Lesson Topics. A.2 Competitive Equilibrium Review Questions

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1 Lesson Topics Substitutes and Complements describe goods that either clash or match. So, they explain the affect of higher-priced Coke on the demand for Pepsi, but not higher-priced housing on the demand for cars. Comparative Statics (1) determines how market equilibrium price and quantity react to a change in a determinant of demand or supply. So, how is customer service affected by increasing US wages? Price Restrictions (8) impose either maximum or minimum legal prices. Unintended consequences include shortages and surpluses, and contrary full economic prices when demanders or suppliers compete. 1

2 Comparative Statics Question. The Wall Street Journal reports that the prices of personal computer components (cases, power supplies, ) are expected to rise by 5 to 8 percent over the next six months. a. Discuss practical implications for the actions of a small firm that makes personal computers. b. Discuss practical implications for the actions of a small firm that makes software. 2

3 Tip: A full answer to each question on this review includes all highlighted conclusions below and an explanation of how you reached those conclusions. Answer to Question: Since the firms are small, they are perfect competitors in their output markets, so they have supply curves. Assume also that demanders are perfectly competitive, so they have demand curves and price and quantity are determined by the intersection of demand and supply. Price Q s P Q d Quantity 0 Q a) After the component (input) prices rise, the supply of personal computers falls, which raises computer price and lowers computer quantity. That has implications for the actions of the personal computer firm. Input suppliers should be told you ll decrease your future orders (for normal inputs). Human resources should plan for future employment reductions, assuming labor is a normal input. 3

4 Marketing should plan to reduce marketing for future reduced sales. (Marketing is a normal input.) b) After the component prices rise, the supply of personal computers falls, which raises prices for personal computer hardware, which lowers demand for computer software (assuming they are gross complements with computer hardware). That lower demand lowers software prices and lowers software quantity. That has implications for the actions of the software firm. Input suppliers should be told you ll decrease your future orders (for normal inputs). Human resources should plan for future employment reductions, assuming labor is a normal input. Marketing should plan to reduce marketing for future reduced sales. (Marketing is a normal input.) 4

5 Price Restrictions Each of the following review questions apply the theory of Price Restrictions to predict the effects on governmental policies intended to protect consumers. 5

6 Price Restrictions Question. You are an aide for the Senate Banking Committee Chairman. He comes to you with a bill that proposes setting limits on what ATM owners can charge non-account holders, over and above what banks charge their own customers. Currently, large banks charge noncustomers an average fee of $1.35 per transaction in addition to the fees the customer's own bank imposes. The Senator asks you to look at a proposal that would place a $0.50 cap on the fees ATM owners can charge noncustomer for accessing their money. If this legislation is enacted, what would be the likely effects? Explain. 6

7 Answer to Question: The proposed price ceiling of $0.50 is effective since it is below the equilibrium price of $1.35. As a result, quantity demanded increases from Q d = E to Q d = B units in the graph below, while quantity supplied decreases from Q s = E to Q s = A units. That is, demanders want to buy B units but suppliers are willing to supply only A units. Therefore, at a price ceiling of $0.50, there is an immediate shortage of B A units, and the smaller quantity (A units) will be exchanged. But competition among demanders to be the ones to buy that A units supplied eliminates that shortage by bidding the price up to the full economic price P F where demand falls to meet supply at A. Solving yields the full economic price P F > $1.35. Demanders are thus hurt by the maximum price, by the rise from the equilibrium price of $1.35 per unit to the full economic price P F per unit. Note that the actual magnitude of the shortage and full economic price depends on the relative slopes of the demand and supply curves. Price Q s P F Q d 0 A E B Quantity 7

8 Price Restrictions Question: Suppose demand and supply are Q d = P + 50 and Q s = (1/2)P 10. a) Compute the equilibrium price and quantity. b) If a price floor of $42 is imposed, find quantity demanded, quantity supplied, and the magnitude of any shortage or surplus at the price of $42. Compute the full economic price received by sellers. c) If a price ceiling of $30 is imposed, find quantity demanded, quantity supplied, and the magnitude of any shortage or surplus at the price of $30. Compute the full economic price paid by consumers. 8

9 Answer to Question: a. Equating quantity demanded and quantity supplied Q d = Q s yields the equation P + 50 = (1/2)P 10. Solving for P yields the equilibrium price of P = $40 per unit. Plugging that into either the demand or supply equation yields the equilibrium quantity of Q = 10 units, since Q d = and Q s = (1/2) b. A price floor of $42 is effective since it is above the equilibrium price of $40. As a result, quantity demanded decreases from Q d = 10 to Q d = 8 = units, while quantity supplied increases from Q s = 10 to Q s = (1/2)42 10 = 11 units. That is, suppliers want to supply 11 units but demanders want only 8 units. Therefore, at the price floor, there is an immediate surplus of 3 = 11 8 units, and the smaller quantity (8 units) will be exchanged. But competition among suppliers to be the ones to sell some of that 8 units demanded eliminates that surplus by bidding the price down to the full economic price P F where supply falls to meet demand at 8; that is, 8 = Q s = (1/2)P F 10. Solving yields the full economic price P F = $36. Going beyond the question asked, suppliers are thus hurt by the minimum price, by the drop from the equilibrium price of $40 per unit to the full economic price of $36 per unit. Price Q s = (1/2)P Q d = P + 50 P F = Quantity 9

10 c. The price ceiling of $30 is effective since it is below the equilibrium price of $40. As a result, quantity demanded increases from Q d = 10 to Q d = 20 = units, while quantity supplied decreases from Q s = 10 to Q s = 5 = (1/2)(30) 10 units. That is, demanders want to buy 20 units but suppliers are willing to supply only 5 units. Therefore, at the price ceiling, there is an immediate shortage of 15 = 20 5 units, and the smaller quantity (5 units) will be exchanged. But competition among demanders to be the ones to buy some of that 5 units supplied eliminates that shortage by bidding the price up to the full economic price P F where demand falls to meet supply at 5; that is, 5 = Q d = P F Solving yields the full economic price P F = $45. Going beyond the question asked, demanders are thus hurt by the maximum price, by the rise from the equilibrium price of $40 per unit to the full economic price of $45 per unit. Price Q s = (1/2)P 10 P F = Q d = P Quantity 10

11 Price Restrictions Each of the following review questions apply the theory of Price Restrictions to predict the effects on governmental policies intended to protect the poor. 11

12 Price Restrictions Question. In 1996, the National Labor Committee, a human rights group, reported that sweatshop labor was used to make clothes for the Kathie Lee [Gifford] line, sold at Wal-Mart. The group reported that a worker in Honduras smuggled a piece of clothing out of the factory, which had a Kathie Lee label on it. One of the workers, Wendy Diaz, came to the United States to testify about the conditions under which she worked. She commented that "I wish I could talk to [Kathie Lee]. If she's good, she will help us." Labor activist Charles Kernaghan spoke to the media and accused Gifford of being responsible for the sweat shop management activity. Gifford addressed Kernaghan's allegations on the air during Live, explaining that she was not involved with hands-on project management in factories. Gifford subsequently contacted Federal authorities to investigate the issue, and worked with U.S. Federal legislative and executive branch agencies to support and enact laws to protect children against sweat shop conditions. She appeared with President Bill Clinton at the White House in support of the government's initiatives to counter international sweat shop abuses. Suppose one of the government initiatives were increased minimum wages in sweat shops. Compute the effect of those increased minimum wages on Wendy Diaz and child laborers in Honduras. 12

13 Answer to Question: The proposed price floor is effective since the minimum wage laws are intended to increase wages above the equilibrium price. As a result, quantity demanded decreases from Q d = E to Q d = A units in the graph below, while quantity supplied increases from Q s = E to Q s = B units. That is, suppliers (workers) want to sell B units but demanders (employers) are willing to buy only A units. Therefore, at a price floor of P M, there is an immediate surplus of B A units, and the smaller quantity (A units) will be exchanged. But competition among suppliers to be the ones to sell that A units demanded eliminates that surplus by bidding the price down to the full economic price P F where supply falls to meet demand at A. Solving yields the full economic price P F < P. Suppliers are thus hurt by the minimum, by the fall from the equilibrium price of P per unit to the full economic price P F per unit. Note that the actual magnitude of the shortage and full economic price depends on the relative slopes of the demand and supply curves. Price Q s P M P Q d P F 0 A E B Quantity 13

14 Price Restrictions Question: A Few Thoughts on the Increase in the Federal Minimum Wage (Story by Richard Troxell, National Chairman, Universal Living Wage Campaign) We must work relentlessly to preserve and promote the `American Dream. We must ensure that every American is working. And we must ensure that every working American is paid a Fair Living Wage. No worker can argue that an increase in the minimum wage isn t a good thing; Evaluate whether Richard Troxell and the Universal Living Wage Campaigners are correct that an increase in the minimum wage is good for workers. 14

15 Answer to Question: The proposed price floor is effective since the minimum wage laws are intended to increase wages above the equilibrium price. As a result, quantity demanded decreases from Q d = E to Q d = A units in the graph below, while quantity supplied increases from Q s = E to Q s = B units. That is, suppliers (workers) want to sell B units but demanders (employers) are willing to buy only A units. Therefore, at a price floor of P M, there is an immediate surplus of B A units, and the smaller quantity (A units) will be exchanged. But competition among suppliers to be the ones to sell that A units demanded eliminates that surplus by bidding the price down to the full economic price P F where supply falls to meet demand at A. Solving yields the full economic price P F < P. Suppliers are thus hurt by the minimum, by the fall from the equilibrium price of P per unit to the full economic price P F per unit. Note that the actual magnitude of the shortage and full economic price depends on the relative slopes of the demand and supply curves. Price Q s P M P Q d P F 0 A E B Quantity 15

16 Price Restrictions Question. Suppose demand and supply for a commodity are Q d = 30 2P and Q s = P. a. For that commodity, compute equilibrium price, quantity, consumer surplus, and producer surplus. b. Suppose that commodity with Q d = 30 2P and Q s = P were unskilled labor and a minimum wage of $12 is imposed. Compute the effect of that minimum wage on the unskilled labor. c. Now instead of labor, suppose that commodity with Q d = 2P + 30 and Q s = P were New York City apartments and a maximum rental price of $5 is imposed. Compute the effect of that maximum rental price on renters. Explain your answers. 16

17 Answer to Question: a. Equating quantity demanded and quantity supplied Q d = Q s yields the equation 2P + 30 = P. Solving for P yields the equilibrium price of P = $10 per unit. Plugging that into either the demand or supply equation yields the equilibrium quantity of Q = 10 units, since Q d = 2(10) + 30 and Q s = Price Q s = P 10 CS PS Q d = 2P Quantity Consumer surplus is the right triangle with height 5 = and width 10, so area CS = ½ (5)(10) = $25. Producer surplus is the right triangle with height 10 = 10-0 and width 10, so area PS = ½ (10)(10) = $50. 17

18 b. A price floor of $12 is effective since it is above the equilibrium price of $10. As a result, quantity demanded decreases from Q d = 10 to Q d = 6 = 2(12) + 30 units, while quantity supplied increases from Q s = 10 to Q s = 12 units. That is, suppliers want to sell 12 units but demanders want to buy only 6 units. Therefore, at a price floor of $12, there is an immediate surplus of 6 = 12 6 units, and the smaller quantity (6 units) will be exchanged. But competition among suppliers to be the ones to sell some of that 6 units demanded eliminates that surplus by bidding the price down to the full economic price P F where supply falls to meet demand at 6; that is, 6 = Q s = P F. Solving yields the full economic price P F = $6. Suppliers are thus hurt by the minimum price, by the drop from the equilibrium price of $10 per unit to the full economic price of $6 per unit. Price Q s = P Q d = 2P + 30 P F = Quantity 18

19 c. The price ceiling of $5 is effective since it is below the equilibrium price of $40. As a result, quantity demanded increases from Q d = 10 to Q d = 20 = 2(5) + 30 units, while quantity supplied decreases from Q s = 10 to Q s = 5 units. That is, demanders want to buy 20 units but suppliers are willing to supply only 5 units. Therefore, at a price ceiling of $5, there is an immediate shortage of 15 = 20 5 units, and the smaller quantity (5 units) will be exchanged. But competition among demanders to be the ones to buy some of that 5 units supplied eliminates that shortage by bidding the price up to the full economic price P F where demand falls to meet supply at 5; that is, 5 = Q d = 2P F Solving yields the full economic price P F = $ Demanders are thus hurt by the maximum price, by the rise from the equilibrium price of $10 per unit to the full economic price of $12.50 per unit. Price Q s = P P F = Q d = 2P Quantity 19

20 Price Restrictions Question. Suppose demand and supply for a commodity are Q d = 30 4P and Q s = 2P. a. For that commodity, compute equilibrium price, quantity, consumer surplus, and producer surplus. b. Suppose that commodity with Q d = 30 4P and Q s = 2P were unskilled labor and a minimum wage of $6 is imposed. Compute the effect of that minimum wage on the unskilled labor. c. Now instead of labor, suppose that commodity with Q d = 30 4P and Q s = 2P were gasoline and a maximum price of $2.50 is imposed (just during in the Arab oil embargo of 1973). Compute the effect of that maximum price on gas buyers. 20

21 Answer to Question: a. Equating quantity demanded and quantity supplied yields the equation 30 4P = 2P. Solving for P yields the equilibrium price of $5 per unit. Plugging that into the demand equation yields the equilibrium quantity of 10 units (since quantity demanded at the equilibrium price is Q d = 30 4(5) = 10). Price 7.5 Q s = 2P 5 CS PS Q d = 30 4P 0 10 Quantity Consumer surplus is the right triangle with height 2.5 = and width 10, so area ½ (2.5)(10) = $ Producer surplus is the right triangle with height 5 = 5-0 and width 10, so area ½ (5)(10) = $25. b. The price floor of $6 is effective since it is above the equilibrium price of $5. As a result, quantity demanded will decrease to Q d = 30 4(6) = 6 units, while quantity supplied will increase to Q s = 2P = 12 units. That is, firms want to hire 6 units of labor but laborers are willing to supply 12 units. Therefore, at a price floor of $6, 6 units will be exchanged. Since Q d < Q s there is a surplus, amounting to 12 6 = 6 units. But since only 6 units are demanded at a price of $6, the full economic price is the price such that quantity supplied equals the 6 units demanded: 6 = Q s = 2P. Solving yields the full economic price of P = $3. Unskilled labor is thus hurt by the minimum wage, by the drop from the equilibrium wage of $5 per unit to the full economic wage of $3 per unit. c. The price ceiling of $2.50 is effective since it is below the equilibrium price of $5. As a result, quantity demanded will increase to Q d = 30 4(2.5) = 20 units, while quantity supplied will decrease to Q s = 2P = 2(2.5) = 5 units. That is, consumers want to buy 20 units but producers 21

22 are willing to supply only 5 units. Therefore, at a price ceiling of $2.50, 5 units will be exchanged. Since Q d > Q s there is a shortage, amounting to 20 5 = 15 units. But since only 5 units are supplied at a price of $2.50, the full economic price is the price such that quantity demanded equals the 5 units supplied: 5 = Q d = 30 4P. Solving yields the full economic price of P = $6.25. Buyers are thus hurt by the maximum price, by the rise from the equilibrium price of $5 per unit to the full economic price of $6.25 per unit. 22

23 Price Restrictions Question. Suppose demand and supply for a commodity are Q d = 10 (1/6)P and Q s = (1/4)P 2.5 a. For that commodity, compute equilibrium price, quantity, consumer surplus, and producer surplus. b. Suppose that commodity with Q d = 10 (1/6)P and Q s = (1/4)P 2.5 were unskilled labor and a minimum wage of $36 is imposed. Compute the effect of that minimum wage on the unskilled labor. c. Now instead of labor, suppose that commodity with Q d = 10 (1/6)P and Q s = (1/4)P 2.5 were medical care and a maximum price of $16 is imposed (with the intention of making medical care more affordable). Compute the effect of that maximum price on buyers. 23

24 Answer to Question: a. Equating quantity demanded and quantity supplied yields the equation 10 (1/6)P = (1/4)P 2.5. Solving for P yields the equilibrium price of P = $30 per unit. Plugging that into the demand equation yields the equilibrium quantity of Q = 5 units. Price CS PS Q s = (1/4)P 2.5 Quantity Q d = 10 (1/6)P 5 Consumer surplus is the right triangle with height 30 and width 5, so area CS = ½ (30)(5) = $75. Producer surplus is the right triangle with height 20 and width 5, so area PS = ½ (20)(5) = $50 b. The price floor of $36 is effective since it is above the equilibrium price of $30. As a result, quantity demanded will decrease to Q d = 10 (1/6)P = 4 units, while quantity supplied will increase to Q s = (1/4)P 2.5 = 6.5 units. That is, firms want to hire 4 units of labor but laborers are willing to supply 6.5 units. Since only 4 units are demanded, the full economic price is the price such that quantity supplied equals the 4 units demanded: 4 = Q s = (1/4)P 2.5. Solving yields the full economic price of P F = $26. Unskilled labor is thus hurt by the minimum wage, by the drop from the equilibrium wage of $30 per unit to the full economic wage of $26 per unit. c. The price ceiling of $16 is effective since it is below the equilibrium price of $30. As a result, quantity demanded will increase to Q d = 10 (1/6)P = 7.33 units, while quantity supplied will decrease to Q s = (1/4)P 2.5 = 1.5 units. That is, consumers want to buy 7.33 units but producers are willing to supply only 1.5 units. Since only 1.5 units are supplied, the full economic price is the price such that quantity demanded equals the

25 units supplied: 1.5 = Q d = 10 (1/6)P. Solving yields the full economic price of P F = $51. Buyers are thus hurt by the maximum price, by the rise from the equilibrium price of $30 per unit to the full economic price of $51 per unit. 25

26 Price Restrictions Question. Suppose demand and supply for a commodity are Q d = 14 2P and Q s = P 2 a. For that commodity, compute equilibrium price, quantity, consumer surplus, and producer surplus. b. Suppose that commodity with Q d = 14 2P and Q s = P 2 were unskilled labor and a minimum wage of $6 is imposed. Compute the effect of that minimum wage on the unskilled labor. c. Now instead of labor, suppose that commodity with Q d = 14 2P and Q s = P 2 were medical care and a maximum price of $4 is imposed (with the intention of making medical care more affordable). Compute the effect of that maximum price on buyers. 26

27 Answer to Question: a. Equating quantity demanded and quantity supplied yields the equation 14 2P = P 2. Solving for P yields the equilibrium price of P = $5.33 per unit. Plugging that into the demand equation yields the equilibrium quantity of Q = 3.33 units. Price CS PS Q s = P 2 Quantity Q d = 14 2P 3.33 Consumer surplus is the right triangle with height 2 and width 4, so area CS = ½ (1.67)(3.33) = $2.78. Producer surplus is the right triangle with height 3 and width 4, so area PS = ½ (3.33)(3.33) = $5.54 b. The price floor of $6 is effective since it is above the equilibrium price of $5. As a result, quantity demanded will decrease to Q d = 14 2(6) = 2 units, while quantity supplied will increase to Q s = (6) 2 = 4 units. That is, firms want to hire 2 units of labor but laborers are willing to supply 4 units. Since only 2 units are demanded, the full economic price is the price such that quantity supplied equals the 2 units demanded: 2 = Q s = P 2. Solving yields the full economic price of P F = $4. Unskilled labor is thus hurt by the minimum wage, by the drop from the equilibrium wage of $5 per unit to the full economic wage of $4 per unit. c. The price ceiling of $4 is effective since it is below the equilibrium price of $5. As a result, quantity demanded will increase to Q d = 14 2(4) = 6 units, while quantity supplied will decrease to Q s = (4) 2 = 2 units. That is, consumers want to buy 6 units but producers are willing to supply only 2 units. Since only 2 units are supplied, the full economic price is the price such that quantity demanded equals the 2 units supplied: 2 = Q d = 14 2P. Solving yields the full economic price of P F = $6. Buyers 27

28 are thus hurt by the maximum price, by the rise from the equilibrium price of $5 per unit to the full economic price of $6 per unit. 28