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CHAPTER

Demand and Supply 53

subcontinent. These queues are the result of price controls; the government preventing domestic kerosene prices from rising along with the oil prices. Sometimes excess demand results in curtailments and supply rationing, as with natural gas price controls and the resulting gas shortages of the mid-1970s in USA, when industrial consumers closed factories because gas supplies were cut off. Sometimes it spills over into other markets, where it artificially increases demand. For example, natural gas price controls caused potential buyers of gas to use oil instead. Some people gain and some lose from price controls. As Figure 2.23 suggests, producers lose: They receive lower prices, and some leave the industry. Some but not all consumers gain. While those who can purchase the good at a lower price are better off, those who have been "rationed out" and cannot buy the good at all are worse off. How large are the gains to the winners and how large are the losses to the losers? Do total gains exceed total losses? To answer these

questions, we need a method to measure the gains and losses from price controls and other forms of government intervention. We discuss such a method in Chapter 8.

r*ce \-onffols ano Lrqur,,eo retroleum


Gas (LPG) Shortages

LPC prices have always been regulated in India. Prior to the mid-1990s, LPG gas prices were highly subsidized. Though the perecentage o{ subsidy has fallen over time, it is still quite significant. To understand the likely impact of such price controls, *" *ill go back to the year 1980 and calculate the impact of LPG price controls at that time. Controls were.gradually lifted during the first few'years of the 21st century. The following data describe the LPG market in 1980:

r r
o

The free'market price of LPG would have been about Rs 40 per r,ncf (thousand cubic feet);

Production and consumption of LPG would have been about 315 Tcf (trillion cubic feet);. The average price of oil (including both imports and domestic production), which affecti both demand and supply for LPG, was about Rs 30/ barrel

A reasonable estimate for the price elasticity of supply is 0.51. Higher oil prices also lead to more gas production because oil and gas a{e often discovered and produced together; an estimate of the cross-price elasticity of supply is 0.05 .{s for demand, the price elasticity is about -0.35, and thecross-pr'ice elasticity rr"ith respect to oil price is about 1.38.You can verify that the following linear Jemand and supply curves fit these numbers:

_ Q : 140 + 4Pc+S.sPo Demand: Q--3Pe+14'5Po


Supply:
-.r-here

Q is the quantity of LPG (in TcO, P" is the price of LPG (in rupees per ncf i, and { is the price of oil (in rupees per barrel). You can also veri$l by equating the quantities supplied and demanded and substituting Rs 30 for Pr,

54

PART

lntroduction: Markets and prices

energy policy continued to influence the evolution of LPC market in ihe 1980s. Today, producers and industrialtonsurners of natural gas, oil, and other commodities are concerned that the government might respond, once again, with price control.e if prices rise"sharply, In Example 8.1 of chapter 8, we show to measure the gains and losses-that result form price controls.

Price regulation yup . major componenl of India's between 1960 and early 1990s and

thatt se demand and supply curves imply an equiribriumfree-market pri{ of Rs 40for LPG. price of gas in 19B0 vras about Rs 20 per mcl substitutlng . The regulated Pc. i, rhe supply fu4cfion gives a guan*ry suppl;ed af 255 kt'. tu: 3r: f:r: Sui{iuting for Po in the dernand funciion glour aq*r"triity iemanded of 3z-t Tcf. Price conirols thus created an excess demand'of Jzi * z3s: 140 Tcl which manifested itself in the forna,of a:widespread btack,market;

SUMMARY
Demand-supply analysis is a basic tool of microeco_ nomics. In competitive markets, demand and supply curves tell us how much will be produced by firms and how much will be demanded by consumers as a function of price. The market mechanism is the tendencv for demand and supply to equilibrate (i.e., for price io move to the market-clearing level), so that there is neither excess demand nor excess supply. Elasticities describe the responsiveness of demand and supply to changes in price, income, or other variables.
For example, the price elasticity of demand measures the percentage change in the quantity demanded resulting from a l-percent increase in price.

5. If we c4n estimate, at least roughly, the demand and


supply curves for a particular market, we can calculate

the market-clearing price by equating the quantity supplied with the quantity demanded. Als;, if w; know how demand and supply depend on other economic variables, such as income or the prices of other goods, we can calculate how the markeiclearin;; price and quantity will change as these other variablei change. This is a means of explaining or predicting
market behavior.

6. Simple numerical analyses can often be done by fitting linear demand and supply curves to data on price
and quantity and to estimates of elasticities. For many markets, such data and estimates are available, and simple "back of the envelope" calculations can help us understand the characteristics and behavior of the
market.

Elasticities pertain to a time frame, and for most goods it is important to distinguish between short-run and long-run elasticities.

OU

.ES-T-I-O N

S FO R R EVI EW
;"";"..u:r",

1. suppose tnut,r..,r,rutt;

curve for ice cream to shift to the right. Why will the

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2.

and the quantity of butter bought ancl sold: (a) an

price of ice cream rise to a new market-clearing ievel? Use demand and supply curves to illustratshow each of the following events would affect the price of butter

3.

increase in the price of cheese (b) an increase in the price of milk; (c) a decrease in average income levels. If a 3-percent increase in the price of corn flakes causes a 6-percent decline in the quantity demanded, what is
the elasticity of demand?

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