Chapter 3 Supply and demand: an introductionAnswers 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). A ‘change in demand’ refers to the effect on demand of a change in one of the nonprice 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. 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. 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. 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 2 3 4 6 a price ceiling leaves surplus-enhancing transactions unexploited.assumption in economics does not mean that economists believe that only one variable changes at a time in the real world. yet it is ‘dumb’ for all to stand. since DVDs and DVD players are always used together. The drought relief makes farming relatively more profitable than before. since playing squash and playing tennis serve broadly the same purpose. Substitutes. left. since public schools and private schools are alternative providers of essentially the same good. Fertiliser is an input. For example. since no one sees any better than if all had remained seated. 8 Answers to problems 1 a b c d 2 a b c Substitutes. Demand curve shifts right: CD players and MP3 players are substitutes. Black market trading and lobbying government to remove price restrictions are both attempts to pocket cash left on the table. right. Whenever there is cash left on the table in a market. in the sense that it passes the cost-benefit test. The improved technique would enable more wheat to be produced with the same inputs. and higher input prices mean that less wheat will be supplied at each price. 7 Cash is left on the table in a market whenever price is prevented from reaching its equilibrium level. left. since disposable nappies can be used in place of cloth nappies. and to help us understand how real-world economic systems work. The discovery is a technological improvement. It may also be ‘smart’ for an individual to refuse vaccination. but the outcome would be ‘dumb’ if all individuals did so. It may be ‘smart’. there is an incentive for both buyers and sellers to try and find ways of effecting exchanges that would make them better off. Complements. The supply curve would shift to the: d 3 a . b c d Demand curve shifts left: the health scare causes preferences to shift away from mobile phones. for each individual in a crowded theatre to stand to get a better view of the stage. Demand curve shifts left. Droughts reduce productivity and destroy crops. 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. Demand curve shifts right: income has risen and overseas vacations are a normal good. Substitutes. right. Thus those who were employed in a job that was just a little better than being a wheat farmer would switch to wheat farming. Rather. such as price and quantity. the price of a complementary good has risen. The result will be an increase in equilibrium price (P to P') and a fall in equilibrium quantity (Q to Q') as shown below. 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 the equilibrium price of childcare (P to P') and an increase in the equilibrium quantity (Q to Q'). leading to a rightward shift in the demand curve for child care (D to D').4 The supply of apples will fall as the cost of an input rises. No change in the supply curve of child care will occur. 5 The demand for child care will increase as the birth rate rises. . 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. a higher equilibrium quantity of rooms rented). of course. 7 Compared with the rest of the year. There will be no change in the supply of cars. more people want to stay in hotel rooms near campus during graduation week. This implies a higher equilibrium price for hotel rooms (and. 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'). Thus the demand curve shifts to the right during these weeks. . this policy will have the effect of increasing gym memberships as intended (Q Q'). The equilibrium price of apples will rise (P to P'). a Streamlining the planning approval process effectively reduces the cost of constructing residential units and will increase supply. 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. 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. a price ceiling on gym memberships will result in excess demand and a loss of economic surplus in the market. but the equilibrium quantity may go either up (Case 1) or down (Case 2) depending on the relative magnitude of the two effects. This results in a reduction in equilibrium price and an increase in the number of units constructed. Note that although the cost of a gym membership has increased (P P'). 9 10 b 11 Dear Minister for Health. This campaign is intended to increase the demand for gym memberships. fewer people will take out gym memberships (Q Q'). as shown by a rightward shift in the demand curve for apples (D to D'). As Figure 1 shows. as shown by the leftward shift in the supply curve (S to S').8 The discovery of the cold-fighting property causes an increase in demand. Importantly. the fungus causes a decrease in supply. although gym memberships will be cheaper (P PC). Figure 1 Figure 2 shows the effects of your second policy: namely. 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. a campaign educating people about the benefits of increased exercise. as shown by the rightward shift in the demand curve. . The demand and supply curves for gym memberships are graphed below. 12 If this transaction takes place.Figure 2 I draw your attention to these likely effects so that you can make an informed decision about which policy is best. Regards. 13 . In other words. based on a comparison of the costs and benefits of the two alternatives. An economic naturalist. giving a total surplus of $300. the buyers’ surplus will be $200 and the sellers’ surplus will be $100. this amount of surplus would remain unrealised due to the potentially surplus-enhancing opportunity remaining unexploited. This economic surplus would be cash that is ‘left on the table’ if the transaction did not take place. 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. .