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Short Answer Questions: Chapter 4
Q1. Explain the difference between separating and pooling equilibrium.
Q2. Do you think a market is always in equilibrium?
Q3. Explain the meaning of the Gresham Law.
Q4. What is a market surplus?
Q5. Do you think it is a sensible to increase production for a firm that faces an inelastic
demand curve?
Essay questions
E1. Describe how the introduction and the spread of Internet may have changed the
market equilibrium in the retail stores market.
E2. Explain why the car insurance market may represent a case of pooling equilibria and
how it can be transformed into a separating equilibrium.
ANSWERS:
Short Answer Questions
Q1. Explain the difference between separating and pooling equilibrium.
A: A separating equilibrium is where a market splits into two clearly identifiable submarkets with separate supply and demand. A pooling equilibrium is a market where
demand and supply for good and poor products pools into one demand and one
supply.
Q2. Do you think a market is always in equilibrium?
A. No, A market equilibrium occurs at the price where the willingness to demand by
consumers meets the willingness to supply by firms. If the equilibrium is unique,
this will happen at a unique combination (price, quantity). Any other combinations
of price and quantity that are not the equilibrium values are described as market
disequilibria.
Q3. Explain the meaning of the Gresham Law.
A. The Gresham’s Law states that an increasing supply of bad products will drive
out good products from the market. It refers to a situation of a pooling equilibrium.
Q4. What is a market surplus?
A. A market surplus is a disequilibrium situation, which emerges any time price is
not at its equilibrium level. If price is above its equilibrium level, the quantity firms
wish to sell at that price is greater than the quantity consumers wish to buy; hence
there is an excess supply. On the other hand, if price is below its equilibrium level,
the quantity firms wish to sell at that price is lower than the quantity consumers
wish to buy; hence there is an excess demand.
Q5. Do you think it is a sensible to increase production for a firm that faces an inelastic
demand curve?
A. No, it is not a sensible strategy if the firm wants to maximise profits because the
price will drop quicker than output increases and your total revenues will fall.
Essay questions
E1. Describe how the introduction and the spread of Internet may have changed the
market equilibrium in the retail stores market.
Answer guidelines. The Internet is a technological improvement that allows retailers
to cut production costs. A cut in the cost of production has the effect of shifting the
supply curve to the right: at any given price, the retailer is willing to sell more
output than before. Ceteris paribus, this would lead to a lower price and a larger
quantity in equilibrium. On the other hand, the Internet may also reduce the costs
that consumer may incur to buy from a shop. Hence, it may also shift the demand
curve to the right. In the new equilibrium position, price may be above, below or at
the same level as the previous one.
E2. Explain why the car insurance market may represent a case of pooling equilibria and
how it can be transformed into a separating equilibrium.
Answer guidelines. The car insurance market is a case where the Gresham Law
applies. Companies would charge a lower price to good car drivers and a higher one
to bad drivers. Hence, if they are unable to separate one from the other and the
market is pooled, one unique equilibrium price will prevail. Such a price will be
lower than what would have prevailed on a sub-market for bad drivers, and higher
than what would have prevailed in a sub-market for good drivers. Hence, bad
drivers will find it more convenient to insure and will drive out of the markets good
drivers who are paying a price they are not willing to pay. A strategy for the
insurance companies is then to separate good from bad drivers and create two submarkets with different demand and supply curves. This is why the insurance
company asks for many details before quoting you a price for car insurance. How
old are you? How many years no claims do you have? Where do you live? What
type of car do you drive? The insurer is trying to separate the market by assessing
whether you are a good, or bad risk.