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Chapter 4Demand, Supply, and EquilibriumQuestionsHow would you define a perfectly competitive market? Use an example to explain how you would apply the concept of ceteris paribus (holding all else equal) in such a market.Answer: In a perfectly competitive market, sellers are selling identical goods and services and individual buyers and sellers are not powerful enough to influence the market price. The reason why we often apply the ceteris paribus concept is that frequently we are interested in what factor is going to shift either the supply or demand curve to the left or right and what factors are going to increase or reduce demand or supply. For instance, one question could be—what is the impact of increasing the minimum wage on the demand for inferior products?How would you define diminishing marginal benefits? Using the examples below, explain if it is possible to experience diminishing marginal benefits.a.You are an ardent fan of animated movies. Are you going to be as excited for the eighth animated movie released in a given year (such as Wonder Woman or Spiderman) as you are when the first is released in the same year?b.You are a foodie (a person who loves eating quality food), and in your spare time you blog about new restaurants opening in localities near you. If 10 new places open up in a short period around your block, what is your possible level of enthusiasm for it?c.You love driving and owning fast sports cars. Will buying an extra unit of such cars have increasing or diminishing returns for you?Answer: Diminishing marginal benefit from a good suggests that the willingness to pay for an additional unit declines as more is consumed.a.The level of excitement decreases somewhat as each new animated movie is released. People may still watch them, but with less and less anticipation.b.As in the previous answer, you may like checking out new places; but it becomes more of a chore than a passion if there are too many restaurants opening in too short a time, and your enthusiasm will probably decline.c.Since you are more than just a fanyou are an addict; the more expensive something is, the more likely you are to buy it, assuming you have unlimited resources of money. For a person with this mindset, the more cars you have the more you crave. This means increasing marginal returns.How is the market demand schedule derived from individual demand schedules? How does the market demand curve differ from an individual demand curve?Answer: We would derive the market demand schedule by summing the individual demands at every possible price. So, for example, if Consumer 1 would buy 6 units of a good when the price is $5 and Consumer 2 would buy 4 units, then the market demand at $5 is 10 units.The market demand curve is the sum of the individual demand curves of all the potential buyers. The market demand curve plots the relationship between the total quantity demanded and the market price, holding all else equal.Explain how the following factors will affect the demand curve for houses in an mercial banks raise the housing loan rate.An increase in immigration results in a large increase in population in the economy.An increase in the income of people in the economy. Answer:Since people usually borrow from banks to finance the purchase of houses, we can consider housing loans and houses as complementary to each other. A higher interest rate will increase the cost of owning a house, leading to a decrease in the demand for houses. The demand curve for houses will shift to the left.The large increase in population will lead to an increase in the demand for houses. The demand curve for houses will shift to the right.Houses are considered as normal goods where people will buy more when their income increases. Hence, higher income will lead to an increase in the demand for houses. The demand curve for houses will shift to the right. In what ways do you think renewable energy is affecting the demand curve of oil? Answer: Renewable energy is much more sustainable. Thus, because of global warming, people are more likely to favor the use of this as opposed to oil, which releases quite a lot of greenhouse gases. It is therefore likely that the demand curve of oil will shift to the left, resulting in lower prices of oil.What does the Law of Demand state? What is the difference between an individual demand curve and a market demand curve?Answer: The Law of Demand states that in most cases, the quantity demanded rises when the price falls (holding all else equal).The market demand curve is the sum of the individual demand curves of all the potential buyers. The market demand curve plots the relationship between the total quantity demanded and the market price, holding all else equal.What is the difference between willingness to accept and willingness to pay? For a trade to take place, does the willingness to accept have to be lower, higher, or equal to the willingness to pay?Answer: Willingness to accept is the lowest price that a seller is willing to receive to sell an extra unit of a good, while willingness to pay is the highest price that a buyer is willing to pay for an extra unit of a good. For a trade to take place, the buyer’s willingness to pay must be greater than or equal to the seller’s willingness to accept.Explain how the following factors will affect the supply curve for cars.An increase in the working age population of a country.A restriction on the inflow of foreign labor employed in the car industry.More companies are producing cars. Answer: The growing working age population increases the pool of workers in the car production industry. This will increase the supply of cars and lead to a rightward shift in supply.The restriction of foreign labor employed in the car industry will increase wages in the car industry, thus increasing the cost of production of cars. The supply curve will shift to the left.As more companies start producing cars, the supply of cars will increase. This will lead to a rightward shift in supply. How do the following affect the equilibrium price in a market?A rightward shift in demandA leftward shift in supplyA leftward shift in supply and a rightward shift in demand of the same magnitudeA small rightward shift in supply and a large leftward shift in demandAnswers: Everything else remaining unchanged, a rightward shift in demand will increase the equilibrium price in the market.Everything else remaining unchanged, a leftward shift in supply will increase the equilibrium price in the market.Everything else remaining unchanged, a leftward shift in supply together with a rightward shift in demand of the same magnitude will increase the equilibrium price in the market.Everything else remaining unchanged, a small rightward shift in supply and a large leftward shift in demand will decrease the equilibrium price in the market. Assume a shipping company is offering a Caribbean cruise for anyone who lives in your city at the fixed price of $200 (the normal price is around $2,000). However, only a hundred people can take advantage of this offer. What would be the optimal way of distributing these tickets? Answer: At $200, it is quite probable that demand will exceed supply. This might lead to long queues or even riots to obtain these tickets. A more optimal option would be to host a public auction where people would be allowed to bid on these tickets. True enough, there would not be a hundred lucky people getting a cruise at a 90% discount, but also, people would not have to stand in a line and spend more time to purchase cruise tickets. The mechanism of an auction would ensure that the people who are interested, who consider it of value, and are able to pay for it will get the tickets.Problems Suppose your country has been doing really well since the end of the global financial crisis and, therefore, the wages have increased by 30 percent since 2008. In parallel, active workers represent 75 percent of the population. Using a generic supply curve and assuming steak is a normal commodity, show the impact on the price and quantity of steaks sold.Answers: When wages increase the demand curve shifts (in this case to the right, see textbook pp. 65). With a higher disposable income, it is logical that people will be able and willing to pay more for steaks. Thus, in this situation the equilibrium price and the equilibrium quantity increase. For further details see attached graph.The following two incidents involve simultaneous shifts in the demand and the supply curves. Analyze the final effects on the equilibrium price and quantity after the changes. Explain your answers.Severe drought at the peak of summer reduces the production of watermelons. With more people consuming the fruit to quench their thirst, the equilibrium quantity is unchanged. The government allocates land to build more houses in the country. At the same time, it relaxes the criteria of citizenship to entice more foreigners to settle down in the country. The price of house increases.Answers:The hot weather reduces the watermelon crop and thus, for a given price, supply decreases. This will increase the equilibrium price and decrease the equilibrium quantity of the fruit. At the same time, when more people consume watermelons, for a given price, the demand for watermelon increases. This will lead to a higher equilibrium price and higher equilibrium quantity of watermelons. Since the equilibrium quantity of watermelons ultimately remains unchanged, the supply curve shifts by the same magnitude as the demand curve.With more land available to build houses, for a given price, the supply of houses increases. This results in a lower equilibrium price and a higher equilibrium quantity in the housing market. As more people take up citizenship in the country, for a given price, the demand for houses increases. This will lead to a higher equilibrium price and a higher equilibrium quantity. Since the price of houses ultimately increases, the demand curve shifts by a larger magnitude than the supply curve.Sketch generic supply and demand curves for the housing market and label the equilibrium price and quantity.A booming economy increases the demand for housing. Show the shift in the demand curve on your graph. What does this do to the price and quantity in the market?You and a friend both notice that more houses are built in response to this change. Your friend says, “this is a sign that the supply curve is shifting as well.” You respond, “no, this is actually just a shift along the supply curve.” To help your friend understand, demonstrate what you mean on your graph.As it turns out, there actually is a shift in the supply curve due to an unrelated breakthrough in construction that lowers the cost of building houses. In what direction does the supply curve shift? Show this on your graph.Relative to the original price and quantity, what is the overall effect of both shifts on price and quantity?Answers:The price increases and the quantity increases. See first diagram.See the two red arrows on the supply curve; this represents a shift along the supply curve, which is different from a shift of the supply curve.A reduction in cost lowers the supply curve vertically, which is the same as a shift to the right, or an increase in the supply. See second diagram below.Quantity increases unambiguously. The overall effect on price is ambiguous as it depends on the size of the supply shift relative to the demand shift. As drawn, there is a slight increase in price, but with a slightly larger supply shift, price could remain the same or be even lower. Thailand is the world’s second-largest producer of Hard Drives after China. In 2011, there were severe floods in Thailand. Because the hard drive manufacturing factories had to shut down due to the flood, the cost of hard drives increased significantly.Draw and discuss a supply and demand diagram to explain the increase in hard drive prices.Is a computer and a hard drive a substitute or a complementary product? Explain.What do you think the impact of this flood has been on the equilibrium price and quantity of computers? Draw a supply and demand diagram for the computer market to explain your answer.Answers:The flood made the supply curve shift to the left, which made the price of hard drives increase and the quantity puters and hard drives are complementary products: one cannot function without the other. In addition, there is no substitute product for a hard drive.Since the two products are complementary, the increase of the price of one will lead to an increase in another. Hence, the price of computers will increase, and the quantity produced will decrease simultaneously, as you cannot create functioning computers without hard drives. The computer supply curve shifts to the left.Suppose nuclear reactors primarily provide the energy supply in your country. Your country is both sunny and windy at the same time and, therefore, many people have decided to set up sun collectors and wind farms as a cheaper alternative to obtaining electricity. Explain how this might affect the price of electricity in the country with the help of a graph. Would it still be feasible to create new nuclear reactors?Answer: The supply curve of electricity would shift to the right as new technology has been installed which makes electricity cheaper. Therefore, while the price of electricity decreases, the quantity of electricity increases. To answer the second question: no, it would not be feasible to open up new nuclear reactors since these are the most expensive options for the production of electricity. For each of the following situations, sketch the demand curve as accurately as possible.Appendectomy is a life-saving operation that some people need. Regardless of the price, the quantity demand is 300,000 every year.For any price above $5 absolutely nobody will buy your lemonade, but for any price below $5 you find that you are able to sell as much lemonade as you like.There is only one buyer. For any price above $100 this buyer wants nothing. For any price at or below $100 this buyer wants exactly 20 units.Answers:A vertical (“perfectly inelastic”) demand curve.A horizontal (“perfectly elastic”) demand curve. Note that above $5 the quantity demanded is zero (drawn explicitly in the graph, but often only implied in other graphs).This is a step “function” that jumps at the price of $100. At a price of exactly $100 the buyer is willing to buy any number of units, so it is actually preferable -- not just permissible -- to fill in this region with a horizontal line. (Also, technically speaking, the demand is not a “function” in the mathematical sense because the price of $5 maps into multiple quantities demanded.) A freshwater aqua farm in Singapore can breed tiger prawns and tilapia. Recently, it was found that there may be a risk of contracting a type of disease from the consumption of tiger prawns—this discovery has led to fear among its consumers. How will this affect the equilibrium price and quantity of tilapia in Singapore? Answer: The fear of contracting a disease from the consumption of tiger prawns decreases their demand. This will lead to a lower equilibrium price, thereby reducing profit in breeding tiger prawns. This, in turn, will decrease the demand for breeding tiger prawns at the freshwater aqua farm in Singapore. The consequent fall in the equilibrium price of conducting aquaculture, leads to an increase in the supply of tilapia. Thus, the supply curve for tilapia will shift to the right. In the diagram below, the equilibrium price falls from P1 to P2 and the equilibrium quantity increases from Q1 to Q2.Market for TilapiaSee Suppose one of your friends offered the following argument: A rightward shift in demand will cause an increase in price. The increase in price will cause a rightward shift of the supply curve, which will lead to an offsetting decrease in price. Therefore, it is impossible to tell what effect an increase in demand will have on price. Do you agree with your friend? If not, what is the flaw in your friend’s reasoning?Answer: The given argument is flawed because it claims that an “increase in price will cause a shift of the supply curve...” The increase in price will cause a movement along the supply curve and not movement of the curve.New York decides to reduce the consumption of sugary soda by imposing a minimum price of $2.50 per soda. The current equilibrium price is $1.50. Sketch the supply and demand for soda and show the effect of this policy. Clearly label the excess supply in your diagram.Answer: 1143000317500Lobsters are plentiful and easy to catch in August but scarce and difficult to catch in November. In addition, vacationers shift the demand for lobsters further to the right in August than in any other month. Compare the equilibrium price and quantity of lobsters in August to the equilibrium price and quantity of lobsters in November. Present and discuss a supply-and-demand diagram to explain your answers.Answer: The August demand and supply curves are DA and SA and therefore the August equilibrium price and quantity are PA and QA. As we move to November, the demand curve shifts to the left to DN and the supply curve shifts to the left to SN. The decrease in demand and decrease in supply both decrease the equilibrium quantity and therefore the November quantity QN is definitely less than QA. The decrease in demand decreases the equilibrium price but the decrease in supply increases the equilibrium price. Therefore, in general, we cannot know if the November price PN is less than, equal to, or greater than PA. In the diagram above, PN is less than PA but if the decrease in demand were small relative to the increase in supply we would have found that PN is greater than PA.As part of U.S. sugar policy (in 2013), the government offered to buy raw sugar from domestic sugarcane mills at an average price of 18.75 cents per pound. The government offer was made for as much raw sugar as sugar mills produced. Any raw sugar purchased by the government was not sold in the domestic market, as this might have caused raw sugar prices to fall. The price of 18.75 cents per pound was above the equilibrium price.Under this policy, what do you think the government’s demand curve for sugar looks like? What impact does this policy likely have on domestic sugar prices? Answers: Since the government is willing to buy any quantity of raw sugar at the 18.75 cents per pound, the demand curve is horizontal at that price. The government’s demand curve is shown in the following figure:Since the government guarantees that mills will get 18.75 cents per pound of raw sugar, they do not have an incentive to sell sugar to any buyer who offers less than that price. In effect, the government is raising the price of raw sugar to 18.75 cents per pounds. Also note that when the price falls below 18.75 cents, the millers sell the sugar to the government. Since the government does not re-sell this sugar in the open market, the domestic market price is very likely to increase. See The equilibrium price of coffee in an economy, measured in dollars, is about $2,000 per ton. To help the coffee farmers earn a higher income, the government set the price to $2,500 per ton.How will this affect the demand and supply of coffee in the coffee market? Construct a diagram for coffee to show the effect of the government action. Will the coffee farmers be better off?Answers:a.The price set above the market equilibrium level will lead to an increase in the quantity of coffee supplied but a decrease in the quantity of coffee demanded in the coffee market.b.At a market price of $2,500 per ton, the quantity supplied will exceed quantity demanded. There will be an excess supply of coffee in the market. Only those farmers who are able to sell their product at the higher price of $2,500 will be better off. Those who are unable to do so will be worse off.Note: This problem requires some basic algebra. The demand for ice cream is QD = 70 ? 4P, and the supply of ice cream is QS = 10 + 2P, where P is the price of ice cream. Find the equilibrium price and quantity of ice cream.Suppose consumers’ income increases and ice cream is considered as a normal good. As a result, the demand curve for ice cream becomes QD = 100 ? 4P. Find the new equilibrium price and quantity of ice cream.Answers: At equilibrium, the quantity demanded must be equal to the quantity supplied. Thus, we have 70 ? 4P = 10 + 2P. Solving for P, we have 60 = 6P and hence, P = 10. Substituting P = 10 into the demand or supply equation, we have Q = 70 – 4 (10) or 10 + 2 (10) = 30. The equilibrium price is $10, and the equilibrium quantity is 30 units.Equating the new QD with QS, we have 100 ? 4P = 10 + 2P. Solving for P, we have 90 = 6P and hence, P = 15. Substituting P = 15 into the demand or supply equation, we have Q = 100 – 4 (15) or 10 + 2 (15) = 40. The new equilibrium price of ice cream is $15 and the equilibrium quantity is 40 units. ................
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