CHAPTER 4: APPLICATIONS OF SUPPLY AND DEMAND

“You cannot teach a parrot to be an economist simply by teaching it to say “supply” and
“demand.””
Anonymous
SUMMARY
A. Elasticity of Demand and Supply
1. Price elasticity of demand measures the quantitative response of demand to a change
in price. Price elasticity of demand (ED) is defined as the percentage change in quantity
demanded divided by the percentage change in price. That is,
Price elasticity of demand = ED
percentage change in quantity demanded
=
percentage change in price
In this calculation, the sign is taken to be positive, and P and Q are averages of old and
new values.
2. We divide price elasticities into three categories: (a) Demand is elastic when the
percentage change in quantity demanded exceeds the percentage change in price;
that is, ED > 1. (b) Demand is inelastic when the percentage change in quantity
demanded is less than the percentage change in price; here, ED < 1. (c) When the
percentage change in quantity demanded exactly equals the percentage change in
price, we have the borderline case of unit-elastic demand, where ED = 1.
3. Price elasticity is a pure number, involving percentages; it should not be confused with
slope.
4. The demand elasticity tells us about the impact of a price change on total revenue. A
price reduction increases total revenue if demand is elastic; a price reduction
decreases total revenue if demand is inelastic; in the unit-elastic case, a price change
has no effect on total revenue.
5. Price elasticity of demand tends to be low for necessities like food and shelter and high
for luxuries like snowmobiles and vacation air travel. Other factors affecting price
elasticity are the extent to which a good has ready substitutes and the length of time
that consumers have to adjust to price changes.
6. Price elasticity of supply measures the percentage change of output supplied by
producers when the market price changes by a given percentage.

B. Applications to Major Economic Issues

7. One of the most fruitful arenas for application of supply-and-demand analysis is
agriculture. Improvements in agricultural technology mean that supply increases
greatly, while demand for food rises less than proportionately with income. Hence
free-market prices for foodstuffs tend to fall. No wonder governments have adopted
a variety of programs, like crop restrictions, to prop up farm incomes.
 8. A commodity tax shifts the supply-and-demand equilibrium. The tax’s incidence (or
impact on incomes) will fall more heavily on consumers than on producers to the
degree that the demand is inelastic relative to supply.
9. Governments occasionally interfere with the workings of competitive markets by
setting maximum ceilings or minimum floors on prices. In such situations, quantity
supplied need no longer equal quantity demanded; ceilings lead to excess demand,
while floors lead to excess supply. Sometimes, the interference may raise the incomes
of a particular group, as in the case of farmers or low-skilled workers. Often,
distortions and inefficiencies result.

CONCEPTS FOR REVIEW

Elasticity Concepts
Price elasticity of demand, supply, elastic, inelastic, unit-elastic demand, ED = % change in Q/%
change in P, determinants of elasticity, total revenue = P × Q, relationship of elasticity and
revenue change
Applications of Supply and Demand
Incidence of a tax, distortions from price controls, rationing by price vs. rationing by the queue
FURTHER READING AND INTERNET WEBSITES
Further Reading
If you have a particular concept you want to review, such as elasticity, you can often look in
an encyclopaedia of economics, such as John Black, Oxford Dictionary of Economics, or David
W. Pearce, ed., The MIT Dictionary of Modern Economics. The most comprehensive
encyclopaedia, covering many advanced topics in four volumes, is John Eatwell, Murray
Milgate, and Peter Newman, The New Palgrave: A Dictionary of Economics.
The minimum wage has generated a fierce debate among economists. A recent book by two
labour economists presents evidence that the minimum wage has little effect on
employment: David Card and Alan Krueger, Myth and Measurement: The New Economics of
the Minimum Wage.
Websites
There are currently no reliable online dictionaries for terms in economics. There are few good
websites for understanding fundamental economic concepts like supply and demand or
elasticities. There is a concise online encyclopaedia of economics at
www.econlib.org/library/CEE.html , which is generally reliable but covers only a small number
of topics. Sometimes, the free site of the Encyclopaedia Britannica at www.britannica.com
will provide background or historical material.
Current issues such as the minimum wage are often discussed in policy papers at the website
of the Economic Policy Institute, a think tank focusing on economic issues of workers, at
www.epi.org
 QUESTIONS FOR DISCUSSION
1. “A good harvest will generally lower the income of farmers.” Illustrate this proposition
using a supply-and-demand diagram.
A good harvest will shift the supply curve to the right (from SS to S’S’) – as more farm
produce is produced at each price:

P D S S'

E
Price

E'

S S' D

Quantity Q

An increase in supply lowers the equilibrium price (the new equilibrium E’ is further down
the price axis than E – the bold red arrows show the changes in price and quantity).
Total revenues are equal to price times quantity (P × Q). P is lower, and Q is higher – so it
is ambiguous as to whether total revenues rise or fall. To determine this, the relationship
between the change in quantity to the change in price, as the equilibrium moves along
the demand curve from E to E’, needs to be known.
The price elasticity of demand measures how much the quantity demanded of a good
changes when its price changes. The precise definition of price elasticity is the percentage
change in quantity demanded divided by the percentage change in price:
percentage change in quantity demanded
ED =
percentage change in price
If the percentage change in quantity is greater than the percentage change in price,
demand is price elastic (ED > 1). If the percentage change in quantity is lower than the
percentage change in price, demand is price inelastic (ED < 1). If the percentage change
in quantity is equal to the percentage change in price, demand is unit-elastic (ED = 1).
The demand curve for farm produce will be price inelastic. That is, even if bread becomes
very cheap, people are unlikely to buy too much more of it – there’s only so much our
taste buds and stomach can stomach! We also won’t store large quantities of bread we
don’t consume immediately, as it goes stale if it is not frozen. Conversely, if bread became
dear, we would still buy similar amounts as it is a necessity – we’d be more likely to cut
back on luxuries to make way for the expensive bread.
 As demand is inelastic, a fall in price will lead to a proportionally smaller rise in quantity
demanded (by definition, ED < 1, so % change in Q < % change in P). Since Q has increased
proportionally less than P has decreased, P × Q will be decreased – i.e. farm revenues are
lower, hence farmers’ incomes are lower.
This can also be seen from the diagram. Revenue is given by the area of the rectangle
drawn from the origin to the equilibrium point. The area of the rectangle drawn to E’ (in
light blue) is less than that of the rectangle drawn to E (in light pink).
This diagram shows that, “A good harvest will generally lower the income of farmers.”
2. For each pair of commodities, state which you think is the more price-elastic and give
your reasons: perfume and salt; penicillin and ice cream; automobiles and automobile
tyres; ice cream and chocolate ice cream.
 Perfume will be more price-elastic than salt. Perfume is much more of a luxury. A low
price would induce people to buy more perfume, but if price were increased too high
people would substitute other goods for it.
Although not a necessity, nearly every household will have some salt as a food
flavouring. A low price will not induce you to stockpile salt, and the price would have
to rise very drastically for people to refrain from buying it.

 Penicillin will be more price-elastic than ice cream. Ice cream will be less price-elastic
because the time for you to consume it is much shorter than for penicillin. Ice cream
melts very quickly (I’m assuming we’re buying a cone – not something you store in the
refrigerator; and even if you did store it, there’s limited space) – so you buy it with a
view of eating it immediately. Even if the price drops drastically, there is only so much
ice cream you are willing to eat immediately.
If penicillin were to drop in price, you would expect hospitals and pharmacies to buy
more, as they can store it for a long time.

 Automobiles will be more price-elastic than automobile tyres. While both are
necessities, and are complements to each other, the following reasons lead me to
think tyres will be more price-inelastic than the car.
A car is more of a luxury good than a tyre – and certainly more expensive. You will take
longer to decide which car to buy, and will be more sensitive to price as it is a larger
expense. Conversely, tyres are relatively cheap and you are most likely to buy one
immediately after an accident; in a hurry, without being too sensitive to price.

 Chocolate ice cream will be more price-elastic than ice cream. If you are specifically
looking for chocolate ice cream, and it rises in price, you are less likely to want to
switch to cheaper vanilla or strawberry ice cream. If any ice cream will do, and
chocolate ice cream rises in price, you will happily switch to cheaper flavours.
3. “The price drops by 1 percent, causing the quantity demanded to rise by 2 percent.
Demand is therefore elastic, with ED > 1.” If you change 2 to ½ in the first sentence,
what two other changes will be required in the quotation?
“The price drops by 1 percent, causing the quantity demanded to rise by ½ percent.
Demand is therefore inelastic, with ED < 1.”
4. Consider a competitive market for apartments. What would be the effect on the
equilibrium output and price after the following changes (other things held equal)? In
each case, explain your answer using supply and demand.

a. A rise in the income of consumers.

Average incomes are a determinant of demand, so a rise in the income of consumers will
increase the demand for apartments. An increase in demand, with supply constant for
the time being, will lead to an increase in the price and quantity of apartments:

P D D' S

E'
Price

S D D'

Quantity Q

b. A $10-per-month tax on apartment rentals.

A $10-per-month tax means that for each ‘quantity’ of apartments, the price of the
apartment (i.e. the rent) will be $10 higher; shifting the supply curve up by $10
everywhere. This is effectively a decrease in supply. The supply curve shifts from SS to
S’S’, leading to a higher price and lower quantity:
 P S'

D S

$10
E'
Price

S'
E

S D

Quantity Q

c. A government edict saying apartments cannot rent for more than $200 per month.
The government edict has placed a maximum ceiling of $200 per month on the price:

P D' D S
E
Price

E' $200 ceiling price

S D' D

Quantity Q

If the edict were not in place, assume the market would clear at E, with supply and
demand being in balance. The maximum ceiling (the grey line) prevents the price from
rising to this point. At the ceiling price, demand does not match supply. There is greater
demand for apartments than supply (DD is further to the right than SS). The red line
illustrates this. There is a shortage of apartments.
A non-price mechanism is needed to ration the deficient supply to the demand – most
likely allocation through the political system, as apartments are given out on some
criteria of need. The demand is reduced to D’D’ and an equilibrium is found at E’. This has
reduced the price and quantity of apartments.
d. A new construction technique allowing apartments to be built at half the cost.
Due to the improved technology of apartment building, the cost of production has been
halved. Twice as many apartments can be provided at the same price. The supply curve
will shift to the right, from SS to S’S’ – the quantity supplied will be doubled for each price.
At the new equilibrium, E’, price will be lower and the quantity will be higher:

P D S S'

E
Price

E'

S, S' D

Quantity Q

e. A 20 percent increase in the wages of construction workers.

A 20 percent increase in the wages of construction workers is an increase in input prices,
and hence an increase in costs of production. The quantity of apartments at each price
will be lowered, and the supply curve will shift to the left, from SS to S’S’. The price of
apartments will rise and their quantity will fall:

P D S' S

E'
Price

E
S'

S D

Quantity Q
5. Consider a proposal to raise the minimum wage by 10 percent. After reviewing the
arguments in the chapter, estimate the impact upon employment and upon the
incomes of affected workers. Using the numbers you have derived, write a short essay
explaining how you would decide if you had to make a recommendation on the
minimum wage.
A minimum wage sets a minimum floor on wages. A supply-and-demand diagram can
illustrate its effects on low paid workers:

Wages D S

Wmin E U LF
Price

Wmarket
M

S D

Quantity Employment

(N.B. I’ve used ‘Wages’ instead of price, and ‘Employment’ instead of quantity. But they
amount to the same thing, as your wage is the price paid for your labour, and
employment is the quantity of workers paid.)
Before the raise in the minimum wage, the market-clearing equilibrium would have been
at M and the market wage paid to the low paid would have been W market. But as the
minimum wage is raised to Wmin, the number of workers demanded moves up the
demand curve, DD, to E. This results in a new equilibrium where fewer workers are
employed, but those that are enjoy a higher wage.
Note also that the number of workers attracted to the market at the higher minimum
wage (perhaps before they had lived on unemployed benefits, or been in education, or
had been retired) moves up the supply curve, SS, to LF. We see that the quantity of
workers supplied exceeds the quantity demanded (SS is further to the right than DD) –
seen in the red line joining E and LF. This represents a surplus of workers –
unemployment, of an amount U.
(N.B. There is a difference in the drop in employment and the rise in unemployment.
Some people who were previously employed will be priced out of the jobs market – this
is the drop in employment. But others, who were not previously working but would have
entered the jobs market enticed by the higher wage, also find themselves priced out.)
So in summary, a rise in the minimum wage will put some people out of work (employment
falls), it would prevent some people from getting a job (unemployment rises), but those
who do work at low wages have a higher wage.
This answer has so far been qualitative. By considering price elasticities, a more
quantitative answer can be given. The minimum wage has risen by 10 percent, so the
percentage change in price (the denominator in the elasticity) is 10 percent. Studies
suggest the price elasticity for low wage workers is 0.1 to 0.3.

percentage change in quantity demanded

ED =
percentage change in price

percentage change in quantity demanded

If ED = 0.1 = ,
10
∴ Percentage change in quantity demanded = 10 × 0.1 = 1%
A 10% increase in price, and a 1% drop in quantity gives:
Total incomes = P’Q’ = 1.1P × 0.99Q = 1.089PQ
So total incomes have increased by 9% (rounded from 8.9% = 1.089 − 1).

If ED = 0.3, the same equation gives percentage change in quantity demanded = 3%

A 10% increase in price, and a 3% drop in quantity gives:
Total incomes = P’Q’ = 1.1P × 0.97Q = 1.067PQ
So total incomes have increased 7% (rounded from 6.7% = 1.067 − 1).

So, a 10 percent rise in the minimum wage, given price elasticities of demand between
0.1 – 0.3, will reduce employment by 1 – 3 percent, but increase total incomes between 7
– 9 percent.

Given this, would I support a raise in the minimum wage? The trade-off is, is a 7 – 9
percent increase in the incomes of low-wage workers worth a 1 – 3 percent drop in
employment among low wage workers? To complicate matters, what would be the
increase in unemployment? The price elasticity of supply of low wage workers would
need to be found for that, and how increased wages interacts with the benefits system
and many other complications of that nature.
Personally I would be disinclined to do so. A raise in the minimum benefits a large subset
of low wage workers (who keep their jobs at higher wages) at the expense of those who
lose their jobs or are priced out of getting a job. Those most affected are most likely to
be the most marginal workers – teenagers who will be scarred for life by not being able
to get a job early on, or those who have poorer prospects anyway, such as the disabled,
or ethnic minorities.
 Also, the increased wages are a cost to the employers of low wage workers. These are
the people who have done most to help low wage workers by employing them, but now
see their profits reduced or cannot expand any more or are put out of business.
My main problem then, is that to help one group of people who are deserving of our help,
we have to hurt others who are equally or more deserving of our help.
I think it would be better to give income support to low wage workers, either through in-
work tax credits or benefits, or from a basic income scheme where all are given a cash
transfer unconditionally. Any of these schemes would have to be paid for, which means
higher taxes and inefficiencies placed elsewhere, which would hurt some. But, this pain
could be taken by those who could better bear it, for instance through a tax on higher
earners. This way, the help to the poor is achieved through some burden placed on the
rich. But the minimum wage helps some of the poor through some burden placed on
other poor people and those who help them. Income transfers seem a more moral course
of action to me. But reasonable people can differ in their normative judgements.
6. A conservative critic of government programs has written, “Governments know how to
do one thing well. They know how to create shortages and surpluses.” Explain this
quotation using examples like the minimum wage or interest-rate ceilings. Show
graphically that if the demand for unskilled workers is price-elastic, a minimum wage
will decrease the total earnings (wage times quantity demanded of labour) of unskilled
workers.
Maximum ceilings create shortages whereas minimum floors create surpluses.
An example of a maximum ceiling would be an interest-rate ceiling. Interest rates are the
price for borrowing money. Drawing a supply-and-demand diagram, with ‘interest rate’
in place of price, and ‘money’ in place of quantity of money:

D S
Interest rate (percent per year)

i market E
Price

E' Interest rate ceiling

i max

S D

Quantity
Money
The market rate of interest, imarket, bringing the supply and demand for money into
balance, would be determined by the intersection of the supply and demand curves at E
in the absence of the interest rate ceiling. If an interest rate ceiling was introduced (as
has happened historically, when usury laws set a limit), then the interest rate would not
reach imarket, but would fall to imax. At this interest rate, we see that the demand for money
is greater than the supply of money (DD is further to the right than SS). There is a shortage
of money for borrowing. A non-price mechanism for rationing the demand for borrowing
money to bring it in line with supply at E’ will be needed. The bold red arrows show that
the interest rate is lower, and the amount of money borrowed is lower.
An example of a minimum floor would be a minimum wage, which is explained in
question 5:

Wages D S

Wmin E U LF
Price

Wmarket
M

S D

Quantity Employment

If instead the demand for unskilled workers is price-elastic:

Wages D S

Wmin E U LF
Price

M
Wmarket

D
S

Quantity Employment
 The total earnings are given by the rectangles drawn from the origin to M and E. The
rectangle drawn to E (in light blue) has a smaller area than that of the rectangle drawn
to M (in light pink). This shows that total earnings at the minimum wage in this price-
elastic case are lower than that at the market wage.
7. Consider what would happen if a tariff of $2000 were imposed on imported
automobiles. Show the impact of this tariff on the supply and the demand, and on the
equilibrium price and quantity, of American automobiles. Explain why American auto
companies and autoworkers often support restraints on automobiles.

[In the question, we need to consider the demand for automobiles by American
consumers, but with supply separately from American producers and world producers. In
all supply-and-demand questions dealt with so far, we have only had to deal with one set
of suppliers. A full treatment of this question would rely on knowledge of international
trade, not yet dealt with so far in the text book. This is a first-attempt at the question,
dealing with the intuition, but not that rigorous.]
A $2000 tariff on imported automobiles shifts the supply curve for imported automobiles
everywhere upwards by $2000. This is a reduction in supply, as the supply curve shifts
from SS to S’S’:

P D S'

$2000
E' S
Price

S'

S D

Quantity Q

The new market equilibrium is found at a higher price and lower quantity. With fewer
imported automobiles entering the American market, and those at a higher price, then
assuming demand for automobiles unchanged, a greater quantity of American
automobiles will be sold at higher price. This is why American auto companies and
autoworkers often support import restraints.
8. Elasticity problems:
a. The world demand for crude oil is estimated to have a short-run price elasticity of
0.05. If the initial price of oil were $30 per barrel, what would be the effect on oil price
and quantity of an embargo that curbed world oil supply by 5 percent? (For this
problem, assume that the oil-supply curve is completely inelastic.)
Assuming oil supply is completely inelastic, then the supply curves will be vertical. The oil
embargo will reduce oil supply by 5 percent, shifting the supply curve to the left, from SS
to S’S’:

P D S' S

E'
Price

D
S' S

Quantity Q

The price of oil will rise, and the quantity demanded will fall. The percentage change in
quantity demanded is 5 percent, as this is the reduction in supply. Given the elasticity of
demand, the percentage change in price can be calculated.
If ED, the elasticity of demand, is 0.05, then:
percentage change in quantity demanded
ED =
percentage change in price
5
0.05 =
percentage change in price
5
So, the percentage change in price = = 100
0.05

The price of oil will be $30 × 2 = $60 per barrel.

In summary, price will rise 100 percent from $30 to $60 per barrel, and the quantity will
fall by 5 percent.
b. To show that elasticities are independent of units, refer to Table 3-1. Calculate the
elasticities between each demand pair. Change the price units from dollars to pennies;
change the quantity units from millions of boxes to tons, using the conversion factor of
10,000 boxes to 1 ton. Then recalculate the elasticities in the first two rows. Explain
why you get the same answer.
Using Table 3-1,
 (1) (2) (3) (4) (5) (6) (7)
P ΔP Q ΔQ P1 +P2 Q1 + Q2 ED
2 2
5 9
1 1 4.5 9.5 0.47
4 10
1 2 3.5 11 0.64
3 12
1 3 2.5 13.5 0.56
2 15
1 5 1.5 17.5 0.43
1 20

If we change quantities: multiplying P’s by 100 (100 pennies in a dollar), and Q’s by 100
(1 million boxes = 100 × 10,000 boxes = 100 tons):
(1) (2) (3) (4) (5) (6) (7)
P ΔP Q ΔQ P1 +P2 Q1 + Q2 ED
2 2
500 900
100 100 450 950 0.47
400 1000
100 200 350 1100 0.64
300 1200
100 300 250 1350 0.56
200 1500
100 500 150 1750 0.43
100 2000

The elasticities are the same. This shows that elasticities are independent of unit. This is
because the elasticity uses percentage changes on both numerator and denominator.
Percentage changes are independent of the units of the quantities, and the ratio of two
percentages are dimensionless.
c. Demand studies find that the price elasticity of demand for cocaine is 0.5. Suppose
that half the cocaine users in New York City support their habit by predatory criminal
activities. Using supply-and-demand analysis, show the impact on crime in New York
City of an interdiction program that decreases the supply of crack into the New York
market by 50 percent. (Assume that supply is completely inelastic for this exercise.)
What would be the effect of reducing supply constraints on criminal activity and on
drug use if the government reduced its interdiction efforts and this lowered the price
of cocaine by 50 percent? Discuss the impact on price and addiction of a program that
successfully rehabilitated half of the cocaine users.
The supply of cocaine is completely price inelastic, so the supply curve will be vertical.
The interdiction program reduces supply by 50 percent – so the supply curve shifts to the
left, from SS to S’S’:
 P D S' S

E'
Price

S' S D

Quantity Q

The price of cocaine will rise and the quantity demanded will fall.
If the percentage change in quantity is 50 percent, and the price elasticity is 0.5:
percentage change in quantity demanded
ED =
percentage change in price
50
0.5 =
percentage change in price
50
So, percentage change in price = = 100
0.5
The interdiction program has doubled the price of cocaine in New York City, as well as
halved its quantity.
It is not obvious what the adjustment will be to this new equilibrium. Will every individual
reduce their consumption by half, spending double the amount of money on cocaine?
Will some cease buying cocaine altogether, while some buy more?
Assuming, as is likely, that a large number of those who resort to criminal activity to fund
their habit still buy cocaine, unless they reduce their cocaine consumption by more than
half, they will be spending more money on cocaine than previously. They will likely
undertake more criminal activity to do this. In fact, the high price and scarcity will act as
a powerful inducement of organised criminal activity – with gangs and the like getting
involved in the drug trade.
If the government then reduced the supply constraints so that the price halved, then the
quantity demanded will double.
If half of the cocaine users were rehabilitated, then the demand would be reduced:
 P D' D S

E
Price

E'
S D' D

As supply is completely inelastic, the reduction in demand will reduce the price, but not
the quantity demanded. Those who were not rehabilitated would buy the cocaine that
the rehabilitated half used to buy, but at a reduced price.
d. Can you explain why farmers during a depression might approve of a government
program requiring that pigs be killed and buried under the ground?
Farmers killing pigs will reduce the supply of pig-based products, like bacon, ham, and
pork onto the market. This will shift the supply curve left from SS to S’S’:

P D S' S

E'
Price

S'

D
S

Quantity Q

The price of pig-produce will rise as the quantity falls. If the price elasticity of demand is
inelastic (ED < 1), then the percentage change in price will be more than the percentage
change in quantity, and total incomes for pig farmers (equal to price times quantity
demanded) will rise. This is likely to be the case as farm produce is a necessity rather than
a luxury, and while people can substitute beef or chicken for a while, few would forgo
pig-products for a great length of time.
 This can be seen on the supply-and-demand diagram, where the area of the rectangle
going from the origin to the equilibrium point increases as the equilibrium price rises.
e. Look at the impact of the minimum wage shown in Figure 4-12. Draw in the
rectangles of total income with and without the minimum wage. Which is larger? Relate
the impact of the minimum wage to the price elasticity of demand for unskilled
workers.
Figure 4-12, with rectangles of total incomes with and without the minimum wage drawn
in, is given below:

Wages D S

Wmin E U LF
Price

Wmarket
M

S D

Quantity Employment

Total incomes are larger when the minimum wage is in place. This can be seen because
the area of the rectangle drawn from the origin to E (in light blue) is larger than that of
the rectangle drawn from the origin to M (in light pink).
This is because the demand for unskilled workers is inelastic. A percentage change in
wages (price) yields a proportionally smaller percentage change in employment
(quantity). Total incomes, which are the product of wages and employment, will be
increased.
9. No one likes to pay rent. Yet scarcities of land and urban housing often cause rents to
soar in cities. In response to rising rents and hostility towards landlords, governments
sometimes impose rent controls. These generally limit the increases on rent to a small
year-to-year increase and can leave controlled rents far below free-market rents.
a. Redraw Figure 4-13 to illustrate the impact of rent controls for apartments.
 P D' D S
E

Price
E' Rent ceiling

S D' D

Quantity Q

Rent controls will reduce rents, but it will create a shortage of apartments, as shown by
the distance between the demand curve DD and the supply curve SS – see the red line.
b. What will be the effect of rent controls on the vacancy rate of apartments?
At the rent ceiling, supply is greater than demand. There is a shortage of apartments – it
is very difficult to find vacancies.
c. What nonrent options might arise as a substitute for the higher rents?
The shortage of apartments means they will need to be rationed by a nonrent
mechanism. A likely mechanism is political allocation to those who meet criteria of need.
d. Explain the words of a European critic of rent controls: “Except for bombing, nothing
is as efficient at destroying a city as rent controls.” (Hint: What would happen to
maintenance?)
Rising prices act as a signal to increase supply. With rent control, prices cannot rise to do
this. Therefore there will be a lack of investment in apartments. If an apartment needed
maintenance, the owner could not charge higher rent to pay the maintenance costs, so
the maintenance would likely not be done.
10. Review the example of the New Jersey cigarette tax. Using graph paper or a computer,
draw supply and demand curves that will yield the prices and quantities before and
after the tax. For this example, assume that the supply curve is perfectly elastic. [Extra
credit: A demand curve with constant price elasticity takes the form 𝒀 = 𝑨𝑷−𝒆 , where
Y is the quantity demanded, P is price, A is a scaling constant, and e is the (absolute
value) of the price elasticity. Solve for the values of A and e which will give the correct
demand curve for the prices and quantities in the New Jersey example.]

New Jersey doubled its cigarette tax from 40 cents to 80 cents per pack in 1998. This tax
increase pushed the average price of cigarettes from $2.40 to $2.80 per pack. Cigarette
consumption decreased from 52 million to 47.5 million packs.
Plotting the two equilibrium points, labelled E and E’, on a price-quantity diagram:

2.85
P 2.80
E'
2.75
2.70
2.65
2.60
2.55
2.50
2.45
2.40 E
2.35
47 48 49 50 51 52 53

Assuming the supply curves are perfectly elastic (so they are horizontal), the supply
curves, SS and S’S’, can be added. Note that the supply curve has been shifted upwards
by 40 cents, the amount of the cigarette tax.

2.85
P 2.80
S' E' S'
2.75
2.70
2.65
2.60 0.40
2.55
2.50
2.45
2.40
E
S S
2.35
47 48 49 50 51 52 53

Any demand curve that joins the two equilibrium points in red will yield the prices and
quantities before and after the tax:
 2.85
P 2.80 S' E' S'
2.75 D
2.70
2.65
2.60 0.40
2.55
2.50
2.45
2.40
E
S D S
2.35
47 48 49 50 51 52 53

The Extra credit part of the question states that the demand curve is of the form:
𝑌 = 𝐴𝑃 −𝑒 .

Before tax, Y = 52 million, P = 2.40, so: 52 × 106 = 𝐴2.40−𝑒 . . . (1)

After tax, Y = 47.5 million, P = 2.80, so: 47.5 × 106 = 𝐴2.80−𝑒 . . . (2)

Taking (1) / (2):

The A’s on the top
52×106 𝐴2.40−𝑒
= and bottom of the
47.5×106 𝐴2.80−𝑒 fraction cancel

2.40−𝑒
1.09 = ∴ 1.09 × 2.80−𝑒 = 2.40−𝑒
2.80−𝑒

Taking natural logarithms (ln or loge) of both sides:

ln(1.09 × 2.80−𝑒 ) = ln 2.40−𝑒 Rules for logarithms:

ln 1.09 + ln 2.80−𝑒 = ln 2.40−𝑒
ln 1.09 − 𝑒 ln 2.80 = −𝑒 ln 2.40 ln ab = ln a + ln b
ln 1.09 = (ln 2.80 − ln 2.40)𝑒 ln cd = d ln c

0.091 = 0.154𝑒

0.091
∴ 𝑒 = 0.154 = 0.59

(N.B. Here, the natural logarithm, ln, is used; although a logarithm with any base, such
as 𝑙𝑜𝑔10, would yield the same result)
 Putting 𝑒 = 0.59 into (1): 52 × 106 = 𝐴2.40−0.59

52 × 106
∴𝐴= −0.59
= 8.7 × 107
2.40

So a demand curve with constant price elasticity, that yields the prices and quantities
before and after the tax, will be of the form:

𝑌 = 8.7 × 107 𝑃−0.59

If this is plotted:

2.85
P 2.80 S' E' S'
D
2.75
2.70
2.65
2.60 0.40
2.55
2.50
2.45
E
2.40
S D S
2.35
47 48 49 50 51 52 53

N.B. Zooming out, to see what a demand curve of constant elasticity looks like:

6.00
P D
5.00

4.00

3.00 S' E' S'

2.00 S E S

1.00
D
0.00
0 50 100 150 200 250 300 350 400