Chapter03 –Demand, Supply, and Market Equilibrium (Appendix)

Chapter 03 Demand, Supply, and Market Equilibrium (Appendix)

APPENDIX QUESTIONS

1. Why are shortages or surpluses more likely with preset prices, such as those on tickets,than flexible prices, such as those on gasoline? LO6

Answer: Preset prices, rather than responding to demand conditions, attempt to predict the level of demand that will produce an equilibrium quantity. If these predictions are incorrect, there will be an imbalance between the quantity supplied and the quantity demanded.

Preset prices often apply to one-time-only events, versus something like gasoline that is sold regularly and repeatedly. Sellers can learn from experience how to adjust prices to best meet demand.

2. Most scalping laws make it illegal to sell—but not to buy—tickets at prices abovethose printed on the tickets. Assuming that is the case, use supply and demand analysis toexplain why the equilibrium ticket price in an illegal secondary market tends to be higherthan in a legal secondary market. LO6

Answer: Ticket prices tend to be higher in illegal secondary markets because sellers face higher costs (thus reducing supply relative to what it would be in a legal secondary market). The additional costs include the higher transactions costs (finding secret locations to transact, monitoring for law enforcement, screening clients, etc.) and compensation for the risk of getting caught (with the associated costs of legal services, fines, incarceration, etc.).

3. Go to the Web site of the Energy Information Administration, , andfollow the links to find the current retail price of gasoline. How does the current price ofregular gasoline compare with the price a year ago? What must have happened to eithersupply, demand, or both to explain the observed price change? LO6

Answer: The answer here will depend on the time of the exercise.

4. Suppose the supply of apples sharply increases because of perfect weather conditionsthroughout the growing season. Assuming no change in demand, explain the effect on theequilibrium price and quantity of apples. Explain why quantity demanded increases eventhough demand does not change. LO6

Answer: The increase in supply will lower the equilibrium price and increase the equilibrium quantity of apples. The increase in supply implies that the supply schedule shifts to the right (more apples are supplied at every price). Quantity demanded increases without a shift in the demand curve because the greater supply causes price to fall. This fall in price causes movement along the demand schedule.

5. Assume the demand for lumber suddenly rises because of a rapid growth of demandfor new housing. Assume no change in supply. Why does the equilibrium price of lumberrise? What would happen if the price did not rise under the demand and supplycircumstances described? LO6

Answer: Buyers are willing to purchase more new housing, causing price and quantity to increase in that market. In order to satisfy the increased demand for new housing, more lumber (and other building materials) is needed. The greater willingness to pay for housing implies a greater willingness to pay for the materials and labor needed to produce that housing. As the resources become increasingly scarce (because of a given supply and increasing demand), the price rises.

If something prevented an increase in the price of lumber (e.g., a price control by government), a shortage of lumber would result and not all of the new houses demanded could be built.

6. Suppose both the demand for olives and the supply of olives decline by equal amountsover some time period. Use graphical analysis to show the effect on equilibrium price andquantity. LO6

Answer: The supply and demand curves would shift left by an equal amount (supply shifts from S1 to S2 and demand shifts from D1 to D2 in the diagram below), reducing the equilibrium quantity and leaving the equilibrium price unchanged.

7. Assume that both the supply of bottled water and the demand for bottled water riseduring the summer but that supply increases more rapidly than demand. What can youconclude about the directions of the impacts on equilibrium price and equilibriumquantity? LO6

Answer: The equilibrium price will fall and the equilibrium quantity will rise. Whenever supply and demand both increase, equilibrium quantity will rise. Equilibrium price falls because the increase in supply is greater than the increase in demand(see figure below).

APPENDIX PROBLEMS

1. Demand and supply often shift in the retail market for gasoline. Here are twodemand curves and two supply curves for gallons of gasoline in the month of May ina small town in Maine. Some of the data is missing. LO6

a. Use the following facts to fill in the missing data in the table. If demand is D1 andSupply is S1, the equilibrium quantity is 7000 gallons per month. When demand is D2 andsupply is S1, the equilibrium price is $3.00 per gallon. When demand is D2 and supply isS1, there is an excess demand of 4000 gallons per month at a price of $1.00 per gallon. Ifdemand is D1 and supply is S2, the equilibrium quantity is 8000 gallons per month.

b. Compare two equilibriums. In the first, demand is D1 and supply is S1. In the second,demand is D1 and supply is S2. By how much does the equilibrium quantity change? Byhow much does the equilibrium price change?

c. If supply falls from S2 to S1 while demand declines from D2 to D1, does the equilibriumprice rise or fall or stay the same? What if only supply falls? What if only demand falls?

d. Suppose that supply is fixed at S1 and that demand starts at D1. By how many gallonsper month would demand have to increase at each price level such that the equilibriumprice per gallon would be $3.00? $4.00?

Answers: (a) See the complete table below for the missing values; (b) equilibriumquantity increases by 1000 gallons per month, the equilibrium prices falls by $1.00;(c) equilibrium price stays the same (at $2.00), equilibrium price rises (from $2.00 to$3.00), equilibrium price falls (from $2.00 to $1.00); (d) 2000 gallons per month,4000 gallons per month.

Feedback: Consider the following table as an example:

Part a: If demand is D1 and Supply is S1, the equilibrium quantity is 7000 gallons per month. We can eliminate all rows except the third row in the table above because we actually have values for the first two rows for D1 and S1 and the fourth row has a value of 5000 for S1. In equilibrium S1 must equal D1, so the only row where this can hold is row 3. So the entry for row 3- D1 is 7000 and the entry for row 3-S1 is 7000 as well.

When demand is D2 and supply is S1, the equilibrium price is $3.00 per gallon. Equilibrium for D2 and S1 occurs at a quantity of 8000. Therefore the price in row 2 is $3.00.

When demand is D2 and supply is S1, there is an excess demand of 4000 gallons per month at a price of $1.00 per gallon.The excess demand of 4000 occurs in row 4 for D2 and S1. This implies the price in row 4 is $1.00.

If demand is D1 and supply is S2, the equilibrium quantity is 8000 gallons per month. Since the equilibrium quantity must equal 8000 for D1 and S2, and the only remaining missing quantity entries are in row 4 for D1 and S2, implies that the entries for D1 and S2 in row 4 (quantities) are 8000.

In summary, we have the following table:

Part b: Compare two equilibriums. In the first, demand is D1 and supply is S1. In the second, demand is D1 and supply is S2. By how much does the equilibrium quantity change? By how much does the equilibrium price change?

The initial equilibrium for D1 and S1 is Q=7000 and P=$2.00. The second equilibrium for D1 and S2 (an increase in supply) is Q=8000 and P=$1.00. Thus, the change in quantity is an increase of 1000 (=8000 - 7000) and the change in price is a decrease of $1.00 (=$2.00 - $1.00).

Part c: If supply falls from S2 to S1 while demand declines from D2 to D1, does the equilibrium price rise or fall or stay the same? What if only supply falls? What if only demand falls?

The initial equilibrium for S2 and D2 is Q=8500 and P=$2.00. The second equilibrium for S1 and D1 (both supply and demand fall) is Q=7000 and P=$2.00. The equilibrium price remains the same at P=$2.00. The third equilibrium for D2 and S1 (only supply falls) is Q=8000 and P=$3.00. Compared to the initial equilibrium price increases from $2.00 to $3.00. The fourth equilibrium for S2 and D1 (only demand falls) is Q=8000 and P=$1.00. Compared to the initial equilibrium price falls from $2.00 to $1.00.

Part d: Suppose that supply is fixed at S1 and that demand starts at D1. By how many gallons per month would demand have to increase at each price level such that the equilibrium price per gallon would be $3.00? $4.00?

Since supply is fixed at S1 and demand starts at D1 the initial equilibrium is Q=7000 and P=$2.00. For the equilibrium price to increase to $3.00 (from $2.00) demand would need to increase by 2000. This would result in an equilibrium Q=8000 and P=$3.00 (D2 and S1). Note: the original demand at $3.00 is only 6000, so to support an equilibrium price of $3.00 demand would need to be 2000 higher. The same logic applies for the equilibrium price of $4.00. If demand is going to support the equilibrium price of $4.00, then demand will need to increase from 5000 (D1) to 9000 (D2). Thus, demand will need to increase by 4000 and the new equilibrium is Q=9000 and P=$4.00 (D2 and S1).

2. The table below shows two demand schedules for a given style of men’s shoes—thatis, how many pairs per month will be demanded at various prices at a men’s clothingstore in Seattle called Stromnord.

Suppose that Stromnord has exactly 65 pairs of this style of shoe in inventory at the start ofthe month of July and will not receive any more pairs of this style until at least Augustfirst. LO6

a. If demand is D1, what is the lowest price that Stromnord can charge so that it will notrun out of this model of shoes in the month of July? What if demand is D2?

b.If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, how many pairs of shoes should Stromnord order if it wants to end the month of August with exactly zero pairs of shoes in its inventory? What if the price is set at $55 for both months?

Answers: (a) $70, $55; (b) Order 1 pair for August; order 49 pairs for August.

Feedback: Consider the following table and information as an example:

Stromnord has exactly 65 pairs of this style of shoe in inventory at the start of the month of July and will not receive any more pairs of this style until at least August first.

Part a: If demand is D1, the lowest price Stromnord can charge $70 if it does not want to run out of shoes in the month of July. A price of $65 would result in a demand of 68 pairs of shoes and Stromnord only has 65 in inventory. (Note: answers must use the values in the table). If demand is D2, the lowest price Stromnord can charge $55 if it does not want to run out of shoes in the month of July because the demand for shoes is only 27 pairs at this price. This is the lowest value in the table.

Part b: If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, then the total demand for these months is 66 pairs of shoes. Since Stromnord has 65 pairs in inventory they will need to order 1 more pair to meet demand for both months. If the price is set at $55 total demand for both months will be 114. Here Stromnord will need to order 49 pairs (=114 - 65).

3. Use the table below to answer the questions that follow: LO6

a. If this table reflects the supply of and demand for tickets to a particular World Cupsoccer game, what is the stadium capacity?

b. If the preset ticket price is $45, would we expect to see a secondary market for tickets?Would the price of a ticket in the secondary market be higherthan, the same as, or lower than the price in the primary (original) market?

c.Suppose for some other World Cup game the quantities of tickets demanded are 20,000lower at each ticket price than shown in the table. If the ticket price remains $45, wouldthe event be a sellout?

Answers: (a) 60,000; (b) Yes, higher; (c) No.

Feedback: Consider the following table as an example:

Part a: Stadium Capacity is 60,000. We can infer this from the constant supply independent of price.

00000Part b: If the preset ticket price is $45 we would expect to see a secondary market because there is a shortage of tickets at this price. The shortage of tickets, which equals 10,000, would allow individuals who have the tickets (or get to purchase the tickets) to resell them for a higher price. This is because the market would result in a higher equilibrium price of $65, which implies some individuals are willing to pay between $46 and $65 for the tickets. Thus, the price in the secondary market would be higher.

Part c: If demand were 20,000 less at each price, the quantity demanded at $45 would only be 50,000 (=70,000 (original demand) - 20,000 (decline in demand)). Since capacity is 60,000 this would not be a sellout.

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