Extra Material complementing Pindyck and Rubinfeld Chapter 2

Learning Objectives

1. Understand the meaning of demand and supply curves, and see how equilibrium is established; 2. Understand the meaning of the slope and intercepts of demand (and supply) curves; 3. Understand the difference between movements along demand and supply curves, and shifts of demand and supply curves; 4. Understand the effect of price ceilings and price floors; 5. Understand the concept of price elasticity as a concept of price sensitivity (+ cross-price elasticity, income elasticity); 6. Understand the relation between revenue and price elasticity of demand; 7. Understand that it does not matter whether firms or consumers pay a per unit tax; 8. Understand the effect of elasticity of demand and supply on tax incidence; 9. Realise how supply and demand analysis can be applied to understand real-world phenomena.

Key Concepts

• Demand (PR pp.23-25, The Demand Curve)

The demand for student rooms in the specified market is a schedule that gives you, for each possible price (monthly rent), the quantity demanded (the number of student rooms rented). Note that all other variables than monthly rent (such as the students’ income, their tastes for living in student rooms rather than with their parents, etc.) are considered constant (“other things equal”). For simplicity, let us assume that there are only six students considering renting rooms in the specified neighbourhood. Assume also that all student rooms in the neighbourhood are identical. Table 1 shows you, for each of these six students, the maximum monthly rent that they would be willing to pay for a student room. These are the students’ reservation prices. Note that, since at the reservation price, the student is indifferent between renting a room and not renting one, by the argument made in the lecture on “Thinking like an Economist”, the reservation price measures the student’s benefit of renting a room. The data in Table 1 can be summarised in a diagram representing the demand curve, given in Figure 1.

| |Abe |Ben |Cathy |Dave |Edie |Frank | |Reservation |€600 |€500 |€400 |€300 |€200 |€100 | |price | | | | | | |

Table 1 Reservation prices of students for student rooms in a neighbourhood of Utrecht.

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Figure 1 Market demand for student rooms.

The monthly rent (the price) is measured along the vertical axis; the number of student rooms rented by students is measured along the horizontal axis. For any monthly rent above €600, nobody rents a student room. The dashed line between a level of 0 and 1 student rooms represents that, at a monthly rent of exactly €600, Abe is indifferent between whether or not to rent a student room. The solid line between a price level of €600 and €500 shows that, for all rents in between these two amounts, only Abe rents an apartment. As soon as the price level hits €500, Ben becomes willing to rent a room, etc. We assume that students, who are indifferent about renting a room, do rent a room, as indicated by the dots. The combination of solid lines and dots in Figure 1 is the demand curve for student rooms in the specified market. There are two ways of interpreting this demand curve. One interpretation is that, for each possible price, it allows you to read along the horizontal axis how many student rooms will be demanded. The quantity demanded as a function of price is referred to as the direct demand. The direct demand in Figure 1 obeys the law of demand, saying that less is bought when prices are higher. A second interpretation is that, for each possible...