Download Markets--OLDA

Principles of Economics
EC 201
Cal Poly Pomona
Fall, 2007
Dr. Bresnock
Name:
Section/Time:
Markets Module Assignment Answers (50 points)
Please limit your answers to the spaces provided. If necessary, write on the back of the page.
Do not attach printout or additional pages. All questions pertain to the Markets module in the
SimEcon software package. Make sure you have read the “Markets Manual” which may be
found at the ClassWeb site prior to beginning the assignment. For many of the assignment's
questions, it will be necessary to refer to those instructions. For many of the assignment's
questions, it will be necessary to refer to your text. Please use this website to obtain the module:
http://class-ms-web.class.csupomona.edu/
To begin the assignment, launch the Markets module and note the “original conditions” which
are the beginning values for each supply and demand variable. Write these values down for
future reference. Now, click on “Continue” in the tool bar at the top of the screen. Write down
the initial equilibrium values for the price, Pe, and quantity, Qe, of wheat.
(1)
Disturb the wheat market by increasing the price of corn from $10/bushel to $12/bushel.
For this market disturbance:
(a)
Write a brief statement explaining how the market responds to this disturbance.
(Be sure to include distinctions between changes in demand vs quantity demanded
and changes in supply vs quantity supplied.) You must print out the graph and
label all distinctions and market adjustments in it. Write the statement in the
space below and attach the graph to the back of this page.
Corn and wheat are substitutes. If the price of corn goes up, people will buy
more wheat, which will increase the demand for wheat. This will increase
the equilibrium price of wheat from $23.39 to $23.49 and will increase the
equilibrium quantity from 869.59 bushels to 874.59 bushels.
The market adjusts to the increase in Demand as shown on the graph on the
next page. The market adjustment process is as follows:
(1)
(2)
(3)
(4)
The increase in demand is indicated by the movement from D1 to D2.
This creates a temporary shortage, (QD > QS), which is indicated by
the distance from Pt. A  Pt. B.
This shortage causes the price to rise to the new equilibrium price PE2
at Pt. C.
This increase in price also causes the quantity supplied to increase to
the new equilibrium quantity QE2.
EC 201
Markets Module Assignment Answers
Page 2
Price
S
C
PE2
A
B
PE1
D2
D1
QE 1
(b)
QE2
QD
Quantity
Compare the old equilibrium price and quantity points and calculate the price
elasticity between those points. You must include a complete calculation and
interpretation of this price elasticity in the space below.
(869.59 – 874.59)
(869.59 + 874.59) / 2
(23.39 – 23.49)
(23.39 + 23.49) / 2
=
1.34
This is elasticity of supply.
The elasticity of supply indicates that for every 1% increase in price, there is
a 1.34 % increase in quantity supplied, and vice versa.
(2)
Fill in the table below which is based on your record of price and quantity information in
the wheat market as the amount of rainfall is changed (by you). (Base your elasticity
calculations on the increases in the price of wheat as rainfall is reduced from 18 inches,
then from 16 inches to 10 inches, etc.) (Round all of your entries to the nearest
hundredth).
Market
Disturb.
Price
Quantity
Total Revenue
Rain = 18
$14.06
962.92
$13,538.655
Rain = 16
$16.39
939.59
$15,399.880
-0.160
Rain = 10
$23.39
869.59
$20,339.710
-0.220
Rain = 08
$25.73
846.25
$21,774.012
-0.286
Elasticity
EC 201
Markets Module Assignment Answers
(a)
Page 3
Review your results and briefly interpret your elasticities in the space below
These are computations of the price elasticity of demand. The Law of
Demand indicates that this type of elasticity will always be negative, which is
the case here. Since the absolute values of all the elasticities are between 0
and 1, we can say that demand is inelastic over the range of prices indicated.
For example, the first elasticity indicated, -0.160, indicates that for every 1%
increase in price, there is a 0.160% decrease in quantity demanded, and vice
versa.
The second elasticity indicated, -0.220, indicates that for every 1% increase
in price, there is a 0.220% decrease in quantity demanded, and vice versa.
The third elasticity indicated, -0.286, indicates that for every 1% increase in
price, there is a 0.286% decrease in quantity demanded, and vice versa.
(b)
Now provide a brief discussion of the relationship between the changes in price,
and your calculations for total revenue and elasticity in the space below. In this
discussion, comment on whether your interpretation agrees with the coverage of
this relationship found in your text and class lecture notes.
Economic theory states that when the absolute value of the price elasticity of
demand is between zero and one, total revenue will increase as the price
increases. This is the case in the example provided. As the rainfall is
reduced, the equilibrium price goes up (due to a decrease in supply). This
increase in the equilibrium price raises the total revenue to the producer.
This is because the decrease in quantity is proportionately less than the
increase in price.
(3)
What are the ceteris paribus supply and demand conditions in the Markets module?
Your answer should first contain a definition of what is meant by ceteris paribus and
what that means in this model of the wheat market. A complete answer will include
verbal and numerical explanations in the space below:
Ceteris paribus means that all other factors other than the one being studied are
held constant. We do this in order to isolate the effects of the factor being studied.
The demand conditions that are held constant are as follows: (1) income of buyers
($5 trillion); (2) prices of substitute goods (Price of corn = $10/bushel); (3) prices of
complement goods (Price of utter = $4/lb.); (4) number of buyers; (5) tastes and
preferences. The supply conditions that are held constant are as follows: 1)
availability and cost of factors of production (Seed cost = $10/lb.); 2) number of
sellers (1,000) and; 3) the state of technology.
EC 201
Markets Module Assignment Answers
Page 4
If one of these factors is not held constant, then the entire curve will shift. For
example, in the last question, supply shifted to the left (supply decreased) as the
rainfall was decreased. This is because as rainfall decreased, the cost of a factor of
production, moist land, increased. This is indicated in the graph below:
S2

P
S1
P2
P1
D
Q2 Q1
Q
Restart the “Markets Module”.
(4)
Choose an “effective” price ceiling. Write the value of your price ceiling here $22 (for
example) . Offer a complete explanation of why your price ceiling is “effective” and the
complete quantitative and qualitative results of this price regulation in the space below.
Include a completely specified graph in your answer.
In order to be effective, a price ceiling must be below the equilibrium price. Thus,
any price below $23.39 would be effective. If the price ceiling was equal to or above
the equilibrium price, then buyers and sellers would just remain at equilibrium. In
this case, the ceiling would have no effect on the market.
When an effective price ceiling is imposed, this forces a price below equilibrium.
The quantity demanded will be greater than the quantity supplied, which creates a
shortage. This is indicated as the distance from Pt. A to Pt. B in the graph on the
top of the next page.
I chose a price of $22.00. This leads to a legal price of $22, an illegal price of $30.35,
a quantity supplied of 800, a quantity demanded of 883.50, and a shortage of 83.50.
See work below (the equation is from the Markets Manual). Farmers’ revenue is
$17,600 and criminals’ profits are $6,680.
QD = 1000 – 10(PW) + 3(PC) -.5(PB) + .3(Pop) + .10(Inc)
= 1000 – 10(22) + 3(10) -.5(4) + .3(250) + .10(5)
= 983.5 – 800
= 83.5 = Shortage = AB
(See Graph on top of next page).
EC 201
Markets Module Assignment Answers
Page 5
The misallocation of resources is found by comparing the quantity supplied of 800
with the equilibrium quantity of 869.59. This difference of 69.59 units represents
the misallocation of resources of too little produced at the price ceiling.
Price
At PC there is a shortage of QD – QS = 83.5
QD – QS = 883.5 – 800 = 83.5
S
PE
A
$22
B
D
Quantity
0
QS
QE
QD
Misallocation of Resources
(5)
Now change your price regulation by imposing a price floor of $35.
Is this “effective”? Why or why not? Your answer must include quantitative and
qualitative results of this price regulation in the space below. Include a
completely specified graph in your answer. Does this sort of wheat price
regulation agree with current U.S. farm policy? Why or why not?
(a)
In order to be effective, a price floor must be above the equilibrium price. If
a price floor was equal to or below the equilibrium price, then buyers and
seller would just operate at equilibrium and the floor would have no impact
on the market. Since $35 is above the equilibrium price of $23.39, it is
effective.
When the price floor is enacted, buyers and sellers will be forced to operate
at a higher price than would clear the market. Quantity supplied would be
greater than quantity demanded, so there will be a surplus. This is indicated
in the graph below. The amount of surplus is indicated by the distance from
Pt. A to Pt. B in the graph below:
Price
$35
A
S
B
PE
D
0
753.5 QE 1450
Quantity
EC 201
Markets Module Assignment Answers
Page 6
A price floor of $35 would lead to a quantity demanded of 753.50, a quantity
supplied of 1450, and a surplus of 696.5. Farmers’ revenues would be $1,450,
because the government would buy up all the surplus produce.
The misallocation of resources is found by comparing the quantity supplied
of 1,450 with the equilibrium quantity of 869.59. This difference of 580.41
units represents the misallocation of resources of too much produced at the
price floor.
This type of regulation has been more typical of U.S. farm policy. Although
U.S. farm policy usually tried to increase the price by paying farmers not to
grow (quantity regulation), the U.S. government also achieved the same end
by setting minimum prices (price floors or price supports). The recent
Freedom to Farm Act (1996) ended price supports to grains, including wheat.
During the transition away from the past subsidy programs, the government
is following a declining subsidy payment plan.
(b)
Suppose that the government wished to achieve the same result with a production
control as the result you achieved with the price floor of $35. What would that
production control be and why? Explain your answer briefly in the space below.
Include a completely specified graph in your answer. Does this sort of wheat
price regulation agree with current U.S. farm policy? Why or why not?
To achieve a price of $35 by controlling production, the government would
limit production to 753.50 units. With only this amount produced, buyers
would be willing to spend $35 for it. This would be indicated as a vertical
supply line at 753.50 units in the graph above.
This is very typical of U.S. farm policy. The government maintains an
artificially high price by controlling production. If you hear people
complaining about the government paying farmers not to grow, this is why.
It is due to the powerful farm lobby that elects two senators from each rural
state.