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CHAPTER 4 Modern Principles of Economics:

Equilibrium: How Supply and Demand Determine Prices Facts and Tools 1. If the price in a market is above the equilibrium price, does this create a surplus or a shortage? Solution 1. A surplus: a lot of unsold goods. 2. When the price is above the equilibrium price, does greed (in other words, self-interest) tend to push the price down or up? Solution 2. Self-interest tends to push the price down: Business owners don’t like having unsold goods, so they cut the price. Note: Greed and self-interest have the same denotation but different connotations. 3. Jon is on eBay, bidding for a first edition of the influential Frank Miller graphic novel Batman: The Dark Knight Returns. In this market, who is Jon competing with: the seller of the graphic novel or the other bidders? Solution 3. He is competing with other bidders. 4. Now, Jon is in Japan, trying to get a job as a full-time translator; he wants to translate English TV shows into Japanese and vice versa. He notices that the wage for translators is very low. Who is the “competition” pushing the wage down: Does the competition come from businesses who hire the translators or from the other translators? Solution 4. Jon is competing with other translators. 5. Jules wants to purchase a Royale with cheese from Vincent. Vincent is willing to offer this tasty burger for $3. The most Jules is willing to pay for the tasty burger is $8 (after all, his girlfriend is a vegetarian, so he doesn’t get many opportunities for tasty burgers). a. How large are the potential gains from trade if Jules and Vincent agree to make this trade? In other words, what is the sum of producer and consumer surplus if the trade happens? b. If the trade takes place at $4, how much producer surplus goes to Vincent? How much consumer surplus goes to Jules? c. If the trade takes place at $7, how much producer surplus goes to Vincent? How much consumer surplus goes to Jules?

Solution 5. a and b and c. The potential gains from trade are $5 of value ($8 − $3 = $5 surplus): It might all be consumer surplus, it might be producer surplus, or it might be some mix of the two. If they trade at $4, $1 of producer surplus goes to Vincent, and $4 of consumer surplus to Jules. If the trade happens at $7, Vincent gets $4 of producer surplus, while Jules gets $1 of consumer surplus. 6. What happened in Vernon Smith’s lab? Choose the right answer: a. The price and quantity were close to equilibrium but gains from trade were far from the maximum. b. The price and quantity were far from equilibrium and gains from trade were far from the maximum. c. The price and quantity were far from equilibrium but gains from trade were close to the maximum. d. The price and quantity were close to equilibrium and gains from trade were close to the maximum. Solution 6. Option d was true: Price and quantity were close to equilibrium, and gains from trade (the sum of the consumer and producer surplus) were close to the maximum. 7. When supply falls, what happens to quantity demanded in equilibrium? (This should get you to notice that both suppliers and demanders change their behavior when one curve shifts.) Solution 7. Quantity demanded falls: This is just moving along the fixed demand curve. The reduced supply pushes up the price, and, at a higher price, buyers reduce their quantity demanded. 8. a. When demand increases, what happens to price and quantity in equilibrium? b. When supply increases, what happens to price and quantity in equilibrium? c. When supply decreases, what happens to price and quantity in equilibrium? d. When demand decreases, what happens to price and quantity in equilibrium? Solution 8. a. When demand increases, price and quantity both rise in equilibrium. b. When supply increases, price falls and quantity rises in equilibrium. c. When supply decreases, price rises and quantity falls in equilibrium. d. When demand decreases, price and quantity both fall in equilibrium. 9. a. When demand increases, what happens to price and quantity in equilibrium? b. When supply increases, what happens to price and quantity in equilibrium? c. When supply decreases, what happens to price and quantity in equilibrium? d. When demand decreases, what happens to price and quantity in equilibrium? No, this is not a mistake. Yes, it is that important. Solution 9. Same as 8. 10. What’s the best way to think about the rise in oil prices in the 1970s, when wars and oil embargoes wracked the Middle East? Was it a rise in demand, a fall in demand, a rise in supply, or a fall in supply?

Solution 10. A fall in supply. The price spiked up, since it was tougher to get oil out of the Middle East. That fits the fall in supply story. 11. What’s the best way to think about the rise in oil prices in the last 10 years, as China and India have become richer. Was it a rise in demand, a fall in demand, a rise in supply, or a fall in supply? Solution 11. A rise in demand. The price spiked up, but more oil has been produced each year. The United States is using a bit less than before, especially since late 2007, but China and India are using more. When the price and quantity both rise, that’s because of a rise in demand.

Thinking and Problem Solving 12. Suppose the market for batteries looks as follows:

What are the equilibrium price and quantity? Solution 12. Price: $4; Quantity: 20 13. Consider the following supply and demand table for bread. Draw the supply and demand curves for this market. What are the equilibrium price and quantity?

Solution 13.

Price: $2; Quantity: 35 14. If the price of a one-bedroom apartment in Washington, DC, is currently $1,000 per month, but the supply and demand curves look as follows, then is there a shortage or surplus of apartments? What would we expect to happen to prices? Why?

Solution 14. There is a shortage of apartments. We would expect rents to rise as buyers who are willing to pay more than $1,000 for an apartment begin to offer higher rents just to secure an apartment; they’d rather pay more than not get an apartment at all.

15. Determine the equilibrium quantity and price without drawing a graph.

Solution 15. Quantity: 150; Price: $32 16. In the following figure, how many pounds of sugar are sellers willing to sell at a price of $20? How much is demanded at this price? What is the buyer’s willingness to pay when the quantity is 20 pounds? Is this combination of $20 per pound and quantity of 20 pounds an equilibrium? If not, identify the unexploited gains from the trade.

Solution 16. At a price of $20 sellers are willing to supply 20 pounds and buyers are demanding 40 pounds. The buyer’s willingness to pay at a quantity of 20 is $45, so the buyers are willing to pay more than the $20 sellers require to sell an additional pound of sugar. Thus, this is not an equilibrium. Unexploited gains from trade are shaded.

17. The market for marbles is represented in the graph. What is the total producer surplus? The total consumer surplus? What are the total gains from trade?

Solution 17. Consumer Surplus = (50)($11 − $5)/2 = $150; Producer Surplus = (50)($5 − $1)/2 = $100; Total Surplus = $250 18. Suppose you decided to follow in Vernon Smith’s footsteps and conducted your own experiment with your friends. You give out 10 cards: 5 cards to buyers with the figures for willingness to pay of $1, $2, $3, $4, and $5, and 5 cards to sellers with the amounts for costs of $1, $2, $3, $4, and $5. The rules are the same as Vernon Smith implemented. a. Draw the supply and demand curves for this market. At a price of $3.50 how many units are demanded? And supplied? b. Assuming the market works as predicted, and the market moves to equilibrium, will the buyer who values the good at $1 be able to purchase? Why or why not? Solution 18.

a. At a price of $3.50, two units will be demanded and 3 units will be supplied. The surplus of one unit will tend to drive the price down. b. The buyer who values the good at $1 will not be able to purchase the good because in equilibrium no one will be willing to offer the good for such a low price. Perhaps this is surprising, since there is a

supplier who would be willing to sell his good for only $1 if that was his only alternative. But since there are other buyers who are willing to pay more, the buyers who value the good at just $1 will be outcompeted by buyers who value the good more highly. Notice that this process of buyers with a high willingness to pay outcompeting buyers with a low willingness to pay is Part 1 of our three-part condition for maximizing the gains from exchange. Namely, the supply of goods is bought by the buyers with the highest willingness to pay. 19. If the price of margarine decreases, what happens to the demand for butter? What happens to the equilibrium quantity and price for butter? What would happen if butter and margarine were not substitutes? Use a supply and demand diagram to support your answer. Solution 19.

The equilibrium price and quantity of butter would decrease. If they were not substitutes, there would be no change in the demand for butter. 20. The market for sugar is diagrammed:

a. What would happen to the equilibrium quantity and price if the wages of sugar cane harvesters increased? b. What if a new study was published that emphasized the negative health effects of consuming sugar?

Solution

20. a. If the wage of sugar cane harvesters increased, then the cost of producing sugar will increase, which shifts the supply curve up and to the left, thereby increasing price and decreasing the equilibrium quantity.

b. If a new study emphasized the negative health effects of sugar, then the demand for sugar would decrease. That is, the demand curve would shift down and to the left, causing the equilibrium price and quantity to decrease.

21. If a snowstorm was forecast for the next day, what would happen to the demand for snow shovels? Is this a change in quantity demanded or a change in demand? This shift in the demand curve would affect the price; would this cause a change in quantity supplied or a change in supply? Solution 21. Demand for snow shovels would increase. This is a change in demand – people want a greater number of snow shovels at any price. The subsequent increase in price would cause a change in quantity supplied (a movement along the supply curve). 22. In recent years, the Paleo diet, which emphasizes eating more meat and fewer grains, has become very popular. What do you suppose that did to the price and quantity of bread? Use supply and demand analysis to support your answer. Solution 22. Demand for bread decreases and thus equilibrium price and quantity decrease.

23. In recent years, there have been news reports that toys made in China are unsafe. When those news reports show up on CNN and Fox News, what probably happens to the demand for toys made in China? What probably happens to the equilibrium price and quantity of toys made in China? Are Chinese toymakers probably better or worse off when such news comes out? Solution 23. Such reports probably reduce the demand for Chinese-made toys, so in equilibrium the price and quantity of Chinese-made toys fall. The bad news makes the Chinese toymakers worse off. 24. Here’s a quick problem to test whether you really understand what producer surplus and consumer surplus mean, rather than just relying on the geometry of demand and supply. For each of the two diagrams that follow, calculate producer surplus, consumer surplus, and total surplus. Assume the curves are perfectly vertical and perfectly horizontal.

Solution 24. In the diagram on the left, the consumer surplus (as drawn) is infinite, and the producer surplus is $0. In the diagram on the right, the consumer surplus is $0, and the producer surplus is $100. 25. The diagram that follows shows the market for agricultural products. The shift from the old supply curve to the new supply curve is the result of technological and scientific advances in farming, including the production of more resilient and productive seeds. Calculate the change in consumer surplus and the change in producer surplus caused by these technological advances. Are buyers better or worse off as a result of these advancements? What about sellers? (Note that you cannot calculate consumer

surplus directly with the information given in the diagram, but you don’t need that information to calculate the change in consumer surplus.)

Solution 25. The change in consumer surplus is shown by the trapezoid between $11 and $8 all the way out from the price axis to the demand curve. The area of this trapezoid is ($11 − $8) × [(3 million + 3.3 million)/2] = $3 × 3.15 million × $9.45 million. (This can also be calculated as the area of a rectangle plus the area of a triangle.) Before the technological advance, producer surplus is ($11 − $5.50) × 3 million × ½ = $8.25 million. After the technological advance, producer surplus is ($8 − $2) × 3.3 million × ½ = $9.9 million. Therefore the change in producer surplus is $1.65 million. Both buyers and sellers have benefited from the technological advance because both have seen an increase in surplus. 26. Now that you’ve mastered interpreting shifts in demand and supply, it’s time to add another wrinkle: simultaneous shifts in both demand and supply. Most of the time, when

we explore simultaneous shifts of demand and supply, we can determine the impact on either equilibrium price or equilibrium quantity, but not both. Fill in the missing cells in the table to see why. Because two curves can shift in two directions, there are four cases to consider. The first column is done for you as an example. Solution 26. See the completed table here.

27. In the last problem, you saw how simultaneous shifts in demand and supply can leave us with uncertainty about the impact on price or on quantity. An increase in both demand and supply will increase equilibrium quantity but have an ambiguous effect on equilibrium price. However, if we knew that there was a significant increase in demand and only a small increase in supply, we could conclude that the price would probably rise overall, albeit not by as much as would have been the case if supply had not increased slightly. In each of the following examples, there are a major event and a minor event. Determine whether each change relates to demand or to supply, and then figure out the impact on price and quantity; be sure to say something about the relative magnitudes of the price and quantity changes. a. Market: Rock salt Major event: A bitterly cold and unusually snowy winter season has significantly depleted the amount of available rock salt. Minor event: There is another snowstorm, and roads and sidewalks need to be salted. b. Market: Smartphones Major event: The proliferation of fast, reliable, affordable (or free) wi-fi and cellular signals increases the usability of smartphones. Minor event: The production of smartphones is marked by modest technological advances. c. Market: Canned tomatoes Major event: A large canned-tomato manufacturer begins to use cheap imported tomatoes from Mexico rather than domestic tomatoes.

Minor event: This causes a public relations fiasco, resulting in an organized effort to boycott canned tomatoes. Solution 27. a. The major event leads to a decrease in supply, and the minor event leads to an increase in demand. Therefore, equilibrium price will go up substantially, and equilibrium quantity will fall less substantially.

b. The major event leads to an increase in demand, and the minor event leads to an increase in supply. Therefore, equilibrium quantity will go up substantially, and equilibrium price will rise less substantially.

c. The major event leads to an increase in supply, and the minor event leads to a decrease in demand. Therefore, equilibrium price will go down substantially, and equilibrium quantity will rise less substantially.

Challenges 28. For many years it was illegal to color margarine yellow (margarine is naturally white). In some states, margarine manufacturers were even required to color margarine pink! Who do you think supported these laws? Why? (Hint: Your analysis in question 8 from the previous section is relevant!) Solution 28. The dairy industry wanted to prevent margarine from being a good substitute for butter in order to keep butter prices high. Yellow-colored margarine is a better substitute for butter than white or pink margarine! Thus, the dairy industry lobbied for laws to prevent margarine manufacturers from making their product look more like butter. It is still illegal to sell colored margarine in Québec, Canada. 29. Think about two products, “safe cars” (a heavy car such as a BMW 530xi with infrared night vision, four-wheel antilock brakes, and electronic stability control) and “dangerous cars” (a lightweight car such as _____ [name removed for legal reasons, but you can fill in as you wish]). a. Are these two products substitutes or complements? b. If new research makes it easier to produce safe cars, what happens to the supply of safe cars? What will happen to the equilibrium price of safe cars? c. Now that the price of safe cars has changed, how does this impact the demand for dangerous cars? d. Now let’s tie all these links into one simple sentence: “In a free market, as engineers and scientists discover new ways to make cars safer, the number of dangerous cars sold will tend to _______________.” Solution 29. a. They are substitutes. b. If it becomes easier to produce safe cars, the supply of safe cars will rise. This will push down the price of safe cars. c. Because the two kinds of cars are substitutes, the fall in the price of safe cars will reduce the demand for dangerous cars. d. decrease. 30. Many clothing stores often have clearance sales at the end of each season. Using the tools you learned in this chapter can you think of an explanation why? Solution 30. At the end of the season, the quantity demanded of some items will be less than the quantity supplied in the form of inventory stocks. To get rid of the excess supply of clothes, producers will have a sale (reduce the price). 31. a. If oil executives read in the newspaper that massive new oil supplies have been discovered under the Pacific Ocean but will likely only be useful in 10 years, what is likely to happen to the supply of oil today? What is the likely equilibrium impact on the price and quantity of oil today? b. If oil executives read in the newspaper that new solar-power technologies have been discovered but will likely only become useful in 10 years, what is likely to happen to the supply of oil today? What is the likely equilibrium impact on the price and quantity of oil today?

c. What’s the short version of these above scenarios? Fill in the blank: If we learn today about promising future energy sources, today’s price of energy will _______ and today’s quantity of energy will __________. Solution 31. a. The supply of oil is likely to rise today. If oil is going to become cheaper in the future, then firms are more willing to pump it out of the ground and sell it today. This will push today’s price down and push today’s quantity of oil up. b. The same thing happens. Oil and solar power are substitutes in many cases (not in all cases!), so cheap solar energy in the future means that oil will be less desirable in the future. Time to pump the oil and sell it today while people are still willing to pay a lot for it! c. The answers are “fall” and “rise.” Naturally, the size of the effect depends on how large and certain future increases are and how easy it is to pump out more oil in the short run. But the direction of the effect is clear. 32. Economists often say that prices are a “rationing mechanism.” If the supply of a good falls, how do prices “ration” these now-scarce goods in a competitive market? Solution 32. Because the price rises, only those people willing to pay the higher price will get the good. The higher price does all the heavy lifting. 33. When the crime rate falls in the area aroun...