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Chapter 5: Using Supply and Demand Chapter 5: Using Supply and Demand Questions and Exercises 1. If price and quantity both rise, the simplest cause would be a shift of the demand curve to the right. 2. If price fell and quantity remained constant, a possible cause would be a shift out to the right of the supply curve and a shift of the demand curve in to the left. Another possibility would be a shift of the demand curve in to the left with a vertical supply curve. 3. Computer pricing of roads could end bottlenecks and rush hour congestion by price rationing. Currently at zero price, at certain times, the quantity demanded greatly exceeds the quantity supplied, resulting in congestion. Raising prices, during those times, could eliminate excess demand and reduce the congestion. This technological change will spread out congestions over wider geographic areas and over the day, as individuals with more flexibility with respect to route and timing will choose to demand less of the current high demand route at rush hour. 4. a. This would represent a shift in demand to the left assuming the decline in Cookie Monster’s popularity represents a decline in the popularity of cookies. The price and quantity of cookies would likely fall as shown in the accompanying graph. b. This is represented by a shift in demand for bread (high in carbohydrates) to the left. Equilibrium price and quantity falls as the graph shows. (Note: this is the same graph as for part a.) 5. a. Both the shift in demand to the right and the shift of supply to the left lead to a higher equilibrium price of oil, in this case over $40 a barrel. The effect on equilibrium quantity is indeterminate. While the shift in demand to the right would lead to a rise in equilibrium quantity, the shift in supply to the left would reduce it. Whether equilibrium quantity rises or falls depends on the relative size of the shifts. The accompanying graph shows no effect on equilibrium quantity and a significant increase in price. Colander’s Economics, 8e. McGraw Hill © 2010 1 Chapter 5: Using Supply and Demand b. The increase in the oil quota shifted supply to the right, reducing the price of oil from $40 a barrel to $38 a barrel in the short term. Equilibrium quantity increased. 6. a. This represents a shift of the supply curve to the left because the offended decide not to supply organs, increasing the legal price significantly and perhaps reducing the equilibrium quantity to a quantity that is below the amount currently provided at zero cost. This is shown in graph (a) below. b. How responsive quantity supplied is to price affects the slope of the supply curve. If quantity supplied is very responsive to price, the equilibrium price might be quite low and legalizing organ sales would have significant benefits to society. In fact, the authors of the study estimate the equilibrium price of kidneys to be less than $1000. In graph (b) below, S1 is much more responsive to price than S0. (a) 7. (b) Political turmoil in South Africa likely led both foreign and domestic investors to question the economic stability of the country. Foreign investors reduced their demand for South African investments, and therefore their demand for the rand. This shifted the demand for the rand to the left. Domestic investors did likewise, shifting their investments to those outside South Africa, shifting the supply of rand to the right. The combination led to a lower price for the rand in terms of other currencies. Colander’s Economics, 8e. McGraw Hill © 2010 2 Chapter 5: Using Supply and Demand 8. Import disruptions shifted the supply curve for rice to the left. Equilibrium price rose and quantity fell as the accompanying graph shows. 9. See the accompanying graph. A price ceiling of PC below equilibrium price will cause a shortage shown by the difference between QD and QS. 10. As you can see in the accompanying graph, the rent controls create a situation in which demanders are willing to pay much more than the controlled price and much more than the equilibrium price. These payments are sometimes known as key money. In this graph, landlords are willing to supply QS at the current controlled rent, PC. Consumers are willing to pay up to PB for the quantity QS. Key money can be an amount up to the difference between PB and PC. 11. See the accompanying graph. A price floor of PF above equilibrium price will cause a surplus shown by the difference between QS and QD. 12. A minimum wage is a price floor as in question 11. A Pmin, above the equilibrium wage will result in the quantity of laborers looking for work to increase to QS and the quantity of employers looking to hire to decrease to QD. The difference between the two is a measure of the number of unemployed. Colander’s Economics, 8e. McGraw Hill © 2010 3 Chapter 5: Using Supply and Demand 13. A $4 per unit tax on suppliers shifts the supply curve up by $4 shown as a shift in the supply curve from S0 to S1. Equilibrium price will rise by $4 only if the demand curve is perfectly vertical. In the case of a vertical demand curve, quantity would not change. Otherwise, equilibrium price rises by less than $4 and equilibrium quantity falls as shown in the accompanying graph. In this example, the price increases by less than $4 and quantity declines. 14. A quota places a quantity restriction on imports. Consumers are willing to pay a higher price for the lower quantity (QQ) than the equilibrium price without a quota. Therefore, quotas lead to higher import prices as shown in the accompanying graph. 15. The demand for rolling machines went up enormously because loose tobacco became a cheaper substitute for the taxed cigarettes and rolling machines are a complement of loose tobacco; some companies more than quadrupled their sales of loose tobacco and rolling machines. 16. Public post-secondary education is an example of a third-party payer market because it is heavily subsidized by state government and in most cases, a student’s parents. Those consuming the good, students, do not pay the entire cost of the education they receive. This likely leads to greater expenditures on postsecondary education than if students had to pay the entire cost of their education. 17. Governments likely support third-party-payer markets for a variety of reasons. It could be that they believe the market does not distribute the good equitably (poorer people have less access to the good); there are positive externalities associated with the good (for example, public education); or that some other market failure exists. 18. a. Equilibrium price is $6 and equilibrium quantity is 300. b. In a third-party payer system where the consumer pays $2, quantity demanded will be 900. Suppliers require payment of $14 to supply that quantity. c. Total spending in a is $1,800. Total spending in b is $12,600. Colander’s Economics, 8e. McGraw Hill © 2010 4 Chapter 5: Using Supply and Demand Issues to Ponder 1. a. Airways have value because they produce revenue and there are only a limited number of airways in the industry. b. Television networks have incentives to produce high definition television only to the extent that they would receive more revenue for using extra bandwidth. 2. a. The supply curve is vertical at 10,000 tickets. We know there is an excess demand at $130 because there is a secondary market for scalped tickets at a higher price. The graph below on the left shows excess demand of Qd – 10,000. b. The people represented by Qd-10,000 will make offers to scalpers for any amount above $130 up to the equilibrium price (if there had been a market) of $2,000. The graph below on the right shows the range of $200 to $2,000. c. If scalping became legalized, more people would be willing to sell their tickets because there is no risk of being arrested and fined. The shift of the supply curve for resold tickets to the right will reduce the secondary-market price of Final-Four tickets. 3. a. A weakly enforced anti-scalping law would add an additional cost to those selling scalped tickets and push up the resale cost of tickets to include the expected cost of being caught, which would be fairly small given weak enforcement. In the accompanying graph, this shifts the supply curve from S0 to S1, Colander’s Economics, 8e. McGraw Hill © 2010 5 Chapter 5: Using Supply and Demand raising equilibrium slightly price from P0 to P1. (Note: This assumes that only selling, not buying, is illegal.) b. A strongly enforced anti-scalping law (against suppliers) would push up prices far more as the cost of supply rose and the supply curve shifted to the left. If enforcement were sufficiently strong, a two-tier price system would emerge with a low legal price at P0 and another very high price, P2. 4. a. Boards often exist to benefit the consumer, but also to benefit those who currently produce. Often those who are currently certified attempt to limit the number of new certifications so as to limit the supply and thus boost the price they receive. b. Possible changes include eliminating the board of certification, limiting its regulation to only those skills that it addresses directly, or requiring continual recertification so that skills of those already certified reflect the current demand for skills in that market. c. A political difficulty with implementing these changes is that a relatively small group of those currently certified will be hurt and will lobby hard for the status quo. Those currently certified may have more “clout” with the board if the board is comprised of certified hairdressers. The benefits of the changes are also large, but they are spread out over large groups of consumers, with each consumer benefiting very little. Therefore, it will be easier for the small group, whose benefit per individual is large, to organize. 5. a. The Oregon Health Plan includes a prioritized list of medical services that determine whether a service is covered. The list is based on comparative benefit to those covered. Those services that have the highest net benefit are ranked highest. Those with a lower net benefit are not covered. b. Economists should not oppose the Oregon Plan because it involves rationing. The market involves rationing through the price mechanism. Economists might oppose the Oregon Plan because in general they support the market as the least-cost method of providing goods and services. Economists are open to the argument that the market may not distribute goods and services in the way that society wants, which may require government intervention. c. In the market, the interaction of demand and supply determines the equilibrium price and quantity that is bought and sold. Those who are able to pay the equilibrium price are the ones who receive the health care. The Oregon Plan uses its benefit-ranking system rather than price as the rationing mechanism. 6. a. Frequent-flyer programs allow companies to lower their effective prices without lowering their reported prices. Companies also use them to get business travelers to choose their airline. Such programs are an example of a third-party-payer system: The business traveler gets the benefit (frequent-flyer miles), while their business pays for the current flight. b. Other examples include points that hotels give to travelers and bonus checks based on charges that Discover gives those who use its credit card. c. Firms likely do not monitor these programs because it would be too costly to do so. Colander’s Economics, 8e. McGraw Hill © 2010 6 Chapter 5: Using Supply and Demand 7. a. An import quota will increase the price of imported sugar. The accompanying graph shows how a higher imported sugar price increases the price that domestic producers can charge and increase the quantity they can supply to the market. For example, at world price P0, domestic consumers demand the quantity E-B from importers and quantity B from domestic producers. After a quota represented by quantity D minus C is imposed, the import price is P1. Domestic consumers demand the quantity D-C from importers and quantity C from domestic producers. b. The government could have imposed a tariff on imported sugar. This would also have raised the price of imported sugar. c. A minimum required import level of 1.25 million will limit the ability of the United States to support domestic sugar prices. The increase in quantity supplied will put downward pressure on sugar prices. 8. a. As shown in the accompanying graph, the controlled price (PC) is below equilibrium. At this price the quantity of apartments demanded (QD) exceeds the quantity of apartments supplied (QS). Since there are more apartments demanded than supplied at this price, apartments are hard to find. b. Since at the existing quantity supplied, Qs, demanders would be willing to pay Pb, there is a strong incentive to make side payments to existing tenants to acquire the apartment. At Pb, more tenants are willing to supply their apartments than at Pc, so a side payment can induce a tenant to give up their apartments. This is one form of rationing. When market price rationing does not take place, some other form of rationing must take its place. c. Eliminating rent controls would most likely allow the market price of apartments to increase and eliminate side payments. The quantity supplied will rise until it equals the quantity demanded at the market price. The price, quantity combination is (Pe, Qe) in the graph. However, if there are few additional apartments available to be rented (the supply curve is almost vertical), then price will increase dramatically and quantity supplied will only rise slightly. d. The political appeal of rent control is that it benefits those who currently rent apartments. Apartment renters who live in rent-controlled apartments are more likely to vote, and this is why it is maintained. There are other possible reasons as well. Colander’s Economics, 8e. McGraw Hill © 2010 7 Chapter 5: Using Supply and Demand 9. a. The government subsidy of mohair provided an enormous incentive for those who were allowed to sell mohair to sell large quantities at lower price than otherwise. The elimination of this subsidy shifted the supply curve to the left (shown below as a shift from Ssubsidy to S no subsidy, increasing the market price for mohair from P0 to P1 and decreasing the quantity demanded and supplied from Q0 to Q1. b. This program was likely kept in existence because not many people knew about it (mohair is a relatively small market), and ranchers had no incentive to broadcast the subsidy. c. A law that requires that suppliers receive $3.60 more than the market price is the same as a tax, but the revenue goes to the supplier. The demand curve would shift to the left (down) to include this tax. The quantity demanded would fall dramatically. Consumers would not support this law because they would have to pay an enormously high price. Suppliers would support this law only if they were guaranteed that they could sell at that high price. 10. Excess supply in U.S. agricultural markets is caused by the government’s policy of agricultural price supports, or price floors on agricultural products. Political forces prevent the invisible hand from working. 11. It would likely increase the number since it reduces the cost of having a car that you drive very little. 12. a. Japan prescribes many more drugs than the U.S. because Japanese doctors have a financial incentive to do so. b. It would lead to many more drugs being produced, even if they were not really innovative, as happened when Japan tried this. c. Drug reps would likely provide free samples and other gifts to doctors and have lunches for them where they tout the advantages of their drugs. 13. a. They would likely fall. In fact, they fell by 13 percent. b. They also would likely fall. In fact, they fell by 22 percent. c. The graphs below show the effect of increasing co-payments. The graph on the left has a co-payment of $15. Consumers demand Q1 and the shaded region Colander’s Economics, 8e. McGraw Hill © 2010 8 Chapter 5: Using Supply and Demand shows the medical claim costs. In the accompanying graph on the right, consumers must pay the first $1,500 of medical costs, demonstrated by the lowershaded region. (For simplicity, we assume that consumers end up purchasing 50 units at a cost of $30 per unit.) As you can see, however, the medical cost to the firm (upper shaded area) is much smaller. In addition, the units of medical services demanded are lower, illustrating the second question – hospital admissions declined. Colander’s Economics, 8e. McGraw Hill © 2010 9 Chapter 5: Using Supply and Demand Appendix A 1. a. The tables are shown below: Price (Dollars per gallon) 0 1 2 3 4 5 6 b. Quantity Demanded (Gallons per year) Quantity supplied (Gallons per year 600 500 400 300 200 100 0 -150 0 150 300 450 600 750 See the accompanying graph. Equilibrium price is 3 and equilibrium quantity is 300. c. P=3; Q=300 2. a. The following are the demand and supply tables after the hormone is introduced: Quantity Quantity Price Demanded Supplied The hormone (a technological advance) shifts the supply curve to the right by 125,000 gallons, The de (dollars per (gallons per (gallons gallon) year) per year) 0.00 600 -25 1.00 500 125 2.00 400 275 2.50 350 350 3.00 300 425 4.00 200 575 5.00 100 725 6.00 0 875 b. The original supply curve is S0. The growth hormone shifts the supply curve to S1 (to the right by 125). Equilibrium price falls to $2.50 a gallon, and equilibrium quantity rises to 350 million gallons (point B). c. The demand curve remains the same at QD = 600 - 100P. The supply curve becomes QS = -25 + 150P. To solve the two equations, set them equal to one another: 600 - 100P = -25 + 150P and solve for P. Doing so, we get P = 2.5. Colander’s Economics, 8e. McGraw Hill © 2010 10 Chapter 5: Using Supply and Demand Substituting this value for P into either the demand or supply equation gives us equilibrium quantity of 350. d. Quantity supplied would be 425 (-25 + 150 X 3) and quantity demanded would be 300 (600 - 100 X 3). There would be excess supply of 125. The price floor is shown in the accompanying graph. 3. a. The demand curve is QD = 10-P; the supply curve is QS = 2P -5. To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $5, Q = 5. b. The new demand curve is QD = 13-P. To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $6, Q = 7. c. The new supply curve is QS = 2P-8. To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $7, Q = 6. 4. a. A demand curve follows the formula QD = a - bP, where a is the quantity-axis intercept and b is the slope of the curve. A shift in demand is reflected in a change in a. An increase in demand increases a and a decrease in demand reduces a. b. A supply curve follows the formula, QS = a + bP, where a is the quantity-axis intercept and b is the slope of the curve. A shift in supply is reflected in a change in a. An increase in supply increases a and a decrease in supply decreases a. c. A movement in supply or demand is reflected in the effect of a change in P on either QS or QD. The equations themselves do not change. 5. a. P = 4; Q = 6 b. Since the government set price is above the equilibrium price, it is a price floor. Thus it would create a surplus. Solving the equations, we see the surplus would be 2 million bushels. 6. a. The new supply equation is QS = -150 + 150(P - 1) where P is the equilibrium price, or QS = -300 + 150P. b. P = 3.60; Q = 240. c. Farmers receive $2.60 per gallon, while demanders pay $3.60 per gallon. 7. a. The new demand equation is QD = 600 -100(P+1) where P is the price suppliers receive, or QD = 500-100P. b. P = 3.60; Q = 240. c. Farmers receive $2.60 per gallon. It doesn’t matter who pays the tax, the market outcome is the same. 8. a. The new supply equation is QS = -150 + 150(P + 1) where P is the equilibrium price, or QS = 150P. b. P = 2.40; Q = 360. c. Farmers receive $3.40 per gallon. Colander’s Economics, 8e. McGraw Hill © 2010 11 Chapter 5: Using Supply and Demand 9. a. b. c. d. Equilibrium price is $2. P = $3 is above equilibrium price, so it is a price floor. There is a surplus of 8. P = $1.50 is below equilibrium price, so it is a price ceiling. There is a shortage of 4. P = $2.25 is above equilibrium price, so it is a price floor. There is a surplus of 2. P = $2.50 is above equilibrium price, so it is a price floor. There is a surplus of 4. Colander’s Economics, 8e. McGraw Hill © 2010 12