Download Principles of Microeconomics Professor Eric Jamelske Homework 2

Economics 268
Principles of Microeconomics
Professor Eric Jamelske
Name ____**SOLUTIONS**_______
Homework 2
Answer the following questions on your own paper and staple your work together with this sheet. Please be
very neat and organized and spread your work out so that each answer is easy to interpret.
In each case below, using a standard supply and demand diagram, draw the supply and demand curves for the given
market situation and identify the initial equilibrium price and quantity. Then answer these questions for the stated
change (shock). Does the supply curve or the demand curve shift and in which direction? What affect will this
shock have on the price and the quantity that is transacted? In each case clearly describe the process of adjustment to
the new equilibrium and adapt your original diagram to illustrate the appropriate changes. Be sure to label all new
curves and key points.
1. In the market for corn, show the effect of a government mandated increase in the amount of ethanol (made from
corn) added to gasoline.
Corn
P
S
P2
P1
D2
D1
Q1
Q2
Q
This policy will increase the demand for corn as it is the main input for ethanol shifting the D curve right ↑D.
The quantity demanded will be higher at all prices causing a shortage and putting upward pressure on price.
As the price rises, sellers will respond by bringing more corn to market ↑ Qs.
P↑
Q↑
1
2. Show the impact of your answer to question 1 in the market for ground beef (corn is used as feed for cattle).
Ground Beef
S2
P
S1
P2
P1
Q2
Q1
Q
Because corn is a major input in the production of ground beef (feed for cattle) the rising price of corn will
increase the cost of producing ground beef shifting the supply curve to the left ↓S.
The quantity supplied will be lower at all prices causing a shortage and putting upward pressure on price.
As the price rises, buyers will respond by purchasing less ground beef ↓Qd.
P↑
Q↓
3. In the market for cars, show the effect of a decrease in the price of steel.
Cars
S1
P
S2
P1
P2
D
Q1
Q2
Q
Because steel is a major input in the production of cars the falling price of steel will decrease the cost of
producing cars shifting the supply curve to the right ↑S.
The quantity supplied will be higher at all prices causing a surplus and putting downward pressure on price.
As the price falls, buyers will respond by purchasing more cars ↑ Qd.
P↓
Q↑
2
4. Show the impact of your answer to question 3 in the market for gasoline
Gasoline
P
S
P2
P1
D2
D1
Q1
Q2
Q
Because gas is complementary to cars the increase in car purchases will mean that people will also want more
gas shifting the demand curve to the right ↑D.
The quantity demanded will be higher at all prices causing a shortage and putting upward pressure on price.
As the price rises, sellers will respond by bringing more gas to market ↑ Qs.
P↑
Q↑
5. In 1995, the Food & Drug Administration (FDA) published new labeling standards for bottled water. Prior to this,
bottlers could sell ordinary tap water under a bottled water label. In fact, the FDA estimated that about 25% of
bottled water was plain tap water. Show the effect of this policy in the market for bottled water.
Bottled Water
S2
P
S1
P2
P1
Q2
Q1
Q
This policy will eliminate 25% of the market supply of bottled water shifting the supply curve to the left ↓S.
The quantity supplied will be lower at all prices causing a shortage and putting upward pressure on price.
As the price rises, buyers will respond by purchasing less bottled water ↓Qd.
P↑
Q↓
3
6. Suppose the market for bottled water prior the change in FDA regulations is characterized by the following
equations for supply (S) and demand (D) with P in dollars per bottle and Q in thousands of bottles.
a. Graphically illustrate the market for bottled water. Be sure to clearly identify the equilibrium price and quantity
given these initial market conditions.
D1: Qd = -100P + 1,150
S1: Qs = 400P - 100
Setting these equations equal yields the solution
P1 = $2.5
Q1 = 900
b. Now suppose the change in FDA policy results in the new supply (S2) given by the equation below. Adapt your
diagram to illustrate this change in market conditions and be sure to clearly identify the new equilibrium price and
quantity.
S2: Qs = 400P - 350
Setting D1 and S2 equal yields the solution
P1 = $3
Q1 = 850
P
Bottled Water
S2
S1
P2 = 3
P1 = 2.5
0.875
D1
0.25
850 900
Q2 Q1
1150
Q of bottles
Thousands
4
7. Ethanol, corn and food revisited.
a. In the market for ethanol, show the effect of a government mandated increase in the amount of ethanol added to
gasoline.
Ethanol
P
S
P2
P1
D2
D1
Q1
Q2
Q
This policy will increase the demand for ethanol shifting the demand curve right ↑D.
The quantity demanded will be higher at all prices causing a shortage and putting upward pressure on price.
As the price rises, sellers will respond by bringing more ethanol to market ↑ Qs.
P↑
Q↑
b. Suppose the economy in part a has only corn and labor as available resources and can only produce two goods
using these resources, ethanol and food. Draw a PPF and a possible production point representing the original
situation before the government ethanol mandate. Now draw another possible point representing the change that will
occur as a result of the government ethanol mandate.
Ethanol
A
Food
As the D ↑ for ethanol, the P ↑ will cause an ↑ Qs as shown in part a.
This process occurs because the P ↑ sends a signal and more of society’s resources are allocated to the
production of ethanol which means society must give up some food moving from point A to point B .
This clearly illustrates the concepts of tradeoffs and opportunity costs. You can’t get more ethanol without giving
up some food.
It is also worth pointing out that the price of food will rise because of the decrease in the supply for goods such
as corn flakes, ground beef, etc…see question 2 above.
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8. Suppose the supply of oil from OPEC (to the rest of the world) is reduced later this year.
a. Oil is also produced in the US (TX, OK, AK). In the market for US produced oil, show the effect of the OPEC
supply reduction.
US Oil
P
S
P2
P1
D2
D1
Q1
Q2
Q
US oil is a substitute for OPEC oil so when the price of OPEC oil rises because of the restricted supply gasoline
refineries will look for substitutes shifting the demand curve for US oil to the right ↑D.
The quantity demanded will be higher at all prices causing a shortage and putting upward pressure on price.
As the price rises, sellers will respond by bringing more US oil to market ↑ Qs.
P↑
Q↑
Drill Baby Drill!
b. In the US market for gasoline, show the effect of effect of the OPEC supply reduction (use a steep D curve).
c. If the demand curve for gasoline were shallower, would the price change for gasoline be larger, smaller, or the
same as that found in part b?
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b. In the US market for gasoline, show the effect of effect of the OPEC supply reduction (use a steep D curve).
c. If the demand curve for gasoline were shallower, would the price change for gasoline be larger, smaller, or the
same as that found in part b?
This OPEC supply reduction will cause the price of OPEC oil to rise. Because OPEC oil is an important input in
the production of US gasoline, the production cost of US gasoline rise shifting the supply curve to the left.
The quantity supplied will be lower at all prices causing a shortage and putting upward pressure on price.
As the price rises, buyers will respond by purchasing less gas ↓Qd.
P↑
Q↓
But by how much?
The responsiveness of the demand curve will matter. A less responsive (steep) demand curve will result in a larger
P increase and a smaller Q decrease for a given supply shock (top picture).
US Gasoline
S2
P
8b.
S1
P1
Dinelastic
Q
S2
8c.
P
S1
P1
Delastic
Q1
Q
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