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This must always be true if the industry™s demand curve has a negative slope, because
the greater quantity supplied can be sold only if the price is decreased so as to induce
customers to buy more.6 The cellular phone industry is a case in point. As more providers

Graphically, whenever a positively sloped curve shifts to the right, its intersection point with a negatively slop-

ing curve must always move lower. Just try drawing it yourself.

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Part 1
68 Getting Acquainted with Economics

F I GU R E 9
Effects of Shifts of the Supply Curve



S0 $7.40

Price per Pound
Price per Pound


I S1 7.20
60 65 78 37.5 50 60
Quantity Quantity
(a) (b)

have entered the industry, the cost of cellular service has plummeted. Some cellular carri-
ers have even given away telephones as sign-up bonuses.
Figure 9(b) illustrates the opposite case: a contraction of the industry. The supply curve
shifts inward to the left and equilibrium moves from point E to point V, where the price is
$7.40 and quantity is 500 million pounds per year. In general:
Any influence that shifts the supply curve to the left, and does not affect the demand
curve, will raise the equilibrium price and reduce the equilibrium quantity.
Many outside forces can disturb equilibrium in a market by shifting the demand curve or
the supply curve, either temporarily or permanently. In 1998, for example, gasoline prices
dropped because recession in Asia shifted the demand curve downward, as did a reduction
in use of petroleum that resulted from a mild winter. In the summer of 1998, severely hot
weather and lack of rain damaged the cotton crop in the United States, shifting the supply
curve downward. Such outside influences change the equilibrium price and quantity. If you
look again at Figures 8 and 9, you can see clearly that any event that causes either the de-
mand curve or the supply curve to shift will also change the equilibrium price and quantity.

The disturbing increases in the price of gasoline, and of the oil from which it
is made, is attributable to large shifts in both demand and supply conditions.
Americans are, for example, driving more and are buying gas-guzzling vehi-
cles, and the resulting upward shift in the demand curve raises price. Insta-
bility in the Middle East and Russia has undermined supply, and that also
raised prices. We have seen the results at the gas pumps. The following news-
paper story describes a sensational sort of change in supply conditions:
Aug. 10 (Bloomberg)”BP Plc and its partners in the Prudhoe Bay oil field in Alaska
will spend about $170 million inspecting and repairing corroded pipelines that shut
most of the production from the largest U.S. oil field.
Including costs to clean up and repair a line that leaked in March, the “rough estimate”
rises to about $200 million, said Kemp Copeland, field manager for BP™s Prudhoe Bay op-
erations. The figures include the cost of replacing 16 miles of feeder pipeline in the field.
The worst cost to BP will probably be the hit to its reputation, said Mark Gilman, an
analyst at The Benchmark Company LLC in New York, who rates the shares “sell.”

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Chapter 4 69
Supply and Demand: An Initial Look

“At some point this is going to prove very costly, as you™re going to be competing
with folks whose reputation has not been subject to the same degree of punish-
ment,” Gilman, who owns a “small” number of BP shares, said today in a phone
The Prudhoe Bay shutdown is the latest blow for Chief Executive Officer John
Browne, who faces a grand jury probe for an earlier Alaska spill, charges of market ma-
nipulation in the U.S. propane industry and fines from a Texas refinery blast that killed
15 workers. BP, which gets 40 percent of its sales from the U.S., last month said it will
boost spending there to improve safety and maintenance.
London-based BP Plc said today it will know by the start of next week whether it can
keep operating the western half of the field, which is currently producing as much as
137,000 barrels of oil a day. The entire field pumps 400,000 barrels a day, or 8 percent of
U.S. output, when fully operational.

BP is asking suppliers U.S. Steel Corp. and Nippon Steel Corp. for faster delivery to
a total of 51,000 feet of pipe it has already ordered for the repairs, BP Alaska President
Steve Marshall said in conference call on Aug. 8. The pipe is scheduled to be delivered
in October the earliest.
A supplier for another 30,000 feet of 24-inch pipe and 52,000 feet of 18-inch pipe is
still needed, said Marshall.
BP, Houston-based ConocoPhillips and Exxon Mobil Corp. of Irving, Texas, are joint
owners in the Prudhoe Bay field. ConocoPhillips, the third-largest U.S. oil company,
earlier today declared force majeure on oil deliveries from Prudhoe Bay.
Force majeure allows companies to avoid penalties for failing to fulfill contracts be-
cause of unforeseen events. ConocoPhillips sells its Alaskan crude oil to refineries and
brokers, according to spokesman Bill Tanner.
SOURCE: Ian McKinnon and Sonja Franklin, “BP Says Prudhoe Bay Repair Costs May Be $200 Million,” with
reporting by Jim Kennett in Houston. Editor: Jordan (rsd)

Application: Who Really Pays That Tax?
Supply-and-demand analysis offers insights that may not be readily apparent. Here is an ex-
ample. Suppose your state legislature raises the gasoline tax by 10 cents per gallon. Service
station operators will then have to collect 10 additional
cents in taxes on every gallon they pump. They will con-
Who Pays for a New Tax on Products?
sider this higher tax as an addition to their costs and will
pass it on to you and other consumers by raising the
price of gas by 10 cents per gallon. Right? No, wrong”or
rather, partly wrong. S1
The gas station owners would certainly like to pass on
the entire tax to buyers, but the market mechanism will M
Price per Gallon

allow them to shift only part of it”perhaps 6 cents per E1
gallon. They will then be stuck with the remainder”
4 cents in our example. Figure 10, which is just another
supply-demand graph, shows why. 2.54
The demand curve is the red curve DD. The supply S1 E0
curve before the tax is the black curve S0S0. Before the
new tax, the equilibrium point is E0 and the price is
$2.54. We can interpret the supply curve as telling us at D
what price sellers are willing to provide any given
Q2 Q1
quantity. For example, they are willing to supply
30 50
quantity Q1 5 50 million gallons per year if the price is
Millions of Gallons per Year
$2.54 per gallon.

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Part 1
70 Getting Acquainted with Economics

So what happens as a result of the new tax? Because they must now turn 10 cents per gal-
lon over to the government, gas station owners will be willing to supply any given quantity
only if they get 10 cents more per gallon than they did before. Therefore, to get them to sup-
ply quantity Q1 5 50 million gallons, a price of $2.54 per gallon will no longer suffice. Only
a price of $2.64 per gallon will now induce them to supply 50 million gallons. Thus, at quan-
tity Q1 5 50, the point on the supply curve will move up by 10 cents, from point E0 to point
M. Because firms will insist on the same 10-cent price increase for any other quantity they
supply, the entire supply curve will shift up by the 10-cent tax”from the black curve S0S0 to
the new brick supply curve S1S1. And, as a result, the supply-demand equilibrium point will
move from E0 to E1 and the price will increase from $2.54 to $2.60.
The supply curve shift may give the impression that gas station owners have succeeded
in passing the entire 10-cent increase on to consumers”the distance from E0 to M”but
look again. The equilibrium price has only gone up from $2.54 to $2.60. That is, the price
has risen by only 6 cents, not by the full 10-cent amount of the tax. The gas station will
have to absorb the remaining 4 cents of the tax.
Now this really looks as though we have pulled a fast one on you”a magician™s sleight of
hand. After all, the supply curve has shifted upward by the full amount of the tax, and yet
the resulting price increase has covered only part of the tax rise. However, a second look
reveals that, like most apparent acts of magic, this one has a simple explanation. The expla-
nation arises from the demand side of the supply-demand mechanism. The negative slope of
the demand curve means that when prices rise, at least some consumers will reduce the
quantity of gasoline they demand. That will force sellers to give up part of the price increase.
In other words, firms must absorb the part of the tax”4 cents”that consumers are unwill-
ing to pay. But note that the equilibrium quantity Q1 has fallen from 50 million gallons to
Q2 5 30 million gallons”so both consumers and suppliers lose out in some sense.
This example is not an oddball case. Indeed, the result is almost always true. The cost of
any increase in a tax on any commodity will usually be paid partly by the consumer and
partly by the seller. This is so no matter whether the legislature says that it is imposing the
tax on the sellers or on the buyers. Whichever way it is phrased, the economics are the same:
The supply-demand mechanism ensures that the tax will be shared by both of the parties.

As we noted in our Ideas for Beyond the Final Exam in Chapter 1, lawmakers and rulers
have often been dissatisfied with the outcomes of free markets. From Rome to Reno,
and from biblical times to the space age, they have battled the invisible hand. Some-
times, rather than trying to adjust the workings of the market, governments have tried
to raise or lower the prices of specific commodities by decree. In many such cases, the
authorities felt that market prices were, in some sense, immorally low or immorally
high. Penalties were therefore imposed on anyone offering the commodities in question
at prices above or below those established by the authorities. Such legally imposed con-
straints on prices are called “price ceilings” and “price floors.” To see their result, we will
focus on the use of price ceilings.

Restraining the Market Mechanism: Price Ceilings
The market has proven itself a formidable foe that strongly resists attempts to get around
its decisions. In case after case where legal price ceilings are imposed, virtually the same
A price ceiling is a maxi-
mum that the price charged series of consequences ensues:
for a commodity cannot
1. A persistent shortage develops because quantity demanded exceeds quantity supplied.
legally exceed.
Queuing (people waiting in lines), direct rationing (with everyone getting a fixed
allotment), or any of a variety of other devices, usually inefficient and unpleasant,
must substitute for the distribution process provided by the price mechanism. Ex-
ample: Rampant shortages in Eastern Europe and the former Soviet Union helped
precipitate the revolts that ended communism.

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Chapter 4 71
Supply and Demand: An Initial Look

Economic Aspects of the War on Drugs
For years now, the U.S. government has engaged in a highly publi- related. One major reason is that street prices of drugs are so high
cized “war on drugs.” Billions of dollars have been spent on trying that addicts must steal to get the money, and drug traffickers are all
to stop illegal drugs at the country™s borders. In some sense, inter- too willing to kill to protect their highly profitable “businesses.”
diction has succeeded: Federal agents have seized literally tons of How would things differ if drugs were legal? Because South
cocaine and other drugs. Yet these efforts have made barely a dent American farmers earn pennies for drugs that sell for hundreds of
in the flow of drugs to America™s city streets. Simple economic rea- dollars on the streets of Los Angeles and New York, we may safely
soning explains why. assume that legalized drugs would be vastly cheaper. In fact, ac-
When drug interdiction works, it shifts cording to one estimate, a dose of cocaine
the supply curve of drugs to the left, thereby would cost less than 50 cents. That, propo-
driving up street prices. But that, in turn, nents point out, would reduce drug-related


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