BUS-111 MICROECONOMICS. PROBLEM SET 2 Demand and Supply

Transcription

1 BUS-111 MICROECONOMICS PROBLEM SET 2 Demand and Supply 1. What effect will each of the following have on the demand curve for petrol? a. a fall in the price of cars. b. a fall in the price of bus tickets. c. a fall in national income. d. a fall in the percentage of people who want to cycle to work. a. a fall in the price of cars is a fall in the price of a complement. This will increase the quantity that consumers wish to buy at each price. The demand curve shifts to the right. b. a fall in the price of bus tickets is a fall in the price of a substitute for car travel. Since car travel is a complement to petrol consumption, this should decrease the quantity that consumers wish to buy at each price. The demand curve shifts to the left. The position is a little more difficult because some buses may also use petrol rather than diesel. The demand by private motorists will fall but the demand from bus operators will rise. I have assumed that the net effect is negative. [This assumption appears to be shared by policymakers who argue that cheaper public transport will discourage car use and reduce pollution from petrol]. c. assuming petrol is a normal good, the lower average income for consumers leads to a fall in demand. The demand curve shifts to the left. d. at least some of the people who previously cycled will go by car or some other means of transport using petrol. This increases the demand for petrol. The demand curve shifts to the right. 2. What effect will each of the following have on the supply curve of coffee beans? a. a severe frost in the growing season in Brazil (Brazil is a major producer of coffee beans). b. a subsidy to coffee producers in Brazil. c. the introduction of a new machine that makes it cheaper to collect coffee beans. a. a severe frost in the growing season in Brazil reduces the quantity of coffee available at each price. This moves the supply curve of coffee bean to the left. b. a subsidy to coffee producers in Brazil means that they are willing to supply a given amount of coffee at a lower price. The supply curve shifts rightwards. c. the introduction of a new machine that makes it cheaper to collect coffee beans means that suppliers can supply a greater amount of coffee at any given price. The supply curve shifts rightwards. 3. What would be the short run effects on the market for fish and chips of each of the following (in terms of price and quantity)? a. an increase in the price of take-away pizzas. b. the public taking more seriously evidence that fatty foods cause ill health.

2 c. the spread of a disease affecting the production and hence cost of potatoes. d. if the disease in (c) caused a health scare. a. an increase in the price of take-away pizzas is an increase in the price of a substitute good. This increases demand for fish and chips (shifts the demand curve to the right): The price increases from P 0 to P 1, and the quantity traded increases from Q 0 to Q 1. b. the public taking more seriously evidence that fatty foods cause ill health will reduce the demand for fish and chips. The demand curve shifts to the left: The price falls from P 0 to P 1, and the quantity traded falls from Q 0 to Q 1. c. the spread of a disease affecting the production and hence cost of potatoes reduces the supply of fish and chips, shifting the supply curve to the left:

3 The price increases from P 0 to P 1, and the quantity traded falls from Q 0 to Q 1. d. if the disease in (c) caused a health scare, there would also be a contraction in demand as some people choose not to eat potato products. The demand curve shifts to the left, as well as the supply curve: The quantity of fish and chips traded definitely falls (from Q 0 to Q 1 ). What happens to the price is unclear. The contraction in supply puts an upward pressure on price, but the contraction in demand puts a downward pressure on price. In the diagram above, the demand effect is greater and the price falls overall. However, it is not clear from the question which effect would dominate, so we cannot tell for sure what would happen to the price. 4. What would be the effects of the following on the equilibrium price and quantity? a. a decrease in income (for a normal good). b. an increase in income (for an inferior good). c. a decrease in the price of a substitute. d. a decrease in the price of a complement. e. an increased preference for the commodity. a a decrease in income (for a normal good) reduces demand. Price and quantity traded fall.

4 b. an increase in income (for an inferior good) reduces demand. Price and quantity traded fall. c. a decrease in the price of a substitute reduces demand. Price and quantity traded fall. d. a decrease in the price of a complement increases demand. Price and quantity traded increase. e. an increased preference for the commodity increases demand. Price and quantity traded increase. 5. Using examples, explain the distinction between a. complements and substitutes. b. inferior and normal goods. a. Two goods are complements if an increase in the price of one causes a fall in demand for the other. These tend to be goods that tend to be used together, for example sand and cement. If the price of cement increased, then many people would put off doing concreting and rendering jobs and so they wouldn t need to buy any sand either. Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. These tend to be goods that could fulfil the same needs, for example beer and wine. If the price of wine increased, then many people would switch from drinking wine to drinking beer. b. Normal goods are those for which demand increases as people become richer. This includes the vast majority of goods from the everyday (e.g. phone calls) to top-end luxury goods (e.g. sports cars). Inferior goods are those for which demand decreases as people become richer. Few goods have this characteristic. The most notable exceptions are value brands which people tend to stop buying when they become richer. 6. Why do prices of some goods, like air flights, rise during times of heaviest consumption whilst others, such as vegetables, fall? The supply of air flights is relatively stable because it takes a long time to bring new planes into operation. The demand for flights, however, fluctuates greatly. In particular, demand for holiday flights are much higher during school holidays than during term time. In a market where supply is stable and demand fluctuates a lot, we would expect high prices to coincide with high quantities (when demand is high) and for low prices to coincide with low quantities (when demand is low). See the diagram below for an illustration:

5 The supply of vegetables fluctuates greatly with the seasons. The demand for vegetables, on the other hand, is relatively stable. People still like to eat peas in the winter, even when they are out of season. In a market where demand is stable and supply fluctuates a lot, we would expect high prices to coincide with low quantities (when supply is low) and for low prices to coincide with high quantities (when supply is high). See the diagram below for an illustration: 7. Free markets are preferable to central planning because the allocation of resources in a free market depends upon both the costs of production and the benefit to the consumer, whereas this is rarely the case in planned economies. Discuss In a free and competitive market, goods are supplied by those suppliers with reservation prices lower than the equilibrium price and bought by those with reservation prices above the equilibrium price. Resources are allocated via the price mechanism, with the equilibrium price being determined by both supply factors (production costs) and demand factors (the value that the consumer places on the product). Under central planning, bureaucrats are responsible for rationing and allocating resources. Ideally, their decisions will be based on factors such as the cost of production and the benefits that accrue to consumers. Unfortunately, good information on these factors is hard for bureaucrats to observe.

6 Consumers will generally have an incentive to over-report the benefits of consumption and producers will generally have an incentive to over-report the costs of production. Bureaucrats may also be subject to political pressures which distort their planning decisions. For these reasons, the allocation of resources in a centrally planned economy is unlikely to reflect accurately the costs of production and the benefit to the consumer.