Chapter 2 the Basics of Supply and Demand

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1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market-clearing level?

Assume the supply curve is fixed. The unusually hot weather will cause a rightward shift in the demand curve, creating short-run excess demand at the current price. Consumers will begin to bid against each other for the ice cream, putting upward pressure on the price. The price of ice cream will rise until the quantity demanded and the quantity supplied are equal. [pic]

Figure 2.1

2. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold:

a.An increase in the price of margarine.

Most people consider butter and margarine to be substitute goods. An increase in the price of margarine will cause people to increase their consumption of butter, thereby shifting the demand curve for butter out from D1 to D2 in Figure 2.2.a. This shift in demand will cause the equilibrium price to rise from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2. [pic]

Figure 2.2.a

b.An increase in the price of milk.

Milk is the main ingredient in butter. An increase in the price of milk will increase the cost of producing butter. The supply curve for butter will shift from S1 to S2 in Figure 2.2.b, resulting in a higher equilibrium price, P2, covering the higher production costs, and a lower equilibrium quantity, Q2. [pic]

Figure 2.2.b

Note: Given that butter is in fact made from the fat that is skimmed off of the milk, butter and milk are joint products. If you are aware of this relationship, then your answer will change. In this case, as the price of milk increases, so does the quantity supplied. As the quantity supplied of milk increases, there is a larger supply of fat available to make butter. This will shift the supply of butter curve to the right and the price of butter will fall.

c.A decrease in average income levels.

Assume that butter is a normal good. A decrease in the average income level will cause the demand curve for butter to shift from D1 to D2. This will result in a decline in the equilibrium price from P1 to P2, and a decline in the equilibrium quantity from Q1 to Q2. See Figure 2.2.c. [pic]

Figure 2.2.c

3. If a 3-percent increase in the price of corn flakes causes a 6-percent decline in the quantity demanded, what is the elasticity of demand?

The elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in the price. The elasticity of demand for corn flakes is [pic]. This is equivalent to saying that a 1% increase in price leads to a 2% decrease in quantity demanded. This is in the elastic region of the demand curve, where the elasticity of demand exceeds -1.0.

4. Explain the difference between a shift in the supply curve and a movement along the supply curve.

A movement along the supply curve is caused by a change in the price or the quantity of the good, since these are the variables on the axes. A shift of the supply curve is caused by any other relevant variable that causes a change in the quantity supplied at any given price. Some examples are changes in production costs and an increase in the number of firms supplying the product.

5. Explain why for many goods, the long-run price elasticity of supply is larger than the short-run elasticity.

The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in price. An increase in price induces an increase in the quantity supplied by firms. Some firms in some markets may respond quickly and cheaply to price changes. However, other firms may be constrained by their production capacity in the short...
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