TOPIC II: Perfectly Competitive Markets: SUPPLY AND DEMAND

Transcription

1 TOPIC II: Perfectly Competitive Markets: SUPPLY AND DEMAND I. Markets as allocators A. What is a market institution? B. How do markets solve the allocation problem? C. Prices and their various meanings Nominal (money) vs. real (relative) II. III. The Supply and Demand Model: The Case of Perfectly Competitive Markets Market Demand (D) A. Factors which influence the quantity demanded in a specified time period B. Concept of a demand schedule (demand) C. Change in quantity demanded as opposed to a change in demand D. Law of Demand? E. Factors which shift the demand curve IV. Market Supply (S) A. Factors which influence the quantity offered in a specified time period B. Concept of a supply schedule (supply) C. Change in quantity supplied as opposed to a change in supply D. Law of Supply? E. Factors which shift the supply curve V. Market Equilibrium Price and Quantity Concepts: A. Equilibrium price and quantity B. Surplus C. Shortage VI. Market Dynamics - changes in P E, Q E when D and/or S Change II 1

2 CONCEPTS AND PRINCIPLES There are numerous mechanisms that strongly influence how scarce resources are allocated among competing wants - from individuals in their everyday decisions - to governments - to religious organizations - to civic groups, etc. Important in all of these cases is the role "markets" play in affecting allocation decisions - what, how, and for whom. We have to study how markets work in order to begin to understand their influence on decision processes and the allocation of resources. Markets exist in many forms, trade between two individuals, retail markets, wholesale markets, the stock exchange, electronic markets in the web, auctions, etc. Common to all markets is the notion of exchange at a market price. This is the money price at which currency ($) is traded for each unit of a good. Understanding the different ways market prices are formed in different markets is an essential part of understanding how markets work to solve allocation processes. Think about the differences in the processes of determining market prices in the following example situations: (1) two individuals bargaining over the price of a used car, (2) the daily price changes in the New York Stock Exchange, bidding for a construction contact,... The process of determining market prices may be different across different market situations, but the role market prices play in the allocation process is the same across different markets. This leads us to our next principle of economics. Principle 5 - In markets, prices serve as signals which influence the allocation of scarce resources toward their most valued uses. Producers use various prices to determine the profitability of alternative ventures they may undertake. Consumers use prices as guides to comparing the opportunity costs of choosing to consume alternative goods (activities). Prices serve as an "invisible hand" guiding the allocation process. We face a problem, however, in understanding how markets work to affect the allocation of resources. All markets are not alike and this affects our ability to analyze how markets work. So we begin with the idea of markets with strong competition - numerous sellers and numerous buyers - all selling and buying an identical commodity (good). This is the market structure we refer to as perfect competition. PRICES Before moving ahead, however, we need to spend a little time thinking about what we mean by price. First, one concept of price is the price per unit: $.75 per soda, $35,000 per car, $120 per share of CBQ stock. The money prices in these examples are also called nominal prices. Another type of price is what we call the real price. The real price is what one actually gives up (measure in other goods) when one buys a good. II 2

3 Questions: Suppose all nominal prices doubled. How would real prices change? How is the consumer price index (the CPI) related to the idea of real prices? A Special Case: Interest rates are a special kind of price. They measure the cost of borrowing money - or the return for loaning money. So, if the interest rate is 10% per year, the price of borrowing $100 is $10. Also, the real interest rate is measured different than other real prices. The real interest rate equals the nominal interest rate minus the inflation rate. So if the interest rate were 10% and the inflation rate was 6%, the real interest rate would be 4%. PERFECTLY COMPETITIVE MARKETS: DEMAND AND SUPPLY Below we build two very important models to help us evaluate how buyers and sellers respond to economic incentives, and how these two models can be combined to examine how highly competitive markets might function. Before we begin, we need to discuss the concept of ceteris paribus. An important conceptual idea that runs throughout economics is to evaluate the effect of a change in the value of one variable on the value of another variable. For example, if the price of gasoline increased from $2.80 per gallon to $3.50 per gallon, how would this change the quantity of gasoline consumers would be willing to purchase. In order to consider such relationships, we must hold constant the values of other variables that might effect decisions. For example, to examine the effect of a change in the price of gasoline on consumers decisions to purchase gasoline, we would want to hold constant other factors such as income, the price of taxi or airline services, etc. To represent holding all other variables or factors constant, we use a term for Latin... ceteris paribus. Why is the ceteris paribus assumption vital to our analysis? II 3

4 THE BUYERS We begin with buyers (consumers) in the market setting. Many factors affect the willingness and ability of buyers to purchase various quantities of a particular commodity (X) during a given time period. Important among these are: price of X quantities consumed and prices of other goods income preferences expectation of future prices whether it is legal or illegal to purchase good X Demand and Quantity Demanded Now let's turn to the specific role of the "Price of X" in determining what we buy and how much we buy. Demand for good X -- The relationship between the quantity demanded of good X during a specific time period and possible prices of good X, ceteris paribus. Ceteris Paribus means holding all relevant factors constant. In more precise terms, we can state the demand relationship in two ways. 1) Maximum quantity method - at each possible price - demand is a schedule (graph) showing the maximum quantity that would be demanded of good X - for a specified time period - holding all other factors constant. 2) Maximum price method - at each possible quantity - demand is a schedule (graph) showing the maximum price (the limit price) consumers could be charged for good X and still be willing to purchase that quantity - for a specified time period - holding all other factors constant. Demand is not a quantity! It is a relationship between quantity demanded and price - but that relationship depends on other things - income, preferences, etc. II 4

5 What does this relationship look like? Principle 6 - "The law of demand" - holding all factors constant, we expect an inverse relationship between quantity demanded of X and the P of X. Change in Demand What would we mean by a change in demand? When demand changes this means that there has been a change in the relationship - shown graphically as a shift outward or inward. How do we describe these shifts? What would lead to such a change? How do we relate changes in demand to limit prices? Consider the two figures shown on the next page. A change in demand implies the demand relationship between price and quantity demanded changes. There is a shift in the demand curve. Decrease in Demand: The demand curve shifts inward (to the left) Increase in Demand: The demand curve shifts outward (to the right) II 5

6 Interpreting an increase in Demand - a rightward or upward movement P x P 1 At each price, the quantity demanded increases P 2 D 2 D 1 Q x / t P x At each quantity, the limit price increases D 2 Q 1 Q 2 D 1 Q x / t So, there are two conceptual ways of thinking about an increase in demand. Make sure you understand the logic behind each of these interpretations. II 6

7 Interpreting a decrease in Demand - a leftward or downward movement P x At each price, quantity demanded decreaes P 1 P 2 D 1 D 2 Q x / t P x At each quantity, the limit price decreases D 1 Q 1 Q 2 D 2 Q x / t So, there are two conceptual ways of thinking about a decrease in demand. Make sure you understand the logic behind each of these interpretations. Understanding the distinction between a change in quantity demanded and a change in demand is very important! Holding all other factors constant, when the P X changes this leads to a change in quantity demanded - a movement along the demand curve. If other relevant things change (such as consumer preferences for the good, consumer incomes, the price of other goods), this will lead to a change in demand - a shift of the demand curve - a change in the relationship between P X and the quantity demanded at each price. Now consider more specifically what factors change demand. II 7

8 Demand Shifters: Factors that shift/change the demand curve 1. A change in consumer preferences for the good. If something changes to make consumers prefer the good more than before - demand increases. If something changes to make consumers prefer the good less than before - demand decreases 2. A change in the consumption of other goods - here we must distinguish between substitutes and complements. Goods X&Y are Substitutes: If the quantity consumed of good Y increases, then the demand for good X decreases. If the quantity consumed of good Y decreases, then the demand for good X increases. Goods X&Y are Complements: If the quantity consumed of good Y increases, then the demand for good X increases. If the quantity consumed of good Y decreases, then the demand for X decreases. NOTE: often substitutes and complements are defined in terms of how a price change in one good affects the demand for another good One must be careful in using this definition. It relates critically to ceteris paribus assumption. If nothing changes for the consumer, but something changes for suppliers that causes a price change, we get the following relationships: Goods X&Y are substitutes: If the Py increases, leading to a decrease in the consumption of Y, then the demand for X increases. If the Py decreases, leading to an increase in the consumption of Y, then the demand for X decreases. Goods X&Y are complements: If the Py increases, leading to a decrease in the consumption of Y, then the demand for X decreases. If the Py decreases, leading to an increase in the consumption of Y, then the demand for X increases. II 8

9 3. A change in expectations regarding the future price of the good. If one updates their current expectations about the future, and now expects the price of X to increase in the future, then the current demand for X will increase. Similarly, if one updates their current expectations about the future, and now expects the price of X to decrease in the future, then the current demand for X will decrease. 4. A change in income - here we must distinguish between normal and inferior goods. Normal Goods: If consumer incomes increase, the demand for normal goods increase. If consumer incomes decrease, the demand for normal goods decrease. Inferior Goods: If consumer incomes increase, the demand for inferior goods decrease. If consumer incomes decrease, the demand for inferior goods increase. 5. Any change that affects the opportunity cost of purchasing the good other than the money price of the good itself. For example, if the legality of purchasing a good changes or if the hassles of buying a good change. Holding P X constant, if the opportunity costs increase, demand will decrease. If the opportunity costs decrease, demand will increase. 6. A change in the number of buyers being considered. If there is an increase in the number of potential buyers, then demand will increase. If there is a decrease in the number of potential buyers, then demand will decrease. The list above is not comprehensive. The list summarizes a broad group of changes that could occur that would change the demand for a good. II 9

10 THE SUPPLIERS Now consider the suppliers (producers) in the market setting. Many factors affect the willingness and ability of suppliers to sell various quantities of a particular commodity (X) during a given time period. Important among these are: price of X profitability of producing other goods costs of production legality of selling Supply and Quantity Supplied Let's turn to the specific role of the "Price of X" in determining what sellers produce and how much they produce. The willingness to supply a good to the market is seen as being a function of the revenue that can be earned and the cost of providing each unit of the good. Revenues and costs of production then determine profits. Supply of good X -- The relationship between the quantity supplied of good X during a specific time period and possible prices of good X - holding all relevant factors constant (ceteris paribus). In more precise terms, we can state the supply relationship in two ways. 1) Maximum quantity method - at each possible price - supply is a schedule (graph) showing the maximum quantity that would be supplied of good X - for a specified time period - holding all other factors constant. 2) Minimum price method - at each possible quantity - supply is a schedule (graph) showing the minimum price (the reservation price) sellers could be paid for the good and still be willing to sell that quantity - for a specified time period - holding all other factors constant. Supply is not a quantity! It is a relationship between quantity supplied and price - but that relationship depends on other things - costs of producing the good. II 10

11 What does this relationship look like? Principle 7 - "The rule of supply" - holding all factors constant, we expect a positive relationship between quantity supplied of X and the P of X. Change in Supply What would we mean by a change in supply? A change in the relationship - shown graphically a shift outward or inward. How do we characterize such shifts and what would lead to such a change? How would we relate changes in supply to reservation prices? Consider the two figures shown on the next page. A change in supply implies the supply relationship between price and quantity supplied changes. There is a shift in the supply curve. Decrease in Supply: The supply curve shifts inward (to the left) Increase in Supply: The supply curve shifts outward (to the right) II 11

12 Interpreting an increase in Supply - a rightward or downward movement P x S 1 S 2 P 1 At every price, the quantity supplied increases P 2 Q x / t S 1 P x S 2 At every quantity, the reservation price decreases Q x / t Q 1 Q 2 So, there are two conceptual ways of thinking about an increase in supply. Make sure you understand the logic behind each of these interpretations. II 12

13 Interpreting a decrease in Supply - a leftward or upward movement P x S 2 S 1 P 1 At each price, the quantity supplied decreases P 2 Q x / t S 2 P x S 1 At each quantity, the reservation price increases Q x / t Q 1 Q 2 So, there are two conceptual ways of thinking about a decrease in supply. Make sure you understand the logic behind each of these interpretations. Understanding the distinction between a change in quantity supplied and a change in supply is very important! Holding all other factors constant, when the P X changes this leads to a change in quantity supplied - a movement along the supply curve. If other relevant things change (such as a change in the cost of providing the good), this will lead to a change in supply - a shift of the supply curve - a change in the relationship between P X and the quantity supplied at each price. II 13

14 We now turn to specific factors that change supply. Supply Shifters So, when the price of a good changes, this creates a movement along the supply curve for that good. What factors shift the supply curve? That is, what factors cause a change in supply? 1. Changes in costs that change reservation prices (minimum acceptable prices) Changes in Production Costs: A decrease in production costs will lower reservation prices which will increase the supply of good X. An increase in production costs will increase reservation prices which will decrease the supply of good X. For example, suppose the price of labor increases. This increases production costs, raises reservation prices, decreases supply. Changes in Opportunity Costs: A decrease in opportunity costs will lower reservation prices which will increase the supply of good X. An increase in opportunity costs will increase reservation prices which will decrease the supply of good X. For example, a change in the legality of selling the good will change the reservation price. If a good becomes illegal to sell, reservation prices will increase, supply will decrease. Also, the producer must consider the opportunity costs of using resources to supply good X instead of using those resource to provide some other good. A farmer can produce soy beans or corn on the same land. If the profitability of growing soy beans increases, this increases the opportunity cost of growing corn, raises reservation prices for corn and thus decreases the supply of corn. 2. A change in the number of sellers. If the number of potential suppliers increases then supply increases. If the number of potential suppliers decreases, this decreases the supply. The list above summarizes a broad group of changes that could occur that would shift the supply for a good. Be sure you understand the logic behind this list and the circumstances in which each one of the changes would increase supply versus when they would decrease supply. II 14

15 MARKET EQUILIBRIUM PRICE AND QUANTITY The next step is to see how Supply and Demand work together to determine the market price and the quantity traded for the good in question. Market Equilibrium Price (P E ) - The market equilibrium price is a special market price. It is the price at which the Quantity Demanded (Qd) by buyers equals the Quantity Supplied (Qs) by sellers. Market Equilibrium Quantity (Q E ) - The quantity traded between buyers and sellers at the market equilibrium price. If the existing market price is above P E, then the Qs is greater than the Qd - there is a surplus in the market. In this case, competition between sellers to sell their product (not to be left out without selling their product) will tend to force the market price downward toward P E. If the existing market price is below P E, then the Qs is less than the Qd - there is a shortage in the market. In this case, competition between buyers to buy the good (not to be left out of buying) will tend to force the market price upward toward P E. Consider the graph shown below. What is P E? What is Q E? What is the surplus at a market price of $20? If the market price were $20, what would be the quantity traded? What is the shortage at a market price of $6? If the market price were $6, what would be the quantity traded? the equilibrium price, P E, and 25 is the equilibrium quantity traded, Q E. $13 is Principle 8 - Market forces will force the market price toward the equilibrium price. If the market price is above P E, there is a surplus. As price falls, the Qs decreases and the Qd increases. If the market price is below P E, there is a shortage. As price increases, the Qs increases and the Qd decreases. II 15

16 S&D -- Change in P E and Q E Mechanics: Single shift in D or S Demand Increase -- rightward shift in demand -- at the current equilibrium price there will now be a shortage. This shortage will lead to a price increase. As price increases, the Qd decreases and the Qs increases until a new P E and a new Q E are reached. Demand Decrease -- leftward shift in demand -- at the current equilibrium price there will now be a surplus. This surplus will lead to a price decrease. As price decreases, the Qd increases and the Qs decreases until a new P E and a new Q E are reached. Supply Increase -- rightward shift in supply -- at the current equilibrium price there will now be a surplus. This surplus will lead to a price decrease. As price decreases, the Qd increases and the Qs decreases until a new P E and a new Q E are reached. Supply Decrease -- leftward shift in supply -- at the current equilibrium price there will now be a shortage. This shortage will lead to a price increase. As price increases, the Qd decreases and the Qs increases until a new P E and a new Q E are reached. See the figures on the next page. Each of the cases for a shift in S or D are shown graphically. Be sure you understand the logic of the movement of price from one equilibrium to another. Mechanics: Simultaneous shifts in D and S Increase in Demand and an Increase in Supply -- Q E increases, impact on P E depends on the magnitude of the shift in S&D. Increase in Demand and a Decrease in Supply -- P E increases, impact on Q E depends on the magnitude of the shift in S&D. Decrease in Demand and an Increase in Supply -- P E decreases, impact on Q E depends on the magnitude of the shift in S&D. Decrease in Demand and a Decrease in Supply -- Q E decreases, impact on P E depends on the magnitude of the shift in S&D. II 16

17 Summary Illustrations on Changes in S&D Case 1: D 1. First, the market is at P 1,Q 1 2. D to D 2-3. At P 1, there is now a shortage (Q D >Q S ) 4. The shortage creates pressure on market price, market price. 5. As P, Q D and Q S, until new equilibrium is reached at P 2,Q 2. Case 2: D 1. First, the market is at P 1,Q D to D 2 3. At P 1, there is now a surplus (Q S >Q D ) 4. The surplus creates pressure on market price, market price. 5. As P, Q D and Q S, until a new equilibrium is reached at P 2,Q 2. Case 3: S 1. First, the market is at P 1,Q S to S 2 3. At P 1, there is now a surplus (Q S >Q D ) 4. The surplus creates pressure on market price, and market price. 5. As P, Q D and Q S, until a new equilibrium is reached at P 2,Q 2. Case 4: S 1. First, the market is at P 1,Q S to S 2 3. At P 1, there is now a shortage (Q D >Q S ) 4. The shortage creates pressure on market price, market price. 5. As P, Q D and Q S, until a new equilibrium is reached at P 2,Q 2. II 17

18 SOLVING APPLICATION QUESTIONS: A technique for analyzing S&D problems As you begin to use the tools of supply and demand to solve problems, think about how you might use the steps below to help guide you in coming to a final answer. 1) Determine the primary market in the problem, and draw a S&D curve to represent the market. Label P E and Q E.. 2) From the question, determine the variable that has changed. Determine whether the variable change affects S or D. 3) Do the mechanics - shift the appropriate curve - determine the impact on P E and Q E. 4) If appropriate - locate secondary markets (markets that are affected by the changes in the primary market). Using information from step 4 - analyze the secondary market. QUESTIONS Short Answer 1. What is the difference between "demand" and "quantity demanded?" 2. When deriving the demand for a product, what is changing? What is being held constant -- ceteris paribus? 3. What is the difference between "a change in demand" and a change in "quantity demanded?" 4 What is meant by an increase in demand? Be very specific. As part of your answer, use the concept of limit prices. Discuss an increase in demand using a graph that characterizes your demand for soda. 5. What is meant by a decrease in demand? Be very specific. As part of your answer, use the concept of limit prices. Discuss a decrease in demand using a graph that characterizes your demand for gasoline. 6. If the demand for soda increases, does quantity demanded also increase? Show this graphically. 7. What is meant by the "time dimension" when one is describing the demand for a good? 8. Holding demand constant, what is the only thing that can cause a change in "quantity demanded?" What are the things that cause a "change in demand?" II 18

19 9. Assume sodas and popcorn are complements. Assume sodas and milk are substitutes. Assume manufacturers of soda face a cost of production increase that results in their increasing the price of soda. On three different graphs (one for sodas, one for popcorn, and one for milk) show a "before price increase graph." Then, on each graph, show what happens when the price of soda increases. 10. What is the difference between "supply" and "quantity supplied?" 11. When deriving the supply for a product, what is changing? What is being held constant -- ceteris paribus? 12. What is the difference between "a change in supply" and a change in "quantity supplied?" 13. What is meant by an increase (decrease) in supply? Be very specific. As part of your answer, use the concept of reservation prices. 14. Holding supply constant, what is the only thing that can cause a change in "quantity supply?" What are the things that cause a "change in supply?" 15. Why are the following statements FALSE? A. Demand increases lead to supply increases. B. The demand for health care is inversely related to price. C. An increase in income will always lead to an increase in demand. D. An increase in supply implies the supply curve shifts up. E. If beer and wine are substitutes, a price increase by wine retailers will increase the demand for and supply of beer. F. An increase in the price consumers are willing to pay for home computers should lead to an increase in the supply of home computers. G. An increase in the supply of oranges would increase the demand for oranges. H. The law of demand states that demand is inversely related to price. I. An increase in the price of Pepsi would increase the quantity demanded of Cokes but not the demand for Cokes. J. An increase in the price of Coke would decrease my limit prices for Coke. K. An increase in the price of Coke would decrease my limit prices for Pepsi. II 19

20 16. Discuss how demand or supply will be affected in each of the following examples -- tie your discussion back to the S&D model we have been using in class. A. the buying of cigarettes is made illegal -- impact on the cigarette industry B. the selling of cigarettes is made illegal -- impact on the cigarette industry C. interest rates on "charge cards" are reduced to 6% -- the impact on retail clothing stores. D. higher licensing fees are placed on trawling for shrimp in the Gulf of Mexico -- impact on the shrimp industry E. higher licensing fees are placed on trawling for shrimp in the Gulf of Mexico -- impact on the beef industry F. the price of natural gas (used in home heating) increases -- impact on the market for firewood G. the minimum wage is increased to $7.00 per hour -- impact on the fast food industry 17. Graphically work through the four basic cases for a change in P E and Q E. In each case, explain how the shift in D or S leads to a shortage or surplus. Discuss how this surplus leads to a change in market price and a resulting change in Qd and Qs until a new equilibrium is reached. 18. Take each example in question show graphically the affect on equilibrium price (P E ) and equilibrium quantity (Q E ) in the relevant markets. 19. What complication arises in our S&D model if there is a change which causes both S&D to simultaneously change? For example, how would P E and Q E be affected if simultaneously it is made illegal to both buy and sell cigarettes? 20. True/False - explain A. tomatoes and lettuce are complements - an increase in cost of producing lettuce will decrease the demand for tomatoes. B. tomatoes and lettuce are complements - an increase in cost of producing lettuce will decrease the supply of tomatoes. C. an increase in the profitability of growing corn will decrease the supply of soy beans. II 20

21 Multiple Choice by Area Prices 1. If the price of a hotdog is $2.00 and the price of a soda is $0.50, the opportunity cost of a hotdog (in terms of soda) is A B C D If the price of a hotdog is $1.00 and the price of a soda is $0.50, the relative price of a soda (in terms of hotdogs) is A B C D If the price of apples increases by 5% and the price of oranges increases by 10%, both the nominal and relative price of apples (in terms of oranges) must have decreased. A. True B. False 4. Assume in 1991 the market price of a Chevy Astro is $16,000 and the market price of a new home is $160,000. In 1992, the price of both goods is expected to increase by 5%. From this information we can conclude that A. in relation to each other, their relative prices will remain unchanged. B. in relation to a new home, the relative price of an Astro will increase. C. in relation to an Astro, the relative price of a new home will increase. D. the relative price of both goods in relation to each other will increase. 5. Throughout much of the 1970s, real interest rates were negative, implying that A. the annual inflation rate was less than nominal interest rates. B. the annual inflation rate was less than the real rate of interest. C. businesses were paying very low (but positive) real interest on savings. D. the annual inflation rate exceeded the nominal interest rate. II 21

22 Demand 1. Which of the following statements accurately illustrates an example of the "law of demand?" A. As incomes have risen over time, demand has increased for luxury goods. B. Recent increases in the domestic price of wine have decreased the demand for domestic wine. C. In the past month the price of automobiles increased 8% leading to a decrease in quantity demanded of 10%. D. All of the above statements illustrate the law of demand. 2. Which of the following statements are correct with respect to a DECREASE in the demand for good X? A DECREASE in demand for X occurs if A. consumers are willing and able to purchase smaller quantities of good X at each possible price of good X. B. consumers purchase a smaller quantity of good X due to an increase in the price of good X. C. the price of good X increases, ceteris paribus. D. decreases in the supply of good X make smaller quantities of good X available. E. All of the above are correct statements regarding the meaning of a decrease in demand. 3. Which of the follow could not cause a shift in the demand curve for coffee, ceteris paribus A. it is discovered that drinking coffee increases the risk of cancer. B. the price of doughnuts (a coffee complement) decreases. C. the price of coffee increases. D. consumer incomes decrease. 4. Which of the following statements correctly represents a change in demand? A. Recent increases in the supply of IBM stock have led to a reduction in the price of IBM stock leading to an increase in demand for IBM stock. B. Because of recent decreases in the price of home computers, consumers have increased their demand for word processing software. C. The recent 5% increase in the price of gasoline has led to a 1% decrease in demand for gasoline. D. All of the above statements represent a change in demand. 5. The Law of Demand specifies that the quantity demanded of Good X is inversely related to the price of Good X. A. True B. False II 22

23 6. In economics, the term normal goods refers to goods A. for which demand decreases when income decreases. B. for which quantity demanded falls as price falls. C. for which supply increases when market price increases. D. both A and B E. both B and C 7. Suppose generic soda is an inferior good and Pepsi is a normal good. If there is an increase in consumer income A. the demand for generic soda will decrease and the demand for Pepsi will increase. B. the demand for both products will increase. C. the demand for generic soda will increase and the demand for Pepsi will decrease. D. the demand for both goods will decrease. 8. Which of the following will NOT affect an individual's demand curve for good x? A. a shortage of good x B. expectations about future income C. tastes and preferences D. time period being considered E. All of the above would be expected to affect an individual s demand curve for good x. 9. If a 5% increase in the price of gasoline leads to only a 1% reduction in the quantity demanded of gasoline, this violates the law of demand. A. True B. False 10. Which of the following statements represents a decrease in demand? A. The recent increase in interest rates has led to a decrease in the demand for loans. B. Because of recent increases in the price of foreign cheese, consumers are now willing to purchase less foreign cheese. C. Recent decreases in the price of natural gas have led to decreases in the demand for electricity. D. All of the above statements represent a decrease in demand. II 23

24 Supply 1. A decrease in the supply of wheat could be explained as a movement downward in the reservation prices of wheat farmers. A. True B. False 2. An increase in the supply of corn occurs when corn farmers are willing to A. supply a greater quantity of corn when the price rises. B. supply a greater quantity of corn when demand rises. C. increase the quantity they supply at each possible market price. D. harvest these crops more intensely if they can receive a higher price in corn brought to market. E. all of the above represent increases in supply. 3. In 1992, Pizza Pie was willing to offer for sale up to 1,000 pizzas per day at a price of $10.00 per pizza. In 1993 they are willing to offer up to 1,000 pizzas at $9.00 per pizza. One would say that there has been: A. a decrease in demand. B. a decrease in supply. C. an increase in demand. D. an increase in supply. 4. A decrease in the cost of providing good X will decrease the supply of good X. A. True B. False 5. The ICM Corporation was previously willing to supply 2,400 stereos at a price of $ per unit. This same supplier is now willing to supply 2,000 units at a price of $400 per unit. This change would be described as a(n) A. increase in supply. B. decrease in supply. C. movement down along their demand curve D. movement up along their supply curve II 24

25 6. Which of the following uses the terminology of economics correctly? A. Due to the world glut (surplus) of oil, the supply of oil has fallen. B. As the price of gasoline has increased, suppliers have increased their supply. C. Computer technology has improved the efficiency in steel production which has led to increases in the supply of steel. D. Due to the U.S. shortage of hardwoods, the supply to the U.S. from foreign countries has increased. S&D - Equilibrium Prices 1. Assume a simultaneous change where: 1) consumers expect the future price of soda to increase, and 2) the supply of coffee (a substitute for soda) has just decreased. With these changes, one would expect to observe in the current soda market A. an increase in demand and an increase in supply. B. a decrease in demand and a decrease in supply. C. a decrease in demand and no change in supply. D. an increase in demand and no change in supply. 2. Assume the market for good X is in equilibrium. If market conditions change, leading to an increase in the supply of good X A. there is a surplus at the existing price, creating an offsetting increase in supply. B. there is a surplus at the existing price, creating an offsetting decrease in demand. C. there is a surplus at the existing price, creating a decrease in price, leading to a decrease in supply and an increase in demand. D. there is a surplus at the existing price, creating a decrease in price, leading to a decrease in quantity supplied and an increase in quantity demanded. 3. Ceteris paribus, an increase in the price of a good resulting from a shortage will A. decrease the supply of the good. B. decrease the quantity supplied of the good. C. decrease the demand for the good. D. decrease the quantity demanded of the good. 4. Supply and Demand refer to the quantities suppliers will be willing to offer and consumers will be willing to buy at the existing market price. A. True B. False 5. A change in demand will cause equilibrium price and quantity traded to move in opposite directions. A. True B. False II 25

26 6. In automobile manufacturing, steel and plastics are substitutes. Thus, an increase in the price of steel will increase both the market demand and quantity demanded for plastics. A. True B. False 7. The quantity of shrimp purchased by consumers has increased by 12% over the past year in spite of the fact that the price has increased by 5%. A reasonable explanation for this is that the demand for shrimp was also increasing over this period. A. True B. False 8. Droughts which destroy wheat crops in other countries would cause an increase in the demand for U.S. wheat resulting in higher wheat prices and an increase in the supply of wheat. A. True B. False 9. Suppose peanut butter and jelly are complements. An increase in the price of peanut butter resulting from an increase in the cost of producing peanut butter will A. increase the supply of jelly. B. decrease the supply of jelly. C. decrease the demand for jelly. D. increase the demand for jelly. 10. According to the Indiana Farmer's Almanac, "The drought of 1991 severely reduced the corn crop of Indiana Farmers." Based on this information you would expect A. the market equilibrium price of Indiana corn to decrease. B. the supply of Indiana corn to increase. C. the demand for Indiana corn to decrease. D. the equilibrium quantity of corn traded in Indiana to decrease. II 26

27 11. The introduction of Digital Audio Tapes will revolutionize the recording industry. Compact discs and Digital Audio Tapes are substitutes. What affect will this have on the compact disc market? A. Equilibrium price and quantity will both increase. B. Equilibrium price and quantity will both decrease. C. Equilibrium price will increase, equilibrium quantity will decrease. D. Equilibrium price will decrease, equilibrium quantity will increase. 12. Which of the following would increase the equilibrium price in the current market for good X? A. The future price of X is expected to decrease. B. X and Y are complements in consumption and the government imposes a tax on the suppliers of good Y. C. X is a normal good and the government decreases income via a 3% increase in income taxes. D. X and Y are substitutes in consumption and there is an increase in the price of an essential input used in the production of Y. 13. Suppose that pretzels and soda are complementary goods and that the price of soda falls sharply as a result of an increase in supply. Which of the following will occur? A. The price of pretzels will tend to rise and the quantity of pretzels purchased will tend to fall. B. The price of pretzels will tend to fall. C. The quantity of pretzels purchased will tend to rise but the effect on price is indeterminate. D. Both the price of pretzels and the quantity of pretzels purchased will tend to rise. 14. Assume farmers in Indiana can grow either corn or wheat. Ceteris paribus, a decrease in the profitability of growing corn would be expected to A. cause an upward movement along the market supply curve for corn. B. increase the market supply of wheat - lowering farmers reservation prices for supplying wheat. C. decrease both the market demand and market supply for corn. D. decrease the demand for wheat leading to an upward movement along the supply market curve for wheat. 15. Suppose that airline travel and taxi services are complements. Further assume that both can be modeled using standard S & D analysis. The likely impact of a wage increase for airline employees would be A. a decrease in demand for airline and taxi services. B. a decrease in supply of airline services and a decrease in demand for taxi services. C. a movement down along the demand curve for airline services and down along the demand curve for taxi services. D. a movement down along the supply curve for airline services and up along the demand curve for taxi services. 16. Assume that computers and computer disks are complements. Ceteris paribus, an increase in the supply of computers will II 27

28 A. increase the supply of disks. B. increase the quantity supplied of disks. C. decrease the supply of disks. D. decrease the quantity supplied of disks. 17. A simultaneous increase in the supply of apples and decrease in the demand for apples will cause A. an increase in the price of apples. B. a decrease in the price of apples. C. no change in the price of apples. D. an indeterminate change in the price of apples. 18. Ceteris paribus, expectations that future interest rates will increase will change the supply and demand for current loans, leading to A. an increase current equilibrium interest rates and an increase in the current equilibrium quantity of loans. B. a decrease current equilibrium interest rates and an increase in the current equilibrium quantity of loans. C. a decrease current equilibrium interest rates and a decrease in the current equilibrium quantity of loans. D. an increase current equilibrium interest rates and an indeterminate effect on the current equilibrium quantity of loans. E. an indeterminate effect on current interest rates. 19. The price of automobiles has been increasing at the same time that the quantity of autos sold has been increasing. These changes would be consistent with A. upward movements along the demand curve for automobiles. B. downward movements along the demand curve for automobiles. C. a leftward shift in the demand curve for automobiles. D. a rightward shift in the demand curve for automobiles. 20. Assume a simultaneous change where: 1) the U.S. government passes a bill which will increase excise taxes on all alcoholic beverages beginning in May of next year and 2) the current supply of wine (a substitute for beer) decreases. With these changes, one would expect to observe in the current beer market A. a decrease in demand and an increase in supply. B. a decrease in demand and a decrease in supply. C. a decrease in demand and no change in supply. D. an increase in demand and no change in supply. 21. Assume X and Y are substitutes. If the supply of X increases, which of the following statements is correct? A. The demand for Y shifts to the left. B. The demand for Y shifts to the right. II 28

29 C. The demand for Y does not change, but the quantity demanded increases. D. The demand for Y does not change, but the quantity demanded decreases. 22. If a decrease in the cost of producing good A causes an increase in the demand for good B, we would say that A and B are A. substitutes. B. complements. C. normal goods. D. inferior goods. 23. Suppose that tea and soda are substitutes and that the price of soda falls sharply as a result of increased competition between soda distributors. Which of the following will occur? A. The price of tea will tend to rise and the quantity of tea purchased will tend to fall. B. The price of tea will tend to fall and quantity purchased will decrease. C. The quantity of tea purchased will tend to fall but the effect on price is indeterminate. D. The price of tea will rise but the effect on quantity of tea is indeterminate. 24. The quantity of whole milk sold annually in the United States has decreased significantly while the price of whole milk remained relatively constant. The decrease in sales in conjunction with virtually no change in price could be explained by A. a decrease in demand and no change in supply. B. an increase in supply and an increase in demand. C. a decrease demand and a decrease in supply. D. a decrease supply and no change in demand. 25. If both supply and demand for new homes increase, which of the following will definitely happen? A. Price will rise. B. Quantity will increase. C. Prices will remain unchanged. D. Quantity will remain unchanged. II 29