Chapter 2: The Basics of Supply and DemandCHAPTER 2THE BASICS OF SUPPLY AND DEMANDTEACHING NOTESThis chapter reviews the basics of supply and demand that students should be familiar with from their introductory economics class. The instructor can choose to spend more or less time on this chapter depending on how much of a review the students require. This chapter departs from the standard treatment of supply and demand basics found in most other intermediate microeconomics textbooks by discussing some of the worlds most important markets (wheat, gasoline, and automobiles) and teaching students how to analyze these markets with the tools of supply and demand. The real-world applications of this theory can be enlightening for students.Some problems plague the understanding of supply and demand analysis. One of the most common sources of confusion is between movements along the demand curve and shifts in demand. Through a discussion of the ceteris paribus assumption, stress that when representing a demand function (either with a graph or an equation), all other variables are held constant. Movements along the demand curve occur only with changes in price. As the omitted factors change, the entire demand function shifts. It may also be helpful to present an example of a demand function that depends not only on the price of the good, but also on income and the price of other goods directly. This helps students understand that these other variables are actually in the demand function, and are merely lumped into the intercept term of the simple linear demand function. Example 2.9 includes an example of a demand and supply function which each depend on the price of a substitute good. Students may also find a review of how to solve two equations with two unknowns helpful. In general, it is a good idea at this point to decide on the level of math that you will use in the class. If you plan to use a lot of algebra and calculus it is a good idea to introduce and review it early on. To stress the quantitative aspects of the demand curve to students, make the distinction between quantity demanded as a function of price, Q = D(P), and the inverse demand function, where price is a function of the quantity demanded, P = D -1(Q). This may clarify the positioning of price on the Y-axis and quantity on the X-axis.Students may also question how the market adjusts to a new equilibrium. One simple mechanism is the partial-adjustment cobweb model. A discussion of the cobweb model (based on traditional corn-hog cycle or any other example) adds a certain realism to the discussion and is much appreciated by students. If you decide to write down the demand function so that income and other prices are visible variables in the demand function, you can also do some interesting examples, which explore the linkages between markets and how changes in one market affect price and quantity in other markets.Although this chapter introduces demand, income, and cross-price elasticities, you may find it more appropriate to return to income and cross-price elasticity after demand elasticity is reintroduced in Chapter 4. Students invariably have a difficult time with the concept of elasticity. It is helpful to explain clearly why a firm may be interested in estimating elasticity. Use concrete examples. For example, a Wall Street Journal article back in the spring of 1998 discussed how elasticity could be used by the movie industry so that different movies could have different ticket prices. This example tends to go over well as college students watch a lot of movies. This type of discussion can also be postponed until revenue is discussed.QUESTIONS FOR REVIEW1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market-clearing level?Assume the supply curve is fixed. The unusually hot weather will cause a rightward shift in the demand curve, creating short-run excess demand at the current price. Consumers will begin to bid against each other for the ice cream, putting upward pressure on the price. The price of ice cream will rise until the quantity demanded and the quantity supplied are equal.Figure 2.12. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold:a.An increase in the price of margarine.Most people consider butter and margarine to be substitute goods. An increase in the price of margarine will cause people to increase their consumption of butter, thereby shifting the demand curve for butter out from D1 to D2 in Figure 2.2.a. This shift in demand will cause the equilibrium price to rise from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2.Figure 2.2.ab.An increase in the price of milk.Milk is the main ingredient in butter. An increase in the price of m