Davidson College Department of Economics

Principles of Economics Problem Set #2 Suggested Solutions

Mark C. Foley Fall 2002

Short Answers 1. Find a recent newspaper or magazine article which descri es a market. !raph and interpret what is happening in that market "sing a model of s"pply and demand. #$lease attach a photocopy or printo"t of yo"r article.% This clearly depends on your individual article. 2. Ch. &' ("estion for )eview *10 OPEC was unable to maintain a hi h price throu h the !"#$s because the elasticity of supply and demand were more elastic in the lon run. %hen the price of oil rose& producers of oil outside of OPEC increased oil e'ploration and built new e'traction capacity. Consumers responded with reater conservation efforts. Thus& supply increased and demand fell& leadin to lower prices for oil in the lon run.

Problems 1. +"ppose the s"pply and demand sched"les for icycles are as follows, $rice -0 100 120 1.0 1/0 1-0 ("antity Demanded #per year% 20 11/ 1. 12 10 ("antity +"pplied #per year% 12 1. 1/ 120 22

#a% !raph these c"rves and show the e0"ili ri"m price and 0"antity. Price of Bicycles

S1
P* = 120 P2=$100 B C A

D1 D2
12 14 16= Q*

Quantity of Bicycles

# % 1ow s"ppose that it ecomes "nfashiona le to ride a ike' so 0"antity demanded at each price falls y . million ikes per year. 2hat is the new e0"ili ri"m price and 0"antity3 +how this sol"tion graphically. E4plain why the 0"antity falls y less than . million ikes per year. (ow at P) * !2$ there is an e'cess supply of bi+es of , million -!. / !2 * ,0 distance A12. %ith e'cess supply& bicycles will be pilin up in the showroom. Competition will soon forces prices to be bid down. As prices fall& suppliers cut bac+ on how much they supply to the mar+et& a movement alon the supply curve from point A to point C. Consumers also react to fallin prices by demandin more& a movement alon the demand curve from point 1 to point C. The e'cess supply is simultaneously reduced by fallin supply and risin demand& until the

mar+et returns to e3uilibrium. Supply does (OT need to fall by the full , million bicycles of initial e'cess supply because fallin prices ma+e demand rise to meet the fallin supply. The new e3uilibrium price is 4!$$ per bicycle and 3uantity demanded is !, million bicycles& point C. #c% +"ppose that instead that several ma5or icycle prod"cers go o"t of "siness' there y red"cing the 0"antity s"pplied y . million ikes at every price. Find the new e0"ili ri"m price and 0"antity. E4plain again why the 0"antity falls y less than . million ikes per year. Price of Bicycles
E D A

S2 S1

$140 P* = 120

D1

12

14

16= Q*

Quantity of Bicycles

At any iven price& , million fewer bicycles are supplied / the supply curve shifts bac+ to S2. At the ori inal e3uilibrium price of 4!2$ per bicycle& there would be an e'cess demand in the mar+et of , million bicycles& distance A5. This leads prices to be bid up. As prices rise& suppliers decide to devote more resources to bicycle production and more bicycles start arrivin on the mar+et -a movement alon the supply curve from 5 to E2. The risin price also ma+es consumers cut bac+ on their purchases of bicycles -a movement alon the demand curve from A to E2. Supply rises to meet fallin demand and a new e3uilibrium is eventually reached at point E. The new e3uilibrium price is 4!,$ per bicycle and the 3uantity sold in the mar+et is !, million bicycles. #d% 2hat are the e0"ili ri"m price and 0"antity if the shifts descri ed in part # % and #c% happen sim"ltaneo"sly3 Price of Bicycles S2 S1
P* = 120 F A

D1 D2
12 16= Q*

Quantity of Bicycles

6n this case' the fall in demand is e4actly met y the fall in s"pply. Fo"r million fewer icycles will e oth demanded and s"pplied' with the e0"ili ri"m price staying at 7120 per icycle' point F. 2. E4plain why the price elasticity of demand varies along a linear demand c"rve' ( 8 a 9 $' from elastic at higher prices to inelastic at lower prices. #: n"merical e4ample may help yo".% The percenta e chan e in price is initially -at points alon the demand curve 6ust after the y7intercept2 small because the price base is relatively lar e& while the percenta e chan e in 3uantity is lar e because the 3uantity base is small. 1ut as the price continues to fall& the si8es of the bases reverse causin the percenta es to also reverse.

;. <he market for Davidson College sweatshirts is descri ed y (D 8 =20 9 12$ and (+ 8 -0 > -$' where ( 8 sweatshirts per week and $ 8 dollars per sweatshirt. #a% Calc"late the e0"ili ri"m price and 0"antity. E3uilibrium occurs where 95 * 9S :2$ / !2P * #$ ; #P .,$ * 2$P P) * <2& and 9) * #$ ; #-<22 * <<.. # % <he Davidson <own Co"ncil is pers"aded that the s"pplier of sweatshirts is not earning eno"gh profit. <he town agrees to "y or sell sweatshirts as necessary to maintain a market price of 7.0. 2hat is the n"m er of sweatshirts o"ght y cons"mers at this price3 2hat does the program cost the town of Davidson3 At a price of 4,$& consumers want to purchase 95 * :2$ / !2-,$2 * 2,$& while the supplier would li+e to sell 9S * #$ ; #-,$2 * ,$$. Thus& at this price there is an e'cess supply of ,$$ / 2,$ * !.$ sweatshirts. To +eep their promise& the Town Council would have to pay 4,$-!.$2 * 4.&,$$. =evenue for the seller is P)9 S * ,$),$$ * 4!.&$$$ with private customers payin P)95 * ,$)2,$ * 4"&.$$ and the Town Council pays 4!.&$$$ 7 4"&.$$ * 4.&,$$. #c% 6s demand elastic' inelastic' or "nit?elastic over this range3 Check oth point and arc elasticity. >sin point elasticity& at the ori inal e3uilibrium& * -!?slope2-P?92 * -7!22 -<2?<<.2 * 7!.!,<. 5emand is elastic at this point. At P * 4,$& * 72.$& thus alon this se ment of the demand curve& demand is elastic. >sin arc elasticity& * -!?slope2-Pav ?9av 2 * -7!22-<.?2##2 * 7!.@& indicatin a ain that demand is elastic in this ran e.

Te'tboo+ Problems A Applications 1. Ch. .' $ro lem *11

-a2

Price of !ic"ets

$#

#$000

!ic"ets

This supply curve is vertical. A constant supply ma+es sense because the arena has a fi'ed number of seats& which will not chan e re ardless of price. -b2 9uantity supplied e3uals 3uantity demanded at a price of 4#. E3uilibrium 3uantity is #&$$$ tic+ets. -c2 (ew e3uilibrium price will be 4!2 and new e3uilibrium 3uantity is #&$$$ tic+ets.

2. Ch. &' $ro lem *; -a2 Bf your income is 4!$&$$$& your price elasticity of demand as the price of compact discs rises from 4# to !$ is C-,$7<22?<.D ? C-#7!$2?"D * -#?<.2-"?722 * 7 ! Bf your income is 4!2&$$$& price elasticity of demand is C-@$7,@2?,:.@D ? C-#7 !$2?"D * -@?,:.@2-"?722 * 7 .,: -b2 Bf the price is 4!2& your income elasticity of demand as your income increases from 4!$&$$$ to !2&$$$ is C-<$72,2?2:D ? C-!2&$$$ / !$&$$$2?!!&$$$D * !!?" * !.22. Bf the price is 4!.& C-!27#2?!$D ? C-!2&$$$ / !$&$$$2?!!&$$$D * !!?@ * 2.2. ;. Ch. &' $ro lem *& -a2 %ith a ,.< percent decline in 3uantity followin a 2$ percent increase in price& the price elasticity of demand is only 7,.<?2$ * 7$.2!@& fairly inelastic. -b2 %ith inelastic demand& the Transit AuthorityEs revenue rises when the fare rises. -c2 The estimate may be unreliable because itEs only the first month after a fare increase. As time passes& people may switch to other means of transportation in response to the price increase. So the elasticity may be lar er in the lon run than in the short run.