Chapter 3 Supply and demand: an introduction

Answers to review questions 1 The equilibrium price of a good is determined by the interaction of the supply and

demand conditions. We can know everything about a good’s cost of production (that is, we can know its supply exactly) yet still not be able to identify the price at which the quantity supplied equals the quantity demanded (graphically, where the demand and supply curves intersect).

2 A ‘change in demand’ refers to the effect on demand of a change in one of the non-price determinants of demand (such as income or the price of related goods), and is shown graphically by a shift of the entire demand curve. A ‘change in the quantity demanded’ refers to the effect on the quantity demanded of a change in the good’s own price and is shown by a movement along the demand curve.

3 When we interpret the demand curve from a horizontal perspective we start with price on the vertical axis and read the corresponding quantity demanded on the horizontal axis. This is consistent with the demand curve telling us how much of a good buyers want to purchase in a given period of time at various prices. The demand curve can also be interpreted in a second way, which is to start with quantity on the horizontal axis and then read the marginal buyer’s reservation price on the vertical axis. This vertical perspective is consistent with the demand curve showing marginal benefits and being used to measure the gains to consumers of being able to participate in the market.

4 When price is below its equilibrium level the quantity that buyers want to purchase exceeds the quantity that sellers are willing to offer for sale. There is excess demand or a shortage. Frustrated buyers will respond by bidding up the good’s price which will, in turn, result in an increase in the quantity of the good supplied and a decrease in the quantity of the good demanded. If the price of the good were prevented by regulations from rising, we would expect to see symptoms of excess demand, such as queues and illegal trading of the good.

When price is above its equilibrium level, the quantity that buyers want to purchase falls short of the quantity that sellers are willing to offer for sale. There is excess supply or a surplus. Frustrated sellers will respond by lowering the good’s price which will, in turn, result in a decrease in the quantity of the good supplied and an increase in the quantity of the good demanded. If the price of the good were prevented by law from falling, we would expect to see stockpiles or quantitative restrictions on output (quotas) emerging.

5 There are clearly many possibilities here. For example, the price of bananas has recently increased threefold. This is due to a decrease in the supply of bananas resulting from the destruction of much of Queensland’s crop by a series of extreme weather events. A leftward shift in the supply curve has increased equilibrium price and reduce equilibrium quantity. The process of moving from the original to the new equilibrium is driven by the upward pressure on price that results from competition among buyers in response to the excess demand that occurs when supply falls.

6 The ceteris paribus assumption means that we are assuming that everything that affects demand or supply, other than the variable that we are analysing, remains unchanged. For example, when we predict that an increase in average household income for a normal good will increase demand, we are assuming that all other factors that determine demand in the market stay the same. That we use the ceteris paribus

assumption in economics does not mean that economists believe that only one variable changes at a time in the real world. Rather, it is a useful trick to employ when using an economic model to isolate the effects of a particular variable on a thing of interest, such as price and quantity, and to help us understand how real-world economic systems work.

7 Cash is left on the table in a market whenever price is prevented from reaching its equilibrium level. For example, a price ceiling leaves surplus-enhancing transactions unexploited. Whenever there is cash left on the table in a market, there is an incentive for both buyers and sellers to try and find ways of effecting exchanges that would make them better off. Black market trading and lobbying government to remove price restrictions are both attempts to pocket cash left on the table.

8 It may be ‘smart’, in the sense that it passes the cost-benefit test, for each individual in a crowded theatre to stand to get a better view of the stage, yet it is ‘dumb’ for all to stand, since no one sees any better than if all had remained seated. It may also be ‘smart’ for an individual to refuse vaccination, but the outcome would be ‘dumb’ if all individuals did so.

Answers to problems 1 a Substitutes, since playing squash and playing tennis serve broadly the

same purpose.

b Complements, since DVDs and DVD players are always used together.

c Substitutes, since public schools and private schools are alternative providers of essentially the same good.

d Substitutes, since disposable nappies can be used in place of cloth nappies.

2 The supply curve would shift to the:

a right. The discovery is a technological improvement. The improved technique would enable more wheat to be produced with the same inputs.

b left. Fertiliser is an input, and higher input prices mean that less wheat will be supplied at each price.

c right. The drought relief makes farming relatively more profitable than before. Thus those who were employed in a job that was just a little better than being a wheat farmer would switch to wheat farming.

d left. Droughts reduce productivity and destroy crops.

3 a Demand curve shifts right: income has risen and overseas vacations are a

normal good.

b Demand curve shifts left: the health scare causes preferences to shift away from mobile phones.

c Demand curve shifts right: CD players and MP3 players are substitutes.

d Demand curve shifts left; the price of a complementary good has risen.

4 The supply of apples will fall as the cost of an input rises, leading to a leftward shift in the supply curve for apples (S to S'). There will be no change in the demand for apples. The result will be an increase in equilibrium price (P to P') and a fall in equilibrium quantity (Q to Q') as shown below.

5 The demand for child care will increase as the birth rate rises, leading to a rightward

shift in the demand curve for child care (D to D'). No change in the supply curve of child care will occur. The result will be an increase in the equilibrium price of childcare (P to P') and an increase in the equilibrium quantity (Q to Q').

6 Car insurance and cars are complements. An increase in the cost of car insurance will thus shift the demand curve for cars to the left. There will be no change in the supply of cars. The result will be a fall in the equilibrium price of cars (P to P') and a fall in the equilibrium number of cars sold (Q to Q').

7 Compared with the rest of the year, more people want to stay in hotel rooms near campus during graduation week. Thus the demand curve shifts to the right during these weeks. This implies a higher equilibrium price for hotel rooms (and, of course, a higher equilibrium quantity of rooms rented).

8 The discovery of the cold-fighting property causes an increase in demand, as shown by a rightward shift in the demand curve for apples (D to D'); the fungus causes a decrease in supply, as shown by the leftward shift in the supply curve (S to S'). The equilibrium price of apples will rise (P to P'), but the equilibrium quantity may go either up (Case 1) or down (Case 2) depending on the relative magnitude of the two effects.

9 A tightening of credit available to housing developers will reduce the supply of units (leftward shift in the supply curve) which will result in a decrease in the number of units and an increase in equilibrium price.

10 a Streamlining the planning approval process effectively reduces the cost of constructing residential units and will increase supply. This results in a reduction in equilibrium price and an increase in the number of units constructed.

b A reduction in immigration will reduce the demand for residential housing units. This results in a reduction in equilibrium price and a fall in the number of units constructed.

11 Dear Minister for Health,

I would like to draw your attention to the likely consequences of the two policies that you have proposed as ways of promoting a higher level of exercise. As Figure 1 shows, a price ceiling on gym memberships will result in excess demand and a loss of economic surplus in the market. Importantly, although gym memberships will be cheaper (P PC), fewer people will take out gym memberships (Q Q').

Figure 1 Figure 2 shows the effects of your second policy: namely, a campaign educating people

about the benefits of increased exercise. This campaign is intended to increase the demand for gym memberships, as shown by the rightward shift in the demand curve. Note that although the cost of a gym membership has increased (P P'), this policy will have the effect of increasing gym memberships as intended (Q Q').

Figure 2

I draw your attention to these likely effects so that you can make an informed decision about which policy is best, based on a comparison of the costs and benefits of the two alternatives.

Regards,

An economic naturalist.

12 If this transaction takes place, the buyers’ surplus will be $200 and the sellers’ surplus will be $100, giving a total surplus of $300. This economic surplus would be cash that is ‘left on the table’ if the transaction did not take place. In other words, this amount of surplus would remain unrealised due to the potentially surplus-enhancing opportunity remaining unexploited.

13 The demand and supply curves for gym memberships are graphed below.

The equilibrium price in this market is the price for which the quantity demanded by buyers equals the quantity that sellers want to supply, or where

1000 – 2P = –200 + 10 P

Rearranging this expression to solve for P yields

1200 = 12P

or P = 100

The equilibrium price of a gym membership is therefore $100 per month. Substituting this price into the demand equation shows that equilibrium quantity is

1000 – 2(100) = 800 memberships per month

confirming the graphical solution shown in the diagram above.

Chapter 5 Demand: the benefit side of the market

Answers to review questions 1 To say that someone needs a good is to suggest that they cannot choose to do without

the good or buy a substitute for it. We are more likely to be mindful of the fact that almost all goods have substitutes if we speak of wants rather than needs.

2 Even though we cannot actually measure utility directly, the marginal utility model helps us to gain a better understanding of how a rational consumer would allocate their income among different goods.

3 The law of diminishing marginal utility says that the first units we consume of a good deliver the highest ‘bang for our buck’. This means that we can generally achieve higher total utility by spreading our incomes over many goods than by concentrating them on only a few.

4 A scarce good must be rationed in one way or another. If its monetary price is zero, people will either have to wait in line for it, as in the free sausage example, or pay a bribe, or incur some other cost to gain access to it.

5 Many people report that they didn’t like spicy food the first time they ate it, or didn’t like a certain comedian the first time they heard them. However, after repeated exposures they often find that they like these experiences more and more. Also, depending on the nature of their condition, some people might derive greater benefit from their second visit within a month to an osteopath than they do from their first.

6 When people are charged for water on the basis of how much they use, they will respond to an increase in its price in the same way that they would to an increase in the price of any other good. In particular, they will find ways of conserving water, by reusing and recycling and by adopting water-saving devices and production methods.

7 When supply increases the price of a good falls and consumer surplus increases for two reasons. The first reason is that buyers who were previously purchasing the good at a higher price now enjoy a greater surplus. The second reason is that when the price of a

good falls, more of it is sold; the additional units sold (except for the last one, for which price exactly equals the buyer’s reservation price) have a positive consumer surplus.

Answers to problems 1 Because willingness to pay for food quality is likely to be an increasing function of

income, we expect the patrons of the gourmet restaurant to have higher incomes, on average, than the patron of the inexpensive cafe. And since willingness to pay for service is also likely to be an increasing function of income, we expect the service in the gourmet restaurant to be of a higher quality as well. Since restaurant patrons tend to leave tips of about 15 per cent of the price of their meals, they do, in fact, pay for and receive higher quality of service.

2 Since the marginal cost of an additional morsel of food is zero, a rational person will continue eating until the marginal benefit of the last morsel (its marginal utility) falls to zero.

3 Maryanne is currently receiving (75 utils/glass)/($2.50/glass) = 30 utils per dollar from her last dollar spent on orange juice, but only (50 utils/cup)/($2.00 /cup) = 25 utils per dollar from her last dollar spent on coffee. Since the two are not equal, she is not maximising her utility. She should spend more on orange juice and less on coffee.

4 Toby is currently receiving (100 utils/gram)/($0.10/gram) = 1000 utils per dollar from his last dollar spent on peanuts, and (200 utils/gram)/($0.25/gram) = 800 utils per dollar from his last dollar spent on cashews. Since the two are not equal, he is not maximising his utility. He should spend more on cashews and less on peanuts.

5 The information given enables us to conclude that Sue’s average utility per dollar is the same for both pizza and yoghurt. However, this information does not enable us to say whether her current combination of the two goods is optimal. To do that, we must be able to compare the values of marginal utility per dollar for the two goods.

6 a Even at twice the original price, the marginal utility per dollar of the 20th

train trip may be higher than the corresponding ratio for any other good that Ann might consume, in which case she would be perfectly rational not to alter the number of trips she takes. After all, missing a trip would mean missing a whole day’s work.

b The higher price of train tickets makes Ann poorer. The income effect of the price increase is what leads to the reduction in the number of restaurant meals she eats.

7 Consumer surplus is the area of the shaded triangle:

(1/2)bh = (1/2) × (80 000 litres/year) × ($8/litre)= $320 000/year.

8 When the price of a slice of pizza is $6 and the price of a DVD rental is $3, the affordable combinations and their corresponding utilities are as listed in the table, which shows that the optimal combination is three pizza slices per week and two movie rentals.

Combinations of pizza and DVD rentals that cost $24 per week Total utility

8 rentals, 0 pizza slices 57 + 0 = 57

6 rentals, 1 pizza slices 57 + 20 = 77

4 rentals, 2 pizza slices 54 + 38 = 92

2 rentals, 3 pizza slices 46 + 54 = 100

0 rentals, 4 pizza slices 0 + 68 = 68

9 a The market demand curve (right panel) is the horizontal summation of the two individual demand curves (left and centre panels). For example, when the price of a ticket is $24, the first consumer will not want to buy any tickets while the second consumer wants to buy 16 tickets.

24

96tickets/yr

Price($/ticket)

48

36

Price($/ticket)

tickets/yr144

tickets/yr

Price($/ticket)36

2424

12 12

16 16

12

80

b Total consumer surplus is the sum of the three shaded areas:

Area of small triangle:

(1/2)bh = (1/2) × (16 tickets/yr) × ($12/ticket) = $96/yr

Area of rectangle:

bh = (16 tickets/yr) × ($12/ticket) = $192/yr

Area of large triangle:

(1/2)bh = (64 tickets/yr) × ($12/ticket) = $768/yr

Total consumer surplus:

$96/yr + $192/yr + $768/yr = $1056/yr