As evidence she notes that while the university has doubled its tuition in real terms over the past 15 years, neither the number nor quality of students applying has decreased. Would you accept this argument? Hint: The official makes an assertion about the demand for admission, but does she actually observe a demand curve? What else could be going on? If demand is fixed, the individual firm a university may determine the shape of the demand curve it faces by raising the price and observing the change in quantity sold.
The university official is not observing the entire demand curve, but rather only the equilibrium price and quantity over the last 15 years. If demand is shifting upward, as supply shifts upward, demand could have any elasticity. Demand could be shifting upward because the value of a college education has increased and students are willing to pay a high price for each opening.
More market research would be required to support the conclusion that demand is completely price inelastic. What is the price elasticity of demand? What is the cross- price elasticity of demand? Now what is the price elasticity of demand?
What is the cross-price elasticity of demand? Suppose that rather than the declining demand assumed in Example 2. How will the price of copper change? To find the new equilibrium price of copper, set the new supply equal to demand so that —6. The price decreased by 10 cents per pound, or Suppose the demand for natural gas is perfectly inelastic. What would be the effect, if any, of natural gas price controls?
If the demand for natural gas is perfectly inelastic, then the demand curve is vertical. Consumers will demand a certain quantity and will pay any price for this quantity. In this case, a price control will have no effect on the quantity demanded. Draw a graph to illustrate your answers.
Equilibrium price and quantity are found at the intersection of the demand and supply curves. When the income level increases in part b, the demand curve will shift up and to the right. The intersection of the new demand curve and the supply curve is the new equilibrium point. We know that the price elasticity of demand may be calculated using equation 2. What are the equilibrium price and quantity? The equilibrium price and quantity are found where the quantity supplied equals the quantity demanded at the same price.
Will there be a shortage, and if so, how large will it be? This will result in a shortage of 4 million. Refer to Example 2. At the end of , both Brazil and Indonesia opened their wheat markets to U. Suppose that these new markets add million bushels to U. What will be the free market price of wheat and what quantity will be produced and sold by U.
If Brazil and Indonesia add an additional million bushels of wheat to U. To find the equilibrium quantity, substitute the price into either the supply or demand equation, e. Unlimited quantities are available for import into the United States at this price. The U.
Price U. Supply U. Demand million lbs. What is the equation for demand? What is the equation for supply? In a free market, what will be the U. At this price, the domestic supply is 6 million lbs. Imports make up the difference and are 16 million lbs. Much of the demand for U.
Suppose the export demand for wheat falls by 40 percent. What happens to the free market price of wheat in the United States? Do the farmers have much reason to worry? The best way to handle the 40 percent drop in export demand is to assume that the export demand curve pivots down and to the left around the vertical intercept so that at all prices demand decreases by 40 percent, and the reservation price the maximum price that the foreign country is willing to pay does not change.
If you instead shifted the demand curve down to the left in a parallel fashion the effect on price and quantity will be qualitatively the same, but will differ quantitatively.
The new export demand is 0. Graphically, export demand has pivoted inwards as illustrated in figure 2. At this price, the market-clearing quantity is Most farmers would worry.
Now suppose the U. With this drop in export demand, how much wheat would the government have to buy? How much would this cost the government? Excess supply is therefore Quantity is measured in tens of thousands of apartments. Price, the average monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from more three-person families coming into the city from Long Island and demanding apartments.
If both the agency and the board are right about demand and supply, what is the free market price? Assuming three people per family per apartment, this would imply a loss of , people. However, excess demand supply shortages and lower quantity demanded are not the same concepts. The supply shortage means that the market cannot accommodate the new people who would have been willing to move into the city at the new lower price.
Therefore, the city population will only fall by ,, which is represented by the drop in the number of actual apartments from 1,, the old equilibrium value to ,, or , apartments with 3 people each. If 50 percent of any long-run increases in apartment offerings come from new construction, how many apartments are constructed?
Therefore, 0. Note, however, that since demand is only , units, , units would go unrented. In , Americans smoked billion cigarettes, or Statistical studies have shown that the price elasticity of demand is Using this information, derive linear demand and supply curves for the cigarette market.
In Example 2. Suppose the long-run price elasticity of copper demand were Following the method outlined in Section 2. The linear demand equation consistent with a long-run price elasticity of Using this demand curve, recalculate the effect of a 20 percent decline in copper demand on the price of copper.
D Equating this to supply, 8. With the 20 percent decline in the demand, the price of copper falls to Using the data given in that example: a. Suppose that war or revolution caused Saudi Arabia to stop producing oil.
These are equated with short-run and long-run demand, so that: To solve this problem, we apply the analysis of Section 2. Solving for e, 1. Substitute the price of oil in the supply and demand curves to verify these equations.
Then set the curves equal to each other and solve for the price of gas. How much excess demand would there have been? With a supply of 19 Tcf and a demand of Suppose that the market for natural gas had not been regulated.
The table below shows the retail price and sales for instant coffee and roasted coffee for and Using this data alone, estimate the short-run price elasticity of demand for roasted coffee. Derive a linear demand curve for roasted coffee. Since the demand curve is assumed to be linear, the elasticity will differ in and because price and quantity are different. Now estimate the short-run price elasticity of demand for instant coffee. Derive a linear demand curve for instant coffee. Which coffee has the higher short-run price elasticity of demand?
Why do you think this is the case? Instant coffee is significantly more elastic than roasted coffee. In fact, the demand for roasted coffee is inelastic and the demand for instant coffee is elastic. Roasted coffee may have an inelastic demand in the short-run as many people think of coffee as a necessary good. Changes in the price of roasted coffee will not drastically affect demand because people must have this good. Many people, on the other hand, may view instant coffee, as a convenient, though imperfect, substitute for roasted coffee.
For example, if the price rises a little, the quantity demanded will fall by a large percentage because people would rather drink roasted coffee instead of paying more for a low quality substitute. In order to understand demand theory, students must have a firm grasp of indifference curves, the marginal rate of substitution, the budget line, and optimal consumer choice. It is possible to discuss consumer choice without going into extensive detail on utility theory.
Many students find utility functions to be a more abstract concept than preference relationships. However, if you plan to discuss uncertainty in Chapter 5, you will need to cover marginal utility section 3. Even if you cover utility theory only briefly, make sure students are comfortable with the term utility because it appears frequently in Chapter 4.
When introducing indifference curves, stress that physical quantities are represented on the two axes. After discussing supply and demand, students may think that price should be on the vertical axis. To illustrate the indifference curves, pick an initial bundle on the graph and ask which other bundles are likely to be more preferred and less preferred to the initial bundle.
This will divide the graph into four quadrants, and it is then easier for students to figure out the set of bundles between which the consumer is indifferent. It is helpful to present a lot of examples with different types of goods and see if the class can figure out how to draw the indifference curves.
The examples are also useful for explaining the significance of the assumptions made about preferences. In presenting different examples, you can ask which assumption would be violated. Explaining utility follows naturally from the discussion of indifference curves. Though an abstract concept, it is possible to get students to understand the basic idea without spending too much time on the topic. You might point out that we as consumers have a goal in life, which is to maximize our utility subject to our budget constraint.
When we go to the store we pick the basket that we like best and that stays within our budget. From this we derive demand curves. Emphasize that it is the ranking that is important and not the utility number, and point out that if we can graph an indifference curve we can certainly find an equation to represent it. Finally, what is most important is the rate at which consumers are willing to exchange goods the marginal rate of substitution and this is based on the relative satisfaction that they derive from each good at any particular time.
The marginal rate of substitution, MRS, can be confusing to students. Some confuse the MRS with the ratio of the two quantities. This ratio is equal to the ratio of the intercepts of a line just tangent to the indifference curve. As we move along a convex indifference curve, these intercepts and the MRS change. You may want to present a variety of examples in class to explain this important concept. What are the four basic assumptions about individual preferences? Explain the significance or meaning of each.
This assumption also means that balanced market baskets are preferred to baskets that have a lot of one good and very little of the other good. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods? A set of indifference curves can be upward sloping if we violate assumption number three; more is preferred to less. The positive slope means that the consumer will accept more of the bad good only if she also receives more of the other good in return.
As we move up along the indifference curve the consumer has more of the good she likes, and also more of the good she does not like. Explain why two indifference curves cannot intersect. The explanation is most easily achieved with the aid of a graph such as Figure 3. We know from the definition of an indifference curve that a consumer has the same level of utility along any given curve. In this case, the consumer is indifferent between bundles A and B because they both lie on indifference curve U1.
Similarly, the consumer is indifferent between bundles A and C because they both lie on indifference curve U2. By the transitivity of preferences this consumer should also be indifferent between C and B. However, we see from the graph that C lies above B, so C must be preferred to B.
Thus, the fact that indifference curves cannot intersect is proven. Jon is always willing to trade one can of coke for one can of sprite, or one can of sprite for one can of coke. Since he is always willing to trade one for one, his MRS is equal to 1. Draw a set of indifference curves for Jon. Since Jon is always willing to trade one can of coke for one can of sprite, his indifference curves are linear with a slope of —1.
Draw two budget lines with different slopes and illustrate the satisfaction- maximizing choice. What conclusion can you draw? Jon will always choose a corner solution, unless his budget line has the same slope as his indifference curves. In this case any combination of Sprite and Coke that uses up his entire income with maximize his satisfaction.
What happens to the marginal rate of substitution as you move along a convex indifference curve? A linear indifference curve? The MRS measures how much of a good you are willing to give up in exchange for one more unit of the other good, keeping utility constant.
The MRS diminishes along a convex indifference curve in that as you move down along the indifference curve, you are willing to give up less and less of the one good in exchange for the other. The MRS is also the slope of the indifference curve, which increases becomes less negative as you move down along the indifference curve. The MRS is constant along a linear indifference curve, since in this case the slope does not change.
The consumer is always willing to trade the same number of units of one good in exchange for the other. Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction.
The MRS describes the rate at which the consumer is willing to trade one good for another to maintain the same level of satisfaction. The ratio of prices describes the trade-off that the market is willing to make between the same two goods. The tangency of the indifference curve with the budget line represents the point at which the trade-offs are equal and consumer satisfaction is maximized.
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