CHAPTER 3 SUPPLY AND DEMAND: AN INITIAL LOOK

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1 CHAPTER 3 SUPPLY AND DEMAND: AN INITIAL LOOK 1. This question is intended to help students develop an intuitive sense of the origins of the demand curve. If you deal with this question in class or discussion section, it will be revealing to aggregate the students answers, and derive a market demand curve. It is also interesting to see whose purchases are sensitive to the price increase, and whose are not, and to speculate upon the reasons for the difference. 2. (a) The demand curve for a medicine that means life or death for a patient will be vertical, provided the patient has access to any money at all. One would not expect a decline in quantity demanded as the price rises, if that decline meant that the patient would die. (b) The demand curve for french fries in a food court with many other stands will be fairly flat, perhaps even horizontal. If the firm raises its price at all, many if not most of its customers will just move to a different stand. Thus a small change in price results in a large change in the amount of fries bought. 3. The answers to all three parts are shown in Figure 3-1. (a) Initially, the equilibrium price is $1.50, and the equilibrium quantity is 24,000 hamburgers, as shown by the intersection of D0 and S0. (b) The decrease in the price of beef increases the supply of hamburgers, from S0 to S1. So the equilibrium price falls (for example, to $1.25), and the equilibrium quantity rises (for example, to 28,000). (c) Returning to the original supply curve, an increase in the price of pizza raises the demand for hamburgers, to D1. This raises the price (for example, to $l.75), and raises the quantity (for example, to 26,000).

2 FIGURE The answers to all three parts are shown in Figure 3-2. (a) Initially, the equilibrium price is $240, and the equilibrium quantity is 32 million bicycles, as shown by the intersection of D0 and S0. (b) If demand falls by 8 million bikes per year, the new demand curve is D1. The price falls to $200, and the quantity falls to 28 million, as shown by the intersection of D1 and S0. Although demand falls by 8 million at each price, the quantity exchanged falls by only 4 million because the price fall has induced a movement out along the new demand curve, as well as a movement back along the old supply curve. (c) If supply falls by 8 million bikes per year, the new supply curve is S1. The price rises to $280, and the quantity falls to 28 million, as shown by the intersection of D0 and S1. Although supply falls by 8 million at each price, the quantity exchanged falls by only 4 million because the price increase has induced a movement out along the new supply curve, as well as a movement back along the old demand curve. (d) If demand and supply each fall by 8 million bikes per year, the equilibrium price is $240, and the equilibrium quantity is 24 million bicycles, as shown by the intersection of D1 and S1.

3 FIGURE The answers to all three parts are shown in Figure 3-3. (a) In market equilibrium, the price is $60 and the quantity is 1,200, as shown by the intersection of D and S0. (b) When the price ceiling of $50 is imposed, the quantity sold falls to 600, because this is all that sellers are willing to offer, even though buyers would prefer to buy 2,200 books.

4 (c) When the efficiency of publishing improves, the supply curve will move out, perhaps to S1. As shown, the price is still $50, the quantity has risen to 1,800, and there is still a shortage. There are two other possibilities, however. Supply could increase enough to intersect with demand at a price of $50, in which case 2,200 books would be sold and the shortage would disappear. If the increase in supply were even greater, the price ceiling would be ineffective, the price would fall below $50 and the quantity sold would rise above 2,200. FIGURE 3-3

5 6. The same diagram, Figure 3-4, can be used for all three cases, because they all entail a decline in demand, from D0 to D1. Price falls from P0 to P1, and quantity falls from Q0 to Q1. (a) In a drought, people have less need for umbrellas, so demand falls. (b) Popcorn is a complement for movie tickets, so when popcorn prices rise, the demand for tickets falls. (c) Coca-Cola is a substitute for coffee, so when the price of the soda falls, the demand for coffee falls. FIGURE 3-4

6 7. (a) Figure 3-5 (a) is the market for apartments. Without rent control, the equilibrium rent is PE and the equilibrium quantity is QE. When the rent ceiling of PC is imposed, the quantity offered on the market falls, eventually, to QC. At this low rent, there is considerable excess demand, or a shortage, for apartments. (b) Figure 3-5 (b) is the market for wheat. Without a price floor, the equilibrium price is PE and the equilibrium quantity is QE. When the price floor of PF is imposed, the quantity demanded in the market falls to QF. At this high price, there is an excess supply of wheat, and if the government is determined to maintain the price floor, it will have to absorb this surplus in one way or another. FIGURE In Figure 3-6 (a), the equilibrium price of milk is PE. The government wishes to raise the price to PF, and it therefore pays farmers to slaughter cattle. As a consequence, the supply curve falls to S1 and the price rises. The market for meat is shown in (b), where the added slaughters increase the supply to S1, cut the price to P1 and raise the quantity to Q1. FIGURE Figure 3-7 shows three different prices. P1 is an effective price ceiling, at which the quantity demanded, G, exceeds the quantity supplied, F. P2 is the equilibrium price, at which the quantity supplied and the quantity demanded are equal, at E. P3 is an effective price floor, at which the quantity supplied, I, exceeds the quantity demanded, H.

7 Consider first the price ceiling, P1. Since supply curves are positively sloped, at this price the quantity supplied must be less than at the equilibrium P2. And since sellers cannot be forced to sell any more than they wish, the quantity exchanged will be F, which is lower than the equilibrium quantity E, in spite of the fact that buyers wish to buy more, G. Consider next the price floor, P3. Since demand curves are negatively sloped, the quantity demanded at this high price will be less than the quantity demanded at the equilibrium. Since buyers cannot be forced to buy more than they want, the quantity exchanged at this price is H, which is less than the equilibrium quantity E. These results follow from the common-sense observation that exchange is voluntary. At any price above or below the market equilibrium price, the quantity exchanged is less than it would be at the equilibrium. FIGURE 3-7

8 10. Figures 3-8 (a) and (b) show the same increase in the demand curve, from D0 to D1. In (a) the supply curve is quite flat, and the resulting quantity increase, from Q0 to Q1, is large, while in (b) the supply curve is steep, and the quantity increase small. The difference is that in (a) the quantity supplied is very sensitive to small changes in price, while in (b) it is hardly sensitive at all. FIGURE The congressman was confused. Figure 3-9 shows the market for natural gas. If the supply curve is S0 and the demand curve D, then the equilibrium price is Pe, and the equilibrium quantity Qe. But a price ceiling of Pc has reduced the quantity sold to Qc. If the ceiling is removed, the quantity produced rises to Qe, but this increase is a market response to the increased price. The congressman has confused a movement along the supply curve with an increase in supply, which would be shown by a new supply curve S1, and which would indeed bring the price down to P1. But there is no reason to think that removal of the price ceiling will lead to such a shift in the supply curve. This is true even if new firms enter the market. Any increase in production induced by an increase in price (whether from existing firms or from new firms) is represented by a movement along the supply curve. A shift in supply occurs only when some factor other than price changes.

9 FIGURE Explanation (b) is more consistent with the data. If the principal change in the market had been an increase in supply of female workers, i.e., explanation (a), then female wages would have fallen. The fact that they increased, while employment also increased, means that demand for female workers must have grown. 13. (a) As Figure 3-10 (b) shows, the supply of tapes falls from S0 to S1. This leads to an increase in price to P1 and a reduction in quantity to Q1. (b) In Figure 3-10 (a), the demand for CDs, a substitute for tapes, rises when the price of tapes rises. Therefore there is both a higher price and a higher quantity of CDs. FIGURE (a) With a 30-cent tax per quart, Table 3-2 must be adjusted: Price Paid by Consumers Price Received by Farmers Quantity Supplied (dollars per quart) (dollars per quart) (billions of quarts per year)

10 (b) Using the new Table 3-2, Figure 3-11 shows that the new supply curve, S1 lies above the original curve, S0, by a distance of 30 cents at each output. The new equilibrium price is $1.40, and the new equilibrium quantity 50 billion quarts. FIGURE 3-11 (c) Yes, milk consumption falls by 10 billion quarts. (d) The equilibrium price rises by 20 cents, which is less than the tax. (e) Consumers pay two thirds of the tax, since the price they pay has risen by 20 cents. Producers pay one third, since the price they receive has fallen from $1.20 to $ (a) In equilibrium, quantity demanded equals quantity supplied: P = P 1500P = P = 12 Substitute P = 12 in either the supply or the demand equation to derive Q = (b) If tourists like t-shirts less, the new demand curve might be Q = P. Using the same method as in part (a), in equilibrium, P = 10 and Q = (c) Opening of the new stores might lead to an increase in the supply curve to Q = P. Set equal to the original demand curve, and using the method of part (a), this yields equilibrium price and quantity of P = 10 and Q =