we imagine that you, the reader, are part of a simple market
experiment. Suppose you were asked to respond to the following survey question: “In a 1-week period, how many slices of pizza
would you be prepared to buy at the following prices: $2.00, $1.50, $1.00, $.50, and $.05?” Every reader would obviously have
his or her own pattern of response. Let us assume a sample of three readers respond in the following way:
Price (per Slice) QD1
QD2
QD3
$2.00 0
2
3
5
1.50
1
2
5
8
1.00
2
2
8
12
0.50
3
3
10
16
0.05
4
4
12
20
QDM
As you can see, the combined responses of the three individuals make up the total market demand (QDM ) for pizza, the sum of
all individual demands.
Market demand is illustrated with a simple numerical function, as shown in Table 3.1. This table shows a hypothetical demand
for pizza. As the price of a slice of pizza falls from $7.00 to zero, the amount that consumers in this market are willing to buy
increases from zero to 700 slices. This inverse relationship between price and the quantity demanded of pizza is called the law of
demand. There may be instances in which consumers behave in an “irrational” manner by buying more as the price rises and less
as the price falls because they associate price with quality. But in the economic analysis of demand, it is assumed buyers do not
associate price with quality and will therefore follow the law of demand.
The law of demand can be observed in the curve shown in Figure 3.1, derived from the schedule of numbers in Table 3.1. Notice
that the curve in this figure slopes downward and to the right, indicating that the quantity of pizza demanded increases as the
price falls, and vice versa.
Table 3.1 Market Demand for Pizza
Price (per Slice) QD
$7.00
0
6.00
100
5.00
200
4.00
300
3.00
400
2.00
500
1.00
600
0
700
A change in the demand for pizza or any other product is indicated by a change in the entire schedule of quantities demanded at
a list of prices, or a shift in the demand curve either to the left or to the right. We see these changes in Table 3.2 and Figure 3.2.
To summarize, we can say the following:
Changes in price result in changes in the quantity demanded (i.e., movements along the demand curve).
Changes in the nonprice determinants result in changes in demand (i.e., shifts in the demand curve).
This difference can be seen in Table 3.2 in the following manner. At the price of $5 the quantity demanded in the first list of
responses (QD1) is 200. If the price drops to $4, then the quantity demanded increases to 300. However, if the demand increases
to QD2, then at the price of $5 the quantity increases to 300 and in fact increases by 100 units at each price being offered.
Figure 3.1 Market Demand Curve for Pizza
Table 3.2 Different Levels of Market Demand for Pizza
Price (per Slice) QD1
$7.00
QD2
0
100
0
6.00 100
200
0
5.00 200
300
100
4.00 300
400
200
3.00 400
500
300
2.00 500
600
400
1.00 600
700
500
0
800
600
700
QD3
Factors that can cause demand to change are called nonprice determinants of demand. Following is a list of these determinants
and a brief elaboration of their impact on demand:
Tastes and preferences. Why do people buy things? Marketing professors, corporate market researchers, and advertising
executives spend their careers trying to answer this question. Economists use a general-purpose category in their list of nonprice
determinants called tastes and preferences to account for the personal likes and dislikes of consumers for various goods and
services. These tastes and preferences may themselves be affected by other factors. Advertising, promotions, and even
government reports can have profound effects on demand via their impacts on people’s tastes and preferences for a particular
good or service.
Income. As people’s incomes rise, it is reasonable to expect their demand for a product to increase, and vice versa. In the next
chapter, the possibility of demand moving in the opposite direction to changes in income is discussed.
Figure 3.2 Shifts in the Market Demand for Pizza
Prices of related products. A good or service can be related to another by being a substitute or by being a complement. If the
price of a substitute product changes, we expect the demand for the good under consideration to change in the same direction
as the change in the substitute’s price. Consider, for example, what would happen to the demand for software if the price of
computer hardware falls, or to the demand for music downloads (from legitimate sites!) if the price of MP3 players falls. It is
reasonable to expect that the demand for the two items would rise as a result of a fall in the price of their respective
complementary products.
Future expectations. If enough buyers expect the price of a good or service to rise (fall) in the future, it may cause the current
demand to increase (decrease). In markets for various financial instruments (e.g., stocks, bonds, negotiable certificates of
deposit, U.S. Treasury bills), as well as for agricultural commodities and precious metals, expectations of future price changes
among both buyers and sellers play an important part in determining the market demand. In most of these types of markets,
speculation among buyers and sellers is an important factor to consider. Buyers and sellers act on a current price of a product not
for its immediate consumption but because of the possibility of gaining from some future transaction. (Recall the old adage “buy
low and sell high.”)
This factor can also affect the demand for consumer and commercial products. For example, the demand for DVD recorders,
digital cameras, home entertainment systems, laptop computers, and personal digital assistants was probably not as high as
sellers expected when these products were first introduced because buyers were waiting for their prices to come down at a later
time.
Number of buyers. The impact of the number of buyers on demand should be apparent; as far as sellers are concerned, the more
the merrier. What is interesting, nonetheless, is how changing demographics and tastes and preferences within demographic
groups can affect the pool of potential buyers for a particular good or service. In other words, sheer numbers (i.e., population)
may not be as important as differences within the population.
We discuss further how changes in these factors change demand and market price. But first we introduce the concept of supply.
By combining supply with demand, we can conduct a complete analysis of the market, both in the short run and in the long run.
Market Supply
The supply of a good or service is defined as
Quantities of a good or service that people are ready to sell at various prices within some given time period, other factors
besides price held constant.
Notice that the only difference between this definition and that of demand is that in this case the word sell is used instead of
buy. Just as in the case of demand, supply is based on an assumed length of time within which price and the other factors can
affect the quantity supplied.
Recall that the law of demand states that the quantity demanded is related inversely to price, other factors held constant. In
contrast, the law of supply states that quantity supplied is related directly to price, other factors held constant. Thus, any
schedule of numbers representing a relationship between price and quantity supplied would show a decrease in the quantity
supplied as price falls.
Table 3.3 shows a hypothetical supply schedule. Also shown are two additional supply schedules, one indicating a greater supply
and the other showing a reduced supply. These schedules are shown as supply curves in Figure 3.3. The supply curve has a
positive slope, reflecting the direct relationship between price and quantity supplied.
Table 3.3 Market Supply for Pizza
P
QS1
QS2
QS3
$7
600
700
500
6
500
600
400
5
400
500
300
4
300
400
200
3
200
300
100
2
100
200
0
1
0
100
0
0
0
0
0
In analyzing the supply side of the market, it is important to make the distinction between quantity supplied and supply. The
distinction between these two terms is the same as that used for the demand side of the market:
Changes in price result in changes in the quantity supplied (i.e., movements along the supply curve).
Changes in nonprice determinants result in changes in the supply (i.e., shifts of the supply curve).
Just as there are nonprice determinants of demand, there are nonprice determinants of supply. A change in any one or a
combination of these factors will change market supply (i.e., cause the supply line to shift to the right or the left). We briefly
discuss each factor to understand why this is expected to occur:
Figure 3.3 Supply Curves for Pizza
Costs and technology. The two factors of costs and technology can be treated as one because they are so closely related. Costs
refer to the usual costs of production, such as labor costs, costs of materials, rent, interest payments, depreciation charges, and
general and administrative expenses—in other words, all items usually found in a firm’s income statement. Technology refers to
technological innovations or improvements introduced to reduce the unit cost of production (e.g., automation, robotics, and
computer hardware and software utilization). Technological changes that result in entirely new products for final consumption
are not considered part of this category. These new products would have to be considered in an entirely different market
analysis. In any event, unit cost reductions, whether from technological innovations or simply management decisions, will result
in an increase in market supply. Increases in the unit cost of production will have the opposite effect.
Prices of other goods or services offered by the seller. From the consumer’s standpoint, any good or service has other goods or
services related to it either as substitutes or as complements. From the producer’s standpoint, there can also be substitutes or
complements for a particular good or service offered in the market. For example, suppose the sellers of pizza notice that the
price of hot dogs increases substantially. In the extreme case, they may drop their line of pizza and substitute hot dogs. Or they
may at least reduce the amount of resources (e.g., labor and store space) devoted to the selling of pizza in favor of hot dogs. In
either case, the market supply of pizza would decrease. If the sellers were already selling two (or more) products, the change in
market conditions would prompt them to reallocate their resources toward the more profitable products. (Given this possibility,
it may be more appropriate to say that the sellers consider pizza and hot dogs as “competing” products rather than as
“substitute” products.)
Future expectations. This factor has a similar impact on sellers as on buyers; the only difference is the direction of the change.
For example, if sellers anticipate a rise in price, they may choose to hold back the current supply to take advantage of the higher
future price, thus decreasing market supply. As we discuss in the “Market Demand” section, an expected rise in price will
increase the current demand for a product.
Number of sellers. Clearly, the number of sellers has a direct impact on supply. The more sellers, the greater the market supply.
Weather conditions. Bad weather (e.g., floods, droughts, unusual seasonal temperatures) will reduce the supply of an
agricultural commodity. Good weather will have the opposite effect.
With this discussion of supply, we are now able to combine supply with demand into a complete analysis of the market.
Market Equilibrium
Now that we have reviewed the definitions and mechanics of demand and supply, we are ready to examine their interaction in
the market. Market demand and supply are compared in Table 3.4 and Figure 3.4.
Table 3.4 Supply and Demand for Pizza
P
QD
QS
$7
0
600
6
100
500
5
200
400
→4 300
300
3
400
200
2
500
100
1
600
0
0
700
0
You can see in both the table and the graph that at the price of $4, the market is cleared in the sense that the quantity
demanded (300) is equal to the quantity supplied (300). Thus, $4 is called the equilibrium price, and 300 is referred to as the
equilibrium quantity. Another way to view this market situation is to imagine what would happen if the price were not at the
equilibrium level. For example, suppose the price were at a higher level, say, $5. At this price, as you can see in Table 3.4, the
quantity supplied would exceed the quantity demanded, a condition called a surplus. At a lower price, say, $3, the situation is
reversed: the quantity demanded exceeds the quantity supplied. This situation is called a shortage. Both the surplus and the
shortage conditions are indicated in Figure 3.4.
Figure 3.4 Supply and Demand Curves for Pizza, Indicating Market Equilibrium
In the event of a surplus or a shortage, various competitive pressures cause the price to change (decrease in the case of a
surplus, and increase in the event of a shortage). The price thus serves to clear the market of the imbalance. The clearing process
continues until equilibrium (i.e., quantity demanded equals quantity supplied) is achieved. In the case of a surplus, sellers
wanting to rid themselves of the extra items offer the product at a lower price to induce people to buy more. At the same time,
as the price falls, suppliers are discouraged from offering as much as before. In the case of a market shortage, as the price rises
toward the equilibrium level, the market is cleared because the quantity demanded decreases while the quantity supplied
increases. In the event of a shortage, sellers try to take advantage of the situation by raising their prices, and people are thus
discouraged from buying as much as before. Also, sellers are induced to offer a greater number of items in the market. Both
actions serve to clear the market of a shortage.
To summarize the material in this section, remember the following definitions:
Equilibrium price: The price that equates the quantity demanded with the quantity supplied (i.e., the price that clears the market
of a surplus or shortage).
Equilibrium quantity: The amount that people are willing to buy and sellers are willing to offer at the equilibrium price level.
Shortage: A market situation in which the quantity demanded exceeds the quantity supplied, at a price below the equilibrium
level.
Surplus: A market situation in which the quantity supplied exceeds the quantity demanded, at a price above the equilibrium
level.
Comparative Statics Analysis
The model of market demand, supply, and equilibrium price and quantity developed in the preceding sections can now be used
to analyze the market. The particular method of analysis we use is called comparative statics analysis. This is a commonly used
method in economic analysis and is used throughout the text. In general, this method of analysis proceeds as follows:
State the assumptions needed to construct the model.
Begin by assuming the model is in equilibrium.
Introduce a change in the model. In so doing, a condition of disequilibrium is created.
Find the new point at which equilibrium is restored.
Compare the new equilibrium point with the original one.
In effect, comparative statics analysis is a form of sensitivity analysis, or what business people often refer to as what-if analysis.
For example, if we were doing a what-if analysis of a company’s cash flow, we would start with a given pro forma income
statement adjusted to provide the cash flow for a given period of time. We would then conduct sensitivity analysis by supposing
certain factors changed, such as revenue, cost, or the rate of depreciation. We would then inspect how changes in these factors
would change the cash flow of the firm over time. In the same manner, economists conduct a what-if analysis of their models.
The term statics alludes to the theoretically stable point of equilibrium, and comparative refers to the comparison of the various
points of equilibrium. The ensuing sections explain exactly how comparative statics analysis is used in the analysis of the market.
Short-Run Market Changes: The “Rationing Function“ of price
Module 3A
Let us continue with our analysis of pizza. Following the steps involved in comparative statics analysis, we start by assuming all
factors except the price of pizza are held constant, and the various patterns of response to price among buyers and sellers are
represented by the supply and demand lines in Figure 3.4. We make a fresh start by redrawing this graph in Figure 3.5. It would
also be useful to recall all nonprice determinants that could affect the demand or supply for a product. They are listed for you in
Table 3.5.
As noted in step 2 in the previous section, we begin this analysis in the condition of equilibrium. This is denoted in Figure 3.5 as
the point where the supply line intersects with the D1 demand line (i.e., the price level where quantity supplied is equal to
quantity demanded).
Based on step 3, we introduce a change in one or more of the assumptions made when the model was constructed. Any one or
more of the factors shown in Table 3.5 can cause this change. Let us assume a new government study shows pizza to be the most
nutritious of all fast foods and that consumers substantially increase their demand for pizza as a result of this study. In Figure 3.5,
this increase is represented by a shift in the demand curve from D1 to D2. As you can see, this shift results in a new, higher
equilibrium price of $4.50. Notice also that the new equilibrium quantity is greater than the original equilibrium quantity.
The comparison of the new equilibrium point with the original one (step 5 in comparative statics analysis) leads us to conclude
that, as a result of a change in tastes and preferences, the price of pizza rises, and so does the quantity bought and sold.
This analysis can be repeated using other possible changes in market conditions (e.g., the price of cheese rises, the price of soft
drinks falls). Each time, the same procedure should be followed. If we consider only one possible change at a time, the effects on
equilibrium price and quantity can be illustrated as in Figure 3.6. Instead of using specific numbers, we have designated the
prices and quantities with the symbols P and Q along with appropriate subscripts. We can summarize the effects shown in the
graphs as follows:
Figure 3.5 Increase in Demand for Pizza and Resulting Impact on Market Equilibrium
An increase in demand causes equilibrium price and quantity to rise. (See Figure 3.6 a.)
A decrease in demand causes equilibrium price and quantity to fall. (See Figure 3.6 b.)
An increase in supply causes equilibrium price to fall and quantity to rise. (See Figure 3.6 c.)
A decrease in supply causes equilibrium price to rise and quantity to fall. (See Figure 3.6 d.)
Table 3.5 Nonprice Determinants of Demand and Supply
Demand
Supply
Tastes and preferences
Income
Prices of related products
Future expectations among buyers
Number of buyers
Costs and technology
Prices of other products offered
Future expectations among sellers
Number of sellers
Weather conditions (particularly for agricultural products)
In Figure 3.6, we observe that the shift in demand or supply has in effect created either a shortage or a surplus at the original
price P 1. Thus, the equilibrium price has to rise or fall to clear the market. When the market price changes to eliminate the
imbalance between quantities supplied and demanded, it is serving what economists call the rationing function of price. The
term rationing is often associated with shortages, but we define it to also include a surplus situation.
Figure 3.6 Changes in Supply and Demand and Their Short-Run Impact on Market Equilibrium (the Rationing Function of Price)
Long-Run Market Analysis: The “Guiding” or “Allocating Function” of Price
The comparative statics analysis presented earlier required only that you consider the response of equilibrium price and quantity
to a given change in supply or demand. This response was dubbed the “rationing function” of price. Let us consider what might
happen as a result of this change in market price. To illustrate this, we examine the market for hot dogs, a presumed substitute
for pizza. The two markets are represented by the supply and demand diagrams in Figure 3.7.
Figure 3.7 Short-Run and Long-Run Changes in Supply (in Response to an Initial Change in Demand)
Now let us assume that at the same time people’s tastes and preferences change in favor of pizza, their tastes and preferences
become more adverse to hot dogs (e.g., for health reasons). The changes in the demand for the two products are shown in
Figure 3.7 by a downward shift in the demand for hot dogs and an upward shift in the demand for pizza (D 1 to D 2). This would
cause a shortage in the pizza market and a surplus in the hot dog market. As we know, the rationing function of price will
immediately start to correct these market imbalances. As the price of hot dogs falls, the surplus is eliminated; as the price of
pizza rises, the shortage is eliminated. (For the purpose of the analysis, it really does not matter where the price of pizza stands
in relation to the price of hot dogs. To simplify matters, we have assumed the two prices were about equal before the change in
tastes and preferences occurred. The point is that after price performs its rationing function, the equilibrium price of pizza will be
higher than the equilibrium price of hot dogs in relative terms.)
Now suppose the prices have indeed changed, and the two markets are once again in equilibrium. What do you suppose will
happen next? As you might imagine, the depressed price of hot dogs will cause the sellers to begin allocating less of their
resources to this market. Some may even go out of the business of making or selling hot dogs. In contrast, the higher price of
pizza will induce the allocation of more resources into this market. New pizza stands and restaurants may be opened. Food
companies may build new plants to produce frozen pizza for distribution through supermarkets. The effect of these follow-on
adjustments to the initial change in equilibrium prices can be seen in the figure as a rightward shift in the supply of pizza and a
leftward shift in the supply of hot dogs.
After this “long-run” adjustment is made, equilibrium price and quantity may return to the levels at which they were before the
initial changes in demand took place (i.e., P 3 in each market may be close to or equal to P 1). But the main point is that Q 3 is
considerably less than Q 1 in the hot dog market and considerably more than Q 1 in the pizza market. These differences
represent the shifting of resources out of the hot dog market and into the pizza market. Several centuries ago, Adam Smith
referred to this shifting of resources into and out of markets in response to price changes as the “invisible hand.”2 Another way
to express these shifts in supply is that they represent a response to “price signals” sent to the owners of the factors of
production. In any event, when resources have been shifted out of the market for hot dogs and into the market for pizza, price is
fulfilling its guiding or allocating function. Defined in a more formal manner, the guiding or allocating function of price is the
movement of resources into or out of markets in response to a change in the equilibrium price of a good or service.
2 For Smith, the “visible” hand was that of the government, which might try to dictate the allocation of resources among
different markets by the command process rather than by the market process.
The preceding example illustrates a basic distinction made in economic analysis between the “short run” and the “long run.” This
distinction has nothing to do directly with a specific calendar time. Instead, it refers to the amount of time it takes for sellers and
buyers to react to changes in the market equilibrium price. The following descriptions of the short run and the long run helps
readers distinguish the two time periods:
Short run
Period of time in which sellers already in the market respond to a change in equilibrium price by adjusting the amount of certain
resources, which economists call variable inputs. Examples of such inputs are labor hours and raw materials. A short-run
adjustment by sellers can be envisioned as a movement along a particular supply curve.
Period of time in which buyers already in the market respond to changes in equilibrium price by adjusting the quantity
demanded for a particular good or service. A short-run adjustment by buyers can be envisioned as a movement along a
particular demand curve.
Long run
Period of time in which new sellers may enter a market or the original sellers may exit from a market. This period is long enough
for existing sellers to either increase or decrease their fixed factors of production. Examples of fixed factors include property,
plant, and equipment. A long-run adjustment by sellers can be seen graphically as a shift in a given supply curve.
Period of time in which buyers may react to a change in equilibrium price by changing their tastes and preferences or buying
patterns. (The Wall Street Journal and other sources of business news may refer to this as a “structural change” in demand.) A
long-run adjustment by buyers can be seen graphically as a shift in a given demand curve.
Another good way of distinguishing the short run from the long run is to note that the rationing function of price is a short-run
phenomenon, whereas the guiding function is a long-run phenomenon.
Let us summarize the short-run “rationing function” and the long-run “guiding function” of price in terms of our example
involving pizza and hot dogs:
Changing tastes and preferences cause the demand for pizza to increase and the demand for hot dogs to decrease.
The changing demand for the two products causes a shortage in the pizza market and a surplus in the hot dog market.
In response to the surplus and shortage in the two markets, price serves as a rationing agent by decreasing in the hot dog market
and increasing in the pizza market. That is, the short-run response by suppliers of the two products is to change their variable
inputs (i.e., movement downward along the supply line in the market for hot dogs, and movement upward along the supply line
in the market for pizza).
In the long run, price fulfills its guiding function by causing sellers and potential sellers to respond by increasing capacity or
entering the market for pizza and by decreasing capacity or leaving the market for hot dogs (i.e., rightward shift in the supply line
for pizza and leftward shift in the supply line for hot dogs).
Figure 3.8 Short-Run and Long-Run Changes in Demand (in Response to an Initial Change in Supply)
As a result of the shifts in supply, new equilibrium levels of price and quantity are established. The new quantities bought and
sold represent shifts in resources out of one market and into the other.
The distinction between short- and long-run changes in the market can also be made in cases that begin with changes in supply
rather than in demand. A classic example is the case of the Organization of Petroleum Exporting Countries (OPEC) and the world
oil market. In the early 1970s, OPEC conspired to raise the price of oil by limiting production to an amount that would support a
price above the current level. The supply-and-demand diagram shown in Figure 3.8 illustrates this action. Table 3.6 provides a
brief description of this illustration. As we can see, limiting the production of oil can be envisioned as a leftward shift in the
supply line to the level where it intersects the demand curve for oil at some designated point above the current market price
(i.e., P 2 rather than P 1). The short-run response by consumers to the increase in oil prices was to reduce their consumption of
oil. However, in the terms specific to our analysis, this reduction can be seen as a decrease in the quantity demanded for oil. In
other words, the decrease in the supply of oil (i.e., the shift of the supply line to the left) prompted a movement back along the
demand curve for oil.
Over time, U.S. consumers began to change their pattern of oil consumption as a result of the high price. They formed car pools,
bought more fuel-efficient cars, lowered their thermostats in their homes, and even tried to follow the new 55-mph speed limit
established on highways thr
