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4.4 Review and Practice

Summary

In this chapter we used the tools of demand and supply to understand a wide variety of market outcomes. We learned that technological change and the entry of new sellers has caused the supply curve of personal computers to shift markedly to the right, thereby reducing equilibrium price and increasing equilibrium quantity. Market forces have made personal computers a common item in offices and homes.

Crude oil and gasoline prices soared in 2008 and then fell back, rising again in 2011 as a result of the disruption created by the Arab Spring. We looked at the causes of these increases as well as their impacts. Crude oil prices rose in large part As a result of increased demand, particularly from China. Higher prices for crude oil led to higher prices for gasoline. Those higher prices not only hurt consumers of gasoline, they also put upward pressure on the prices of a wide range of goods and services. Crude oil and gasoline prices then decreased dramatically in the last part of 2008, as world growth declined.

The model of demand and supply also explains the determination of stock prices. The price per share of corporate stock reflects the market’s estimate of the expected profitability of the firm. Any information about the firm that causes potential buyers or current owners of corporate stock to reevaluate how profitable they think the firm is, or will be, will cause the equilibrium price of the stock to change.

We then examined markets in which some form of government price control keeps price permanently above or below equilibrium. A price floor leads to persistent surpluses because it is set above the equilibrium price, whereas a price ceiling, because it is set below the equilibrium price, leads to persistent shortages. We saw that interfering with the market mechanism may solve one problem but often creates other problems at the same time. We discussed what some of these unintended consequences might be. For example, agricultural price floors aimed at boosting farm income have also raised prices for consumers and cost taxpayers dearly, and the bulk of government payments have gone to large farms. Rent controls have lowered rents, but they have also reduced the quantity of rental housing supplied, created shortages, and sometimes led to various forms of “backdoor” payments, which sometimes force the price of rental housing above what would exist in the absence of controls.

Finally, we looked at the market for health care and a special feature behind demand and supply in this market that helps to explain why the share of output of the United States that is devoted to health care has risen. Health care is an example of a market in which there are third-party payers (primarily private insurers and the government). With third-party payers the quantity of health-care services consumed rises, as does health-care spending.

Concept Problems

  1. Like personal computers, digital cameras have become a common household item. Digital camera prices have plunged in the last 10 years. Use the model of demand and supply to explain the fall in price and increase in quantity.
  2. Enron Corp. was one of several corporations convicted of fraud in its accounting practices during the early part of this decade. It had created dummy corporations to hide massive borrowing and to give it the appearance of extraordinary profitability. Use the model of demand and supply to explain the likely impact of such convictions on the stocks of other corporations.
  3. During World War II there was a freeze on wages, and corporations found they could evade the freeze by providing other fringe benefits such as retirement funds and health insurance for their employees. The Office of Price Administration, which administered the wage freeze, ruled that the offer of retirement funds and health literature was not a violation of the freeze. The Internal Revenue Service went along with this and ruled that employer-financed retirement and health insurance plans were not taxable income. Was the wage freeze an example of a price floor or a price ceiling? Use the model of demand and supply to explain why employers began to offer such benefits to their employees.
  4. The text argues that political instability in potential suppliers of oil such as Iraq and Venezuela accounts for a relatively steep supply curve for crude oil such as the one shown in Figure 4.2 "Increasing Demand for Crude Oil" Suppose that this instability eases considerably and that the world supply curve for crude oil becomes much flatter. Draw such a curve, and explain its implications for the world economy and for typical consumers.
  5. Suppose that technological change affects the dairy industry in the same way it has affected the computer industry. However, suppose that dairy price supports remain in place. How would this affect government spending on the dairy program? Use the model of demand and supply to support your answer.
  6. People often argue that there is a “shortage” of child care. Using the model of demand and supply, evaluate whether this argument is likely to be correct.
  7. “During most of the past 50 years the United States has had a surplus of farmers, and this has been the root of the farm problem.” Comment.
  8. Suppose the Department of Agriculture ordered all farmers to reduce the acreage they plant by 10%. Would you expect a 10% reduction in food production? Why or why not?
  9. The text argues that the increase in gasoline prices had a particularly strong impact on low-income people. Name some other goods and services for which a sharp increase in price would have a similar impact on people with low incomes.
  10. Suppose that the United States and the European Union impose a price ceiling on crude oil of $25 per barrel. Explain, and illustrate graphically, how this would affect the markets for crude oil and for gasoline in the United States and in the European Union.
  11. Given that rent controls can actually hurt low-income people, devise a housing strategy that would provide affordable housing for those whose incomes fall below the poverty line (in 2010, this was about $22,314 for a family of four).
  12. Using the model of demand and supply, show and explain how an increase in the share individuals must pay directly for medical care affects the quantity they consume. Explain how this would address the total amount of spending on health care.
  13. Given that people pay premiums for their health insurance, how can we say that insurance lowers the prices people pay for health-care services?
  14. Suppose that physicians now charge $30 for an office visit and insurance policies require patients to pay 33 1/3% of the amount they pay the physicians, so the out-of-pocket cost to consumers is $10 per visit. In an effort to control costs, the government imposes a price ceiling of $27 per office visit. Using a demand and supply model, show how this policy would affect the market for health care.
  15. Do you think the U.S. health-care system requires reform? Why or why not? If you think reform is in order, explain the approach to reform you advocate.

Numerical Problems

Problems 1–4 are based on the following demand and supply schedules for corn (all quantities are in millions of bushels per year).

Price per bushel Quantity demanded Quantity supplied
$0 6 0
1 5 1
2 4 2
3 3 3
4 2 4
5 1 5
6 0 6
  1. Draw the demand and supply curves for corn. What is the equilibrium price? The equilibrium quantity?
  2. Suppose the government now imposes a price floor at $4 per bushel. Show the effect of this program graphically. How large is the surplus of corn?
  3. With the price floor, how much do farmers receive for their corn? How much would they have received if there were no price floor?
  4. If the government buys all the surplus wheat, how much will it spend?

Problems 5–9 are based on the following hypothetical demand and supply curves for apartments

Rent/Month

Number of Apts.

Demanded/Month

Number of Apts.

Supplied/Month

$0 120,000 0
200 100,000 20,000
400 80,000 40,000
600 60,000 60,000
800 40,000 80,000
1000 20,000 100,000
1200 0 120,000
  1. Draw the demand and supply curves for apartments.
  2. What is the equilibrium rent per month? At this rent, what is the number of apartments demanded and supplied per month?
  3. Suppose a ceiling on rents is set at $400 per month. Characterize the situation that results from this policy.
  4. At the rent ceiling, how many apartments are demanded? How many are supplied?
  5. How much are people willing to pay for the number of apartments supplied at the ceiling? Describe the arrangements to which this situation might lead.