EC111 Chapter 3 Review Questions

Explain the law of demand. Why does a demand curve slope downward? How is a market demand curve derived from individual demand curves?

As prices change, buyers will change the quantity they demand of that item. If the price drops, a larger quantity will be demanded. If the price rises, a lesser quantity will be demanded. Its downward slope reflects the law of demand—people buy more of a product, service, or resource as its price falls. The relationship between price and quantity demanded is inverse (or negative). An inverse relationship between two variables will always provide a negative slope. By adding the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand.

Explain the law of supply. Why does the supply curve slope upward? How is the market supply curve derived from the supply curves of individual producers?

As prices rise because of increased demand for a commodity, producers find it more and more profitable to increase the quantity they offer for sale; that is, the supply curve will slope upward from left to right. Clearly, firms would rather sell at a higher price than at a lower price. Moreover, it is necessary for firms to demand a higher price as they increase production. This comes about because as they produce more and more, they start to run up against capacity constraints and costs rise. At any given time, a plant has a given size. As production increases, the firm will need to add an extra shift and then a third shift, both perhaps at higher wages. It may run out of warehouse space and have to rent at higher cost from another firm. It may have to pay extra to get increasingly urgent raw material, and so on. The market supply curve is derived by horizontally adding the individual supply curves.

What effect will each of the following have on the demand for small automobiles such as the Mini-Cooper and Fiat 500? a. Small automobiles become more fashionable. b. The price of large automobiles rises (with the price of small autos remaining the same). c. Income declines and small autos are an inferior good. d. Consumers anticipate that the price of small autos will greatly come down in the near future. e. The price of gasoline substantially drops.

Demand increases in (a), (b), and (c); decreases in (d). The last one (e) is ambiguous. As autos and gas are complements, one could argue that the decrease in gas prices would stimulate demand for all cars, including small ones. However, one could also argue that small cars are attractive to consumers because of fuel efficiency, and that a decrease in gas prices effectively reduces the price of the "gas guzzling" substitutes. That would encourage consumers to switch from smaller to larger cars (SUVs), and demand for small automobiles would fall. This presents a good illustration of the complexity of many of these changes.

For each stock in the stock market, the number of shares sold daily equals the number of shares purchased. That is, the quantity of each firm's shares demanded equals the quantity supplied. So, if this equality always occurs, why do the prices of stock shares ever change?

During any given stock trading session, there will be both prospective buyers and sellers, each willing to buy or sell a certain number of shares depending on price. If at the current price (e.g. the day's opening price) the quantity of shares demanded exceeds the quantity of shares supplied, buyers must increase their price offers to induce sellers to offer enough shares. This will cause share prices to rise until quantity demanded equals quantity supplied. Suppose that during the trading session there is a report of bad economic news. Sellers may respond by trying to sell more shares than buyers are wanting at the current price. In order to find enough willing buyers, sellers will have to offer their shares at lower prices. On any given trading day, there will be multiple equilibrium prices, many of them not lasting for more than a few minutes (or even seconds).

What are the determinants of supply? What happens to the supply curve when any of these determinants changes? Distinguish between a change in supply and a change in the quantity supplied, noting the cause(s) of each.

The non-price determinants of supply are: resource (input) prices, technology, taxes and subsidies, prices of other related goods, expectations, and the number of sellers. These determinants will cause a shift in the supply curve. Anything causing an increase in supply will shift the supply curve to the right. A decrease in supply will be shown by a shift to the left. As price increases, the quantity supplied increases. An increase in price causes a movement up a given supply curve. A decrease in price causes a movement down a given supply curve, decreasing quantity supplied.

In 2001 an outbreak of foot-and-mouth disease in Europe led to the burning of millions of cattle carcasses. What impact do you think this had on the supply of cattle hides, hide prices, the supply of leather goods, and the price of leather goods?

The supply of cattle hides was reduced, raising the price of hides. Because hides were more expensive, it became more costly to produce leather, reducing the supply and raising the price of leather goods

What are the determinants of demand? What happens to the demand curve when any of these determinants change? Distinguish between a change in demand and a movement along a fixed demand curve, noting the cause(s) of each.

There are determinants of demand, which are factors that may shift the demand curve, or cause a "change in demand." These are the number of buyers, the tastes (or desires) of the buyers, the income of the buyers, the changes in price of related commodities (substitutes and complements), and expectations of the buyers regarding the future price of the commodity under discussion.The determinants of demand will cause a shift in the demand curve. If it is something that increases the demand, the curve will shift to the right. A decrease in demand will be shown by a shift to the left. This is representative of quantity demanded changing at every price, either increasing or decreasing.A change in price causes movement along the commodity's demand curve. This movement is called a change in quantity demanded. A decrease in price leads to movement down the demand curve, or an increase in quantity demanded. Increased price leads to movement up the demand curve, or a decrease in quantity demanded.

Label each of the follow scenarios with the correct combination of price change and quantity change. In some scenarios, it may not be possible from the information given to determine the direction of a particular price change or a particular quantity change. We will symbolize those cases as, respectively, "P?" and "Q?" P↓ Q? P↑ Q? P? Q↓ P? Q↑ a. On a hot day, both the demand for lemonade and the supply of lemonade increase. b. On a cold day, both the demand for ice cream and the supply of ice cream decrease. c. When Hawaii's Mt. Kiluea erupts violently, the demand on the part of tourists for sightseeing flights increases but the supply of pilots willing to provide these dangerous flights decreases. d. In a hot area of Arizona where they generate a lot of their electricity with wind turbines, the demand for electricity falls on windy days as people switch off their air conditioners and enjoy the breeze. But at the same time, the amount of electricity supplied increases as the wind turbines spin faster.

a. P: ?, Q: increases The equilibrium quantity will definitely increase as the rightward shifts of both curves guarantee that their intersection point will also shift to the right. However, the change in price will depend on which curve shifts further to the right. If the demand curve shift horizontally further than the supply curve, the equilibrium price will rise (and visa versa). b. P: ?, Q: decreases With both curves shifting to the left, their intersection will also shift to the left. Thus, the equilibrium quantity will definitely decline. However, the direction of the price change will depend on which curve shifts further to the left. If the demand curve shifts further than the supply curve, then the intersection point will move down vertically, implying that the equilibrium price will fall. On the other hand, if the supply curve shifts further to the left, then the intersection point will be higher vertically, implying that the equilibrium price will rise. c. P: increases, Q: ? With demand increasing and supply decreasing, the intersection point between the demand curve and the supply curve will have to be higher. Thus, the equilibrium price will definitely rise. However, the change in the equilibrium quantity is uncertain. It will depend on whether the horizontal rightward shift of the demand curve is bigger or smaller than the horizontal leftward shift of the supply curve. If the demand curve moves right more than the supply curve moves left, then the equilibrium quantity will increase. By contrast, if the supply curve moves to the left more than the demand curve moves to the right, the equilibrium quantity will fall. d. P: decreases, Q: ? With demand falling and supply increasing, the intersection point between the demand curve and the supply curve will definitely move down vertically. Thus, the equilibrium price will definitely decline. Whether the equilibrium quantity increases or decreases will depend on which curve shifts further. If the rightward shift of the supply curve exceeds the leftward shift of the demand curve, then the equilibrium quantity will increase. By contrast, if the leftward shift of the demand curve exceeds the rightward shift of the supply curve, the equilibrium quantity will decrease.

What effect will each of the following have on the supply of auto tires? a. A technological advance in the methods of producing tires. b. A decline in the number of firms in the tire industry. c. An increase in the prices of rubber used in the production of tires. d. The expectation that the equilibrium price of auto tires will be lower in the future than currently. e. A decline in the price of the large tires used for semi-trucks and earth-hauling rigs (with no change in the price of auto tires). f. The levying of a per-unit tax on each auto tire sold. g. The granting of a 50-cent-per-unit subsidy for each auto tire produced.

a. Supply will increase because the technological advance allows the tire manufacturers to produce more tires using the same amount of inputs. b. Supply will decrease because there are less firms in the industry. c. Supply will decrease because the increase in the price of rubber results in an increase in production costs. Thus, each firm will need to charge a higher price at each level of output (or supply less at each price). d. Supply will increase because the expectation that the equilibrium price of auto tires will be lower in the future causes firms to sell their inventories today while the price is still high. e. Supply will increase because the decline in the price of large tires used for semi trucks and earth-hauling rigs (with no change in the price of auto tires) will cause firms to reduce production of large tires (now commanding a lower price) and produce more auto tires. These two goods are substitutes in production. f. Supply will decrease because per-unit tax on each auto tire sold increases the cost of production since the tire manufacturers must now pay for input costs PLUS the per unit tax. g. Supply will increase because the 50-cent-per-unit subsidy decreases the cost of production. The tire manufacturers receive the subsidy, which they can subtract from their input costs.