CHAPTER 4 - WORKING WITH SUPPLY AND DEMAND
ANSWERS TO EVEN-NUMBERED PROBLEMS
2.
a. With the $2 price ceiling people would still demand 60,000 bottles of maple syrup
per month, but the suppliers would only be willing to supply 30,000 bottles (that is,
10,000 bottles less than before the supply curve shift). Thus the supply curve shift
leads to an even higher shortage of 30,000 bottles per month.
b. If all of the maple syrup supplied (30,000 bottles) is purchased and resold in the
black market, the black market price would be greater than before the supply curve
shift. The black market price is read off the demand curve, as the price that
corresponds to 30,000 bottles. Because the demand curve is downward sloping, the
price that corresponds to 30,000 bottles is higher that the price that corresponds to
40,000 bottles (which was the old black market price, before the supply curve shift).
Draw a graph to convince yourself.
4.
In order for the $0.60 tax to be divided equally between buyers and sellers, the price
paid by buyers would have to be $0.30 higher than it was originally and the after-tax
price received by sellers would have to be $0.30 lower. That is, the new market price
paid by consumers would have to be $3.00 + $0.30 = $3.30 and the price received by
sellers would have to be $3.00 - $0.30 = $2.70. From the diagram, however, it is clear
that at $3.30 per gallon, consumers would want to purchase more than 300 million
gallons per day while at $2.70 per gallon (after taxes), sellers would want to offer
fewer than 300 million gallons. Therefore, with an equal split of the tax, the market
could not be in equilibrium.
6.
a. Total farm acreage in the U.S. is a stock variable, because it measures the quantity
of farms that exist in the U.S. at a point in time.
b. Total spending on food in China is a flow variable, because is measures the
spending over some period of time.
c. Total value of U.S. imports from Europe is a flow variable, because it measures the
value of imports over time.
d. Worldwide iPhone sales is a flow variable, because it measures the number of
iPhones sold over a period of time.
e. The total number of parking spaces in Los Angeles is a stock variable, because it
measures the quantity of parking spaces at a point in time. In contrast, the total number
of newly constructed parking spaces per month would be a flow variable.
f. The total value of human capital in India is a stock variable, because it measures the
value of human capital at a point in time.
g. Investment in new human capital in India is a flow variable, because it measures the
amount of investment over a period of time.
Chapter 4 Working with Supply and Demand
8. For the following answers assume that the existing stock of homes in Monotone, AZ is Q.
a. We start off at point A, where the housing market in Monotone is in equilibrium.
Without the special tax breaks, 500 new homes would be built in Monotone (dashed
vertical supply curve to the right of S1). With the special tax breaks we observe an
additional 300 new homes built, resulting in a new stock of Q+800 homes (vertical
supply curve S2). The special tax breaks only affect the home builders, i.e. suppliers,
and have no effect on demand. Demand, as usual in Monotone, shifts to the right by
500 homes. Since supply shifted to the right by more than demand, the price of homes
in Monotone will fall from P1 in the old equilibrium (point A) to P2 in the new
equilibrium (point C).
a)
Tax Breaks for Home Builders
S1
S2
Price of
Homes
B
P1
A
C
2
D2
D1
Q
Q+500
Q+800
Stock of
Homes
b. If interest rates fall, it effectively becomes cheaper to buy a house, thus shifting
demand for homes to the right by more than 500 (D1 shifts to D2). The vertical supply
curve however only shifts to the right by 500 homes, as usual for Monotone. Since
there is a greater rightward shift in demand than in supply, the price of homes
increases from P1 to P2, as we move from the old equilibrium (point A) to the new
equilibrium (point C).
Chapter 4 Working with Supply and Demand
b)
Interest Rates Fall
S1
Price of
Homes
S2
C
P2
P1
A
D2
D1
Q
Q+500
Stock of
Homes
c. If zoning laws prevent construction of new homes in Monotone, the supply curve is
fixed at S1, while the demand shifts rightward from D1 to D2 by 500 homes, as usual.
This will lead the price to increase from P1 to P2.
c) Zoning Laws – No New Construction
S1
Price of
Homes
C
P2
P1
A
D1
Q
Q+500
D2
Stock of
Homes
Chapter 4 Working with Supply and Demand
d. If in addition to zoning laws, home buyers’ expectations about the future go up (i.e.
they expect their homes to be more valuable in the future) then demand shifts to the
right by more than 500 homes. As in part c. supply is fixed at S1, but demand shifts
from D1 to D2. The resulting price P2 is even higher than in part c.
d)
Zoning and Expectations Go Up
S1
Price of
Homes
C
P2
P1
A
D2
D
1
D1
Q
Stock of
Homes
Q+500
e. We assume that before the earthquake, both the supply and demand in Monotone
shifted to the right by 500, as usual (S1 shifts to S2 and D1 shifts to D2). The
earthquake destroys 2,000 homes, shifting supply to the left to S3. At the same time
3,000 homeowners decide they don’t want to own homes in Monotone, shifting
demand to the left to D3. The resulting price, P2 is lower than the original P1.
e)
Earthquake, People Leaving
S3
S1
S2
Price of
Homes
B
P1
A
P2
C
D2
D3
Q -2500 Q -1500
D1
Q
Q+500
Stock of
Homes
Chapter 4 Working with Supply and Demand
10.
a. Before any changes in price, the value of equity is equal to the down payment,
$100,000.
b. Before any changes in price, the simple leverage ratio is $400,000/$100,000 = 4.
c. The new value of your equity is $500,000 - $300,000 = $200,000. The new simple
leverage ratio is $500,000/$200,000 = 2.5.
d. False. As you can see from parts b. and c., an increase in the value of a home, with
no additional borrowing or repayment, decreases the degree of leverage on the
investment in the home. (However, note that if the initial leverage was 1, then a
change in price does not change the simple leverage ratio. You can work this out on
your own.)
MORE CHALLENGING QUESTION
12.
a. You borrow $100,000 beyond the original mortgage over the three years. Your
original equity was $100,000 and the original debt was $300,000. When the value of
the home increases to $500,000, and you keep the same equity, it must be that your
total debt is $500,000-$100,000 = $400,000, which implies that your additional debt is
$100,000.
b. Your simple leverage ratio at the end of the three years is $500,000/$100,000 = 5.
c. If the total debt associated with your home is $400,000, then your equity is wiped
out if the price of your home falls to $400,000. If we start with a price of $500,000, a
fall to $400,000 would be a 20% fall in the price, since ($500,000-$400,000)/$500,000
= 0.20. Hence, the price of your home could fall up to 20% before your equity is
wiped out.