ECON-CL-2-ANSW.doc

1 ECONOMICS: EXERCISES CLASS 2: THE FUNDAMENTALS OF DEMAND AND SUPPLY ________________________________________________________________________ Discussion Questions Answers 1. (a) Define Market, Supply, and Demand and explain the connection between a market, demand and supply. (b) What is meant by demand, and what is the demand curve? (c) Define the term demand in economics. (a) Markets may be viewed as institutions that facilitate the process of exchange by providing regularized channels of communication between potential buyers and potential sellers of goods and services (Recall that I used Amazon and other markets as an example of such a regularized market). Despite their diversity, certain basics of economic principles apply to all of them. The law of supply and demand is thus a proposition predicting how individuals tend to behave in response to changes in their economic environment. Hence, if individual suppliers tend to be willing to sell more of a good or service as its price increases, and if individual buyers tend to be willing to purchase more of a good or service as its price falls, then all transactions taking place in a market will tend to be carried out at a particular, determinate price, which is a price such that the quantity of the good or service buyers wish to purchase exactly equals the quantity which suppliers are willing to sell. (b) Demand refers to the relationship between the quantity of a good that an individual or group desires and is able to buy at a particular time, and the price per unit of the good, factors other than price being equal. The desire to buy is not by itself sufficient to constitute demand, it must be accompanied by sufficient purchasing power. The demand relationship can be viewed in either of two ways. First, it can be viewed as specifying the maximum quantity of a good that an individual or group desires and is able to purchase at a given price. Second, it can be viewed as specifying the maximum price per unit that an individual or group of individuals is willing and able to pay for a given quantity of a good. Recall that a demand curve is a graphical representation of this relationship between the quantity of the good demanded and the price of the good (other factors remaining constant). (c) In economics, demand is defined as a schedule which shows the various amounts of a product which consumers are willing and able to purchase at each specific price in a set of possible prices during some specified period of time. Note the phrase, willing and able, because willingness alone is not effective in the market. One may be willing to buy Apples iPhone 12, but if this willingness is not backed by the ability to buy, that is, by the necessary pounds or euros, it will not be effective and, thus will not be reflected in the market. Therefore, given a set of prices and quantities for a product or good. The demand schedule in and of itself would not indicate which of the possible prices will actually exist in the market for the iPhone-12. This depends on both the demand and su pply. Demand is just a tabular statement of a buyer’s plans, or intensions, with respect to the purchase of the iPhone 12 or any other product, say, for example, Microsoft surface computer. It is also important to understand that to be meaningful, the quantities demanded at each price must relate to some specific time period – a day, a week, a month, and so forth. The phrase, a consumer will buy 10 flash drives per annum at £20 per flash drive is clear and very meaningful.

2 2. (a) What is the law of demand? (b) How can it be explained? (c) How is the market demand derived? (d) What are some of major determinants of the demand for a good? (e) Graphically, why does the demand curve, which represents all price and quantity demand possibilities, downward sloping and to the right? (a) The law of demand refers to the inverse or negative relationship that exists between the price and the quantity demanded of a good by an individual or group per time period. That is, as one variable increases, the other decreases. The law states that the quantity of a good demanded by an individual or group is greater (less) the lower (higher) the per unit price of the good, other things being equal. Put differently, it states that the maximum per unit price at which an individual or group member is willing and able to buy a given quantity of a good is greater (less) the smaller (larger) the quantity of that good, other factors remaining the same. (b) The law of demand is explained by the substitution and the income effects. The substitution effect results when the price of a good falls and consumers substitute that good for other goods which are now relatively more expensive. The income effect results when the price of a good falls and consumers can purchase more of the good because their real income is now higher. Most goods are normal in the sense that consumers purchase more of those goods when their income rises. Some inexpensive goods, such as potatoes and pasta, however, are considered inferior in the sense that consumers purchase less of those goods when their income rises. (c) The market demand curve for a good is obtained by the horizontal summation of the demand curves of all the consumers in the market. If all consumers were identical, the market demand curve would have t he same shape as the individual’s demand curves, except that the quantity on the horizontal axis of the market demand curve would be a multiple of the quantity on the horizontal axis of the individual’s demand curve. (d) Some of the major determinants of the demand for a good are: Tastes or preferences of consumers The number of potential buyers and their incomes The price of substitute and complementary goods Consumer expectations of future prices and their future incomes. (e) Refer to class discussion. Thus graphically, the downward sloping demand curve can be as shown. The demand curve slopes downward and to the right because there is an inverse relationship between price and the quantity demanded. The law of demand, which states that individuals buy more of any good at a lower price than they do at a higher price, is reflected in the downward slope of the demand curve. And as shown, the quantity demanded at a price of £5 would be 10 litres of petrol per week. And so, if the price of petrol is reduced to £4, the quantity demanded will increase to 20 litres, while with a dramatic fall in price, a price of £1, then individuals will be more willing and able to buy 70 litres of petrol.

4 (b) The demand a firm such as Apple faces for its iPhone 12 depends on all the forces that affect market demand for the iPhone 12, as well as the forces that are specific to the industry and Apple. The market forces include the price of the iPhone 12, the number of consumers in the market, consumers’ incomes, the price of related (i.e., substitute phones for the iPhone 12) mobile phones, and consumer tastes for the product. Among the forces that are specific to the industry and Apple are consumers’ expectations regarding the future price of the iPhone 12, Apple ’s level of advertising and marketing efforts, the pricing and marketing policies of other firms in the industry, as well as the availability of credit (should the consumer need to obtain the phone on contract), and the type of products Apple sells. 6. In the early 2000s, the price of steel which has an international market increased. Changes in demand and supply are reflected on the London Metal Exchange, where the international price of steel is established. Suppose the price of steel in 2005 increased suddenly from $0.32 per pound to approximately $0.42 per pound. Diagram and explain what may have caused the sudden shift in the demand curve for steel (Hint, the period coincides with the rapid economic growth of China)? The rise in the price of steel was attributed largely to an increase in demand, shown as a shift to the right of the demand curve (refer to class discussion). The graph also shows a very steep supply curve, which indicates that the steel industry was unable to supply much more steel even at very high prices. For instance, there was not enough time for steel smelters to increase production to meet the surge in demand. Under such circumstances there is usually a sharp increase, as illustrated by the increase from 1 P to 2 P in the graph. It should be noted that the demand curve shifted mainly because of increased purchase of steel by China in the world market which is priced in dollars. 7 . Explain what is meant by producers’ goods? By a firm’s derived demand for the inputs it uses in production? (b) Why i s the demand for durable goods (both consumers’ and producers’) less stable than the demand for normal goods? (a) Producer goods refer to goods such as raw materials, semi-processed materials, and equipment, that are used by firms to produce the goods and services demanded by consumers (i.e., consumer goods). Thus, the demand for producers’ goods is a derived demand , meaning that it is derived from the demand for the commodities for which the inputs are used. The greater is the demand for the goods and ser vices a firm sells, the greater us the firm’s demand for the inputs or resources required to produce those goods and services. (b) The demand for durable goods such as cars, washing machines, computers, refrigerators, capital equipment, and storable commodities, is less stable or more volatile than the demand for nondurable goods. The reason for is because the purchase of durable goods can be postponed by spending more on repairs and maintenance or by working off inventories until the economy improves, in the expectation of lower prices in future time periods. When the economy does improve, credit incentives are introduced, the lower prices materialize, and consumers and producers then greatly increase their demand for durable goods.

5 8. (a) What is meant by the term supply, and what is a supply curve? (b) State the law of supply, and (c) What are the major determinants of supply, that is, the position of the supply curve? (d) What is the distinction between a change in supply and a change in quantity supplied? Illustrate using supply curve diagrams. The supply curve of a good refers to the relationship at a particular time, between the price offered for the good and the quantity of it that sellers are willing to sell. The quantity of a good that an individual or group is willing to sell depends, other factors being equal, on the per unit price of the good. Or, to describe the same relationship in a different way, the minimum per unit price which will induce an individual or some members of the group to sell units of the good depends on the number of units, other factors again being equal. A supply curve is a graphical representation of the relationship between the price of a good and the quantity supplied. (b) The law of supply states that there is a direct relationship between price and quantity supplied. As price rises, the corresponding quantity supplied rises, and as price falls, the quantity supplied also falls. In other words, it simply states that producers are willing to produce and offer for sale more of their products at a high price than they are at a low price. (c) The first major determinant of supply is the cost of the resources used to produce a good. The second major determinant of supply is the technology by which a good is produced, that is the technique according to which resources are combined to produce it. The third main major determinant of supply is expectations regarding the price of the product, its complements and substitutes. The fourth major determinants of supply are custo mers’ incomes which can play a significant role in determining supply. The fifth major determinant of supply is the total market supply which depends on the number of suppliers, given the size of each. (d) A supply curve represents the relationship between the quantity of a good that potential sellers will supply and the per unit price offered for the good, other factors remaining the same. Thus, a change in supply refers to a change in the relationship between the quantity of a good that suppliers are willing to sell and the per unit price of the good due to a change in one of the factors which affect this supply relationship. That is, a change in supply means that at any given price sellers are willing to sell more or less than they were previously. A change in supply is represented graphically, therefore, by a change in the position of the supply curve, as shown in the diagram. Thus, if 1 S represents the initial state of supply, an increase in supply is indicated by a rightward and downward shift in the supply curve, e.g., to 2 S . At any given price, a larger quantity will be supplied than initially at 1 S . Likewise, a leftward and upward shift in the supply curve e.g., to 3 S , indicates a decrease in supply, for, at any given price, a smaller quantity will be supplied than initially at 1 S . If on the other hand, the quantity of the good that will be supplied at each possible price remains unchanged, but price changes, the response to the price change is a change in the quantity supplied. The set of different quantities that will be supplied at different prices, other factors remaining constant, is just what a supply curve represents. A change in quantity supplied in response to a price change is represented, then, by movement to a different point on the same supply curve. For example, if, other factors remain constant, price rises from 1 P to 2 P . In Figure b, suppliers will supply a larger quantity, 2 Q , as compared to 1 Q at 1 P . Likewise, if the price falls from 1 P to 3 P , suppliers will supply a smaller quantity, 3 Q as compared to 1 Q at 1 P .

7 11. Pia owns a design your own pizza restaurant. If a new student accommodation building opens up across the street from her, what will probably happen to the prices she can charge for her pizza? Illustrate using supply and demand curve diagrams. Refer to the diagram used in class discussion. Using the supply and demand curve, the situation before the new student accommodation building opens is shown at the initial equilibrium point. The equilibrium point which is determined by these two curves is e with price P and quantity Q. The opening of a new student accommodation building would give Pia new potential customers, causing the demand curve for her pizza to shift out to 1 D , as shown in Figure 2. This new demand leads to a new equilibrium point e, with a new price of 2 P and a new quantity supplied and demanded of 2 Q . Thus, an increase in demand results in an increase in both the equilibrium price and the equilibrium quantity. 12. Due to a new breakthrough in microchip, the cost of producing Tablets fall dramatically. What would be the effect of this on the equilibrium price and quantity in the Tablet market, assuming all other things remain unchanged? Again, refer to class discussion and the diagram used. Here, Figure 1 showed the market before the change occurs, with the equilibrium point at 1 1 ( , ) P Q . Note that the problem states that the costs of producing Tablets has fallen, meaning that this change is likely to result in a decrease in the price that the firm/producer is willing to accept for his product at any quantity supplied. That is, a downward shift occurs in the supply curve, from 1 S to 2 S as shown in Figure 2. Thus, the new equilibrium point 2 P , 2 Q shows that price will decrease from 1 P and the quantity sold will increase from 1 Q to 2 Q . 13. Briefly explain the price elasticity of demand and why a negative sign is inserted in front of demand elasticity. The price elasticity of demand is a measure of the extent or degree to which the quantity of a good demanded , Q, responds to changes in the price, P, of the good. Specifically: , , Percentage change in quantity demanded Elasticity e percentage change in price = − / / Q Q Q P P P P Q   = − = −    Where ΔP represents the change in the price of the good, and ΔQ represents the resulting change in the quantity of the good demanded. Demand is said to be elastic if e > 1, inelastic if e < 1 and unitary elastic if e = 1. The demand curve diagrammed represents a typical demand curve, which is downward sloping. This means that price and quantity demanded moves in opposite directions. As price increases, quantity demanded decreases while as price decreases, the quantity demanded increases. To see why the negative sign is employed. Let’s suppose we move from point A to point B.

8 As the diagram indicates, ΔP = P B – P A is negative, while ΔQ = Q B – Q A is positive. Since in determining elasticity, we would be dividing by a positive number (ΔQ/Q) by a negative number (ΔP/P), our elasticity coefficient would be negative. Therefore, by convention we add the minus sign to make the elasticity coefficient positive. The same reasoning applies when we move from point B to A. Note that in the case of supply, we do not need a minus sign since quantity demanded and price change in the same direction. Problems 14 Given the market demand schedule below for product V, diagram the demand curve and find the elasticity ( e ) for a movement from point B to point D and from D to B. Point P v (£) Q v _____________________________ A 8 0 B 7 100 C 6 200 D 5 300 F 4 400 G 3 500 H 2 600 L 1 700 M 0 800 _______________________________ From D to B 200 7 7 2 100 D B B D B B Q Q P e P P Q −    = −  = − =    − −    From B to D 200 5 1.67 2 300 B D D B D D Q Q P e P P Q − −    = −  = −     −   