Solutions to Additional Exercises
Additional Exercises
Question1
Explain each of the following statements using supply and demand diagrams.
a) When there is a drought in southern Europe, the price of olive oil rises in supermarkets
throughout Europe.
b) When the Olympic Games were held in London in 2012, the price of hotel rooms in central
London rose sharply.
c) When conflict breaks out in the Middle East, the price of petrol in Europe rises and the
price of a used Mercedes falls.
Solutions
a.
Drought damages the olive crop, reducing the supply of olives. This can be seen in figure as a
shift to the left in the supply curve for olives. The new equilibrium price is higher than the old
equilibrium price.
b.
Olympic games attracted a lot of visitors to London, all needed somewhere to stay. So, extra
demand for hotel rooms would have shifted the demand curve to the right. Thus, the
equilibrium increased sharply.
c.
When a war breaks out in the Middle East, many markets are affected since there is a large
amount of crude oil is produced there. The war disrupts the oil suppliers shifting the supply
curve for petroleum to the left as shown in the figure below. The result is a rise in the
equilibrium price of petroleum. This leads to increase in the cost of operating a Mercedes. As
a result, the demand for used Mercedes will decline, because people in the market for cars
will not find the car as attractive. Thus, demand curve for used Mercedes shifts to the left
while the supply curve shifts to the right. The result is a decline in the equilibrium price of
used Mercedes.
Question 2
Consider the market for large family saloon cars (minivans). For each of the events listed here,
identify which of the determinants of supply or demand are affected. Also indicate whether supply
or demand is increased or decreased. Then show the effect on the price and quantity of large
family saloon cars (minivans).
a) People decide to have more children.
b) A strike by steel workers raises steel prices.
c) Engineers develop new automated machinery for the production of cars.
d) The price of estate cars rises.
e) A stock market crash lowers people’s wealth.
Solutions
a) If people decide to have more children (a change in taste), they will want larger vehicles
(minivans, saloons) for carrying their children around, so the demand for large family
saloon cars will increase. Supply won’t be affected. The result is a rise in both price and
quantity, as shown below.
b) If a strike by steelworkers raises steel prices, the cost of producing a minivan rises (a rise in
input prices), so the supply of minivans decreases. Demand won't be affected. The result is
a rise in the price of minivans and a decline in the quantity, as shown below.
c) The development of new automated machinery to produce minivans is an improvement in
technology. The reduction in firms' costs results in an increase in supply. Demand isn't
affected. The result is a decline in the price of minivans and an increase in the quantity.
d) The rise in the price of estate cars affects demand for large family cars like minivans
because estate cars are substitutes for minivans (that is, there is a rise in the price of a
related good). The result is an increase in demand for minivans. Supply is not affected. In
equilibrium, the price and quantity of minivans both rise.
e) The reduction in peoples' wealth caused by a stock-market crash reduces their income,
leading to a reduction in the demand for minivans, since minivans are likely a normal good.
Supply isn’t affected. As a result, both price and quantity decline.
Question 3
Using supply and demand diagrams, show the effect of the following events on the market for
sweatshirts.
a) A drought in Egypt damages the cotton crop.
b) The price of leather jackets falls.
c) All universities require students to attend morning exercise classes in appropriate attire.
d) New knitting machines are invented.
Solutions
a) When a drought in Egypt damages the cotton crop, it raises input prices for producing
sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in the figure.
The new equilibrium has a higher price and lower quantity of sweatshirts.
b) A decline in the price of leather jackets leads more people to buy leather jackets, reducing
the demand for sweatshirts (on the assumption that sweatshirts and leather jackets are
substitutes for one another). The result is a decline in both the equilibrium price and quantity
of sweatshirts.
c) The effect of universities requiring students to engage in morning exercise classes in
appropriate attire is to raise the demand for sweatshirts. The result is an increase in both the
equilibrium price and quantity of sweatshirts.
d) The invention of new knitting machines increases the supply of sweatshirts. As the figure
shows, the result is a reduction in the equilibrium price and an increase in the equilibrium
quantity of sweatshirts.
Question 4
The market for pizza has the following demand and supply schedules:
a) Graph the demand and supply curves. What is the equilibrium price and quantity in this
market?
b) If the actual price in this market were above the equilibrium price, what would drive the
market towards the equilibrium?
c) If the actual price in this market were below the equilibrium price, what would drive the
market towards the equilibrium?
Solutions
a) Quantity supplied equals quantity demanded at a price of €6 and quantity of 81 pizzas.
b) If price were greater than €6, quantity supplied would exceed quantity demanded, so
suppliers would reduce their price to gain sales.
c) If price were less than €6, quantity demanded would exceed quantity supplied, so suppliers
could raise their price without losing sales. In both cases, the price would continue to adjust
until it reached €6, the only price at which there is neither a surplus nor a shortage.
Question 5
Consider the market for smart phones. Initially the market demand for these phones is given as P =
500 – .005Q and the market supply for these phones is given as P = .005Q.
a. Given this information, what is the equilibrium price and equilibrium quantity of
smart phones in this market?
To find the equilibrium quantity set the market demand curve equal to the market supply curve:
500 - .005Q = .005Q or Q = 50,000. Use this quantity in either the demand or supply curve to
find the equilibrium price: P = 500 - .005(50,000) = $250.
b. What is the value of consumer expenditure on smart phones given this initial
information?
Consumer expenditure in this problem will be equivalent to total revenue. This implies that
consumer expenditure can be found by multiplying the equilibrium price times the equilibrium
quantity. Thus, consumer expenditure = ($250 per smart phone)(50,000 smart phones) =
$12,500,000.
Now, suppose that tastes and preferences for smart phones changes so that at every price
an additional 20,000 phones are demanded. There are no changes in the market supply
curve.
c. Given this information, what is the new equilibrium price and equilibrium quantity
of smart phones in this market?
To find the new equilibrium price and equilibrium quantity of smart phones you need to first
find the new demand curve. You know from the given information that the demand curve has
shifted to the right by 20,000 units at every price: the new demand curve is therefore parallel
to the initial demand curve. This implies that the two demand curves have the same slope. You
also know that the point (120,000 smart phones, $0 per smart phone) sits on the new market
demand curve. Use this point and the slope of the original demand curve to find the new
demand curve: P = 600 - .005Q. Once you have the new marked demand curve use this demand
curve and the supply curve to find the new equilibrium price and equilibrium quantity in the
market. Thus, 600 - .005Q = .005Q or Q = 60,000 smart phones. Plug this quantity back into the
new market demand curve or the supply curve to find the equilibrium price: P = 600 .005(60,000) = $300 per smart phone.
d. Given this new information, what is the value of consumer expenditure on smart
phones in this market?
Consumer expenditure in this problem will be equivalent to total revenue. This implies that
consumer expenditure can be found by multiplying the equilibrium price times the equilibrium
quantity. Thus, consumer expenditure = ($300 per smart phone)(60,000 smart phones) =
$18,000,000.
Now suppose that the government implements a price floor in the market for smartphones
and this price floor is set at $150 per unit.
e. Describe the impact of this price floor on the market for smart phones and in your
answer explain why this is the impact.
This price floor will have no impact on this market. For a price floor to be effective it must be
set at a level that is greater than the equilibrium price in the market since a price floor is a
minimum price that can be charged for the good. If the price floor is set at a level below the
equilibrium price then consumers will continue to pay this equilibrium price and producers will
continue to charge this equilibrium price and the price floor will not have any impact on the
market.
The government decides to institute a price ceiling in this market for smart phones instead of
the price floor. The government sets this price ceiling at $400.
f. Describe verbally (no numbers needed here) the impact of this price ceiling on the
market for smart phones and in your answer explain why this is the impact.
A price ceiling represents a maximum price that can be charged for a good. For a price ceiling
to be effective it must be set below the equilibrium price in the market. In this example the price
ceiling is effective since its level ($200 per unit of smart phones) is less than the equilibrium price
of $250 in this market. When a price ceiling is effective there will be excess demand at the price
ceiling price since suppliers will supply fewer units than the number of units demanded by
consumers.