Answers for This Time
Supply and Demand
1. A recent article in The Wall Street Journal discussed the trend in home sales. Last year there were record sales of 5.1 million new and used houses despite the fact that there was a 10 percent rise in the median price of new homes. At the time, the median price of homes was $53,500. Given your knowledge of the market system, can you explain this puzzling result - a positive relationship between the change in price and the quantity demanded? (Ignore inflation.)
What are the facts? We have seen both quantity (home sales) and price (median price of homes) rise. As you can see from the diagrams, this could be explained by an increase in demand for homes. This rightward shift in the demand curve produces the desired results. You can see this result in the graphs below. The only shift in either the supply or demand curve would be the increase in demand. It would be possible to find combinations of shifts in both supply and demand that would produce the desired result. For example, a substantial increase in demand that accompanies an increase in supply could produce the desired result.
2. Use a supply-demand diagram to demonstrate the following situations.
To answer many of the additional questions you should use the graphs below. These represent the four possibilities if we have a shift in one of the curves.
a. recession's impact on the market for domestic automobiles
The recession will lower household income which will reduce households' demand for automobiles. The demand curve shifts in.
b. reduction (elimination) of import quota on Japanese cars on the market for domestic cars in the U.S.
The elimination of the quota on Japanese cars will likely increase the supply of Japanese cars supplied to the US which will reduce their price. Because Japanese and American cars are substitutes, we should expect that a decrease in the price of Japanese cars to decrease demand for American cars.
c. impact of drought on the cereal market
The drought will raise the cost of production or lower the yield (productivity) on the farms. Both hurt the seller and the supply curve shifts in.
d. impact of the Bank of England's decision to reduce its holdings of gold on the price of gold
The reduction of the Bank's holdings of gold will put additional gold on the gold market that will be demonstrated by an outward shift in the supply curve.
e. price decline in gold associated with the recent downward revisions in expected inflation
A little bit tougher. Gold is an asset which protects investors from inflation (at least they think so). If inflation increases, investors (demanders) will want to hold more gold (less financial wealth) and this will increase the demand for gold.
f. impact on stock prices of the aging of the baby boomers
Timing is everything. At the present time the boomers are in their peak "saving" years so you would expect that the demand for stock would increase as boomers look for a place to "park" this savings. When the boomers get to retirement age, the pattern will be reversed and the boomers will begin to dissave which will result in lower demand for stock - an inward shift in the demand curve..
g. impact on the price of rental housing of the lengthening of depreciation schedules and the passive income loss restriction
The depreciation schedules influence sellers. By lengthening depreciation schedules the government is lowering the costs of owning the properties. The result will be an outward shift in the supply of homes. This is what we saw in the early 1980s in the aftermath of the 1981 tax cut.
h. impact of IBM compatibility feature of new Apple computers on the market for Apple computers
This was done by Apple to reduce the cost to users of incompatibilities between their Macs and the PC which dominate the market. Apple expected that this would increase demand for their machines - an outward shift in the demand curve.
i. the existence of scalpers at the World Series games
Scalpers would be an example of what we could expect to see when there is a shortage. The problem here is that the price is too low-below the equilibrium.
j. empty seats at a recent Broadway play
Empty seats would be an example of a surplus. The problem here is that the price is too high-above the equilibrium.
k. the decision on part of the Brazilian government to burn some coffee so that it would not reach the marketplace.
This decision works only if demand is inelastic. In this situation the change in quantity would be less than the change in price so the reduction in quantity when the harvest is burned would be less than the price increase. The price increase would dominate the quantity decline - the result being an increase in revenue.
3. Find a headline in a newspaper or magazine that is related to price changes and convert the words in the article to a supply-demand graph.
4. Assume that someone high up has found out that you have mastered many of the basic economic principles and you are asked to be a consultant to the Bay Area Transit Authority. Your job is to raise revenue. You need to decide on the appropriate price change - should you increase or decrease the tolls on the bridges coming into San Francisco?
We can see that this is an elasticity problem because we are being asked to link revenue and price, so let's return to the discussion of the determinants of elasticity.
Given these assumptions regarding demand, we would conclude that demand is inelastic. We would then go to the equation that linked revenue and elasticity and see that when demand is inelastic, an increase in price will not substantially lower driving and revenue will increase.
5. At this time I would like you to consider the possibility of raising the sin taxes (booze and butts) to raise revenue. Do you think it will work? For example, would you propose a rise in the RI sin taxes as a way of raising additional revenue, some of which may be earmarked for higher education?
There are three ways to approach this question, verbally, graphically, and algebraically, but regardless of the approach, the question is all about the responsiveness of demand. What would happen if demand dropped significantly as a result of adding a higher tax to the price? Without the need for any high powered economic or math, we would expect that the tax revenue earned from the sales could actually decline if the decline in demand was greater than the increase in the tax rate.
The measure of responsiveness that economists tend to use is elasticity. If demand were elastic, we would expect demand to be responsive to price changes. If we looked at this graphically, we would draw a relatively flat demand curve. In the diagram below, the left-side diagram would be the picture if demand were responsive while the right-side diagram represents an inelastic demand.
Returning to our problem, should we expect demand to be responsive to the price increase. To answer this we need to return to the determinants of elasticity. When we talk about booze and butts, we are talking about products that may be addictive and that have few substitutes which is why we tend to find inelastic demand. The problem here is that we are not talking about booze, but Rhode Island booze-and there are a good number of substitutes for Rhode Island booze. Because of the small size of the state and the fact that the majority of the population lives close to a border, we would expect that these people could easily find a cheaper substitute if Rhode Island raised the price of booze by raising its taxes. Massachusetts found out about this when they attempted to raise the tax on booze and people began streaming across the border into the New Hampshire state liquor stores.
How do we look at this graphically? Let's assume that there is an increase in the tax which we could demonstrate as an inward shift in supply-a shift from the red to the black supply curves. In the initial situation the revenue earned from selling the output was the areas A + C. After the increase in supply, the revenue area is B + A. Revenue will increase as a result of the decrease in supply if A>C, which is the case in the right-hand diagram (steep demand curve - inelastic demand). What we see is that when demand is elastic, sales revenue will decrease if we increase the price or decrease supply. In this case we would expect the increase in the tax to reduce state excise tax revenue.
Elastic Demand Inelastic Demand
6. A common belief is that the demand for gasoline is inelastic. Some even suggest this is one of the reasons why the expenditures on foreign oil continue to increase as the price of oil increases. To study the demand for gas, a group recently conducted a study in which they interviewed a number of Shell gasoline stations scattered around the country. The results showed a price elasticity of demand to be 1.43. Should this be taken as proof of an elastic demand for gas? Explain the basis for your decision in a brief memo. This is not a statistics question.
7. What impact will the internet have on demand elasticity? You are to find an article that you use as a basis for your opinion. Be sure to provide me with a copy of the article.
The place to look here is in the determinants of elasticity. The determinant that is most likely to be affected is the availability of substitutes. With the internet you are likely to be better able to do comparison shopping which should increase the price elasticity of demand.