# 3. Microeconomic Laws of Demand and Supply - Sample Problems

### 1. Laws of Demand and Supply

1. According to the Law of Demand:
1. price and quantity demanded are inversely related.
2. price and quantity demanded are directly related.
3. price and quantity demanded are negatively related.
4. the demand curve is a straight line.
5. the demand curve slopes upward to the right.
6. the demand curve slopes downward to the right.
7. consumers wish to buy more of a good the higher their incomes, ceteris paribus.
8. consumers wish to buy more of a good the lower the price of that good, ceteris paribus.
9. consumers wish to buy more of a good if the price of a substitute good increases, ceteris paribus.
10. when supply increases, demand increases

Answer: (a), (c), (f), and (h) are the correct answers. The Law of Demand establishes the relationship between the price of a good or service and the quantity demanded, all other things being unchanged (ceteris paribus). Price and quantity have a negative or inverse relationship - as one goes up the other goes down. The demand curve, which is a graphical representation of the Law of Demand, slopes downward to the right. Answers (g) and (h) refer to violations of the ceteris paribus assumption that lead to changes in demand (a shift in the demand curve). Answer (j) could be interpreted as a correct answer only if it were rewritten "when supply increases, the quantity demanded increases". A similar question could be asked about the Law of Supply.

### 2. Equilibrium-Disequilibrium-Price Controls

1. A surplus in a market will exist when:
1. firms offer for sale more than consumers wish to purchase at the market price.
2. firms offer for sale less than consumers wish to purchase at the market price.
3. the quantity of supplied exceeds the quantity demanded at the market price.
4. the quantity of demanded exceeds the quantity supplied at the market price.
5. the market price is above the equilibrium price.
6. the market price is below the equilibrium price.
7. the government has imposed an effective price floor.
8. the government has imposed an effective price ceiling.
9. the market price is prevented from falling to its equilibrium value.
10. the market price is prevented from rising to its equilibrium value.

Answer: (a), (c), (e), (g), and (i) are the correct answers. The incorrect answers represent the opposite situation of a shortage in a market. The answers to this question would also be the correct answers for the question "what happens when the government imposes an effective price floor?"

2. If price is above the equilibrium price, what causes it to return to the equilibrium level? If it is below equilibrium, what forces it up?

Answer: If the price of a product is above the equilibrium price, the quantity supplied will be greater than the quantity demanded and a surplus will result. With a surplus producers will face growing inventories. To reduce their inventories producers must lower their prices. The market price will decline until the equilibrium level is reached.

If the price of a product is below equilibrium, the quantity supplied will be less than the quantity demanded and a shortage will result. Producers will see a decline in the inventories. The shortage can be eliminated only by allowing the market price to rise to the equilibrium level. The increase in price will motivate firms to produce more while also reducing the quantity demanded until the market returns to equilibrium.

3. Let's assume the farm lobby has convinced the Federal government that a price support (price floor) for corn is needed to protect the small family farm. What will happen to the prices and quantities of corn, corn-based cereal, and wheat-based cereal?

Answer: A price support for corn will raise the price of corn above the equilibrium level and create a surplus of corn (the quantity demanded will be less than the quantity supplied). The higher price for corn (an input in the production of corn-based cereal) will decrease the supply of corn-based cereal (shift the corn-based cereal supply curve to the left) resulting in an increase in the equilibrium price and a decrease in the equilibrium quantity of corn-based cereal sold. The higher price of corn-based cereal (a substitute in demand for wheat-based cereal) will increase the demand for wheat-based cereal (shift the demand curve for wheat-based cereal to the right) resulting in an increase in the equilibrium price and quantity of wheat-based cereal.

We could make this even more complicated by assuming that wheat and corn are substitutes in production. With an increase in the price of corn, some farmers will switch from producing wheat to producing corn. The supply curve for wheat will shift to the left, increasing the market price for wheat. This increases the production costs for wheat-based cereal, which shifts the supply curve for wheat-based cereal to the left. This impacts the market price of wheat-based cereal, and the demand curve for corn-based cereal, and so on. The interactions can become very complicated when substitutes in production (corn and wheat) relate directly to substitutes in demand (corn-based cereal and wheat-based cereal).

So what do we do with that surplus of corn that we are now producing? In the past the Federal government has purchased the surplus corn and then given it to local governments for school lunches and poor countries as humanitarian aid. The policy designed to protect the family farm by guaranteeing higher prices then results higher cereal (and other grain product) prices for consumers and a new tax burden (government buying the surplus corn) for the benefit of schools and foreign aid.

### 3. Demand Curve Shifts

The difference between a change in "demand" and a change in the "quantity demanded" is very important. Consider the following question:

1. What, if any, of the following will cause a change in demand?
1. change in income
2. change in consumer tastes
3. change in the price of a complement in demand
4. all of the above
5. none of the above

Answer: The correct answer is (d) all of the above because all factors cause the demand curve to shift. We use the term "demand" by itself to refer to the entire demand curve. A "change in demand" refers to a shift in the demand curve. A change in the market price by itself does not cause a change in demand or the demand curve to shift. Some factor other than price (such as income, tastes, or the price of a complement or substitute in demand) must change before the demand curve will shift.

2. Now consider the following question:

3. What, if any, of the following will cause a change in the quantity demanded?
1. change in income
2. change in consumer tastes
3. change in the price of a complement in demand
4. change in supply
5. change in the market price

Answer: This time the correct answers are (d) and (e). This is a tricky question. As we noted in the answer to the previous question, a change in the price of a good will cause a change in the quantity demanded. This means that as we move along a stable demand curve the price of the product and the quantity demanded changes, i.e., as the price increases the quantity demanded declines. But what may cause the price of a product to change if the demand curve is stable? It could be from the government imposing a price ceiling or price floor. Ot it could be because of a shift in the supply curve. We use the term "supply" by itself to refer to the entire supply curve. A "change in supply" refers to a shift in the supply curve. A shift in the supply curve (d) will result in a movement along a stable demand curve to a new equilibrium price and quantity. A movement along a stable demand curve represents a change in quantity demanded.

4. What happens to the demand for Coca Cola if the price of Pepsi decreases? What happens to the demand curve for Coca Cola? What are the effects on the equilibrium price and quantity of Coca Cola?

Answer: If Coca Cola and Pepsi are substitutes in demand, then a decrease in the price of pepsi will increase the demand for Coca Cola--the demand curve for Coca Cola will shift to the right. If the demand for Coca Cola increases then the equilibrium price and quantity will both rise. Note that the first two questions "what happens to the demand for..." and "what happens to the demand curve for..." are identical. When we use the term "demand" we are referring to the demand curve. When we use the term "quantity demanded" we are referring to a point on the demand curve.

5. Why is the price of gasoline usually higher than the summer than in the winter?

Answer: More people travel during the summer months than during the winter months. Kids are out of school and families drive on vacations. The roads at the Grand canyon are bumper-to-bumper. The demand curve for gasoline shifts to the right during the summer months and back to the left during the winter months. Consequently, the equilibrium price and quantity rise in the summer and fall in the winter.

### 4. Supply Curve Shifts

1. Why is the price of fruit usually higher than the winter than in the summer?

Answer: This is probably not a case of people eating more fruit during the winter. It is not the demand curve that shifts but the supply curve. The supply of fruit is reduced during the winter because of the colder weather. During the winter the supply curve shifts to the left resulting in a higher equilibrium price and lower quantity. During the summer the supply curve shifts back to the right for a lower equilibrium price and higher quantity.

2. Which of the following variables will not change the supply of a good (i.e,, cause the supply curve to shift)?

1. a change in the cost of production
2. an improvement in the technology of the production process
3. a change in the price of the good
4. a decrease in the price of an input used in the production
5. a decrease in the wages of workers that produce the good
6. a shift in the demand curve for the good
7. a change in the price of a substitute in production
8. a change in the price of a substitute in demand
9. an increase in consumer incomes

Answer: (c), (f), (h), and (i) do not affect the supply curve. Only factors that affect the economics of the production process directly will cause a supply curve to shift. The trickiest is possible a change in the price of the good (c). A change in price will only result in a change in the quantity supplied, or a movement along a stable supply curve. A shift in the demand curve (f) may be the cause of the change in price and quantity supplied. A change in the price of a substitute in demand (h) or a change in income (i) would cause the demand curve to shift.

We could make this question more difficult and ask what would cause an increase in supply (shift the supply curve to the right). Now you would not only be required to know what would cause the supply curve to shift, but also in what direction. For example, a decrease in the wage of workers (e) would lower the cost of production and result in an increase in supply.

### 5. Curve Shifts and Equilibrium Change

When the demand curve, or supply curve, or both curves shift there will a a change in the equilibrium price, or equilibrium quantity, or both. In the previous two sections the questions centered on what causes each curve to shift and in what direction. Questions in this section add the additional problem of what happens to the equilibrium price and quantity.

For example, use the following possible answers for the next 4 questions:

1. price increase, quantity increase
2. price decrease, quantity decrease
3. price increase, quantity decrease
4. price decrease, quantity increase

1. What would happen in the market for margarine if the demand for margarine decreased?

Answer: (b) We start with an easy one. When we say demand has decreased we mean the demand curve has shifted to the left. When the demand curve shifts to the left both the equilibrium price and quantity decline.

2. What would happen in the market for margarine if consumer incomes decreased (assuming margarine is a "normal" good)?

Answer: (b) Here we add a complication in that you have to determine what effect a decrease in income will have on either the demand curve or the supply curve. A change in income affects only the demand curve. The supply curve is unaffected. A decrease in income will reduce demand for a normal good (the demand curve will shift to the left). (The demand curve for an inferior good would shift to the right, or in the opposite direction of the change in income.) When the demand curve for margarine shifts to the left (the supply curve is unaffected) the result will be a lower price and quantity.

3. What would happen in the market for margarine if the supply of butter (a substitute in demand) increased?

Answer: (b) This is really a two part question. The immediate question is what happens to the price of butter when the supply of butter increases (the supply curve for butter shifts to the right) and the demand curve for butter remains unchanged. The price of butter declines. Second, what happens to the demand curve for margarine if the price of a substitute in demand (butter) declines? The demand for margarine will decline (the demand curve shifts to the left) because consumers will switch away from buying margarine to the now less expensive butter. When the demand curve for margarine shifts to the left (the supply curve is unaffected) the result will be a lower price and quantity.

4. We can summarize the previous three questions in a table with two twists. First we change "margarine" to "gasoline" and second we ask you to identify which demand or supply ceteris paribus assumption is violated.

 Answer code to violation of a ceteris paribus assumption Demand D1 Change in consumer income D2 Change in tastes D3 Change in price of a complement in demand D4 Change in price of a substitute in demand Supply S1 Change in price of an input to production process S2 Change in production technology or environment S3 Change in price of a complement in supply S4 Change in price of a substitute in supply
 Questions and Answers: Question: What would happen in the market for gasoline if... Ceterisparibusviolation Change in demand or supply Change in product price Change in equilibrium quantity • the demand for gasoline decreased? D1, D2, D3, or D4 Gasoline demand curve shifts left Price of gasoline declines Declines • consumer incomes increased (assuming gasoline is a normal good)? D1 Gasoline demand curve shifts right Price of gasoline increases Increases • the supply of diesel fuel increased (assuming diesel fuel is a substitute in demand)? D3 Gasoline demand curve shifts left Price of gasoline declines Declines • the cost of crude oil used to produce gasoline increases? S1 Gasoline supply curve shifts left Price of gasoline increases Declines • a new production process is developed that lowers the cost of producing gasoline? S2 Gasoline supply curve shifts right Price of gasoline declines Increases • the price of diesel fuel increased (assuming diesel fule is a substitute in production) S4 Gasoline supply curve shifts left Price of gasoline increases Declines

5. The price of gasoline nearly doubled over the last two years. Nevertheless, more gasoline was sold this year than 2 years ago. This must mean the demand curve for gasoline is upward sloping (as price increases the quantity demanded increases). What's wrong with this statement.

Answer: In any market there are many things going on at the same time. First, the price of gasoline is going up because the cost of production has increased. The price of crude oil, the natural resource input in the production of gasoline has also gone up by a similar amount. When the costs of production rise the supply curve will shift to the left. When the supply curve shifts to the left we get an increase in equilibrium price and a reduction in quantity sold. So why did sales of gasoline increase? The demand curve for gasoline has been steadily shifting to the right at the same time. A growing population of drivers (market size), the huge increase in less fuel efficient vehicles like sport utility vehicles (changing tastes for a complement in demand), and growth in household incomes (gasoline is a normal good) all contribute to increased demand for gasoline. The demand curve shifting to the right also leads to higher quantities as well as higher prices. The supply curve shift and the demand curve shift both contribute to higher prices. The positive quantity effect from the demand curve shift overcomes the negative quantity effect from the supply curve shift. The lesson is that in any market there are many things going on at the same time. To fully understand market behavior it helps to have an economic model that lets you evaluate the individual impacts of these many changes.

6. The price of gasoline has more than doubled since the early 1970s. Nevertheless, more gasoline was sold this year than 30 years ago. This must mean the demand curve for gasoline is upward sloping (as price increases the quantity demanded increases). What's wrong with this statement.

Answer: Here we have an explanation that adds to the previous question's answer of increasing demand. It's not the absolute price level that is important but relative prices. How has the price of gasoline changed relative to the price of other goods and services? As it turns out the relative price of gasoline (or the "real" price of gasoline) has actually declined over this time period. Because the price of gasoline relative to many other goods and services (housing, health care, food, etc.) has actually declined we would expect an increase in the quantity demanded. Of course we still have the other explanations such as higher incomes, population growth, and the resurgence of gas-guzzling cars that lead to a shifting demand curve. The lesson is that when looking at changes over long periods of time just looking at the trend in one variable in isolation can lead you astray. You must make comparisons to changes in other economic markets.