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.

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

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.

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.

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.

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 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.

10

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.

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.

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.

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.

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.

Many people report that they didnt like spicy food the first time they ate it, or didnt
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.

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.

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 buyers 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.

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.

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.

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.

The information given enables us to conclude that Sues 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.

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
days work.

b
7

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.

Consumer surplus is the area of the shaded triangle:

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

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

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.

Price
($/ticket)
36

24

24

24

12

12

12

96

Price
($/ticket)
36

Price
($/ticket)

tickets/yr

16

48

tickets/yr

16

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

80

tickets/yr
144