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 goods 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 goods 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 buyers 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 goods 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 goods 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 Queenslands 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

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. 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 b c d 2 a b c Substitutes, since playing squash and playing tennis serve broadly the same purpose. Complements, since DVDs and DVD players are always used together. Substitutes, since public schools and private schools are alternative providers of essentially the same good. Substitutes, since disposable nappies can be used in place of cloth nappies. right. The discovery is a technological improvement. The improved technique would enable more wheat to be produced with the same inputs. left. Fertiliser is an input, and higher input prices mean that less wheat will be supplied at each price. 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. left. Droughts reduce productivity and destroy crops. Demand curve shifts right: income has risen and overseas vacations are a normal good. b c d Demand curve shifts left: the health scare causes preferences to shift away from mobile phones. Demand curve shifts right: CD players and MP3 players are substitutes. Demand curve shifts left; the price of a complementary good has risen.

The supply curve would shift to the:

d 3 a

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.

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').

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').

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).

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. 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 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. 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.

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

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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.