Problem Set 1: Suggested Solutions Microeconomics: Professor Owen Zidar

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1 1. Market for Bananas Problem Set 1: Suggested Solutions Microeconomics: Professor Owen Zidar (a) Set demand equal to supply and compute: 2p + 2 = 8 4p 6p = 6 p = 1 (b) Plug in the equilibrium price in either the supply or demand function: Q = = 4 (since supply equals demand in equilibrium, it doesn t matter which one we use). (c) Same as in (a) but with the new demand function: 12 4p = 2p = 6p p = 5/3 (d) See figure. (e) When people learn about the health benefits of bananas, they will shift towards consuming more bananas and less apples. (One way to put this is that the value of bananas in terms of apples has increased.) This is what is reflected in the outwards shift in demand. The outwards shift in the demand for bananas will be accompanied by an inwards shift in the demand for apples. As a result, the price

2 of apples, the equilibrium quantity of apples, and the expenditure on apples will go down. 2. Market For Gasoline (a) Set demand equal to supply and compute: p = 10 2p 3p = 10 p = Q = 10/3 (b) Same procedure as in (a) but with the new supply function: 10 2p = p 2 12 = 3p p = 4, Q = = 2 (c) See figure. (d) In the long run, demand will shift down. Equilibrium quantity will be reduced even more and the price will go down. The effect of a price change will be greater in the long run since people have time to adapt. (This is sometimes referred to as the second law of demand.) 3. Mad Mike Mike s reasoning ignores the fact that equilibrium price and quantity are determined by demand and supply. If we use is method, we will just be observing a bunch of equilibria, not trace out a demand curve. (Different points at which supply is equal

3 to demand.) Mike s method would make sense, however, if we know that supply shifts but the demand curve is constant. 4. How Much Did Demand Fall? Suppose that prices fell 10%, the supply elasticity ε S ε D = 2, and supply didn t change. = 2, the demand elasticity (a) Demand fell by 40%. % D % S % P = ε S ε D.10 = % D 0 2 ( 2).10 = % D = % D (b) Demand fell by 20%. % D % S % P = ε S ε D % D.2.10 = 2 ( 2).40 = % D.2.2 = % D (c) The increase in supply lowers prices, leaving less work for the demand shock. (d) Demand fell by 30%. % D % S % P = ε S ε D % D.2.10 = 2 ( 3).50 = % D.2.3 = % D (e) More elastic demand means that quantities are going to be more responsive to a

4 given change in prices, so the movement along portion of the percentage change in quantity is larger, leaving more work for the demand shock. Recall where the expression for the price change comes from: % Q D = % Q S % D + ε D % P = % S + ε S % P % D + ε D (.1) =.2 + 2(.1) % D + ε D (.1) =.4 For the last expression to hold, when the movement along portion, i.e., ε D (.1) goes from 2(.1) to 3(.1), % D needs to increase. 5. Supplemental Challenge Problem: Do Product Boycotts Work? Suppose that (i) some people want to boycott tuna that harms dolphins and (ii) we have the following pre-boycott conditions: Q D = P Q S = 50 (P 5) for P 5, 0 else. (a) What is the equilibrium before the boycott? Q D = Q S P = 50(P 5) 60P = 5250 P = 87.5 Q = 4125 (b) Would a boycott be effective (i.e. would it lower the price to target sellers) if 25% of consumers observed the boycott and 50% of sellers were targeted? Specifically, what is the equilibrium price and quantity if all observers shop in the non-target market while non-observers shop only in the target market? Would having two separate markets be a sustainable equilibrium (hint: what would non-observers likely do in this situation)?

5 What happens if all observers shop in non-target market, while non-observers shop only in target market? Q D = Q S.75( P ) = 25(P 5) (1) P = Q D = Q S.25( P ) = 25(P 5) (2) P = 50 Problem: non-observers just switch. Why should they pay higher price? Thus, this equilibrium won t work. Instead, the two segmented markets will collapse to single market; there is only one price ($87.50). Happens whenever Share non-observers > Share target suppliers, so that non-observers shop in both markets. (c) Would a boycott be effective (i.e. would it lower the price to target sellers) if 50% of consumers observed the boycott and 50% of sellers were targeted? What happens if all observers shop in non-target market, while all nonobservers shop in target market? Q D = Q S.5( P ) = 25(P 5) (3) P = Q D = Q S.5( P ) = 25(P 5) (4) P = Two separate markets with the same price. Every boycotter shops at dolphin-safe tuna; every non-boycotter shops at dolphin-harming tuna.

6 Knife s edge case: Share non-observers = Share target suppliers. (d) Would a boycott be effective (i.e. would it lower the price to target sellers) if 75% of consumers observed the boycott and 50% of sellers were targeted? What happens if all observers shop in non-target market, while all nonobservers shop in target market? Q D = Q S.25( P ) = 25(P 5) (5) P = Q D = Q S.75( P ) = 25(P 5) (6) P = Despite price gap, boycotters will not switch! Boycott harms target suppliers. Share non-observers < Share target sellers. (e) Would a boycott be effective (i.e. would it lower the price to target sellers) if 50% of consumers observed the boycott and 75% of sellers were targeted? What happens if all observers shop in non-target market, while all nonobservers shop in target market? Q D = Q S.5( P ) = 37.5(P 5) (7) P = Q D = Q S.5( P ) = 12.5(P 5) (8) P = Despite price gap, boycotters will not switch! Boycott harms target suppliers.

7 Again Share non-observers < Share target sellers. (f) What do these four cases tell us about product boycotts more generally? When are boycotts more likely to be effective? The key issue is the size of observer group relative to size of target group. If target share is smaller than non-observer share, boycott doesn t work. Boycotts will be more likely to work if: Lots of people boycott Target share is really big. A canonical example of this analysis is Becker (1957) on discrimination by white employers against black workers. Interestingly, the predictions hold up pretty well (Charles and Guryan JPE 2008). There s a nice Chicago Booth Review discussion of this by Kevin Murphy in an article titled How Gary Becker saw the scourge of discrimination. Here is a link: how-gary-becker-saw-the-scourge-of-discrimination